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Are Unicorns Killing the 2016 IPO Market?

Rising regulatory burdens combined with a surfeit of venture capital are making new stock offerings passé. That’s good for investors.

By Alexander Eule                
  

A paradox is brewing in Silicon Valley and beyond. Entrepreneurs and venture capitalists have spent the past decade creating bulletproof technology companies, a direct response to the Valley’s 1990s failures. The private firms—such as Uber Technologies, Dropbox, and Airbnb—have legitimate business models that are disrupting mature markets, and capital has poured in. The so-called unicorn class now has 147 members, each with a value, on paper, of at least $1 billion.

But the mythical beasts are running into a mundane reality. While venture capitalists are eager to pump money into the potential “next big thing,” individual investors are hardly clamoring to get into the act. There hasn’t been an initial public offering for a Silicon Valley–based tech company in seven months.
 
The IPO lull isn’t just in tech. Five months into the year, just 31 companies have gone public in the U.S. That’s down from 69 in the first five months of 2015, and 115 over the same five-month period in 2014, according to Renaissance Capital, manager of IPO exchange-traded funds, including Renaissance (ticker: IPO). While the public’s coolness has been well reported by the business press, there’s a more important message buried beneath the headlines: The bad news for IPOs could be a bullish sign for the market.

U.S. IPOs are in long-term decline. (Hand) iStock; (Egg) Masterfile

Since 2000, there have been eight calendar years with fewer than 100 IPOs. In the 12 months following each of those years, the Standard & Poor’s 500 index climbed an average of 13.1%, including dividends, according to data compiled by Jay Ritter, a University of Florida professor who has studied the IPO market for 35 years. In the 12 months following a strong year for IPOs—100 or more offerings—the S&P 500 lost an average of 1.2%.

There are many factors at play here. A robust IPO market typically comes during a period of irrational stock market exuberance. IPOs peaked at 677 in 1996 and averaged 474 in the late 1990s before the Nasdaq crashed in early 2000. They picked up steam again in 2004, heading into the housing crash. Usually, rising markets beget more IPOs, which adds to the paradox of the current climate. “The lack of IPOs when stock indices are near their record highs is unprecedented,” Ritter says.

Bankers, lawyers, and accountants say a confluence of events has contributed to the current IPO lull. The brutal stock market crash of 2008-09 has curbed investor enthusiasm for speculation, and, not coincidentally, new sources of liquidity have emerged for company founders and insiders. At the same time, regulatory changes have simultaneously made it easier to stay private and harder to be public.

And in a business where timing is everything, getting it wrong is more devastating than ever. Take Square(SQ), the financial technology firm, which went public in November. The stock has struggled to maintain its IPO price, which was already lowered by bankers prior to the offering. Other notable tech outfits that went public last year, including Fitbit (FIT), Box (BOX), Etsy (ETSY), and Pure Storage (PSTG), have suffered even worse fates.

CURIOUSLY, WHILE IPOS have faded, venture-capital firms are still cashing in through mergers and acquisitions. M&A for VC-backed companies has held fairly constant for the past decade, at about 120 mergers per quarter. The first three months of 2016 saw 112 such VC-backed deals, according to Dow Jones VentureSource.

                 
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Put another way, the IPO weakness is less about the sellers and more about suddenly discerning buyers. “The IPO market has become more institutional, because most individual investors and their advisors are buying indexed products,” says Kathleen Smith, principal at Renaissance Capital. “They are not in there flipping IPOs. The individual investor participation, which tends to be the easy money, is not there, and it’s very unlikely to come back.”

Thus, Uber continues to grow behind closed doors. Last week, the ride-hailing service raised $3.5 billion from Saudi Arabia’s Public Investment Fund. With a $62.5 billion valuation, Uber is more valuable than 85% of the companies in the S&P 500. Lodging-rental platform Airbnb already rivals the world’s largest publicly traded hotel companies, with a value of $25.5 billion.

But there are cracks forming in the lavish world of private investment that go beyond the unicorn class. A year ago, venture-capital investments were being made at a median valuation close to $60 million, a record high. The valuation fell precipitously in the first three months of this year, to $19.7 million, according to Dow Jones VentureSource.

Many think the corrections are necessary to revive the IPO market. Square’s IPO price valued the company below its last round of private investment, leading some to believe that companies and bankers were taking the corrective needed to restore public offerings. Instead, the market for tech IPOs entered an even-deeper freeze, leading to the current seven-month lull.

There are new signs that the freeze might be thawing, albeit slowly. Several small IPOs have priced in recent weeks. San Francisco–based Twilio filed its IPO papers two weeks ago, suggesting it could be listed soon. The firm, which helps companies build mobile-communication tools, is valued at $1 billion, according to a Wall Street Journal/Dow Jones VentureSource database.

James Palmer, head of equity capital markets for the Americas at UBS, says IPOs have been complicated by a host of global events this year, including the timing of the Federal Reserve’s interest-rate hikes, the Spanish election, and the U.S. election. “I think you’ll see the real IPO retest in 2017, as it relates to Silicon Valley,” he says.

EVEN IF ALL OF THE UNICORNS find a way to go public, it won’t change a broader point: U.S. IPOs are in long-term decline. From 1980 to 2000, an average of 310 companies went public every year, according to Ritter. Since then, the average has fallen to just 111. The Nasdaq has recovered from its dot-com bubble woes, but IPOs have not.

The new dynamic has forced mutual funds to look at private firms for growth opportunities. Fidelity Investments, T. Rowe Price Group, and Wellington Management all have sizable stakes in unicorns, though they remain a small slice of their total holdings.

Andrew Boyd, head of global equity capital markets at Fidelity, views the moves as down payments on long-term investments, and he expects the companies to go public when they’re ready—even if it takes some time. Fidelity invested in Facebook (FB) prior to its IPO, for example, and is now its largest investor.

“The detriments have grown,” Boyd says of going public, but “the benefits have not shrunk. You just have to need to be more prepared than you were in the past.”

In effect, Fidelity and others have created a well-funded minor-league system in which companies can hone their business models outside of the public spotlight. Public investors are spared pain when immature companies flame out. A similar path in the 1990s might have spared investors much agony.

MOST PARTICIPANTS in the IPO process say being public has become a hassle that’s best avoided for as long as possible. The U.S. Congress obliged, to a certain degree, when it passed the JOBS Act in 2012.

While the legislation was intended to ease the IPO process for small companies, the net effect has been to stall the market.

In one key provision, the JOBS Act allowed companies to accumulate up to 2,000 private investors before being forced to disclose public-company type information, and that limit no longer includes employees granted stock as compensation; previously, the limit was 500. The original, lower figure forced Facebook to go public in May 2012, before it was ready. While Facebook is thriving today, the stock stumbled out of the gate, mainly because it had not yet figured out how to make money on smartphones.

PwC has built a consulting practice to avoid those scenarios, says Mike Gould, a PwC partner and its IPO-services leader. The firm offers an IPO-readiness assessment and provides counseling on how to go—and how to be—public. “Fifteen years ago, we used to get a phone call that said we’re putting a registration statement together in the next few months. It was very much a fire drill,” Gould says. “Now, we’re generally getting the phone call two to three years earlier. It’s a more orchestrated process.”

Josh Bonnie, an IPO-focused partner at law firm Simpson Thacher & Bartlett, has more to discuss with clients since Congress passed the Sarbanes-Oxley Act in 2002, which raised the bar for public-company disclosures. “The truth is the IPO market took a one-two punch,” he says.
“The tech bubble crashed in 2000—that dried up a lot of the flow of new companies to the market. We had a financial crisis, and Congress responded with the Sarbanes-Oxley Act. The bottom line is that it became more expensive to be a public company. It just naturally shifted the cost-benefit analysis for companies to stay private until they were bigger.”

Congress is also using public companies to advance policy goals. Bonnie points to mineral mines in the Congo, which are helping to fund warfare. Instead of passing a law against the importation of the minerals, Congress pointed its quill at public companies, requiring a new set of disclosures. “When you’re a public company, you get hit with all this public-policy stuff,” Bonnie says. “It’s just become that much more of a hassle.”

Notes UBS’ Palmer: “With the speed and availability of information, which has come concurrently with the advent and growth of the hedge fund industry, stocks move like lightning, particularly at lofty valuations, where there aren’t traditional earnings metrics.”

Fitbit, the activity-tracking pioneer, has delivered a series of better-than-expected quarterly reports after going public last June. Even so, its shares are down 26% since then, and the company’s every move is being tracked in the harsh light of the stock market. The company’s new smartwatch was deemed a failure by investors months before it hit the shelves. By the time the watch was available, it barely mattered; the stock had already fallen 50%. Decent sales for the watch have hardly revived the stock.

LAST YEAR, Nasdaq (NDAQ)—the still-dominant market for tech stocks and a major beneficiary of IPOs—agreed to buy SecondMarket Solutions, a well-known marketplace for private stock. The acquisition will bolster Nasdaq’s own fledgling private-market business, which includes Pinterest, DocuSign, Shazam, and Tango, all members of the $1 billion-plus unicorn club. In a 2015 year-end report, the unit, known as Nasdaq Private Market, said transaction volume had reached $1.6 billion, a slight uptick from 2014.

Shortly after the SecondMarket deal was announced last year, Nasdaq CEO Bob Greifeld told Barron’s that it would prove significant over the coming years. “I certainly think it’s our job to provide to companies that want to stay private for a longer period of time the ability to bring liquidity—one, to their employees, and two, to their early-stage investors,” he said. “That need is there.”

The typical company on the private Nasdaq exchange is now nine years old with 440 employees and is worth $1.8 billion. “This profile is similar to the traditional definition of a public mid-cap company,” Nasdaq Private Market noted in its recent report. “The line between public and private is becoming increasingly arbitrary.” 

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