Fixing the IPO Market

A new paper from two Harvard Kennedy School researchers explores the decline of IPOs and what should be done about it.
Jack Pead and Marshall LuxApril 3, 2018
Fixing the IPO Market

If anyone underestimated the continuing powerful role initial public offerings (IPOs) play in the perception of U.S. financial markets, the debut of Dropbox on the Nasdaq on March 23 should have remedied that.

In a week when stocks were crashing after revelations about Facebook and White House moves against China on tariffs, the 11-year-old San Francisco cloud-storage startup raised its target price from $16 a share to $21, then saw its stock on Friday trade up to $29, before closing at $28.48, up 36%.

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The Dropbox IPO was viewed with great relief in Silicon Valley, which saw it as a possible catalyst for other private tech companies, from Airbnb to Uber, each valued at well over a billion dollars and dubbed “unicorns.” Those companies have resisted going public, choosing instead to finance themselves with multiple rounds of private capital.

The rise of the unicorns has just been the highest-profile manifestation of a long slump in IPOs since 2000, when the dot-com bubble burst and the number of IPOs fell and failed to recover in the succeeding 18 years.

In truth, one successful tech IPO is unlikely to alter deeper-seated tendencies of the U.S. IPO market.

Recently, we tackled a number of fundamental questions about IPOs in a paper we researched and wrote under the aegis of the Harvard Kennedy School of Government: “Hunting High and Low: The Decline of the Small IPO and What to Do About It.”

decline in IPOsWe set out to understand what drove the striking decline in IPOs and where IPOs fit into the larger context of the capital markets. Was the decline caused by one major factor — say, regulation — or multiple factors? Will legislative and regulatory remedies or a raft of new proposals and recommendations reenergize the IPO market? How important are IPOs to the vitality of the U.S. economy?

The long IPO slump has convinced policymakers and practitioners that something in the U.S. financial system is broken and needed to be fixed. The decline has led to calls for legislative and regulatory remedies, producing legislation like the JOBs Act of 2012, aimed at easing some of the burdens on smaller companies seeking IPOs. In the last year, officials from both the Securities and Exchange Commission and the Treasury Department of the Trump administration have renewed calls to rejuvenate IPOs.

Our conclusions, we think, reflect the complexity of the U.S. capital markets. The dearth of IPOs is not a crisis, but it is a concern. It is clearly linked to another trend that also began around 2000: the fall in the overall number of U.S. public companies. And while it may be an exaggeration to lay the decline of IPOs on regulation alone, we believe that policies that ease the burden of smaller companies eager to go public could foster a healthier IPO market without spawning unintended consequences.

In the paper, we sought to master the history, literature, and data on IPOs, which have long been viewed as synonymous with entrepreneurial vitality, job creation, and technological innovation. What’s clear about IPOs is how large volumes of companies making their debuts — as occurred in the late 1990s — is not an historical norm. In fact, a booming IPO market is unusual in U.S. economic and financial history. With the exception of the 1920s, IPOs became prominent only in the 1960s, declining in the 1970s, surging to record heights in the 1980s and 1990s, then receding again. Those 1990s heights have become a sort of baseline for a healthy IPO market and economy.

Moreover, an analysis of IPO statistics over time reveals that the decline in offerings is skewed, particularly when you break out numbers by company or offering size. Initial public offerings from smaller companies have suffered disproportionately to those of larger ones. And the decline in smaller companies has grown greater with time.

This weakness appears to have many sources.

While legislation like Regulation Fair Disclosure, Sarbanes-Oxley, and Dodd-Frank have deterred some companies from shouldering the expense and liability of becoming a public company, other, more organic changes also played roles: the reduction of coverage of smaller pre-IPO companies by Wall Street equity research teams after the settlement with New York attorney general Eliot Spitzer in 2003; the overall economic refocusing on larger companies by a consolidating Wall Street and increasingly passive-oriented institutional investors; and even the decimalization of equity markets in 2001, which favored electronic trading but that also reduced the profits of investment banks from the underwriting of smaller, less-liquid IPOs.

“We suggest extending the five-year EGC period to 10 years and increasing the size thresholds above which companies are required to release more detailed reporting.”

Significantly, for all the alarm over IPO levels, the number of startups in the U.S. appears to be fairly stable.

One reason may be the steady rise of private capital in financing markets, from private equity to sovereign wealth funds. Startups now have more options outside of IPOs, including remaining private or opting for a sale to larger company or to a private-equity buyout.

The unicorn phenomenon is evidence of this abundance of private capital. A number of unicorns have also begun to seek IPOs — Snap last year, Dropbox recently, and Spotify (via a direct listing) on Tuesday — suggesting that unicorns may be a temporary phase between a venture-backed startup and the public markets.

Lastly, it’s not easy from a legislative or regulatory standpoint to alter these often-evolutionary trends. That’s not because policies designed to boost IPOs have not had an effect, at least over the short run. But many of those policies may produce undesirable tradeoffs, from the formation of bubbles (like dot-com mania) to the fact that IPOs may thrive only at the expense of other key components of a complex ecosystem of deep, efficient, and highly diversified financial markets.

What can be altered, we believe, are the regulatory burdens and potential liabilities that have proliferated for public companies since 2000.

Many smaller companies have resisted the leap to undertake an IPO because of what awaits them as public companies — not just the expense and trouble of meeting onerous regulatory mandates, but of coping with a shareholder-centric governance system that emphasizes short-term quarterly returns and produces flocks of aggressive activist investors.

We think the JOBS Act was a good start in thinning out some of the regulatory undergrowth for so-called emerging growth companies (EGCs), notably on pre-IPO listing requirements and post-IPO disclosure requirements. The fact that 87% of companies pursuing IPOs since 2012 have taken on the EGC mantle is evidence that startups favor the benefits of that designation.

We believe that the initial impulse of the JOBs Act should be continued — and extended. We suggest extending the five-year EGC period to 10 years and increasing the size thresholds above which companies are required to release more detailed reporting, more quickly. We support raising the shareholding threshold for making investor proposals, as means of curbing the number of frivolous resolutions. And we favor allowing companies to mandate arbitration in shareholder disputes in order to reduce costly, distracting litigation.

Generally, we urge policymakers to undertake the larger project of rationalizing SEC disclosure requirements, which have proliferated in number and complexity in the past few decades. Broadly speaking, the problem of IPOs appears to be rooted in the mounting difficulties of operating as a public company, with everything from governance limitations to litigation to market pressures to a lack of analyst coverage.

While it’s true that IPOs are just one component in a complex and evolving market system, they remain extremely important as the gateway to the public markets. Certainly, companies seeking IPOs do generate jobs, innovation, and technology. But IPOs are also necessary to ensure the continuing health of public markets, which provide vital benefits not just to public companies, but also to institutional and individual investors.

Marshall Lux is a fellow at the Harvard Kennedy School of Government. Most recently, he served as a senior partner and managing director at The Boston Consulting Group (BCG), and the head of its North American private equity practice, which he helped build. After 9/11, Lux was one of the leaders of a cross-firm consortium looking at the cost of the attack on various New York industries, personally overseeing the financial module.

Jack Pead is a master in public policy candidate at the Harvard Kennedy School. His studies focus on financial regulation and climate change policy.