Restarting the IPO Market

To get the initial public offerings market going again, issuers may have to make their deals more enticing to investors.
Vincent RyanMarch 21, 2016
Restarting the IPO Market

The last time initial public offerings were as unwelcome as they have been the last three months was the first quarter of 2009, when the Treasury Department was spending billions to stabilize banks and only one U.S. IPO priced. The quarter before that, the fourth quarter of 2008, was the same story: one deal.

Now, despite the absence of a mind-blowing financial crisis, the IPO market is bogged down again. The first quarter of 2016 brought seven IPOs (as of March 17), raising proceeds of about $600 million. That’s a far cry from the 27 deals that raised $4.5 billion a year ago by this time, or the 64 offerings that raised $10.6 billion in 2014’s first quarter.

The oil glut, China’s economic slowdown, renewed worries about Europe, and market volatility carry the blame for the stuck market.

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“[When the equities] market is trading down, and when investors get nervous, they either go to cash or find large companies in safe industries [to invest in]. They abandon new companies,” says Kathleen Smith, principal at Renaissance Capital, a manager of IPO-focused exchange-traded funds.

Says Dan Klausner, managing director in the capital markets advisory practice at PricewaterhouseCoopers and a former banker: “The buy side is worried about their existing stocks and positions; they’re paying attention to other things.”

Although Renaissance Capital’s index of U.S. IPOs, IPOUSA, has turned around since early February, it was still negative for the year as of March 18, at -6.8%. In contrast, the S&P 500 had a slightly positive return of 0.28%. “The return on existing IPOs is the fuel that drives the performance of new IPOs,” says Smith.

Just about any expert in IPOs expects the market doldrums to end. Klausner looks at the discounts on follow-on offerings to determine if the IPO window is set to open again. “If existing public companies can raise capital at discounts that narrow, that’s a good sign,” he says. “A big discount would be 10%; low single digits is good.” The CBOE Volatility Index (VIX) slid significantly below 20 in late February, a signal that markets may be calming.

But for companies that have been waiting for signs that it’s OK to get the wheels rolling on their IPO, though, there is plenty to think about before they launch.

A Reconciliation

The first companies out the door won’t have it easy. Renaissance Capital calls these “IPO icebreakers.” They “tend to have strong, secular growth profiles” and “defensible business models,” says Renaissance. “Thanks to attractive valuations, they usually outperform the market by a significant margin.”

The Renaissance report offers two examples, both from May 2009, soon after the post-Lehman market trough. One was OpenTable (now part of Priceline), whose technology platform helped restaurants increase traffic despite weak consumer spending. The other was SolarWinds, whose low-cost software provided an attractive option for price-conscious companies.

The sticking point for companies queued up to go public during the next IPO cycle will be reconciling the valuation differences between the private and public markets.

Whatever a company’s private valuation, “it can’t be disconnected from its public peers,” says Smith. A peer’s valuation has most likely contracted the last six months. But even if its valuation has bounced back, the normal IPO discount from public peers is 13% to 15%. With investors soured on companies that don’t earn a profit, this time higher IPO discounts — as high as 30% — might be in order.

That’s going to force some companies to downsize their offerings or even succumb to a “down round,” or an IPO that values the issuer at less than the private valuation from venture capitalists. Both of these situations were already happening in 2015, with the $30 billion in proceeds the lowest since 2009.

Companies that want to executive successful deals will also have to consider the following:

Use the Fast Act? CFOs who like the JOBS Act accommodations for IPO filers may want to take advantage of the Fixing America’s Surface Transportation (FAST) Act, passed in December. The act allows emerging growth companies (EGCs) to keep their registration statements confidential longer — the public unveiling can be left until 15 days before the IPO road show, down from 21 days. In an uncertain market when plans get can get derailed quickly, six days can be meaningful. “It gives an issuer more time to make that decision whether to publicly file,” says Robin Feiner, a partner in the capital markets practice at law firm Proskauer. “They can terminate a plan without the world knowing.”

The FAST Act also allows, in some instances, a company to omit audited financials for a prior year if they would not be needed in the prospectus at the time of pricing. For example, before the FAST Act, if an EGC filed an IPO in December 2015 with an offering date in April 2016, it would have had to include in its SEC filing annual audited financials for two years, in this case, 2013 and 2014. It would have to do so even though it would be adding 2015 full-year financials to its prospectus before the IPO.

Under the FAST Act, the issuer still has to report two years of financials. But in the above case, the issuer would have to include only 2014 full-year financials in the initial registration statement. “You don’t have to go back in time and report that older year [2013] and incur that cost,” Feiner says.

Have a rationale for using a multiple-class structure. In a precarious market, it pays not to give investors any reason to avoid an IPO. Offerings in which an issuer has multiple classes of common stock, giving insiders and sponsors special voting rights, used to be difficult to launch. But in 2015, 24% of issuers used a multiple-class structure, up from 15% in 2014, and it didn’t seem to hurt pricing or aftermarket performance, says Feiner.

The buy side accepts these structures when it’s the only way they can get a piece of a quality company, says PwC’s Klausner. However, investors will ask questions about the arrangement. Says Feiner, “You can’t just put in a dual-class voting structure without a rationale for it.”

Keep secondary components to a minimum, if used at all. As Proskauer says in its third annual study of the IPO market, “IPOs are increasingly unlikely to be a liquidity event.” In 2015, only 19% of IPOs had a secondary component (in which some proceeds go to current stockholders), compared with 28% two years before, according to Proskauer. Volatile markets “prefer to see deals where the proceeds are going to the company and not to current stockholders cashing out,” says Feiner. “In tougher markets, sometimes there will be pushback on a secondary piece.”

Says Klausner: “You want to provide the shareholders with liquidity, but you don’t want to do that at the expense of the company.” However, sometimes secondary pieces are added for good reason, like when the primary offering is too small to create a liquid market in the stock.

Disclose material weaknesses? There is a growing tendency to report material weaknesses in the registration statement. From Oct. 1, 2014, to Sept. 20, 2015, nearly a third of the 217 companies that went public reported a material weakness, according to a study by PwC’s deals practice.

“Investors generally recognize that these companies are not as sophisticated as larger organizations in terms of resources, processes, and controls,” PwC writes. “Even though full compliance with the documentation and testing of [internal controls over financial reporting] may not be immediately required, pre-IPO companies, particularly those with
less than $500 million of revenue, should consider using the registration process as an opportunity to provide appropriate warning to the market regarding [material weaknesses] if one exists.”

Be ready. Who knows how long the IPO market will be open when it does rally. In 2015, many companies had a long wait in the IPO queue, due partly to market conditions: the average time between submission of a first registration statement and pricing of the offering rose to 149 days last year, from 124 days in 2014. Frozen IPO markets can take some time to thaw. But companies that want to go public should be preparing anyway.

“The IPO markets might be tough now, but if a company is considering an IPO, even if it’s not going to do it until 2017, it’s not too early to start thinking about financial statements, corporate governance, capital structure, and other things,” Feiner says.

Feiner counsels issuers to get through the registration submission process with the SEC as soon as possible, so that they’re in control of the timing. “Once the company has cleared all [of the SEC’s] comments, then it and the bankers can determine when is the right time to go from a market perspective,” she says.

What issuers may find this time around, though, is that success will hinge largely on price. For Klausner, price is always the number-one issue. The issuer’s valuation has to make it worthwhile for the asset manager to pick up the prospectus “and do the work” on the stock, says Klausner. “You have to be at a price that gets them interested, or they are not going to pick it up.”

When will there be an IPO that creates a slipstream that other companies can ride behind? After IPOs sputtered and stopped in the fourth quarter of 2008, it took until the third quarter of 2009 for pricing activity to rebound. Using that yardstick, the IPO market could be stagnant until the fourth quarter of 2016. It would be dangerous, however, to assume it couldn’t bounce back sooner.