It has been a fascinating year for initial public offerings. This week, news came out that the proposed IPO of WeWork (a lessor of shared office spaces) was not going well, with the company’s predicted valuation falling to as low as $15 billion from the $65 billion that its investment bankers originally predicted. WeWork, which is not profitable, is looking to follow in the footsteps of other money-losing companies that have gone public this year, with Beyond Meat (BYND-NASDAQ), Lyft (LYFT-NASDAQ), Uber Technologies (UBER-NYSE), Pinterest (PINS-NYSE), and Slack Technologies (WORK-NYSE) being the most visible examples.
It’s a lot of work to go public. Besides investment bankers, the company must hire lawyers to produce 200 page documents. And these people don’t work for free! The investment banks underwriting the Uber IPO were paid $122 million! Plus, a company’s management team has to go on a lengthy roadshow to try to convince investors to participate in the IPO. Then there are ongoing regulatory requirements that demand, among other things, quarterly earnings disclosure. And on top of this, the company is opening itself up to public scrutiny (from competitors, among others) as opposed to flying under the radar as a private company.
Public listings are becoming less fashionable
The traditional thinking is that companies go public so that they will have access to a much larger pool of investor capital from the general public. Historically it had been difficult for companies to raise money privately, as potential investors were limited to high net worth individuals and select institutions.
However, as the following chart shows, the cumulative net equity issuance for publicly-listed companies in the U.S. has been negative since the mid-1980s. This means companies have been buying back more shares than they have been issuing.
Compounding the effects of negative net equity issuance have been mergers and acquisitions. The next chart shows the result: there are currently half the number of public companies in the U.S. than there were in the late 1990s.
There are a few reasons why more companies are avoiding the public markets. First, there has been an increase in the capital available from private equity firms. A privately-financed startup with a valuation greater than $1 billion used to be so rare that it was called a “unicorn”. Today, there are 150 such companies in the world. Contributing to this increase in private financing was a 2012 legislation change in the U.S. that raised the maximum number of shareholders in a private company to 2,000 from 500. Second, there has been a steady decline in interest rates since the early 1980s. This has made debt financing progressively more attractive when compared to equity financing. Third, the secondary markets for private companies’ shares has expanded in recent years, resulting in increased liquidity for investors who want to transact.
Window of opportunity
Back to our original question. If there are so many benefits to staying private, why has this year seen so many headline-grabbing IPOs? In our opinion, these companies are going public because the timing is right. We have frequently mentioned that we think current equity market valuations in the U.S. are elevated. This has made it hard for us – value investors – to buy shares at low prices. The flip side of this, though, is that it has made it easy for companies (or shareholders) to sell shares at high prices. In other words, we believe the companies that have gone public this year recognized that they could get an attractive valuation for doing so.
How high are the valuations? We’ve joked about this in the past, but it’s tough to value a company with a reasonable price-to-earnings multiple if the company has negative earnings. Today’s investors in the IPO market seem to be looking past this troublesome detail by moving up the income statement and valuing these companies on multiples of earnings before interest and taxes (“EBIT”), earnings before interest, taxes, depreciation, and amortization (“EBITDA”), or earnings before everything (aka “sales”):
It is rare for us to participate in an IPO. In the last seven years we have done so exactly once. Part of the reason is because companies are smart enough to IPO when they can sell their shares for a high price – and we don’t want to be buying at a high price. But another reason is that there is a significant information asymmetry between the buyers and sellers in an IPO. Unlike the secondary public markets, where both buyers and sellers are operating from the same publicly-disclosed earnings information, a company selling its shares in an IPO has much more information about its operations than do the investors buying. Sure, the company has to issue a prospectus, but no matter how voluminous that document is, it doesn’t compare to the knowledge of the company’s insiders.
We doubt our stance on IPOs will change. That one offering we did participate in? It was a company that was spun-out of the Saskatchewan provincial government bureaucracy. Instead of insisting on the maximum possible IPO valuation, government officials wanted the valuation to be cheap enough to encourage taxpayers to invest personally. We don’t see opportunities like that arise often, but if we were ever to see it again, we would likely have IPO number two under our belts.