Initializing IPOs

The recent spate of super hot IPO launches and announcements ignite the revitalized investment sector.

After a long hiatus the
recently revitalized IPO (Initial Public Offering) market seems to have regained
it’s vigor with a re-initialization due to strong
performing technology offerings in the capital markets. The sector is in a
viable launch mode and near full strength. This is a boon to would be hopeful
technology entrepreneurs, investment bankers and the U.S. Economy. Conversely,
the majority of people will only be able to read or hear about IPO’s but will never
actually have any possibility of participating in or acquiring any of the
issues–it is a very clubby set. Historical profit margins at 26 % on
first day returns almost insure that it will stay out of reach and the domain
of institutional and ultra high net worth investors. Sorry, Guys.


My career was built on IPO investment banking and I had a significant
participation in over $68B of deals in a three and a half year period. The bulk of my time at CMG in those days was in the pursuit of IPO
participation mandates. The recent capital markets activity has re-underlined
the importance of this incredibly, dynamic market that most entrepreneurs
aspire to participate in.

There are 3 key quintessential things about the IPO Market-1) the first is that
they move in windows of opportunity, 2) the second is that they must have favorable market conditions for strong valuations, 3) the third is
that they are highly dependent on the investment banks that price and circulate
the issues so that there is significant interest and demand–that
means that people purchase the stock through secondary trading in the open
market. An underlying factor for consideration is that no one ever gets as much
of an issue as they want (excluding a few super powerful billionaires in
finance)…everyone receives only a portion, usually 10 % of what they
requested. This means if they were allocated 100,000 shares, their
retention–what they will be circled on (retain or keep) will be 10
percent of that amount–10,000 shares.

The banks want them to purchase the rest in
the open market.

This is one of the reasons that LinkedIn skyrocketed and then
plummeted back to earth–initial recipients were attempting to lock in first
day gains from the greatly reduced pre-market prices. It seems as though they
were wise to do so, academic studies show that most companies with dramatically
high first day pops tend to be poor performers in the long run. It could be
argued (many have in the case of LinkedIn i.e. Peter Thiel) that a price pop
indicates incorrect pricing and makes the company lose tremendous amounts of
real dollar value that the company won’t realize because it has effectively
been handed over to investors. Nearly everyone is aware of this, yet every
company brags about the size of the first day price pop. Go figure.

I happen to have the
distinct pleasure of having 2 of the most significant voices on price
determination in regards to capital market new issues as advisory board members
of my firm. The foremost European expert on flotation prices is highly published
professor Dr. Tim Jenkinson of Oxford, the United States counterpart on IPO’s pricing is Dr. Paul Gompers of Harvard–both have distinctive work that I would direct
you to review for deeper understanding. Without stealing any of their thunder I
will state that Wall Street categorically prices Internet stocks low. Why?
There are a myriad of reasons that can be postulated however it is a fact that it
generates huge returns on the first day for initial investors. This however is
only one of the factors driving price.

When the
investment banks set prices there are many factors used in the formula which includes
the current market valuations of comparable companies to determine the price
range. The recent flurry of technology and Internet IPO’s garnered hearty
valuations and market traction. They are
the beneficiaries of high multiples and prices due to 3 factors: 1) Small
Floats, 2) Pent up demand and 3) Market Dominance, these factors in combination
with scarcity and a savvy investment banker with a rolodex equals equal tremendous
price pops. Internet companies Zynga, Twitter and of course, Facebook
will benefit from these dynamics.


Last week one of the most
highly anticipated capital markets events was announced–the Groupon
IPO–Groupon filed its $750mm offering on the back of the highly successful
LinkedIn IPO launch. Groupon’s proposed launch comes on $645 mm in earnings for first
Quarter 2011(after
making $713m for 2010) from
it’s reported subscriber base of 83m which was up exponentially from the
152,000 reported in 2009–giving the 2 1/2 half year old company a valuation of
over $20b…I guess Andrew Mason wasn’t crazy to spurn the $1B on the $6B valuation from Facebook founder Mark
Zuckerberg after all..

Clearly investor interest is back in the IPO sector, there has been over $22B
in IPO’s in the United States alone in the 64 deals that have been
launched this year. The deal pipeline per Dealogic shows roughly 169 companies waiting
in the pipeline. The phenomenon hasn’t been concentrated in just the U.S.–it has had global depth and been wide in the breadth of companies listing outside of the narrow
tech sector. Recently, the Russian search engine Yandex raised $1.3B with Spain’s lottery “Loterias”
joining the capital market frenzy with a $7.5b euro flotation, while luxury
goods makers Ferragamo and Prada have upcoming launches for limited stakes in
their enterprises. Even Borat’s beloved Kazakhstan is creating IPO’s for their state assets… very nice!

Most people remember the IPO function in the capital markets being synonymous
with instant wealth for the company’s founders. Finance professional know that
the capital markets were the way for sponsor companies (read private equity firms)
to “take chips off the table” or get liquidity out of their investments and
make an exit through these transactions. The nature of the capital markets are
radically different at this juncture.

From a practical perspective, investment banks and the private equity sponsors have viewed the process and have utilized the capital markets–as
liquidity events. What’s different now is that a number of deals are being
completed to minimize debt. One place that this is evident is in the recent
event with Freescale. I remember when Freescale initially went public in
2004. I later saw it privatized by a private equity firm through a heavily leveraged
transaction. I watched in astonishment as I saw it return to being publicly
traded again–not for liquidity but to relieve debt. This same scenario
was the reason for the re-IPO of AIG–debt relief to the government, the main
driver of the pricing and subsequent launch. Expect this to insure more
rational capital structures, this will mean that when the companies go public
the equity sponsors will be staying invested longer rather than using the IPO as an exit.

Although the sector is hot and has strong positives, any discussion of IPO’s must include the recent decline in value in Chinese IPO’s –the reverse mergers in particular are
being found to be fraudulent and cooking the books–this is of no surprise to
legendary short seller Jim Chanos. I recently had the opportunity to have a
poolside chat with Jim and his thoughts (and YouTube videos) are now eerily being echoed in the
markets. I believe once again Jim will have the opportunity to say I told you
so …

To many the capital markets may still seem a little schizophrenic as they examine how a company such as LinkedIn with $7mm in revenues can have an IPO that outperforms a company like Glencore with revenues of $144.9 billion (over $7 million an employee) with real assets. This
bifurcation of fortunes is inextricably tied to demand and pricing–see your investment banker. So to a large degree IPO market offerings are somewhat subject to the machinations of investment banks–this isn’t entirely bad. A hot IPO market will benefit M&A as the acquisition power of public currency is used to acquire other companies. Alternatively, the dual track method which consists of attempting to sell a company while going through the IPO process often garners more attractive prices.The dual
track is highly useful in M&A, and can realize a 25% improvement in price by providing a
premium valuation to an outright sale–savvy firms will utilize this. Finally, expect broader stock market volatility to aid institutional investors in pushing back against the higher price range when the investment banks set prices, this is combination with listing companies pushing for higher ranges in the valuations should help long term performance in the future and strengthen our economy.


About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago