Market failure? The two different faces of the IPO market
July 2014 • Research • Rebuilding trust • by William Wright
It has been such a long time since anyone involved in the IPO market in Europe has had anything to cheer about that it seems almost unfair to pour cold water on their excitement. But although volumes have surged to record levels in the past few months, sometimes you can have too much of a good thing.
In stark contrast to the impressive volumes, the performance of IPOs in the aftermarket has been less impressive – so much so that it could choke off a sustained recovery in the new issue market before it has even got going.
On the face of it, the IPO market in Europe is having a roaring time. The value of IPOs in Europe has more than tripled so far this year compared with 2013, according to Dealogic, and Europe has even overtaken the US market (which itself is enjoying its best year for IPOs since 2007).
The recovery in the UK, which is enjoying a record year for IPOs, has been particularly strong. The chart below from Dealogic looks more like it could be showing the growth in users of the latest social networking company instead of the growth in IPOs:
This all fits in neatly with the post-crisis narrative of Europe shifting from a bank-financing led model to a capital markets-led model (which is exactly the sort of shift that New Financial exists to encourage). Perhaps a little too neatly.
There is a but, and it’s a big one. Getting excited by the rapid growth in the volume of IPOs without looking at their post-issue performance is a little bit like applauding a bank for the rapid growth in its loan book without worrying about credit quality and default rates.
Price tension between issuers and investors is an intrinsic part of the IPO market. Some IPOs trade up in the aftermarket, and some don’t. For all of their undoubted brains and big fees, investment banks have yet to work out the formula that defines which deals do well and which do not.
Out of sync
But that balance has gone badly wrong in the past few months, particularly in the UK where nearly six out of 10 IPOs are trading below their issue price and where an investor who had bought every IPO this year would be sitting on a negative return.
The chart below plots the number of IPOs in the UK on a rolling six months basis and the proportion of those IPOs that were trading above their issue price on any given date this year (based on my own analysis of a data set of 97 UK IPOs and their post-issue day-by-day trading history sourced from Factset).
At the start of this year, just under 60% of the IPOs from the previous six months were trading above their issue price, but as the excitement in the IPO market grew, this proportion rose steadily to a remarkable 78% by the end of February (that is, as of the end of February, nearly eight out of 10 IPOs from the previous six months were trading above their issue price).
As the supply of new IPOs increased, people began to worry about indigestion, and the proportion of IPOs trading above their issue began to fall. It dropped below 50% in mid-April and has stayed there ever since. As of the 17 June, just 44% of UK IPOs over the previous six months were trading above their issue price.
The same trend is clear in terms of the average returns on IPOs. This chart takes the same dataset but looks at the average post-issue return of UK IPOs over the previous six months.
Over the first months of this year, you would have been sitting on an average return in the high teens had you bought every IPO in the UK over the previous six months. That return started to fall rapidly in March and turned negative in mid-May. The average post-issue return of UK IPOs over the previous six months stood at -6% on 17 June (and has probably fallen since). To put that in perspective, if you had instead invested in the FTSE All-Share the day before each IPO you would have made a return of about 1%.
It could just be bad luck. Who could have guessed that investors would decide that a company that sells washing machines online (AO World) is a company that sells washing machines instead of a technology company? Or that a company that company that enables you to order takeaway meals online (Just Eat) is maybe just a giant kebab shop with big computer servers. Inevitably some people got a little excited about the sort of valuations they could achieve and a little blasé about the quality of some of the companies coming to market.
A structural problem
Or it could be more structural (here’s an interesting interview with venture capitalist Marc Andreesen about the decline and fall of the IPO market in the US). The high costs, bureaucracy and uncertainty of going public may put off even the most promising companies and reduce the potential audience for new issues. The fickle nature of the issuers, investors and investment banks involved may inevitably lead to overshooting in both directions and a structurally weak market. What we are left with is an episodic market that fails to fulfil its basic purpose of raising new equity capital for investment. The moment the IPO market windows opens, so many people try to jump through it that it can get blocked very quickly. With the current crop of deals and their miserable performance, the danger is that it could remain firmly shut for months if not years to come.
Given the importance of the IPO as a mechanism for capital raising and encouraging the shift away from bank financing, we will be running a series of events and research on ‘Fixing the IPO market’ involving all of the different constituencies starting in the autumn.