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Is the IPO market really opening up? A trio of IPOs ( Arm , Instacart, Klaviyo ) have investors excited that we are re-entering a golden age of IPO issuance. Over the weekend, Goldman Sachs’ chief U.S. equity strategist David Kostin said the IPO market was becoming more “normalized,” meaning issuance was starting to pick up. Sounds good, except Kostin issued two caveats: investors should be “wary of IPOs that come to market at extremely high valuations” and profitability was key to after-market success: “We expect profitability will be especially important for upcoming IPOs. With capital markets closed for nearly two years, unprofitable companies have been forced to fund operations by spending cash balances. This experience has driven investors to prefer stocks with high levels of current profitability.” That means investors are looking for 1) much lower valuations, and 2) profitability. Some companies, like Instacart, may indeed satisfy those two requirements. Many other tech unicorns (those with valuations north of $1 billion), perhaps most, will not. Different than the last IPO gold rush The last IPO goldrush, in 2020-2021, was under very different circumstances. Back then, we had a huge rebound in the stock market in mid-2020 along with plummeting interest rates. Those two factors went a long way toward explaining the crazy high valuations IPOs fetched in that period: “The distribution of 2020-21 IPO returns was not especially dependent on valuations, except at the extreme,” Goldman’s Kostin said in a recent note to clients. The macro environment is different today. True, the S & P is on an uptrend but interest rates, the other major macro determinant for IPOs, are much higher than in 2020-2021. Low rates were a major factor in the earlier high valuations: “Real interest rates plunged to a record low of -1.0% during 2020-21 and risk assets surged in price, led by long duration assets, including IPOs,” Kostin noted. “[But] before we see a broad-spectrum re-opening of the IPO market, we still need clarity around interest rates, inflation, and recession potential,” said Eric Bellomo, PitchBook’s ecommerce analyst. What about those lower valuations? A large part of the IPO market is backed by venture capital firms. How excited are they about this “reopening” and much lower valuations? Maybe not so excited. Kostin, citing FactSet, noted that 39% of IPOs since the start of 2020 were primarily financed by VC firms prior to IPO, vs. 23% of IPOs from 1995-2019. Why is that important? Those venture-backed companies had high valuations. Nizar Tarhuni, vice president of research at Pitchbook, notes that an index of VC-backed companies that have gone public in the last 2 years indicates that in 2021 those companies collectively traded at about a 25x price/sales ratio. “Today those businesses are trading at 5x price/sales and that has been steady for a number of quarters,” he told me. In other words, there has been a big haircut in companies that have gone public. Instacart is experiencing this painful reality even before the IPO, with a valuation of $39 billion a couple years ago now reduced to roughly $10 billion. That has left several venture capital backers of Instacart with losing investments. Pitchbook notes that investors who only jumped in following its 2018 Series F, which priced just shy of $30 per share, “are likely to be underwater in at least some of their investments.” That includes DST Global, General Catalyst, and T. Rowe Price, all of which participated in the Series G round of funding in 2020 at a $13.8 billion post-money valuation. Lower valuations for investors and venture capital The good news is, lower valuations give investors on the first day of trading a greater chance at making money after trading starts. The bad news is, some of these tech unicorns will likely pass on taking a huge public haircut. Tarhuni estimates there are roughly 800 or so unicorns that on average haven’t raised capital in over 17 months. “They’re going to need to raise soon and the pricing dynamics don’t look great,” he told me. “If you have to absorb some negative pricing, companies are better off doing that out of the public spotlight and I think unless you have some company-specific items that close the door to private financing, you’ll go that route.” Profits matter As for profitability, Goldman notes that there was a smaller share of profitable IPOs during the IPO gold rush of 2020-2021 than the prior 20 years. Only 14% of IPOs were profitable in the first quarter they went public in 2020-2021, versus 41% that were profitable from 2001-2019. That too was a major factor in the poor performance of the 2020-2021 IPO class. What’s next? This leaves many companies in a real pickle. Companies like Instacart, which are profitable and have already accepted a lower valuation, are in good shape. Many others are not. Nizar tells me that companies contemplating an IPO have three choices: 1) raise additional capital in the private markets, 2) merge or be bought out; or 3) move into the public markets. Can companies stay private and still raise money? Nizar says some still can: “We think there is a tremendous amount of dry powder sitting on the sidelines,” he tells me. “The VCs will allocate a disproportionate amount of capital to their highest-probability companies of success (turning an operating profit) and [let] others fend for themselves.” Fend for themselves? That sounds ominous, which is why Nizar believes that down the road there will be a serious reckoning of companies that cannot meet the criteria to successfully go public. He sees a wave of M & A coming, with many unicorns acquired by firms specializing in distressed M & A. Finally, a smaller percentage will take their medicine and move into the public markets, accepting a far lower valuation. “In this market environment, the companies that move into the public space will be the best in class of the late-stage venture capital markets.”
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