IPOs

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A recent paper titled, “Why do firms go public through debt issuance instead of equity?” reviews the characteristics of companies that choose to access the public market through debt issuance.  There were approximately 600 initial debt offerings from 1987 to 2016.  Public debt issuers tend to be larger companies with higher ratios of operating cash flows to capital expenditure and are often sponsor-backed.  There is no industry concentration.  A small percentage (16%) subsequently issue equity through an IPO.  When companies with public debt eventually do go public, they face lower underpricing than companies in the same industry that undertake traditional equity IPOs.

In a recent paper titled, “Voluntary Disclosure and Firm Visibility: Evidence from Firms Pursuing an Initial Public Offering,” authors Michael Dambra, Bryce Schonberger, and Charles Wasley review the benefits of pre-IPO press releases and investor meetings. Based on a sample of 569 IPOs undertaken from 2004 to 2014, the median IPO company issues two press releases in the year before the IPO and 16.7 percent of the companies attend an investor conference in that year. The authors conclude that private companies that engage in pre-IPO communications about their business and products enhances firm visibility and results in, among other things, more positive filing price revisions during the IPO process, more dispersed investor ownership, and greater coverage in the post-IPO period. The authors also conclude that in contrast to concerns that removing restrictions on communications in proximity to securities offerings would encourage companies to hype their stock prior to raising capital, there is no evidence that private companies that engage in pre-prospectus disclosures display inflated prices that reverse over time. As we have suggested in other posts, perhaps, in connection with other capital formation initiatives, the time may be ripe for the Securities and Exchange Commission to revisit securities offering reform and revamp the communications rules and safe harbors.

Since the financial crisis, the IPO market has been somewhat volatile, but in the last few quarters, the market has shown growth. A recent Audit Analytics report notes a number of factors that may contribute to the relatively slow rate of growth of the IPO market, including the abundant availability of private capital (both equity and, increasingly, debt), the overcorrection of the market for historically high IPO valuations, and M&A exits.

Based on data provided in the report, there have been 1,758 IPOs since 2008. 66% of these IPOs were completed after the enactment of the Jumpstart Our Business Start Ups (JOBS) Act.  At the time of this post, there have been 27 IPOs withdrawn in 2018, according to Nasdaq.  The report also notes that there has been a 46% decline in the number of SEC registrants.

Both regulators and Congress have taken steps to ease the burden of accessing the public capital markets.  For example, the report highlights the expanded ability to submit draft registration statements confidentially to all companies, which took effect in July 2017.  Based on Audit Analytics data, the report noted that EGCs made up 70% of all IPOs in the first quarter of 2017, and now EGCs make up almost 90% in 2018.  IPO costs are one of the main reasons for companies deferring their IPOs.

Shifting focus to unicorns, Audit Analytics reported that these companies, which are valued at over $1 billion, made up only 7% of all IPOs in the first quarter of 2018.  In 2017, 10 unicorns went public, which represented 2% of all IPOs completed and in 2016, 11 unicorns went public, representing 5% of all IPOs.

Audit Analytics also looked at total IPO proceeds raised by year, as shown above.  Post JOBS Act, IPO proceeds seemed to steadily increase and then dropped again significantly in 2015 and 2016.  Based on their data, the report notes that the second and third quarters are the strongest for IPO activity, which leads us to believe that 2018 will finish on a positive trajectory.

Read Audit Analytics’ full report for more.

In a paper titled, “IPO Lockup Expirations: A Persistent Anomaly of Scale,” author Kevin Green reviews the decline in stock prices following the expiration of lockup agreements relating to initial public offerings.  Green reviewed all IPOs from 1988 to 2014 and then observed the trading activity around the lockup expiration.  Despite the availability of information to market participants regarding the timing of IPO lockup expirations, trading activity around the time of lockup expirations still is anomalous. Trading activity significantly increases following lockup expiration.  The stock price for non-VC backed IPOs declines modestly leading up the the lockup expiration compared to VC-backed IPOs, and rebounds in a five-day window following lockup expiration.  However, for VC-backed IPOs, there was a substantial decline in the period immediately prior to the lockup expiration. Short selling activity spikes immediately prior to lockup expirations (which demonstrates, among other things, borrow availability) and then falls below average pre-lockup expiration levels. Short sellers do not appear to be able to predict correctly which VC-backed IPOs will decline post-IPO expiration.  Green concludes that market inefficiencies play a role but the abnormal returns are sensitive to the size of the capital investment.  Limits on the capital deployed or on the scalability of the investment may explain why the abnormal return patterns persist.

Although Securities and Exchange Commission Chair Clayton has made clear that the Commission does not intend to focus on addressing mandatory arbitration provisions in the near term, the controversy regarding action in this regard remains active.  A coalition of bipartisan state treasurers (California, Illinois, Iowa, Oregon, Pennsylvania and Rhode Island) delivered a letter to the Commission expressing their “serious concern” that the Commission may consider allowing IPO issuers to adopt mandatory arbitration provisions.  The letter repeats many of the arguments made by investor and consumer protection groups in their letters to the Commission, noting that the cost for individual pension plan members, including teachers, municipal workers, and other individual investors associated with bringing an individual action on securities law claims would be too costly.  This would mean, according to the state treasurers, that securities regulators would be left responsible for all oversight, without private shareholder litigation to police the capital markets.

The House Financial Services Committee met last week and approved eight capital formation-related bills. The bills require the Securities and Exchange Commission to take action to change certain of its definitions in its rules and provide guidance on a number of securities-related issues.  These include amending the definition of a qualifying investment; requiring a study on IPO underwriting fees with the Financial Industry Regulatory Authority; and requiring a study on expanding investments in small-cap companies. Committee Chairman Jeb Hensarling noted that these bills “…will help our small businesses gain capital, help entrepreneurial ventures, and help companies in America go public and stay public.”

Below we provide a summary of the principal bills:

H.R. 6177, the “Developing and Empowering our Aspiring Leaders Act,” requires the SEC to revise the definition of a qualifying investment to include equity securities acquired in a secondary transaction.

H.R. 6319, the “Expanding Investment in Small Businesses Act,” requires the SEC to study whether the current diversified fund limit threshold for mutual funds of 10% constrains their ability to take meaningful positions in small-cap companies.

H.R. 6322, the “Enhancing Multi-Class Share Disclosures Act,” requires issuers with a multi-class stock structure to make certain disclosures in any proxy or consent solicitation materials.

H.R. 6324, the “Middle Market IPO Underwriting Cost Act,” requires the SEC, in consultation with FINRA, to study the direct and indirect costs associated with small and medium-sized companies to undertake initial public offerings.

H.R. 6320, the “Promoting Transparent Standards for Corporate Insiders Act,” requires the SEC to consider certain amendments to Rule 10b5-1 and directs the SEC to consider how any amendments to Rule 10b5-1 would clarify and enhance existing prohibitions against insider trading while also considering the impact of any such amendments on attracting candidates for insider positions, capital formation, and a company’s willingness to operate as a public company.

H.R. 6323, the “National Senior Investor Initiative Act of 2018,” creates an interdivisional task force at the SEC, to examine and identify challenges facing senior investors and requires the Government Accountability Office to study the economic costs of the exploitation of senior citizens.

On February 2018, the Securities and Exchange Commission (“SEC”) approved the New York Stock Exchange’s (the “NYSE”) proposal to permit qualifying private companies to use “direct listings” to list their shares on the NYSE so long as the direct listing is accompanied by a concurrent resale registration statement under the Securities Act of 1933. To accommodate these direct listings, the NYSE modified its Rules 15, 104, and 123(d). In March 2018, the NYSE issued an information memo highlighting the changes.

NYSE Rule 15 sets forth the requirements for a pre-opening indication, which is the price range within which the opening of trading for a security is anticipated to occur. When the opening transaction on the NYSE is anticipated to be at a price that deviates by more than the “Applicable Price Range” from a specified “Reference Price,” then the Designated Market Maker (“DMM”) must publish a pre-opening indication before a security opens. Under amended Rule 15, the reference price for directly listed securities is defined as: (i) the most recent transaction price if the security had recent sustained trading in a private placement market or, if none, (ii) a price determined by the NYSE in consultation with a financial adviser to the issuer of such security.

Rule 104 sets forth the responsibilities and duties of a DMM. Changes to Rule 104 require that the DMM first consult with the financial adviser to the issuer before a direct public offering (DPO) for securities that do not have a recent sustained history of trading in a private placement market. This consultation aims to promote a fair and orderly opening of such security. Last, the SEC approved an amendment to NYSE Rule 123(d) and granted the NYSE discretion to declare a regulatory halt in a security that is the subject of an initial pricing on the NYSE if that security has not been listed on a national securities exchange or traded in the over-the-counter market pursuant to FINRA Form 211 immediately prior to the initial pricing. This regulatory halt would be terminated when the DMM opens the security. The NYSE Information Memo on Direct Listings can be found in full here.

Despite the NYSE accommodations for DPOs, the Financial Industry Regulatory Authority, Inc. (“FINRA”) advises its member firms to exercise caution when recommending and entering unpriced customer orders at and around the opening on the first day of trading of a direct listing of a security. FINRA notes that there is potential for substantial variance in the opening price of a direct listing and in the subsequent prices at which trading on the secondary market occurs on the first day of trading. As a consequence, FINRA is concerned that without the use of a limit price, customers may receive execution at prices that are not in line with their expectations. Instead, FINRA encourages its member firms to consider using and recommending priced, customer limit orders. FINRA Regulatory Notice 18-11 can be found in full here.

The U.S. IPO market has kept a steady pace through the second half of 2018, according to EY’s quarterly IPO trends report.

54 IPOs were completed in the second quarter of 2018, raising $12.9 billion, which amounts to a total of 101 IPOs, raising $29.9 billion for the first half of the year.  This is a 20% year-over-year increase in proceeds, and a 30% year-over-year increase in volume compared to the second half of 2017.

The median deal size for IPOs in the second quarter was $124.2 million, with only one IPO raising over $1 billion in proceeds.

The technology sector saw both the highest number of IPOs completed and the most proceeds raised in the second quarter of 2018, with 17 transactions, raising $5.1 billion.  Many of these tech sector-IPOs were done by unicorn companies.  Below we provide a graph of the top five sectors by number of IPOs based on EY’s data.

In addition, EY reports that 39 of the newly public companies chose to list on the Nasdaq, while 15 listed on the NYSE during the second quarter of 2018.

For more, see EY’s Global IPO trends: Q2 2018 report.