Understanding IPO Performance Metrics
With the year coming to a close, we are also seeing the end of Initial Public Offering (IPO) season in public markets. Often, a firm will go public as its next step in growth, to gain access to capital markets, or if market sentiment is positive, secure a high price and reap the benefits of cheap equity capital. This year saw some notable entries into the public market to take advantage of at least one of these reasons, and two very successful IPOs were Snowflake, and Palantir, however, not all faced this same short-term prosperity.
While day one returns may be substantial, the IPO is not the be all and end all of investing. Frequently, firms tend to soar on day one, but face severe price drops in the following days, but it’s important to ask why some firms succeed long term compared to their peers who soared on day one, but saw long term underperformance. Historically, IPO underpricing has held true for highly anticipated offerings, but upon investor realization of the true intrinsic value, the price point settles to a realistic expectation within the market.
In our previous newsletter, I discussed the efficient market hypothesis and how investment prices are a reflection of all available information, both public and private. This same concept holds true to the IPO as private firms have substantially less information available on day one. As such, investors may demand the issue be discounted to reflect the risk of entering into a new security. This may be done by the issuing firm itself as it seeks to attract new investors, or it may be requested by the institutional investors that traditionally hold the majority of shares as compensation for taking on the added risk. Additionally, a financially conservative firm may deliberately underprice its offering to ensure there is no overstatement of value (under-promise, over-deliver)
Consequently, if a firm is widely sought after, the release of information to the public markets will cause this underpricing to be very prominent as day one returns rise, one such example is the public launch of Beyond Meat in 2019, but like Beyond Meat, the long-term performance of many firms following a public debut has been lackluster. Those that tend to perform best are the ones who are deliberately conservative in their valuations as day one returns may be high, but as investors price the issue, see positive long-term performance as the price rises to a true intrinsic value.
Some of the theories and implications from long term underperformance stem from three main schools of thought: 1) Divergence of opinions, 2) Market Optimism/Pessimism, and 3) Overinvestment. The first explanation of underperformance stems from the aforementioned lack of information to create an efficient price, and as excitement for the issue settles, the price also settles, and perhaps not in the way investors had hoped. Moreover, many firms will launch an IPO in an upward trending market to secure a good price, but as market sentiment falls, or perhaps economic events cause stagnated returns, the new issue will see downward pressure on its price. Finally, the third, and arguably most frequent cause of underperformance is the firm undertaking value destroying projects that are ultimately reflected in the price seen by shareholders.
While it is important for institutional, and at times retail investors to participate in IPOs, high risks are present and perhaps greater than that of an investment into seasoned securities. As such, it is extremely important to conduct appropriate research, ensure the industries in which your investments are held are well understood, and that you are paying a fair price for your investments to achieve your goals and obtain long term capital appreciation.
Written by Adam Prittie, Investment Advisor