A high-flying initial public offering market is often seen as an early indicator of froth in the secondary market, and can be a warning of a budding stock market bubble.
In the months leading up to the dot-com crash, the IPO market was red hot, particularly for technology companies listing on the Nasdaq stock exchange. A dangerous IPO trend emerged.
According to a 2003 article from the Journal of Finance, the average first-day return for an IPO in 1996 was about 17%, with the median around 10%. By 1999, these figures had risen to 73% and 40%, respectively.
Internet IPOs averaged an incredible first-day return of 89%, with a median of 57%, throughout 1999 and 2000.
To investors, it seemed like these companies could do no wrong. They looked past the companies’ lavish spending, rapid cash burn and lack of clear business models. Investors stopped caring about traditional valuation metrics like free cash flow and focused instead on metrics like monthly average users.
Today, a new kind of dangerous IPO trend is emerging, and I’m still trying to figure out exactly what it means.
The key to this trend is found in the “Use of Proceeds” section of the form S-1 that each company must file with the Securities and Exchange Commission prior to an IPO. This is the section where the company explains exactly how it will use the proceeds of its IPO.
The alarming trend that I’m noticing is the recent spate of high profile IPOs through which none – or almost none – of the proceeds will actually go to the company’s operations. Instead, the proceeds are being used to buy out existing investors – generally private equity firms and company executives.
Surely no one would want to buy an IPO that the company’s own executives are selling, right? Wrong. So far, these IPOs have all priced at the top of their range and had very successful first days.
The high profile GoDaddy (NASDAQ: GDDY) IPO was largely set up to buy out existing shareholders and contributed little to GoDaddy’s cash accounts.
Virtu Financial (NASDAQ: VIRT), the first-ever publicly traded high-frequency trading firm, also structured its IPO with a priority on paying off existing investors. The company used just about all of its post-expense proceeds to buy out private equity investor Silver Lake Partners.
Interestingly, Silver Lake Partners is also one of the investors that was bought out in the GoDaddy IPO.
Fast food company Bojangles (NASDAQ: BOJA) will be just the latest example of the trend when it goes public later this year. In its S-1 filing, the company disclosed that “all of the shares of our common stock offered hereby are being sold by selling stockholders. … Accordingly, we will not receive any proceeds from the sale of shares in this offering.”
The problem with drawing conclusions about what looks to me like shareholder-unfriendly IPOs is that this may be merely a symptom of the broken IPO market we’ve seen since 2009.
Many industry-dominating companies have emerged during this time. But without a healthy IPO market, these entrepreneurs have turned to private equity firms to fund growth. Now these PE firms want to exit their positions and take profits on their investments. Hence, the IPOs are structured to give these firms an exit.
Should we avoid these IPOs because existing investors want out? Or should we accept that incoming investors buying shares in an IPO from an outgoing PE investor is a sign of the times?
My gut tells me that I don’t want to be buying shares from company insiders and longtime investors that want out. And experience tells me to trust my gut.
Beware this dangerous IPO trend.
Apple’s most closely guarded secret
On April 27, Apple blew away expectations yet again by beating Wall Street’s earnings estimates. Without a doubt, Apple is soaring higher than ever. Yet few analysts realize is that a little-known company is destined to soar right along with it. It’s Apple’s most closely guarded secret…one they would prefer you never know. Discover it right here.