In the decade after the dot-com bust in early 2000, the market for initial public offerings (IPOs) in the United States has been quite dormant.
Whereas 300 to 400 companies went public each year in the United States during the 1980s and 1990s, that number has dropped to less than 100 since 2001. Many regulatory changes have been recently proposed to encourage more capital formation and many commentators hoped that the Facebook IPO could be a turning point for the market, encouraging followers. Instead, Facebook’s share price dropped from its $38 (U.S.) offering price on May 18 to a low of just under $26 on June 5. Over the month following the Facebook flop, there were no IPOs. On June 20, the U.S. Senate Banking Committee began new discussions regarding IPO reforms.
While changes to encourage more IPOs would on some levels seem positive (arguably encouraging and supporting more new venture start-ups), it would be useful to look more closely at how the IPO market has evolved for investors. Simply stated, IPOs from the 1980s and 1990s were, on average, terrible investments.
Yes, many IPOs had very strong openings, with first-day returns over the two decades averaging a little under 20 per cent. Investors holding the IPOs for longer than one day, however, did not fare very well. If you bought every IPO from 1980 to 2000 and held for three years, your average return would have been about 8 per cent a year less than if you had instead put your money in a market index (for example, the S&P 500). Given the extra risks to investing in newly public companies, IPO performance was very disappointing.
This negative situation peaked during the Internet bubble. If you had bought every IPO in 1999 and 2000 and held for three years, your average annual raw return would have been a loss of 17.8 per cent. During the glory days of the IPO market, many companies were coming to market in part because investors were not disciplined, and overpaid for stories of growth that simply couldn’t emerge.
Since the IPO bubble burst in 2000, fewer companies have come to market – but their performance has been much better. Average first-day returns have been lower (about 12 per cent), but the longer-term returns have at least beat the market. If you invested in every IPO from 2001 to 2010 and held for up to three years, your average annual return would be about 1 per cent better than the market index.
This suggests that part of the reason for the decline in number of IPOs is that investors finally found discipline – they rejected companies with unreasonable hopes for growth and instead invested in stronger, more established firms at fair valuations.
To me the Facebook IPO stands as a cautionary tale to investors (and bankers) that it is easy to slip into bad habits. Most investors put aside discipline and simply assumed Facebook would “pop” no matter what price was established in the IPO. Apple Inc. co-founder Steve Wozniak, for example, famously commented that he would invest in Facebook no matter what the opening price was.
While a bit of irrational exuberance from investors can be understood, it’s still not clear why Morgan Stanley and Facebook’s army of bankers got it so wrong. When the bankers first approached investors, they indicated that a price between $28 and $35 a share seemed reasonable. Interestingly, their initial assessment was pretty much spot on, with Facebook now trading within that range, closing Friday at $30.72. Nonetheless, the bankers agreed to increase the price to $38 after approaching investors on the IPO’s road show.
While it’s impossible to know exactly what happened, the bankers, while hard working and smart, clearly misread the signals. It reminds me of an example from the early 1990s that first piqued my interest in the IPO market.
Back in 1993, basketball legend Wilt Chamberlain attempted to raise $10-million in an IPO to support the restaurant chain he founded. Investors appeared to respond positively and the IPO was priced at $7 a share, or about 200 times earnings. It turns out the roadshow “demand” was not real and the shares quickly tumbled to $4.63, at which point bankers cancelled the deal.
Wilt Chamberlain was a star, and the apparent excitement at the road show was simply fans hoping to hear from the man who scored 100 points in a single game (and in 1992 reported other remarkable statistics in his autobiography A View From Above). Like Mr. Chamberlain, Mark Zuckerberg is a star, and bankers clearly misread the interest from those clamouring to see how the man behind the hoodie would perform at the road show.
Cautionary tales such as the Facebook IPO can be truly positive events if read the right way. In this case, I hope regulators don’t overreact with changes that make matters worse, investors return to the disciplined approach to evaluating IPO investments that has emerged since 2000, and bankers remember the Wilt Chamberlain effect – that signals can be misleading, especially when CEOs have star status.
Craig Dunbar is a professor of finance and economics at the Richard Ivey School of Business at the University of Western Ontario.
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