By Kashif, Investment Analyst at PrivCo, a private company financial intelligence platform
Absurd growth expectations, market volatility, peak market valuations, and rate hikes could dash all hope of a graceful public exit for many companies. Again.
We love private companies–it’s what we do best. When a company IPOs, we’re admittedly sad to see them go, but that’s the circle of life in this business. Even the most patient investor or the most prudent company eventually reaches a point when it needs the kind of capital and scale that only a massive public offering can provide.
But something weird has been going on in the IPO game lately.
Late last year we published a list of 130 companies who were most likely to IPO in 2017. Since then, several of those CEOs have explicitly announced that they will not go public this year, postponing indefinitely. Meanwhile, 2016 ended up having the most IPOs formally withdrawn since right before the market crash in 2007. And completed IPOs in 2016 were at the lowest level since the depths of the crisis in 2009. Unfavorable market conditions are most often cited as the reason for delay.
Simultaneously, the S&P and Dow kept hitting record highs by year-end, which would seem like a good time to get the best value for your stock. And pundits from venture capital and Wall Street could be heard repeating, ad nauseum, that 2017 will be the breakout year for companies (particularly in tech) seeking to go public.
Our take is that companies will IPO this year, possibly in great numbers, because they’ll need the capital when VCs fall short and investors want to finally cash out. There’s a huge catch, however: the IPOs will happen at steep discounts from their intended valuations.
Using PrivCo’s private company database, we stacked up data on IPO candidates, including revenues, valuations, completed IPOs, and IPO withdrawals, and pitted them against various market factors to determine how IPOs will be affected this year. Here’s the list.
Many aspiring unicorns are valued far higher than already-record-high market valuation multiples, placing absurdly unrealistic growth pressures on companies that can only result in a down IPO.
With U.S. stock markets at record highs, the S&P 500’s revenue multiple is at a level unseen since the internet bubble in 2000 (currently around 2x). Meanwhile, the most likely IPO candidates are valued magnitudes higher, ranging from Xiaomi ($45bn at 3.6x with no profitability in sight) to IPO darling Snap, Inc. ($26bn at 70x).
The implied revenue growth rates for companies on the high end–WeWork, Palantir, or Snap–would have to be sustained in the high double-digits for years, on top of having their bottoms line scrutinized. It’s a tough bar. Just one quarter of unremarkable user or earnings growth would cast doubt on the entire company’s trajectory, or even the industry. Before investors ever get to that point of correction, however, it’s likely that these astronomical valuations will come down to earth upon IPO.
High market volatility is poisonous to IPOs, and there’s a good chance that will affect valuations this year.
For the better part of this century, market volatility (as measured by the CBOE’s VIX Index) has been a good indicator of IPO volume and demand. At times, average annual VIX levels and the number of IPOs appear to move almost in a mirror image. When the year’s VIX average exceeds ~15, IPOs are muted. We’re hovering around that pivotal level right now, though it’s hard to tell where it will be just weeks into 2017, especially with the uncertainty surrounding an untested president who has barely assumed office.
The dotted and dashed lines in the chart below are a projection of where IPO volume will go depending on the direction of market volatility (dotted for higher volatility, dashed for lower). There are a lot of opportunities for the market to get paranoid in 2017, and any subsequent volatility will lessen demand and hurt IPO valuations.
Companies tend to increasingly withdraw their IPOs when investors believe the market is nearing its peak–and we might already be at that point right now.
With the Dow struggling to hit a symbolic 20,000 and certain valuation metrics at pre-recession levels or even all-time highs, it’s becoming incredibly likely that equity markets have maxed out for the indefinite future.
It’s harder for an IPO to “pop” when the broad market stops rising, as it occurs concurrently with a falloff in demand. Without that much-needed pop, an IPO could result in a down valuation (see Square) and ticked-off investors and employees. Thus, cancelled IPOs are quite common when investors perceive that the market is too hot to justify.
Because we can’t be certain that markets have peaked (mostly due to market-bolstering Fed activity and President-elect Trump’s pro-corporation/Wall Street policies), we’ve posed two scenarios below: (1) dotted lines indicating that the market will continue rising, making investors increasingly uncomfortable, lowering demand for IPOs, and resulting in even more IPO withdrawals by companies seeking more enthusiasm in the market; or (2) dashed lines projecting that we’re past the peak, prices are getting more palatable, demand for IPOs is recovering, and consequently, companies are convinced to stay the course on IPO plans.
Rising interest rates have a substantially negative effect on the amount of money raised through IPOs. Rates will continue to rise indefinitely and slash the proceeds from any IPOs in the coming years vs. a zero rate environment.
The chart below shows the only direction we can go: rates will rise, and any given IPO will have far more trouble raising the requisite capital than it would have in the heady 0% years of 2009-2015.
Conclusion: The possibility that IPO candidates are more overvalued than an already-overvalued market, that the market has peaked, higher volatility is up ahead, and rising rates all negatively impact investor demand and could lead to fewer IPOs at much worse valuations. 2017 could be an even more challenging year for the glut of unicorns itching to go public than in years past.
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