Tuesday, March 22, 2016

The IPO Market – First Quarter Showers May indeed bring Subsequent Flowers

Until recently, rapidly growing technology start-ups, aspiring to perhaps one day be public, seemed to embrace the old adage: It takes money to make money. When money was readily available to finance growth as long as management could tell a good story, start up after start up scrambled like four-year olds at an Easter egg hunt to gather up as much as they could.  However, they may have been adhering to the wrong proverb.  Perhaps the more appropriate wisdom came from Thomas Jefferson: “Never spend your money before you have earned it”.  We think it highly likely that over the next few quarters, participants in the IPO market will have data to conclude which was better advice.

Just six months ago, spending to grow, even if the positive unit economics and cash flow were on the come requiring a leap (and a bound) of faith, a young company’s management team appeared wise to pursue a competitive moat based on scale, growing as fast as possible. Let the P part of the P&L sort itself out over time.  Damn the torpedoes; go for growth and scale funded by enormous private fund-raising rounds.

Ah, but some of the key “sugar daddies” didn't see the opportunity through quite the same lens.  Public markets did not sing from the same hymn book as their private market brethren.  In 2015, realized IPO valuations did not reflect that same optimism for growing companies in big markets with hefty losses.  Companies that successfully executed an IPO in 2015 often - as in close to 60% of the time according to Renaissance Capital’s 2015 US IPO Review - saw their stocks quickly tumble below issue, and now are living through the painful aftermath with employees, partners, customers and board members. 

If it is true that misery loves company, then there is some solace. According to the same Renaissance Capital analysis, if an investor bought the entire IPO class in 2013 and held through 12/31 of that year, that portfolio would have appreciated 40.8%.  Had they repeated the exercise in 2014, the gain would have been 21%.  Had they followed that tried and true strategy in 2015, those investors would have lost 2%, versus a 0.7% loss for the S&P500 last year. Worse still and again according to Renaissance Capital, had one invested in every VC backed tech IPO in 2014 and 2015, the portfolio would have returned 7% by year-end 2015.  Alas, if one had simply parked money in a NASDAQ index fund, the gain during those two years would have been 20%. No wonder many public investors went to the sidelines and participation in IPOs narrowed dramatically as 2015 progressed.
Fast forward early 2016. As lore has it, March, often a robust IPO month, did indeed come in like a lion.  Unfortunately, it was Cecil. The good news is that while that poor beast is in permanent repose, the 2016 IPO market may yet stretch, stir and awake from the long nap, refreshed, perhaps healthier and ready to go.

Why the optimism in the face of no visible evidence?

First, the VIX is falling.  Volatility is the enemy of the IPO.  When all equity positions look risky, who needs to pile on the incremental challenge of unproven, statistically likely to trip, always unpredictable new issues?  Conversely, when the market chills a bit, and the VIX falls as it has been doing each week since the beginning of February, investors turn their attention from risk avoidance to incremental upside, a mindset favoring IPOs.

Second, public equity is looking increasingly compelling if for no other reason than the private funding environment has grown much more challenging.  Companies relying on unending, generous access to late stage equity to fund further growth are scrambling to come up with a new game plan.  Of course, many raised enormous piles of cash while the getting was good and therefore have a robust bank account. However, history suggests that when money flows freely, emerging companies have a tendency to develop free-wheeling, slow to break habits that eat through bank balances like termites through grandma’s back deck. When private money is hard to come by, public money, even with inherent attached obligations, looks increasingly appealing.

Third, Last year’s “growth, at any cost, is good” mentality has given way to that old bugaboo, insistence on potential profitability. Public investors want to see proof not only of growing ongoing engagement from existing customers, a sign that the offered product or service has convincing value, and therefore a reliable, sustainable, expanding revenue base, but also a tangible demonstration of how that revenue stream will someday yield positive free cash flow.  Companies investing rationally in their product roadmaps and in deepening integration with (and value to) customers, will likely have a much easier time winning the hearts and minds of IPO investors (when they come out from under their desks).

When investors are fearful that private company secular tailwinds will slow, leaving them becalmed in a big market with hungry shark incumbents competing for the same, dwindling school of customers, the upstarts can only prevail if they offer something compelling, proprietary and sustainable.  As of March 2016, our conversations with investors suggest that competitive barriers, an ability to maintain a leadership position even in a long economic slog and a rational view of valuation are now more critical to the investment decision than yesterday’s secular trends, fairies and sugar plum TAMs. The market where “land-grab-today-at-any-cost-and trust-we-can-monetize-this-big-opportunity-later” wins has left the room. Conversely companies that embrace the mindset and work to deepen moats today while keeping spending under control should be well served when public investors’ un-circle their wagons and again seek out new territory.

Our strong sense is that the uncertainty created by a tighter private funding market is leading companies to rapidly embrace the principles that public investors say they want, a more balanced approach towards growth and profitability and a focus on moats and again, justifiable valuation expectations. Our optimism for the new issue market ahead is based on our belief that this revised thinking will result in stronger, more compelling IPO candidates.

So, once the clouds clear and a brave bellwether opens the market, is it all clear skies and sunshine ahead?  Of course not.  Some companies will come to market with models reminiscent of that FarSide cartoon mathematician “And then, a miracle occurs”, and some of those IPOs will fly off the shelves.  What happens to those companies after the lock-up release 180 days later will be anyone’s guess.  Having seen this movie before, we can say that if history is any guide, emerging companies that are hunkered down in the current environment, perhaps foregoing triple digit growth in the drive toward the sustainability afforded by a viable model displaying balanced growth and profitability, are the best bets.

The current IPO forecast is gloomy; no doubt.  However, what is going on beneath the visible cloud cover just may be enough to afford public investors positive returns again in the IPO pool when the sun shines and it is time to dive back in.