Last summer, on the heels of the Facebook (FB) IPO debacle, PIMCO’s Bill Gross caused a stir when he posited that “the cult of equity is dying.” While such a dire prognosis from one of the world’s most prominent bond fund managers might be easily dismissed as “talking one’s book,” there’s no denying that market crashes, repeated scandals, dizzying “risk-on, risk-off” market calls, and the meager returns of the last decade have challenged the patience and faith of equity investors. So is it any wonder that 2012 was another disappointing year for initial public offerings?
The numbers are grim. Renaissance Capital’s recently released global IPO market review (PDF) reported that global IPO proceeds declined by 27.8% in 2012. And while last year’s sharp decline was largely attributed to weakness in China and continued fallout from the sovereign debt crisis, it also appears to be part of a longer term trend: Over the past decade, the average annual number of IPOs in the US plunged by about two-thirds from the level seen during the 1980–2000 period.
What ails the IPO market? Are we witnessing a structural market change, a secular decline, or simply a cyclical downturn that will reverse?
Most explanations for the ongoing weakness in the IPO market focus on the increased regulatory burden on public companies and their underwriters. In the US, compliance with the Sarbanes-Oxley Act (SOX) of 2002 — designed to protect investors from fraud — has been disproportionately costly to smaller companies. Similarly, Regulation FD (2000) and the Global Settlement (2003) have also been cited as reasons for the shrinking IPO market. Leaving aside the merits of the greater fairness, transparency, and stricter accounting controls that SOX and other regulations have mandated, the evidence is clear that in the post-SOX era fewer firms are going public and more public companies are going private (PDF). The fast-growing $3 trillion private equity business has stepped in to at least partially fill the void created by the IPO slump, snapping up companies that otherwise might have sold shares to the public. Of course, slack demand for IPOs has meant that these PE firms have had a more difficult time monetizing their investments.
A recent paper, “Where Have All the IPOs Gone?” puts forth a new hypothesis to explain the waning interest in IPOs. The problem, according to authors Xiaohui Gao, Jay Ritter, and Zhongyan Zhu, is not “regulatory overreach,” but rather the deterioration in the profitability of small companies brought on by the quicker pace of technological innovation and globalization. They note that among small company IPOs, the percentage of firms reporting losses in the three years post-IPO grew from 58% in the 1980–2000 period to 73% in 2001–2011. The authors conclude that small, private firms can generate higher profits by being part of a larger company, making acquisition preferable to an IPO.
Regulators and legislators have taken notice of the moribund IPO market and, undoubtedly with the best of intentions, have naturally offered up some ill-advised solutions. In India, where the investing public has always preferred gold and real estate to equities, there has long been a perception that the market for IPOs is rigged. In response, Indian regulators have gone to arguably extreme measures, recently proposing that investors be provided refunds from selling shareholders on IPOs that fall sharply after their public debuts.
In the US, the JOBS Act, passed by Congress in 2012, has been promoted as a cure to what ails the IPO market and, by extension, a sluggish economy. By rolling back corporate governance and accounting rules for “emerging growth companies,” which the law generously defines as firms with up to $1 billion in annual revenues, the JOBS Act is designed to spur new offerings. And while any impact on the IPO market has not yet been felt, the loosening of investor protections does not sit well with many, including CFA Institute.
Gau, Ritter, and Zhu expect the JOBS Act and other regulatory stimulus efforts to have an inconsequential impact on IPO activity and think we are unlikely to see the number of deals return to the levels seen in decades past. Renaissance Capital, on the other hand, sees the JOBS Act, which allows for confidential filings with the SEC, creating a “shadow backlog” of deals that may surprise on the upside in 2013.
As the sting of the Facebook offering fades, investors will almost certainly return to the IPO market. The buzz surrounding an anticipated IPO by Twitter makes this clear. Less certain is the commitment of small firms, as the IPO does not appear to be the end game that it once was for those seeking to raise capital.