The real reason IPOs pop (and what it means for direct listings)

May 31, 2017

In my last role as an equity analyst, I analyzed over twenty tech IPOs. Given this experience, I am always amused when I see commentators argue against an IPO pop, saying that companies are "leaving money on the table" by pricing their shares too low. Even more fascinating is the hodgepodge of arguments made as to why companies should aim for a pop, which can be generally summed up as "everyone else does it, it looks bad if you can't manage a normal IPO."


There's nothing wrong with that argument (it is undoubtedly true!), but it misses the point: yes, pops are standard practice, but why do they exist in the first place? 


The real reason IPOs pop:


The simple reason is that when a company IPOs, it is suddenly dropped into a constant, fierce competition for investor attention. Most public equity assets are invested by teams of analysts supporting portfolio managers who make the actual investment decisions. All of these investment professionals are completely overwhelmed by the information available to them: a typical mutual fund portfolio manager has an investable universe of at least five hundred companies (often more like three thousand), and a typical analyst has at least thirty. At Putnam (one of the larger asset managers) I was personally responsible for covering every technology company with less than $15bn of market capitalization- a set of some five hundred companies that grew by one with each new tech IPO. 


That's an impossible task for anyone, and so most investors use tactics to figure out where to spend their time. Some screen for stocks fitting certain characteristics, others attend dozens of meetings until they hear a good story, others build detailed quantitative models. The key though is that for the few hundred professional investors who control the lion's share of the assets in any given sector (and thus drive valuations in most cases), all of them are running some sort of time allocation algorithm.


So when a new company is being added to the list, if investors expect it to be fairly valued out of the gate they have no reason to spend time on it over any other company on their list. In order to meet with a company on the roadshow, pitch it to portfolio managers, read the whole S-1, etc., they need to be compensated in expectation. Therein lies the "pop": the notion that bankers are trying to leave some money on the table incents professional investors to do their homework and jockey for it by demonstrating to management teams that they have studied the business and deserve an allocation. As a result, IPOs in general start out with a base of engaged, "ramped" analysts and portfolio managers who have an internal concept of the underlying company's business model and value and act accordingly. Without the pop, professional investors would treat IPOs like any other public security, and many would end up under followed initially. One key point here is that since most investors are "long-only" i.e. only buy, don't sell, valuation increases with exposure. Every incremental hour of mutual fund attention is a potential buyer with no downside risk (unless the investor in question already owns shares or can short them). Of course investor behavior would change over time in response to the newfound alpha to be generated in underfollowed recent IPOs, but like many things that can be a slower process than economic models would have us believe.


What this means for direct listings:


Some companies arguably don't need a pop because they are so important/interesting that investors will pay attention regardless. Others need an extra large pop because their business models are especially difficult/time consuming for investors to get comfortable with (see: CVNA and most of ad-tech). The equation looks something like this:

If a company is far to the bottom left of the graph (Uber, for example, comes to mind), they may be able to get away just fine with a direct listing. Things may not go as smoothly as a well managed IPO, to be sure, but investors are guaranteed to pay lots of attention to Uber even if it decides to list on the South African stock exchange. 


Most companies aren't so lucky, and are well served by the typical IPO process and a pop. It exists for a very good reason.



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