In the wake of the Twitter IPO announcement, Tyler
Cowen asks if the return to public equities is now lower. His theory, about
a wealthier world that causes successful companies to stay private for longer
seems flawed but he brings up an interesting question.
It is worth thinking about what has changed recently where we now see many more
mega IPOs. In 1986, Microsoft had its
IPO, raising $61 million dollars with valuation
almost $800 million dollars. This would be $1.7 billion dollars in 2013
dollars. In 1993 Allstate had the biggest initial public offering ever up to that point by a US company. It sold $2.12 billion worth of stock at a price that gave it a valuation of $11.8 billion dollars or $19 billion in 2013 dollars. This large IPO was possible at the time because it was a spinoff from Sears.
More recently, Linked-in went public in 2011 for $4.5 billion and Facebook
went public in 2012 for $90 billion. With Facebook now comfortably above its
IPO price, Twitter is planning on going public with analysts estimating its IPO
market capitalization between $10 and $20 billion dollars.
There are many differences between the world that spawned
the Microsoft IPO and today’s markets, but the below might be the most
1. Sarbanes Oxley raises the cost of going public. When
Sarbanes Oxley costs average over a million dollars the cost benefit analysis of
going public doesn't make sense until a company has a significantly higher
valuation/revenue stream than it would have needed in the past.
2. With many companies putting off going public a new
financial ecosystem developed to fund these companies. Late stage VC firms like Andreessen
Horowitz entered into the market. Not only do they have billions of
dollars they need to deploy but they actively help the companies they invest
in. This further raises the opportunity cost for companies thinking about going
to the public markets.
3. A growing secondary market in shares of startups lets
many founders and early employees diversify a significant amount of their new
worth out of the company. When these employers feel financially secure this
reduces the incentive for an immediate IPO.
4. With the internet and globalization, network effects are
much more important and markets are much more likely to be winner take all. Once
the winners are established their market capitalization will be significantly
higher than companies in the past. This doesn't stop companies from going public
sooner by itself, but it does mean that by the time the company feels that it
is stable enough to be traded on the public markets its market capitalization
will be much higher.
Given all of these factors, the higher market capitalization
of IPOs makes a lot of sense. What this means for public equity returns is more
The first factor prevents many companies from going public
until they are much more successful. This includes companies that go on to be
successes but there are also companies that end up as failures or frauds that
would be detected by tougher accounting laws that public market investors are
never exposed to. Small companies will also often sell themselves to larger
companies rather than enter the public markets. Overall it is difficult to
calculate the direct effect of this factor on public market returns.
The factor that really penalizes public market investors is
that a healthy secondary market means there are not as many situations where a
company will go to market merely for the sake of allowing its management team
to cash out. When there is demand for liquidity, the people on the side of the
trade giving liquidity will on average make a higher return. The reduction of
this factor could lower returns for public market investors in general. At the
very least it should cause a reduction in the size premium. And from the chart below, we see that size
was never a particularly attractive risk premium to be long in the first place. Momentum, market return, value and even the
risk free rate have outperformed the classical size risk premium factor.
French’s Data Library
The winner takes all (most) nature of many of markets today
is both a blessing and a curse for public equity investors. It isn’t always private companies like
Facebook or Twitter who create new markets, as Apple investors from the early
2000s know very well. At the same time, other public companies, Microsoft is an
example that comes to mind, will often spend billions of dollars trying to be
the winner in a new market but fail
miserably. And if companies really are
sustainable pseudo-monopolies, then public market investors have a chance of benefiting
from investing in them even after IPOs.
When thinking about what impacts public market returns it is
fun to think about things like the impact of mega IPOs will be but it is better
to double check theory again the basic fundamentals. We currently have an
equity market that is yielding over 6% while investment grade debt yields,
depressed by quantitative easing and low rate expectations, are below 4%. Until
the past few years, investors in bonds have been paid a premium over earnings yield
because they are taking on inflation risk and their earnings will not go up. The
last time this happened we have to go back to a time period when equities were
viewed as a realm for uncouth gamblers and everyone knew that railroad bonds
were the key way to keep their money safe.
Source: Bloomberg, Barclays
Given the current valuation dynamics, it isn’t likely that
the average return on publicly-held companies has moved lower.