Pando

2017 offers almost no hope, unless you're itching for an IPO

By Kevin Kelleher , written on December 23, 2016

From The IPOs Desk

Everyone is glad to see 2016 go.

Turn on the TV or radio, or check some newsfeed, and you can't escape someone pointing out how shitty a year it was. We are all Chris Gaines now. And yet, what few are saying – what nobody wants to say, because New Year's Day is about hope if nothing else – is that if you hated 2016 there is little reason to believe 2017 will be any better.

Unless, that is, you are itching for an IPO. Then you have reason to hope. Or, more accurately, you have little other option than to hope.

2016 was the second-day hangover of an exuberance that never quite qualified a fully engorged bubble. Scratch that. It was the third-day hangover. After 56 tech IPOs debuted in 2014, raising $33 billion (more than half of this was raised by Alibaba). If 2015 was a hard comedown – 26 companies that year raised $7 billion – 2016 was the unexpected and unwanted faceplant following that comedown.

Last year, 21 tech companies went public on US exchanges, raising $3 billion. And it wasn't just tech left hungry. Among venture-backed IPOs, 42 companies raised $3.5 billion. Overall, 105 IPOs in all industries raised $19 billion. Optimists will quickly point out that this figure is nearly double the 63 IPOs that debuted in 2009, in the wake of the worst financial crisis since the Great Depression.

Okay fine, but two points. First, there was no financial crisis to speak of in 2016. And second, the median deal size in 2009 was $155 million, per Renaissance data. This year, it was a modest $95 million. And last year, the median raise was $94 million. In other words, fewer companies raising less. A lot less, even by the Great Recession standards.

There is a hearty silver lining in the data, but first one more sad but telling statistic. Renaissance Capital manages an IPO index, which has an ETF tracking it, because it's a handy proxy for how investors would fare if they tried to snap up IPOs once they hit the public market. The Index outperformed both the S&P 500 and the Russell 3000 in 2012 and 2013, then underperformed both indices in the past three years. 

This means that actively and purposefully investing in IPOs for the past three years would have returned less than plunking cash into a Vanguard index fund once a year and then zoning out to your cord-cutter's over-the-top digital TV plan until Carson Daly's New Years Eve jarred you unpleasantly out of your investment stupor.

Which brings us to the silver lining. Data shows that IPOs in 2016 performed better in the aftermarket than they had in the two previous years. The average return on 2016 IPOs was 23%, the highest since 2013, and many tech offerings did even better. So modest are expectations for IPOs that investors are more willing than they've been in a while to pick them up after they start trading, not before. We may be entering a contrarian's dream market.

That is in stark contrast to a private-round market that so inflated the valuations of companies that they seemed unfit for public consumption, or, if ingested, too rich for common tastes. Solid enough companies like Box and Square debuted and dropped below their offering prices, then recovered. The Class of 2016 is doing even better. Twilio is up 111% from its offering price. Nutanix is up 81%. And Acacia Communications is up 185%. 

Not all tech IPOs fared so well. Line, the Japanese messaging app, staged the year's largest US tech IPO, raising $722 million, roughly a quarter of the year's tech proceeds. It is up only 2.6% from its offering price. Line's revenue grew by 17% in the first nine months of 2016. And it swung from a loss of 7.7 billion yen ($66 million) to a profit of 5.3 billion yen ($45 million).

By that measure, Line is exactly the kind of IPO that investors would want to see: established business model, growing revenue, surfacing from the sea of losses to the paradise of profitability. In a good market, tech investors love this. And we're in a good market, going into 2017. So Line is the model for a tech IPO, right? Why is it not rising, but so flat?

One reason. Line went public as a profitable company in July at $42 a share. Line's stock price rose to $51 a share but has fallen back to $33 a share since then. Why? Line's recent earnings report offers a clue. Revenue growth slowed to 12%. Facebook's revenue growth, by contrast, is up 56%. Welcome to today's IPO market. Where you can invest in a modestly priced, if struggling startup. Or you can invest in a tech incumbent, growing faster than most startups.

Line offers a cautionary tale to tech IPOs that hope to trade on their brand names. If you want to go public in this market on the back of your company name, or if you hope your IPO can burnish that name, take a look at Groupon (2011), Twitter (2012) or GoPro (2014). All have lost more than half their market value since going public.

The IPO/Brand symbiosis thing has been missing for a few years. Go ahead and dream about hoisting the banner of your corporate logo high and triumphant above the traders on some stock exchange. But stop thinking any cheer you hear on some closing bell will be from anyone you didn't somehow pay for. You need more than brand. 

You need to be more. You need to be Snap.

The Snap IPO narrative is the neatest one, the one investors would love to invest in. If Snap goes public and others follow, the Olympic flame of the tech IPO could burn on. But there is a cloud around Snap, one that could spawn rainbows or lightning storms. We won't have even a clue until the prospectus is filed.

Snap in 2017 is that white male thumb coiled against a white male middle finger, poised to unleash – with a crass, snapping sound - a digital revolution... designed by a white man. As with previous revolutions, Wall Street only cares if it makes money. If it does, other will follow. Some, like Dropbox, will be overdue. Some, like Airbnb, will be healthy financially but embattled politically. Still others, like Uber, may well be like investing in some scarred veteran of dog fights - still alive but too limping and with too few prospects in its premature middle age to enable betting on fighting another day.

Whether or not Snap sinks, however, the fate will remain the same for the smaller fry. That is, it may pay for investors to keep avoiding the brand names. Like Acacia and Twilio in 2016, the safest bets in 2017 may be the tech startups that floated under the radar of brand-obsessed investors. The reason goes back to an explanation Renaissance gave in its summary of the drought of 2016 IPOs

the primary reason for the lack of tech IPOs is the public-private disconnect on valuation, a tension that can only be remedied by VCs caving in to their growing urgency to sell aging vintages in their portfolios, or by time as companies grow enough to justify their lofty private valuations.

And therein lies the IPO narrative of 2017. Not just the tension between private and public valuations. But the way that tension will be resolved. The laws of finance are aligned enough with the laws of physics to know this: What floated up must come down. It's up to the venture capitalists. If they don't sell or take public their overpriced startups soon, they will need to sell or take public their startups at an even more ridiculous valuation.