By Phil Mackintosh, Chief Economist, Nasdaq
We recently wrote about how strong the IPO market was in 2020 despite the obstacles caused by COVID-19. Last year, 471 companies (including SPACs) came to market, representing a record level not seen since 1999. We also noted that newly listed IPOs (excluding SPACs) in 2020 saw an average first-day return, commonly called an “IPO Pop,” that was more than double the longer-run average, at 38% (Chart 1).
Let’s take a deeper dive into IPO pops and try to understand what makes them change.
Chart 1: IPO pops in recent years
Missed opportunity or liquidity premium?
IPO pops are not new. According to data from Jay Ritter, the average IPO pop from 1980 through 2020 was 18.4%. That still means first-day returns in 2020 were strong, but they were not as large as the Dot-Com bubble, where IPOs averaged over a 60% increase on the first trading day.
From an issuer’s point of view, the IPO pop might look like a missed opportunity. Issuing stock to investors at a consistent discount to their day two prices seems suboptimal. But that misses some fundamental differences between public and private listings: daily liquidity, competitive spreads and access to a wide range of mutual funds and retail investors – all of which have been shown to reduce costs of capital and increase valuations.
The “pop” highlights the significant liquidity premium a stock receives when it joins listed markets. By reducing an issuer’s cost of capital public markets also improving future investment opportunities and returns.
The IPO process
The traditional IPO process usually includes a company raising additional capital from institutional investors the night before a stock’s new ticker starts trading on an exchange.
Typically, a consortium of investment banks (underwriters) will run a process called “book building,” where they reach out to their institutional clients to assemble orders at different prices that institutional investors are willing to pay for the IPO. The price where the underwriters consider demand adequately covers the issuers’ supply is known as the offer price. That is the price that all investors are allocated stock in the IPO. Sometimes with popular IPOs, investors will receive a fraction of their original order.
Chart 2: The typical IPO process
The next day, the listing exchange will open the stock for trading, and the shares can be purchased by the general public. The first opening auction runs like all other exchange auctions, although usually later in the day, reaching a price where demand and supply are equal. That auction forms the stock’s first opening price.
How efficient are IPO markets at pricing deals?
If demand remains strong for the IPO, the opening trading price should be higher than the offer price. But that’s not always the case.
An average gain of 18.4% on day-one makes IPO investing sound like a pretty attractive investment strategy. However, 31% of IPOs actually fall on their first day of trading compared to their offer price. Additionally, nearly 50% of IPOs fall on their second day of trading (versus their day 1 close).
In addition, data below shows popular IPOs are more likely to outperform. But because of their popularity, investors are also more likely to be under allocated (filled on only part of their order) on those deals.
That all highlights some of the additional risk in accurately valuing an IPO. With no public prices and no trading history, a larger risk premium also needs to be factored in.
Chart 3: Around 31% of IPOs fall on the first day
But what if we could trade with perfect hindsight? Are there factors that contribute to IPOs’ first-day returns?
A small float might help squeeze any demand
As we noted above, usually an IPO is completed for an increment of the company’s total shares. The percentage of a company’s total shares outstanding that are available for the public to trade is also known as ‘float.’
In the 1980s, the average float size of IPOs was around 30% (purple line in Chart 4, inverted). However, we can see that more recently average float size has declined to around 20% in 2020.
The green line shows the trends in IPO pops over the same time, by inverting the float axis as we have, it appears that a smaller float may, on average, boost the IPO pop. However, the relationship is far from perfectly correlated.
Chart 4: Inverse relationship between IPO float size and IPO pop
Popular, big deals appreciate the most
Before the final IPO price is set, the underwriter will estimate a range of where the IPO may be priced. However, if the deal turns out to be more popular than expected, the actual offer price may be higher than the filing range.
Using our own data from 2010 through 2020, we looked at the offer price relative to the filing range and what happens on day-one trading (the IPO pop). We see that not only are IPO pops higher for those that price above the high end of the filing range, but larger companies also tend to have even larger pops.
From an economic perspective, it makes total sense. A deal with more demand will strike a higher price, and that might also translate to strong day-one demand.
However, you would also expect that markets would be more efficient than that. Underwriters should have a fair idea that a deal will be popular and set the range accordingly. Even then, once the book builders know initial demand exceeds supply, you would expect the offer price might then reflect fair valuation. The data, however, highlight the complexity of estimating investor demand and their private valuations on a new stock.
Chart 5: Higher expected demand generally leads to larger pops
It’s better (but not imperative) to IPO into a rising market
According to data from Jay Ritter, the first-day returns are higher for IPOs when preceding market returns are higher. For example, when the market declined in the three weeks prior to an IPO, the average IPO popped 7.2% compared to 9.2% when the market increased over 2.5% in the three weeks prior.
Using our own data on IPOs from 2010 to 2020, we see the average IPO pops were larger if the market has rallied in the 3-weeks before the IPO than if it saw flat or negative returns.
Again, we also see these returns being stronger for larger company IPOs.
Chart 6: Larger companies have better trailing market returns
Earnings don’t matter as much
First-day returns for technology sector IPOs tend to be higher than non-tech IPOs. Ritter’s data shows that the average IPO pop from 1980 through 2020 was 31.2% for tech IPOs versus 11.1% for other sectors.
People often talk about the fact that many tech IPOs are yet to turn a profit. Interestingly, IPOs without earnings have experienced an average first-day return higher than for those with positive earnings.
However, that likely also reflects stronger growth prospects for upstart tech companies. Many of the largest companies in the U.S. today were once one of those tech companies that started with negative earnings.
Chart 7: Average IPO first-day returns
Even if we combine all these measures together, with perfect hindsight, we’re only able to explain around 20% of the total IPO pop. That highlights the risk of bidding into an IPO bookbuild. As the options market shows, even in efficient markets, risk has a price (and a required return) too.
What does this all mean?
Many view the IPO pop as a cost to issuers. It’s one of the attractions of SPACs and direct listings.
However, the IPO pop also highlights how much being public can reduce a company’s cost of capital. Public markets create increased transparency and liquidity that provides confidence as well as a broader investor base. IPOs put a value on how much that public listing provides.
Robert Jankiewicz, Research Specialist of Economic and Statistical Research at Nasdaq, contributed to this article.