The Pipeline: M&A and IPO Insights | Season 4 | Ep. 4 - The Challenges the SEC and High-Profile Companies Face With the IPO Market

View Full Transcript

Joe Mantone   

Welcome to another episode of The Pipeline an S&P Global Market Intelligence podcast that dives deep into the world of M&A and IPOs. I'm your host Joe Mantone and today I will speak with Jay Ritter who is the director of the IPO Initiative at University of Florida's Department of Finance. Jay has spent decades researching IPOs and he is a go- to source for anyone who is interested in learning about the topic. Jay thank you for joining us.

Jay Ritter

Pleased to be here.

Joe Mantone

So Jay I want to chat about your work with the IPO initiative. I also want to get into some of your thoughts on the SEC's efforts to increase IPOs and I want to hear your take on some of the high profile IPOs SpaceX and OpenAI that we're expected to see later this year. To get us started can you explain a little bit about the IPO initiative what it is and how it came about?

Jay Ritter

A few years ago I retired from teaching. I'm professor emeritus and my dean and I decided rather than having a title of just professor emeritus since I was still working part-time dealing with IPOs  maintaining my website and talking with journalists that I needed a title And we were around for a title and came up with director of the IPO initiative.

Joe Mantone
And your website I know it includes a host of data about IPOs and it goes back some time right?

Jay Ritter
Yes for most tables I started in 1980. Some of the tables started out as tables from academic articles most academics they publish something and then forget about it. After publishing them I decided well you know each year I can keep updating it. But then a lot of the tables came about in response to questions from journalists and policy makers and venture capitalists about you know what about tech stocks? How have their IPOs done relative to companies in other industries? What about profitable companies and you know six years ago when the SPAC boom started I added some things on on SPACs.

 

Joe Mantone

It's great you make those updates and the data is open to anybody right? yes. Have there been any groups who have used your data that sort of surprised you made you say "Wow I didn't realize this was going to be relevant to this type of user?" 

Jay Ritter

Not really. I get the combination of students around the world asking questions journalists policy makers SEC people et cetera. Actually next week I've got a call scheduled with  French government officials about what they can do to get more IPOs in France.  You know venture capitalists and others use it for benchmarking.

Joe Mantone

France that's interesting. Would you say that your database is sort of a keeper of records or do you advocate for any particular policy stance?

Jay Ritter
Well I I've got opinions on various policies but mainly I want to be able to provide facts so that people can make evidence-based decisions. Some of the segmentations that are there. For instance, I separate penny stocks indeed in in almost all of the tables I out penny stock IPOs.  Most of them only raise $6 million or so.  They generally have no institutional following. Since a lot of the numbers are equally weighted averages of returns or profitability that that including apples and oranges might give a distorted view of what the apple market is like.  The bigger IPOs that institutional investors in invest in are quite different from the penny stock IPOs that are pedaled to unsophisticated retail investors.

Joe Mantone

Right. Okay. So you try to strive to make the data clean and keep up the integrity. And then in your conversations with regulators is that where you might express an opinion or a thought on a certain topic?

Jay Ritter

 Yes for penny stock IPOs which in the eighties and nineties were fairly common. In 1990 the Penny Stock Reform Act what was passed that put in certain requirements but it actually NASDAQ's listing requirements had been altered that had largely cleaned up the penny stock IPO market.  Before the SEC Belatedly acted.  And then from 2000 until about three years ago there were only a couple of penny stock IPOs per year on average. But then the last two years there had been a huge surge in them.  Many of them little companies from China and Hong Kong.  And but most of them have plummeted it in price. and because there were a lot of them in the last couple of years it then became a policy issue. And in September NASDAQ proposed changing their listing requirements to which has since been implemented to now require a minimum of $15 million of proceeds and 25 million for companies from China and Hong Kong.  That this has almost completely eliminated the penny stock IPOs this year.

Joe Mantone

So were you influential in that change?

Jay Ritter
Probably not. I provided evidence on my website about just how poorly.  The long run returns have been I actually had contacted some officials about the problems with these penny stock IPOs but I'm sure that it was on their radar screen even before I explicitly said you got to do something about these.

Joe Mantone

Gotcha. Understood. Okay. And then here in the US the SEC has made some efforts for years including the current SEC chair Paul Atkins on trying to entice more companies to go public. What are your thoughts on these efforts?

Jay Ritter

I think some of the efforts are desirable. The 2012 Jobs Act had a number of provisions in them.  Some of the provisions were aimed at trying to make it easier to go public. But the Jobs Act also had some provisions that made it easier for crowdfunding. Easier for some aspects of private markets and on net the improvements in private markets largely offset the improvements in public markets that were set up in the Jobs act.  I actually testified before the Senate subcommittee that that was working on the Jobs Act and I said that a lot of the provisions.  I didn't think we're got to have much effect on IPO activity and with the benefit of 14 years of evidence I have not changed my opinion along those lines. But there would probably be fewer IPOs if some of the provisions hadn't been implemented in particular. Testing the waters that allow that are in the process of going public to discuss with institutional investors about willingness to pay. Even before the roadshow starts it was a good idea.  The confidential filings have been very popular with companies the ability to file with the SEC . And not disclose information to competitors or the public until shortly before an IPO if the company decides to go ahead has been very popular.  These provisions were originally restricted to so-called emergent growth companies. Where the main feature is less than a billion dollars of annual revenue but has since been extended to all companies these have been popular and encouraged some companies to go public. But overall I think a lot of these regulatory changes. While desirable have had fairly minimal effects on IPO activity because the main issues for a given company deciding to go public or not have been determined by  some other bigger picture issues outside of the control of regulators.

 

Joe Mantone

Chairman Atkins has argued that the SEC has lost its focus on economic materiality being its guiding light. In your data do you see any correlation between the increase in disclosure requirements and the decline in public listings? 

Jay Ritter

It's hard to really get to cause and effect there be because a lot of these changes have been gradual. for instance in 1980 when Apple Computer as it was called then went public.  The prospectus was 47 pages long. There was no risk factor section.  Now it's very common for a major company going public to have a prospectus well over 200 pages in length with a 50 page risk factor section of which 45 pages are things like. Interest rates might go up oil prices might go up the sky might fall. Stuff has nothing specific to do with that company makes it harder for investors to read the prospectus and zero in on what's important about this company without spending hours looking at irrelevant stuff. Now it's not at all clear that the SEC is requiring these really long risk factor sections. A lot of it's just kind of lawyer proofing it to deal  with potential lawsuits from plaintiff attorneys who are got to argue if the stock price goes down. Well one of the reasons your stock price went down is because oil prices went up and you didn't disclose to investors that oil prices might go up. So what tends to happen is with each additional IPO all of the risk factors that that were contained in other prospectuses are included plus a new one that might be specific to this company. And so the risk factor section just keeps getting longer and longer. Not because of SEC requirements but just because companies and their attorneys say look the cost of adding this isn't all that high. We can cut and paste from a previous prospectus and might help us in in a future lawsuit by being able to say yeah. We warned you about the fact that oil prices might go up.

 

Joe Mantone

Litigation concerns are something that Chairman Atkins cites as a reason for companies not going public. He has backed the idea of mandatory arbitration which would require parties to resolve disputes through a private arbitrator rather than go through the court system. Mandatory arbitration almost always favors companies rather than investors. If this became the norm for IPOs what would happen to valuations? I know there's concern out there that it could lower valuations because investors would have less recourse. What are your thoughts on the topic?

Jay Ritter

First of all the SEC proposal is to permit companies if the company wants to have arbitration as an alternative to class action lawsuits. And as you just pointed out it's not at all clear that companies going public will implement this option if there's potential fraud. And investors are about the possibility of potential fraud making it easier to collect to deter that fraud might make investors more willing to invest and pay a higher price.  On the other hand that there is a concern a valid concern about excessive lawsuits. Just having the plaintiff lawyers try to reach a settlement where the lawyer's pocket.  Some money with without investors benefiting. And where does that money come from? Well it comes from the company pockets either directly or through directors and officers and insurance.  Which would lower the value of shares to the degree that potential investors are thinking well one of the costs as a public company is the insurance costs or lawsuit costs for nuisance lawsuits. Or even if there is valid reason where the company engaged in fraud.  Where does that money come from? It does it come out of one pocket to go into the other pocket with lawyers taking something out in between. You know that that's not enhancing company value. And to the degree that the executives who are perpetrating a fraud aren't being penalized directly it's not clear how much of the deterrence effect works. If it's innocent shareholders that are in the end paying for these lawsuits the executives only to the degree that their shareholders are paying.  Maybe it's more appropriate for the executives to pay directly. On the other hand, you don't want things to be too punitive.  In that it deters people from becoming executives or you know for that matter directors of a company if they didn't have d and o insurance.

Joe Mantone

Right. Yeah. So a lot to think about there. If you were advising Chairman Atkins what would you suggest as a way to sort of help increase the number of public companies?

Jay Ritter

There's no magic bullet life is full of trade-offs. You know the US has well-functioning capital markets not perfectly functioning capital markets that are the envy of the world. Not only well functioning capital markets but in particular the creation of valuable profitable tech companies is the envy of the world. But US doesn't get things perfectly. And designing the right rules for shareholder protection for that matter for bankruptcy situations involves various trade-offs where  it's hard to get the details right. And also the right mechanisms can change over time. For instance as technology changes what may have been optimal in 1933 and 1934 when the US Securities and Exchange Commission started might not be optimal now and some of the requirements some of the regulations that have been there in the past should probably be changed over time. If for instance one of the issues that that has been discussed is quarterly reporting the US did not always have quarterly reporting by publicly traded companies.  Before the 1950s quarterly reporting even semi-annual reporting. It was not mandatory. Then in the 1950s semi-annual every six months became mandatory.  And then it was only in the 1970s that quarterly reporting became mandatory in some other countries around the world quarterly reporting is not mandatory.  It might be the case that for some companies quarterly reporting is desirable for other companies maybe not so much the case and having one size fits all regulation might not be the best way to do it.

Joe Mantone

So you would be an advocate for giving companies the option to report quarterly or not?

Jay Ritter

Possibly. My suspicion is for most large companies even if they had the option of not doing quarterly reporting they would continue to do quarterly reporting. Investors might be willing to apply a discount to companies that worked reporting as frequently.  For that matter companies can and do put out eight Ks with material information in between quarterly earnings announcements. And companies should be putting out information about material events rather than waiting to quarterly reporting or annual reporting.

Joe Mantone

Yes I think we saw that with the Jobs Act right? The Jobs Act gave some companies the option to opt out of some requirements for Sarbanes-Oxley I believe it was but many of those companies were doing it anyway.

Jay Ritter

Yeah. And the SCC has also made distinctions between large reporting companies and in smaller.  Companies and these have been in regulations various regulations for many decades. For instance with the shelf registrations for many years that they were limited to companies only above a certain market cap. of these regulations have been changed over time. For instance with IPOs and emerging growth companies.  Some of the regulations that the lower requirements with emerging growth companies have been extended to all companies now and some of the things that are available to emerging growth companies where they didn't have to do certain things. A lot of companies have voluntarily done it anyway. With more companies staying private longer the SEC has talked about making it easier for a greater number of investors to get exposure to the private markets. Some of the ideas are having 401ks invest in private equity and also widening the definition of accredited investors. What are your thoughts on this? Would this only give companies more reason to stay private ? I think this would discourage companies from going by making it a little more attractive to remain private. In general I am not a fan of. allowing individuals to put retirement account money into private credit private equity  these opaque asset classes.  And  the main reason is the following. I don't think there's a free lunch sitting there that only wealthy individuals and institutional investors  are permitted to access.  In the United States capital markets work pretty well. If there's an asset class that's offering high risk adjusted returns money flows into that asset class. And until the risk adjusted returns come down to competitive levels and I think we've seen that with private equity and private credit and venture capital where so much money has flowed in that it's not at all clear to me that the limited partners are. Going to be earning expected returns any higher than they can get in publicly traded securities.  it's not as if there's a higher return sitting there that individual and investors are missing out on. For any five year period one year period 10 year period a given asset class might outperform or underperform. But on a point forward basis I see no reason to think that limited partners in venture capital funds or private equity funds are going to be getting higher risk adjusted returns than will be available in public markets.

Joe Mantone

Okay. Speaking of returns I wanted to ask you a bit about your research and some current market dynamics. Your research has shown that large cap IPOs often underperform the S&P 500 in the early years as a publicly traded company. There are a few potential high profile IPOs of large companies being discussed this year. SpaceX and OpenAI are two of them that have really high valuations on the private market. Will these companies face a more difficult task in trying to outperform the broader market if they do become publicly traded companies? 

Jay Ritter

There are several ways to slice the data. My research has found and there's a table on my IPO data website showing it that probably the best single predictor of long run performance  and my preferred measure is three years after the IPO. Is the revenue of the company before going public.  For companies that have inflation adjusted annual revenue of at least a hundred million dollars on average they jump on the first day. During the next three years for investors who bought in the market companies that have at least a hundred million dollars in sales that basically match the market neither underperforming substantially nor overperforming substantially.  On the other hand companies with few sales have not done well. I on average they have substantially underperformed especially those with less than $50 million in annual sales.  I think this is actually one of the reasons why. There have been fewer of these smaller companies going public.  Institutional investors have said look with all the venture capital money available why are you rushing to go public? It's hard for small companies to compete against the big boys. So you know to the degree that SpaceX Anthropic, OpenAI you know they they've already got tens of billions of dollars of sales that they're clearly in this a hundred million dollar in up category. If you use a billion dollars of revenue as the cutoff.  The billion dollar companies on average have done well also by matching the market. On the other hand companies with really high price to sales ratios. Have not done as well.  And that's where I've got concern about SpaceX OpenAI, Anthropic  SpaceX in including xAI and X used to be known as Twitter and Starlink  and their rocket launches. It has annual revenue right now about $30 billion if they go public at a 1.5 trillion valuation that's a price to sales ratio of 50.  And historically there haven't been all that many companies with revenue of at least a hundred million dollars and a price to sales ratio of over 40 that have gone public. On average they have then underperformed when you're going public at such a high valuation ratio. The company has to grow its revenue and grow profits whether it's profitable now or not to  justify that valuation. And basically everything has to go right. and it's just really hard for a company even a great company like SpaceX to have everything go right to grow into that valuation. at 1.5 trillion let's say the company eventually. Sells at a PE ratio of 20 that means $75 billion of annual after tax profits. very few companies have ever achieved that level. With SpaceX it could happen. in March PitchBook put out an analysis about how can we justify a 1.5 trillion valuation for SpaceX.  That their main assumption was that the number of users of starlink would grow from 20 million currently to 1.2 billion. Worldwide users that could happen. Areas around the world re relying on the internet access through satellites rather than fiber optic especially if you're in a low density population area. Rather than having somebody lay a long fiber optic line to your house just using a satellite makes total sense. And starlink has great technology and SpaceX lowers launch costs with Starship sometime in the next couple of years.  It's very possible that the launch costs per kilogram put into space are going to come down a lot. They'll be able to lower the the cost to users of starlink. It's quite possible that it's it is going to be an enormous market with very big gross margins. but. Stuff happens. The possibility that things don't work out according to plan is definitely there.  For all of the companies with significant revenue that have gone public with really high price to sales ratios there's always been a great story for why can potentially make really big future profits. And sometimes it happens. It happened with Zoom video communications when they went public in 2019.  They actually went public at a price to sales ratio of about 20. but then COVID hit that they they got lucky and demand  for their products took off. But all sorts of other companies that have gone public at really high price to sales ratios. Just haven't been able to execute  and that's the danger with open ai anthropic and SpaceX great companies but what's the right valuation?

Joe Mantone

So do you have any concern that if we see a lot of these companies go public at high valuations that we might be returning to the speculative deals that we saw during the. Com boom?

Jay Ritter
I think a big difference there is a lot of the companies that went public then were at a very early stage you know somewhere pre-revenue they to. Did not have a a product that had demonstrated success in the marketplace. You know Starlink has 20 million users paying users great product. SpaceX has very low cost rocket launches and they they've got great technology. and they're in businesses where there aren't got to be a lot of competitors.  Bringing down profit margins. It's not the restaurant business where if you're not making money now when are you going to and you know nobody makes enormous profit margins in the restaurant business.  But there are some verticals narrowly defined industries where there might be a network effect you know with Google who wants to use the eighth best search engine.  With Facebook if all your friends are using Facebook why do you want to use a social media platform that's got a tiny market share? There are some areas with network effects where it tends to be winner take all where it can be. profitable and a big addressable market. There are other industries where the technology is so complicated that the possibility of many new entrants coming in and successfully competing  and driving down profit margins. Is minimal for the Dutch company ASML for they're lithography machines. They are really complicated.  They don't have to worry about competition for building big commercial jet liners. Airbus and Boeing have a duopoly.  Other companies around the world  have tried to compete. it's just really complicated to get everything right. and with open AI anthropic SpaceX I think it's very likely that they're got to have very little in the way of competition potentially really big markets. They should be valued at high valuations, but the sky is not the limit.

Joe Mantone

So the concerns there are more along the lines of shareholder returns not meeting expectations as opposed to companies failing like they did during the dot com days?

Jay Ritter
 Right, with SpaceX if it goes public at a 1.5 trillion valuation. What if it grows to become one of the world's most valuable companies in the league with alphabet and Nvidia at over $4 trillion? Well that's only 200% upside potential.  When Nvidia went public in January of 1999 . After the first day of trading they had a market cap of $600 million. There was a lot of upside potential there. If they had gone public at a valuation of $600 billion the upside potential would've been a lot less.

Joe Mantone

Okay great. Well we'll see how it all plays out. I think this has been a really interesting discussion and Jay I appreciate all the time that you have taken with us today. So thank you very much for joining.

Jay Ritter

My pleasure. That'll do it for this episode of the Pipeline Podcast.

Joe Mantone

We thank Jay Ritter Director of the IPO Initiative and Professor Emeritus at the University of Florida for joining us. And we thank you for listening.