One of the fascinating developments during the COVID-19 pandemic was Wall Street’s short-lived obsession with IPOs and SPACs. What are they, why did they become so popular, and why did they drop off so quickly?
What is an Initial Public Offering (IPO)?
An IPO is when a private company first sells shares of stock to the public. Selling stock to the public means the company is transitioning from private ownership to public ownership. The IPO process is often referred to as “going public.”
What is a Special Purpose Acquisition Company (SPAC)?
A SPAC is a company without commercial operations, formed to raise capital through an IPO and then acquire another existing company. SPACs target private companies to acquire, and the acquisition serves as another means to take that private company public. From the perspective of the private company being acquired, a SPAC can be attractive because it generally only takes a few months to complete and go public. In contrast, the conventional IPO process can take anywhere from 6 months to more than a year.
SPACs are often called “blank check companies” because they provide investors little information before investing. When it raises capital, the SPAC may not yet have a company targeted that it wants to acquire. So the investor is making a speculative bet that the SPAC will acquire a good company to take public.
Why were IPOs and SPACs so popular in 2020-2021?
2021 was a record-setting year for companies going public. More than 900 companies went public via IPO or SPAC in 2021, raising around $300 billion combined. In 2020, IPOs and SPACs raised over $160 billion combined. Both numbers topped the previous record for IPOs, which came at the height of the dot-com bubble in 1999 with $108 billion raised.
SPACs, in particular, have been an interesting development in the past couple of years. Before 2020, SPACs made up a very small portion of newly-public companies. Then they surged to become just as popular as traditional IPOs in early 2021.
Why was the 2020-2021 environment so appealing for these companies to go public? Essentially their valuations were trending higher than ever, so the owners and founders of these companies took advantage of the opportunity to strike while the iron was hot. In addition, interest rates were still hovering near zero, which makes smaller companies more attractive since they can cheaply finance new projects that help them grow. There was also increased demand from individual investors stuck at home via pandemic lockdown restrictions. Likewise, these investors had a sudden surplus of investable cash due to government stimulus and limited spending on entertainment and travel.
Although 2021 was a record-breaking year for raising cash, the initial performance of those now-public companies paints a gloomier picture. High growth stocks experienced a broad selloff toward the end of 2021 that has continued through the first three quarters of 2022, and recent IPOs have not been excluded from the carnage.
Two-thirds of the companies that went public in the U.S. in 2021 were trading below their IPO prices by the end of 2021. Moreover, through the first three quarters of 2022, nearly 90% of companies that went public in 2021 are trading below their initial offering prices, close to -50% on average.
In the final months of 2021, it became evident that inflation was a significant problem faced by the U.S. as we began to emerge from the pandemic. As a result, the Federal Reserve would have to tighten monetary policy to fight inflation. In the eyes of investors, that essentially means “the party’s over” for the high-flying IPOs and speculative growth investments that had performed so well over the past 1 to 2 years.
Diminished Investor Appetite
Investors tend to view IPO investments as “getting in early” on a newly-public company and expect those investments to perform well. When monetary policy is loose and the broad stock market rips upwards with seemingly endless gains, IPOs tend to do well. However, when broad market sentiment turns sour, and a batch of recent IPOs start performing as badly as we’ve seen over the past year, the appetite for risky high-growth investments diminishes quickly.
We’ve seen this play out in 2022, as the IPO pipeline has frozen. Through the end of August, traditional IPOs were on pace to raise less than $10 billion for the year. With the Federal Reserve signaling that they’ll continue tightening financial conditions until inflation is under control, the near future is not very appealing for IPO valuations. However, lower valuations could create more attractive entry points for investors when IPO activity kicks up again in the future.
The recent choppy performance of IPOs is a good example of how quickly high-risk investments can decline in a broad market pullback. Did you get burned by owning too many speculative growth investments? Talk to your advisor to ensure you are taking the appropriate risk.
Anthony Harcourt,CIMA, is a Portfolio Manager at Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.BedelFinancial.com or email Anthony at email@example.com.