OPINION | The performance of Australian initial public offerings over recent years has been telling. On average, there has been money to be made in the initial trade but this effect has faded after six months, with the average domestic IPO underperforming the market by about 7 per cent after two years.
Investors would be right to question what’s causing the IPO fade. While it is dangerous to generalise, we have observed a noticeable reduction in quality and an increase in price multiples commanded among the most recent crop of floats.
Financial sponsors have been the driving force behind just under half of Australian IPOs over the last two years. This incentive to optimise pricing may also be having a negative influence on after-market performance. Increasingly, vendors are retaining shareholdings at IPO, providing comfort to new investors but also creating an overhang with the prospect of secondary-market sales.
Vendors extracting higher multiples may help explain the short-term fade. Not that long ago, companies seeking an IPO were frequently priced at a discount to their listed peers, recognising the risk attached to investing in companies with limited visible track records. If those businesses delivered as expected, they typically outperformed for the first 12 months, trading nearer a public market multiple, at least until delivering a maiden profit result. Often as those companies approach their second result, the challenge to sustain year-one growth assumptions becomes apparent, gravity kicks in and the initial outperformance fades.
While there are clear exceptions, the trend outlined above highlights an important shift among the more recent IPO cohort. Companies have increasingly listed at public-market multiples, leaving no margin of safety, providing no discount to reflect IPO risk and offering little room to grow into a public-market multiple.
Whether the mispricing of IPO risk reflects the scarcity of businesses exhibiting growth, the absence of value or merely the trappings of a bull market remains unclear. But with 31 per cent of IPOs in the last two years missing prospectus forecasts and 43 per cent missing year-two consensus forecasts, the recent crop of IPOs has been a clear disappointment. What is harder to explain is the fade coming sooner than the earnings miss, implying investors are perhaps doing a better job identifying the likely miss.
Regardless, the early performance fade and poor medium-term performance of recent Australian IPOs is having a clear impact. Investors are growing increasingly cautious and demanding an appropriate discount to reflect the risks of investing in companies with short or opaque track records.
On the other side, vendor expectations have yet to be reset. A high proportion of assets coming into the market are struggling to accept a new pricing reality; often these are private equity-backed businesses and/or companies acquired at high multiples.
With institutional investors growing more cautious and stubbornly high vendor expectations, the pipeline has dried up and few companies are now seeking to stage an IPO. It’s telling that there have been only two successful IPOs in 2017 with more than a $50 million market capitalisation (almost halfway through the year). Compared with the peak of 41 IPOs in 2014 and the 19 seen in 2016, the contrast is stark.
Like many investors, we take a cautious approach to investing in IPOs, given the narrow decision timeframes (restricting our ability to undertake detailed due diligence), short operating track records and, frequently, forecasts that imply an unsustainable future growth trajectory.
We expect the appetite for retail IPOs in particular to remain weak, as recent data suggests consumer spending remains tepid and there is near-hysteria about the imminent arrival of Amazon. However, with many investors holding high cash balances, we believe there is still robust demand for appropriately priced IPOs.
Investors would be wise to keep past success stories front of mind. Successful IPOs in recent years – including many private equity-backed companies – have typically shared a few common traits: experienced management with strong alignment through ownership, realistic and demonstrable organic growth, and strong cash flows. We’ve also seen examples of businesses that are unfamiliar to the market, favouring investors with intensive research processes that are more likely to find price inefficiencies – and, of course, that IPO discount.
Katie Hudson is an executive director and head of Australian equities research at Yarra Capital Management.