Why Should IPOs Be Easy, Anyway?

Photographer: Jin Lee/Bloomberg

There are some very good reasons not to leave these doors unlocked.

Update, Sept. 12: Twitter Inc. filed to go public after markets closed today. Long expected, it’s the kind of official filing that a couple of years ago would have elicited a voluminous discussion of financial performance. Some of that will still happen, but not yet — because the details of Twitter’s filing are confidential, thanks to the JOBS Act.

Designed to foster more IPOs for “emerging growth” companies, the IPO provisions of the law have become a way for most companies that want to go public do so with less investor scrutiny. The new rules have cut the time that all that information is available to the public to three weeks before the roadshow.

Issuers naturally love this. They have the chance to address issues before investors start gnawing on them. Probably more important, shortening the time that investors have to chew over the details suits the rhythm of the investing news cycle. Instead of letting investors get bored with an IPO over a period of months, it lets companies build up excitement in a short period before the offering. That certainly makes IPOs easier to pull off. In this post, The Market Now addressed whether easier IPOs are good for investors. Spoiler: They’re not.

PS: Matt Levine at Bloomberg View doesn’t buy the argument that less time for investors to digest Twitter’s prospectus will be an issue for anyone. Says Levine, “You get a month to read the prospectus. That is enough, I promise you. It’s not gonna be that interesting.” True! That issuers love the new ‘confidential’ IPO rules, though is pretty clear: they’re certainly using them enough. Twenty-one days is plenty of time to analyze the financials. Is it enough time to get bored with the IPO? I’ll bet that Facebook would have been thrilled to compress the news cycle instead of having critics jawboning over its amendments and financial for an extra two months.

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Bloomberg’s Lee Spears and Noah Buhayar today report on the coming initial public offering of Third Point Reinsurance Ltd., a Bermuda insurance company backed by hedge fund manager Dan Loeb. Third Point Re.’s path to an IPO has been eased by the Jumpstart Our Business Startups — aka the JOBS Act. Spears and Buhayar point out that with just 17 employees, including 16 in Bermuda, Third Point Re isn’t exactly a major engine of U.S. job creation.

The IPO provisions of the JOBS act, sold as a way to stimulate the growth of U.S. companies, have effectively become an easier default path to the public markets. Spears and Buhayar raise an important questionabout job creation. There’s another question worth raising about the JOBS act IPOs: who in heaven’s name thought that it was a good idea to make IPOs easier in the first place?

The basic problem with IPOs isn’t that they are too hard. It’s that they are too easy. In general, newly public companies tend to underperform the market. And the earlier companies go public the worse they tend to fare. Take a look at the chart below, based on the invaluable data that University of Florida professor Jay Ritter has compiled on long-run IPO performance.

The chart shows the three year returns of initial public offerings from their first day close, based on the company’s sales in the year leading up to the IPO. Companies that went public between 1980 and 2011 with sales of under $10 million (adjusted to 2005 dollars) had a three year return a full 47.3 percent below the market. Companies with sales of $10 million to $20 million underperformed the market by 36.5 percent. And so on … until we finally reach the biggest IPOs, the only category to do better than the market.

What this chart doesn’t show is that it’s the companies with sales of under $50 million that had the biggest first day pops, 23.3 percent on average.  You can see Ritter’s full study on his website; it’s worth looking at for anyone interested in IPOs.  Essentially, the “emerging” companies favored by the JOBS Act wind up returning more for favored banking clients who get them on the first day, and doing badly for long term buy-and-hold investors

In addition to creating unexpected beneficiaries like Dan Loeb, the easier IPO terms of the JOBS Act lower a bar that was already low.  Many of the most successful technology IPOs — think Google — have been for companies that were earning money. By contrast, companies that couldn’t handle the (not-so-great) burdens of the old IPO rules most likely have no business going public.  There have always been plenty of startups eager to tap the public markets early in their development. That doesn’t mean investors or regulators are wise to let them.

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