Eye On The Market podcast

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Michael Cembalest

Okay. Good morning, everybody. This is Michael Cembalest with the Eye on

the Market podcast, which is now both in audio and video versions. So

thanks for listening. Every couple of years I write a deep dive paper on

private equity and venture capital from the perspective of limited

partner investors in those investment vehicles. And I decided to switch

it up this year instead and write about the IPO market, which are the

companies that all of those financial sponsors bring public.

00;00;31;20 - 00;01;00;39

Michael Cembalest

And I decided to do it now because enough time has passed for us to

assess the impact of the crop of 2020 and 2021 IPOs on the investment

universe. And it's not pretty, but it's not as bad as you might think. So

that's what this IPO paper is all about. It's called Mr. Toad's Wild Ride

and is drawn from a Disney RKO short film from “The Wind in the Willows”

in 1949.

00;01;00;41 - 00;01;22;57

Michael Cembalest

So with that, let's get started. And obviously you can look in the Eye on

the Market for all the details. I just wanted to hit some of the

highlights on this podcast. So for many years, here's the irony. There

was a lot of hand-wringing in the industry and by academics that there

was a slowdown in the pace of new listings and IPOs.

00;01;23;14 - 00;01;44;23

Michael Cembalest

And my answer is be careful what you wish for. You just might get it.

Because we had an explosion of IPO activity in 2020 and 2021, both of

which have now collapsed in large part because of the poor performance of

some of those recent vintages. And that's what we discussed and analyzed

in this paper.

00;01;45;06 - 00;02;13;31

Michael Cembalest

So the thing to remember about IPOs is they're a very skewed asset class.

Here we're looking at net returns of IPOs over two years. And net means

net of an equity market benchmark. Right. You always have to analyze IPOs

relative to something. What's your opportunity cost? And here we're using

the Small Cap Growth Index as a benchmark because there's lots of tech

and biotech and healthcare that dominate IPO issuance.

00;02;13;31 - 00;02;36;18

Michael Cembalest

And so that's why we're using a Small Cap benchmark. And here you can see

the skew. The vast majority of these lose money over a two-year basis

relative to the benchmark. But then you've got this tail of mega-winners,

which offsets that. And the value proposition for long-term investors in

IPOs has always been, do the handful of winners offset the bulk of the

losers?

00;02;36;32 - 00;03;04;12

Michael Cembalest

And until 2020, the answer to that question was generally yes. But then

this recent crop of IPOs really kind of damage that story because there

were so much of them. So let's take a closer look. And here, look what I

mean by the skew in the market. If we take away just the top 3%, best 3%

performing IPOs, look what happens to your average absolute return and

your average net return.

00;03;04;56 - 00;03;30;55

Michael Cembalest

They get hit pretty hard. And so that's an example of a very skewed

market. So here is another way of looking at things. This is the share of

all IPOs that either have negative absolute or net returns two years

later. Obviously, relative to that benchmark, we're talking about, even

in good times, somewhere between 30% to 50% or a little more of these

IPOs generate negative returns.

00;03;31;18 - 00;03;59;10

Michael Cembalest

Look what happened in 2020 and 2021. We had a surge in the number of

underperforming IPOs. So, this was unfortunately the confluence of

monetary stimulus, fiscal stimulus, lots of risk appetite, and a lot of

companies that were brought public that probably shouldn't have been. And

here, this is another way that we track how the IPO market is doing.

00;03;59;41 - 00;04;25;28

Michael Cembalest

The orange line is the average return, and the blue line is the median

return. Any skewed universe is always going to have a much higher average

than median return. Activist investing is another great example of that.

And from 2010 to 2019, even though the median deal that you might have

invested in didn't make any money, on average you did because of those

handful of winners.

00;04;25;51 - 00;04;53;49

Michael Cembalest

So on a two-year basis, the value proposition of IPO investing for the

decade of the 2010s was a positive experience. And then look what

happened from those 2020 and 2021 IPOs. They really kind of decimated the

history of this thing. To understand the impact on an IPO investor, we

can't simply compound these annual returns because in 2020 and 2021,

there were so many more IPOs that got issued.

00;04;54;18 - 00;05;19;34

Michael Cembalest

So we use a simplified portfolio framework to say, well, what if somebody

put $100 into every IPO, held it for two years before selling and then

measured their performance versus that Small Cap Growth Index? Here you

can see that you would have made money for the vast majority of that

2010s decade. And then you would have given a bunch of it back in 2021

and 2020.

00;05;19;54 - 00;05;45;40

Michael Cembalest

And specifically, if you invested in all sectors, you would have given

back all of your gains from 2019, which are substantial, but you would

have still retained those gains from the prior decade. And so, let's dig

into this because there's a big difference between tech and healthcare

and specifically biotech. If we look at technology, this is really the

brightest spot of the entire IPO market.

00;05;46;04 - 00;06;14;02

Michael Cembalest

And even with the 20, look at this chart, even with the 2021 and 2020

vintages, you only gave back a half a year versus your accumulated gains.

And so, in other words, yeah, the crop of 2020 and 2021 IPOs and the

technology sector had their issues, but they only mildly dented the

historical returns a long-term IPO investor would have had. Looks very

different in the healthcare sector.

00;06;14;11 - 00;06;42;34

Michael Cembalest

The chart on healthcare shows you gave back not just half a year, but two

years of accumulated gains. And biotech and pharma is an interesting

place as it relates to the IPO market. The premise is to give investors a

chance to recognize the value creation associated with the proof of

concept on the drug. So that would be phase three trials.

00;06;42;52 - 00;07;20;11

Michael Cembalest

FDA adoption, entitlement program coverage and things like that. But

since you're exposing investors to those positive events, whenever they

don't happen, you can lose a lot of money. And that's part of what

happens in the IPO market. And the longer you hold some of these IPOs in

the healthcare sector, the worse they actually do. So the table that

we're showing here that obviously you can look at in the Eye on the

Market as we increase our holding period from one year to two years to

three years, the technology sector returns go up, whereas the healthcare

returns actually go down.

00;07;20;56 - 00;07;41;56

Michael Cembalest

The first table that we have shows the average returns. When you can

really see this, is the median returns. And so when we look at the median

returns, they really get hammered in the healthcare sector, whether we're

looking at healthcare services or pharma and biotech as we go from one to

two to three years.

00;07;42;27 - 00;08;02;32

Michael Cembalest

So as I said, what is happening between years one, two and three in the

healthcare sector to make these IPOs underperform so much? And what we

did was we looked at all of the hundreds of healthcare IPOs over the last

13, 14 years and between years one and two, an enormous number of them

crash and burn.

00;08;03;04 - 00;08;27;44

Michael Cembalest

So we have a chart in here that looks at them by decile, right? So we

take all these pharma biotech IPOs and we decile them. Even the 70th

percentile biotech IPO didn't make any money. It was flat. Right. So you

actually go to the 80th percentile of IPO performance to make money. The

rest of them were either flat or lost a lot of money.

00;08;28;02 - 00;08;53;27

Michael Cembalest

And so, again, there's a lot of drug development failures that take

place. And you're really participating in this for the handful of

winners. In contrast to all of this analysis, we also looked in this

study at IPO flipping, right. So IPO flipping is a casual way of saying

that people buy IPOs and sell them within a few days, and a few days

either meaning literally the end of the first day close or within seven

days.

00;08;54;07 - 00;09;16;59

Michael Cembalest

And this is kind of a remarkable investment Opportunity said, I haven't

seen too many things that look like this in terms of just how stacked in

favor of the investor is. So this chart, we have a bunch of different

charts in the paper on IPO flipping, but this one shows the distribution

of returns. Overwhelmingly, 80% of the time, IPO flipping has worked.

00;09;17;22 - 00;09;39;40

Michael Cembalest

Now, when it doesn't work, you can still lose a serious amount of money.

But when you look at the weighted average outcomes from IPO flipping,

they're extremely beneficial to investors. And not only that, even with

the bad crop of 2020 and 2021 IPOs, they didn't really do a lot of damage

to the history of IPO flipping. So it's been a very successful category.

00;09;41;21 - 00;10;09;53

Michael Cembalest

I do want to spend a couple of minutes on the SPACs because more than the

metaverse and more than unprofitable hydrogen and EV companies and crypto

and things like that, SPACs are probably the best example of too much

policy, too much risk appetite, and people completely losing sight of all

their underwriting bearings. And I wrote about SPACs during the peak of

the boom in early 2021.

00;10;10;29 - 00;10;34;58

Michael Cembalest

It was a piece called Hydraulic Spacking that was very critical of the

adverse selection of companies that were coming public. And everything

that's happened in the SPAC market since then has been borne out by that

initial fear I had about what was going on. We have a chart in here that

shows that SPACs grew to be the same size as the entire IPO market in

2020 and 2021, which is ridiculous, since it barely existed before that.

00;10;35;29 - 00;11;03;21

Michael Cembalest

And if we take a look at the average returns on SPACs relative to the

market, they've lost almost 60% versus the stock market. I mean, I've

rarely seen anything as bad as this. And so I anticipate that there's

going to be a permanent demise of this particular financing approach, say

for a handful of these things every year.

00;11;04;08 - 00;11;32;11

Michael Cembalest

So that is a very quick overview of some of the more important and

interesting parts of this IPO analysis. We also looked at the consumer

sector, the diversified sector. We looked at mainland China, we looked at

renewable energy IPOs, which has been have been a very difficult place to

invest. We've looked at size effects and we also looked at financial

sponsors because I wanted to see how the sponsors are doing themselves.

00;11;32;26 - 00;11;56;01

Michael Cembalest

Now, it's not the job of a financial sponsor to generate great returns

post-IPO, right? Financial sponsors job is to deliver high returns to the

limited partners in their vehicles. But as investors in IPOs and as

people who manage money in public equities, I was interested in whether

there were any consistent patterns of financial sponsors bringing good

deals to market or not.

00;11;56;46 - 00;12;16;01

Michael Cembalest

And so we get into that a little bit in the paper, and we do show a list

of the financial sponsors that have had the best track record of bringing

IPOs to market that maintained their value two years later. So anyway,

thank you very much for watching and listening. The Eye on the Market is

available to look at today.

00;12;16;37 - 00;12;27;31

Michael Cembalest

In early September, we'll revisit the business cycle and whether or not

this recent immaculate disinflation is sustainable. But until then, thank

you very much for listening, and we'll see you next time.