Wall Street’s Pullback Shows Hot IPOs’ Inherent Risks

At what point is the word “overheated” an understatement?

Thursday’s steep U.S. stock market selloff — with major indexes down as much 5 percent despite no obvious catalyst in sight — serves as a reminder that sentiment rules investors’ mindsets, perhaps more so than fundamentals. And for one subset of publicly traded firms — recent initial public offerings (IPOs) — volatility might loom especially large.

True, the Renaissance Capital IPO ETF — comprised of some 60 of the past two years’ largest IPOs — is up some 60 percent year to date, CNBC reported. And this year’s parade of IPOs is in the triple digits, with some 111 companies going public to date and raising just under $38 billion.

That doesn’t even include special purpose acquisition companies, or SPACs — companies that raise cash first and use it later to buy up privately held firms. SPACs have raised more than $33 billion so far in 2020 through 84 IPOs, compared to just 59 SPAC IPOs that took in $13.6 billion for 2019 as a whole, according to SPAC Research.

Renaissance Capital Co-Founder Kathleen Smith told CNBC that 70 percent of Wall Street’s recent IPOs are currently trading above their IPO price. That beats the historic average of about 50 percent.

Tech IPOs get the big nod here, with platform companies holding sway and generating outsized post-IPO returns. For example, shares of online car buying firm Vroom might have fallen some 12 percent Thursday (Sept. 3), but they’re still up about 200 percent since the company went public.

And you no doubt know Zoom Video Communications, used almost ubiquitously for face-to-face video meetings these days. It’s up some 75 percent since the company’s IPO even after factoring in Thursday’s 10 percent pullback.

The adage “buy what you know” is perhaps at work here. Investors know that software is increasingly important to corporate and individual consumers alike.

That’s a mindset that might be underpinning Airbnb’s reported decision to turn down billionaire investor William Ackman’s bid for a merger with his SPAC. By pursuing a traditional IPO instead, Airbnb is effectively betting that existing early investors will be rewarded before their options expire, and that there’s still money to be made by going public the traditional way.

Like many other high-growth companies working their way through the pandemic, profits have been elusive for Airbnb. And beyond just Airbnb, when any unprofitable company stages an IPO, investors who buy shares are betting that revenue growth and profits will eventually come.

Consider Palantir Technologies, which plans to soon stage an eagerly anticipated IPO. Palantir had 25 percent revenue growth in 2019, but the data analysis firm hasn’t been profitable for roughly 20 years, according to Fortune. The magazine said Palantir lost $580 million on $743 million in revenue last year.

And investor sentiment for even profitable techs can turn quickly. After all, the tech-heavy Nasdaq Composite Index fell 5 percent Thursday to 11,458.1.

Therein lies IPOs’ catch-22. Moving swiftly to get to market and strike while the iron is hot can have the paradoxical impact of making investors skittish about “froth” in the markets.

We’re only a few days into September after an August that saw more than 40 U.S. IPOs (per CNN). Yet trading has been rocky so far this month.

But for at least some IPO firms with little or no operating black ink, buyers are betting that questions about value fall by the wayside. Instead, investors are hoping someone will be willing to buy their shares in the relatively near term at a higher price than they themselves paid. But as Thursday’s big market pullback shows, that might be a dicey proposition.