IPOs Are Going Out of Style

Maybe it's because there's so much private financing available.

They don't make them like that anymore.

Photographer: Spencer Platt/Getty Images

A number of people who are watching the ebullient tech startup scene have raised a red flag over the dearth of initial public offerings in the sector. The Wall Street Journal reports

Technology companies’ share of U.S. initial public offerings has fallen to a seven-year low...Only 11% of U.S. IPOs so far in 2015 involved tech companies...Meanwhile, shares in many of the companies that have gone public aren’t performing well. 

The data send a strong signal that the broader markets aren’t eager to buy everything venture capitalists are selling[.]

The Journal's thesis -- that tech IPOs are low because of low demand -- has a slight problem. As the article points out, tech stocks that have gone public in the past couple of years have performed badly after their share sales. But when stocks perform poorly after an IPO, it means that the public bought at inflated prices. And if the public bought at inflated prices, it means that demand was very high, not low. Investors snapped up any tech IPO they could get their hands on, even if it meant paying a premium. 

So tech IPOs are declining not because the public is shunning them, but because tech companies are choosing to stay private. 

If you're a young, growing company and you want to expand, you need to raise lots of money. Traditionally, the public markets were the main place to get those boatloads of cash. But nowadays there are other options. For example, an increasing number of tech industry observers have noted the rise of what's called the private IPO or quasi-IPO phenomenon, in which tech companies raise more and more late-stage venture or other private capital instead of going public. In recent years, the total amount of money going to late-stage venture financing rounds of more than $40 million has completely eclipsed the amount of money being raised in IPOs. 

Some believe that this shift indicates a tech bubble in the private markets. Whether that is true is hard to know, although the phenomenon isn't restricted to tech. Throughout corporate America, more and more companies are choosing to stay private. 

In a recent working paper, economists Craig Doidge, G. Andrew Karolyi, and Rene M. Stulz find that the U.S. has had a steep decline in the number of publicly listed companies since the mid-1990s:

Every year between 1996 and 2012 saw a decrease in the number of exchange-listed firms. The total number fell from 8,000 to 4,100 over this period, while the rest of the world saw an increase from 30,700 to 39,400.

Because this phenomenon is specific to the U. S. it means that this is being caused either by federal policy, or by peculiar characteristics of U.S. financial markets. 

Many people point a finger at the 2002 Sarbanes-Oxley Act, which imposed heavy new obligations on public companies. Doidge et al. point out that the trend of declining IPOs predates SarbOx by about six years. So though the act may have exacerbated the trend, it probably isn't the only cause. 

Another factor is the decreasing dynamism of U.S. business. Since about 2000, the rate of new incorporations has been falling. As Doidge et al. document, a wave of mergers and acquisitions has also contributed to the reduction in the number of listed companies. But the reasons why dynamism has declined and mergers have risen remain unclear. 

A final factor might simply be the growth of the private-equity industry. In the old days, listing one's company on the public exchanges was really the only way of getting access to the mass of investors. But nowadays, most of investors' capital is managed by mutual funds and other institutional investors. These intermediaries can in turn become limited partners in private-equity and venture-capital funds. And the funds can then invest in a large diversified portfolio of nonlisted companies. 

So whereas in days past, a retail investor like me couldn't own stock in closely held Uber Technologies, I can now own it indirectly through a chain of middlemen. Companies can therefore avoid the increased transparency and regulatory burden involved in becoming publicly listed, yet still have some access to the nation's reserve of savings. 

Whatever the cause of the U.S. turn away from publicly listed companies, the important question is: Is this a bad thing? Many investors, such as venture capitalist Marc Andreessen, say that public markets force managers to think only in the short term, while private companies are able to think long-term. And there is some data to support that argument -- private companies tend to invest much more of their earnings than publicly listed companies. 

So it may be that public exchanges are an idea that has failed the market test, and that U.S. companies and the U.S. economy will benefit from the shift to private financing. Alternatively, it's possible that the relative opacity and illiquidity of private markets will cause more harm than the short-termism of public markets. Either way, economists should be paying a lot more attention to this tectonic shift in the U.S. model of capitalism.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Noah Smith at nsmith150@bloomberg.net

    To contact the editor responsible for this story:
    James Greiff at jgreiff@bloomberg.net

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