IPOs Make a (Slow) Comeback. Thanks, Ray
from
November/December 2003
by Shelley Neumeier
Ray McKewon, a founder, executive vice president, and board member of Accredited Home Lenders, took his sub-prime mortgage company public in February. It was only the third IPO of 2003, coming just a few days after a tiny $9 million offering by Bancshares of Florida and a larger deal ($198 million) by auto insurer Infinity Property and Casualty. Accredited was by no means a hot stock on its debut. At $8, it came out at the bottom of its range, a range that had already been lowered. It ended its first day below the offer price, always a bad sign. And it didn’t provide an immediate kick-start to the moribund IPO market: Only 10 new issues came out in the first half of the year—the worst six months since 1975, according to market strategist Richard Peterson of Thomson Financial, a provider of financial-industry data and technology.
So why should the market be thanking McKewon?
Because of the courage it took to go public when he did—kudos that Bancshares and Infinity can share, of course. Their stock has done okay, but not as well as Accredited’s. It reached a high of more than $25 in mid-June and was still about double the opening price in September. That kind of performance has emboldened other companies to follow McKewon’s lead.
“The leading indicator for the IPO market is the returns on recent IPOs,” says Kathleen Smith, an analyst at Renaissance Capital in Greenwich, Connecticut, which researches new issues and runs the IPO Plus Fund. The indicator points up: Of the 10 IPOs that debuted in the first half of this year, all are trading above their offering prices. The IPO Plus Fund was up 33% at the end of August, less than the NASDAQ index but well ahead of the S&P 500. “Once the IPOs that are done work, investors develop confidence, and it has a domino effect,” Smith says. “Others see that the water is safe.”
Indeed, after that barren first six months, eight companies went public in July alone, some with encouraging results. Digital Theater Systems Inc., which provides surround sound for movies, opened at $17 and immediately shot up to almost $25, the best first-day performance since 2001. Software maker InterVideo Inc. jumped 33% on its mid-July debut, after coming out above its price range. Nearly 50 other companies are in registration, including the Milwaukee media conglomerate Journal Communications and online retailer RedEnvelope Inc.
Still, we’re a long way from the eight-deal-a-week frenzy of 1999. Mark Loehr, CEO of SoundView Technology Group, a Connecticut investment bank that helped take InterVideo public, says the enthusiasm he’s seeing today is “maybe one-eighth” of what it was during the heyday. “The Internet bubble was a once-in-a-lifetime experience,” says Jay Ritter, an IPO expert and the Cordell Professor of Finance at the University of Florida. Even after the flurry of issues in July, Thomson Financial’s Richard Peterson says we could well be on track for the third straight year of fewer than 100 deals.
The companies that make it out the door will be different animals from those that thrived during the go-go era. They’ll come from a broad range of industries—finance, health care, media, retail, and even food, as well as technology. And they’ll be on sturdier financial footing. “The bar has been raised so high that the profile of the IPO stock coming to market is much more pristine than we’ve seen in the past,” says David Menlow, president of IPOfinancial.com, an information service. “These are companies with profits rather than perceptions.”
That means they will also be older. Over the past two decades, Jay Ritter says, the median age of a company going public has been seven years. In 1999 and 2000 it fell to just five. And then, in the past two years, it jumped to 14. “The market went from one extreme to another, from welcoming young companies to proclaiming them guilty till proven innocent,” says Ritter.
The unforgiving market and still-sluggish economy are making some IPO-watchers—especially those in the venture capital world—less than sanguine about the outlook for new issues. “The bulk of what VCs invest in is information technology, and we’re in a very dry spell for sales for those companies,” says John Taylor, head of research at the National Venture Capital Association. “Until they can get traction and prove themselves, I don’t see bright prospects for IPOs.” He says the wait until VC-backed companies start going public in significant numbers will be at least a “several-quarter proposition.”
Further damping the IPO market is the caution and fear that permeates boardrooms and investment banks. Call it the Sarbanes-Oxley effect, though in truth the rules contained in that massive corporate governance act are responsible for only part of the new prudence. Investor hostility generated by the implosions of Enron, WorldCom, and others contributes to the anxiety, as does the $1.4 billion settlement between 10 major Wall Street firms and New York State attorney general Eliot Spitzer. No company wants an investigation by the Securities and Exchange Commission. No one wants a visit from Spitzer. No one wants expensive shareholder lawsuits. Together, these factors are making it more difficult, costly, and time-consuming for companies to come to market.
Another problem is that the intricacies of Sarbanes-Oxley aren’t well understood, even by the regulators. “We were all trying to operate in the new Sarbanes-Oxley environment,” says Accredited’s Ray McKewon, whose company first filed to go public in July 2002 but didn’t get SEC approval until October of that year. “No one knew what the rules were. We had to go through the process with them.”
Then there’s the expense. “Sarbanes-Oxley unquestionably has imposed additional costs on being a public company,” says professor Jay Ritter. Start with the disclosure and certification requirements. The act requires a CEO to personally sign off on financial statements; before doing that, executives want to make sure the books are clean. This means that the internal control process must be rigorous. “Who can touch the money? Who signs off on travel and entertainment?” says Mark Loehr of SoundView, ticking off a host of questions that have come up for both the companies he helps take public and his own firm. “You probably have to hire an independent auditing firm to review everything.” That, he says, can cost between $25,000 and $75,000.
Putting together an acceptable board isn’t easy or cheap, either. Sarbanes-Oxley attempts to quell nepotism and conflicts of interest by mandating that a majority of board members be free from material ties to the company. Directors on the audit, compensation, and nominating committees must be totally independent. And someone has to be good with numbers: Sarbanes-Oxley recommends (but does not require) that at least one member of the audit committee be an expert in preparing or auditing financial statements.
McKewon says Accredited added two outside members to its five-person board before going public—active-duty U.S. Navy captain Gary Erickson and former Freddie Mac chairman Richard Pratt—and set up a nominating and board governance committee. Luckily, the board already had a highly numerate outside director to head the audit committee: Jody Gunderson, a CPA who helps purchase and manage loan portfolios for Cargill Financial Services.
Complying with all the new rules and recommendations puts pressure on board members, especially those on the audit committee. As Corporate Board Member reported in our last issue, directors on such high-profile committees may be looking for extra money, perhaps as much as 20% more than the job used to command. They’re also more likely to insist on sufficient directors’ and officers’ liability insurance, which is getting pricier as well. Marc McCabe, a senior vice president at Nasdaq Insurance Agency, which brokers insurance for fast-growing private companies as well as for those listing on NASDAQ, estimates that D&O premiums have increased anywhere from 40% to, in extreme cases, 400% in the past two years. A company that’s doing a $150 million offering and wants a $5 million policy can now expect to pay $300,000 to $400,000 a year for D&O insurance, he says.
Companies impatient to go public might do best to hold off for a while, since we’re in what David Menlow of IPOfinancial.com calls still very much a buyer’s market for IPOs. While that’s great for investors, it can be tough on companies trying to raise capital. “If a CEO asked me whether to go public today, I’d tell him to wait,” says Menlow. “He would be bringing the company public at a lower level than what he probably could get in nine months or a year.”
That was perhaps true of Accredited. The company raised more than $77 million by selling shares at $8 in February. In early September, the same shares had doubled in value. But when Accredited went public, “we made the best decision we could, based on the considerations of the time,” McKewon says. “It worked—it worked remarkably well. Could it have worked better? Probably. But we would have had to know things that weren’t knowable.”
Okay, so it stings a little. But again, thanks.
