Nutanix, the leading hyper-converged infrastructure (HCI) player, is the latest in a recent string of strong IPOs. Nutanix increased its initial filing range, priced above the increased range, and saw its stock shoot up 131% on its first day of trading this past Friday.
Sentiment has turned quickly. The Nasdaq closed December 29, 2015 above 5,100, within 1% of its then all-time high. But, by early February of this year, the Nasdaq had plummeted over 800 points, suffering a 16% decline in just over a month. With the market in free fall, high-growth tech IPOs grounded to a halt. First quarter saw the fewest IPOs since the global financial crisis. With the public market’s demise, hedge funds, mutual funds and sovereigns pulled back from later stage venture financings, and sirens began to sound in Silicon Valley that the day of reckoning for unicorns was approaching.
While many unicorns have had to hunker down and there have been a few flame outs, amazingly, as we sit here at the start of Q4, the IPO market is now on the verge of turning white hot again. In fact, the Nutanix IPO comes after other recent VC-backed tech IPO winners such as Twilio, Line, Talend, Gridsum and Apptio, which are up from IPO 329%, 47%, 45%, 30% and 36%, respectively.
How can this be? Why is the IPO window opening? What is driving this phenomenon and what implications will it have for startups?
Benchmark Watching. Public fund managers, whether hedge fund or long only, care mostly about beating their benchmark, which is usually an index and varies depending on a fund’s strategy. When markets gyrate wildly, as they have this year, fund managers are apt to miss a few of the market’s zigs and zags, making keeping up with benchmarks quite difficult. To outperform benchmarks, fund managers can look to IPOs, which aren’t part of any indexes, as a way to gain some incremental basis points of return.
IPO Performance & Asset Class. Most public fund managers receiving an IPO allocation are not planning for a long term hold. They often manage very large funds and simply can’t build a large enough position in a newly public company to warrant the work involved. Instead, they’ll take an IPO allocation with the hopes of earning a few easy basis points of return for their fund before “flipping” out of the stock. The problem for fund managers trying to gain an edge with an IPO allocation is that IPOs often don’t perform well, and especially when there are a few IPOs in a row that fail to pop, fund managers quickly sour on new issuances. The “IPO window” is usually considered shut when fund managers stop buying.
Conversely, when a few IPOs pop, fund managers take note. Eager for gains, fund managers can quickly change their stance relative to IPOs, as they’ve done in this most recent surge. Despite the fact that the fortunes of Twilio, Talend and Nutanix have very little in common, their IPOs are linked for fund managers looking for a pop. The IPO Class of late ’16 has now been formed and there are undoubtedly many Pre-IPO companies hoping to join this esteemed class, planning their IPOs now.
The “Specter” of a Down Round. In late ’15, I predicted ’16 would be a big IPO year. My premise was based on the view that, given a dearth of late stage capital, companies would have no other option than public offerings to raise money. What I failed to appreciate was the negative stigma attached to pricing IPOs as down rounds. Fear of down rounds stopped several companies from testing the IPO waters earlier in the year. Now that the IPO Class of Late ’16 has shown that filing an IPO as a down round doesn’t necessarily mean stocks won’t catapult past late stage VC prices, this fear is abating. Expect more companies to try their luck soon; admission to the IPO Class of Late ’16 will be as coveted as was the “unicorn club” of ’15.
Implications
Timing is Everything. As the IPO window opens wide, more companies are encouraged to jump through. No party lasts forever however, and eventually lower quality deals will spoil things for the best companies. Over-supply is typically the downfall of a hot IPO market in two ways. First, when the IPO calendar gets too crowded, this glut will cause investors to choke, resulting in weaker companies failing to get public successfully. Second, some of the high fliers may falter as they report earnings and investor lock ups come off after 180 days. With far more shares freely tradable, its not uncommon to see significant downward pressure on newly public stocks 5-6 months after IPO. Hence, if you’re a promising pre-IPO candidate, once your ducks are in a row, there’s no time like the present.
Timing is Meaningless. The IPO is only one small step. For management teams, VCs and long term shareholders, far more important than an IPO pop is stock performance over several years. Stock prices over time have everything to do with predictable, strong financial performance, growing market opportunity and limiting surprises. Whether a company had a hot IPO becomes a distant memory quickly – see Facebook versus Twitter for proof. Make sure you’re ready for the journey if you opt to test the IPO waters.
The IPO market is back for now. The next few months will certainly be interesting to watch as more companies test the waters. As long as the quality bar for new issuances stays high (and I hear from several bankers there are many promising companies in the IPO pipeline presently), I suspect we’ll see increased momentum around IPOs for a while. The IPO class of late ’16 may grow and become the IPO class of late ’16 / early ’17 before we know it. Then, my prediction for a hot ’16 IPO market, won’t be wrong, just off by six months!