Written By: Agustin Lebron
Pinterest. Lyft. Uber. Spring 2019 has been the season of IPOs: lots of big ones are happening, more are on the way, and everyone is talking about them. What’s more interesting is that a lot of them, frankly, have been going rather badly. Why is this happening? And what can we learn from it?
Let’s recap what IPOs are all about. All companies start out as an idea. But that idea needs capital to get a business spun up, and more capital to produce something customers want to buy. The first bit of money invariably comes from the founders themselves, or their friends and family. Over time as the business grows, capital begins to come from outside angel investors. I’m an angel investor myself, and I can attest to the fact that it’s not for the faint of heart. It’s high-risk, and most investments fail.
Nonetheless, if a business keeps growing then venture capitalists (VCs) enter the picture. These are large organized pools of money that invest in growing, privately held companies. A few rounds of this sort of funding later, public markets come into the picture: the VC’s “exit”, that is, the point at which they actualize their profit on the investment, is when the company files papers to become a public company. This IPO (initial public offering) is an opportunity for founders, angels and VCs to sell a piece of the company to the broader investing public, thereby cashing out (at least partially) on their investments.
That tidy picture has been upended in the last decade with the growth of the unicorns. Unicorn is a term for a privately-held high-growth VC-funded company that’s worth over $1 billion. Historically, companies have an IPO well before they reached these valuation levels. But Google’s IPO in 2004 (selling around $2 billion of itself to public investors) changed that calculus.
A New Normal
Private investors (VCs, large funds) saw that it was possible to remain private much longer than they supposed. No longer were public markets necessary in order raise large amounts of money. Companies and VCs told themselves that staying private brought advantages: freedom from the supposedly short-term thinking of public investors, less onerous regulation, and the freedom to pursue big ideas without regard for immediate profitability.
Cut to the present. With huge amounts of capital now available privately, companies like Uber and Lyft drove a car through the idea of achieving profitability and going public. Losing large amounts of money today began to be seen, paradoxically, as a signal to private investors that the company was after truly enormous future profits. Uber reported (to private investors, technically) that it had lost $1.8 billion in 2018, with no realistic prospects for profitability anytime soon. Private investors, enamored with visions of eventual self-driving Ubers with zero labor costs, stomached these losses in the name of a driverless techno-future dream monopoly.
And in 2019 Uber and its investors decided to IPO. Surely everyone else would be similarly enamored. What’s a few billion dollars today compared to inevitable hundreds of billions in a decade or two? It’s pretty clear now that public markets had other ideas.
First, Lyft’s IPO underperformed expectations. Uber then tried to IPO into an environment that was fast becoming skittish about pie-in-the-sky future visions. And the 29 (!) underwriters for the IPO (mostly investment banks whose job was to pitch the deal to large institutional investors) found themselves in an odd situation: most of the people they were hoping to sell shares to were already investors in Uber! This should come as little surprise. You don’t put together a valuation in the tens of billions by calling up mom and pop over the years. Fidelity, T. Rowe, and other large funds already had large stakes in Uber and, in the light of the Lyft underperformance, they had little appetite for more. In fact, large investors were already looking for ways out! And we all saw what happened as a result.
By now, Uber is the poster-child for the 2019 IPO flameout, but the same story can be told about Lyft, Pinterest, and many others. But what lessons can we draw? I see two big ones:
- It’s fine to have a long time horizon to evaluate a truly big and truly new idea. But when that big idea needs a lot of unlikely things to go right, you need to sit down and actually multiply those probabilities. The resulting probability is going to be even smaller. In Uber’s case, lofty valuations require that it maintain minimal regulatory oversight, in particular with respect to the labor laws governing its “contractors”. Also, the big technical bets on self-driving cars (a still-unproven technology) have to pay off at the same time that society manages to solve the regulatory, insurance and logistical challenges of a driverless future. That’s a lot that has to go right to justify a $100 billion valuation (which is what Uber’s valuation hit at its 2015 peak) for a company that’s losing over a billion dollars a year.
- More importantly, the 2019 IPO season reminds us all again about the dangers of groupthink. It’s much easier to justify nosebleed valuations when all you see are like-minded investors and fellow-travelers in the same boat as you. Private markets are, well, private. There is less diversity of opinion, significantly less incentive to really kick the tires on an idea, less disclosure, less oversight, less everything. Once these companies IPOed, they opened themselves up for the first time to the collective wisdom of everyone, not just a few select insiders. If the only people who see the emperor are his courtiers and hangers-on, it’s harder for someone to say he has no clothes. Public markets function as a large town square where everybody can see and hear everybody else. It just takes one little boy to open our eyes.
After all that’s happened, what should you do when the next IPO comes around? Get short? Or bet against the backlash? If you were looking for an answer, I’m sorry to say I don’t have one for you. As I explain in my new book The Laws Of Trading, no one does. The whole point of trading is figuring out what the marginal person in the market hasn’t figured out. That’s one of the laws!
Every situation is different, and in order to be a good trader, or indeed a good decision-maker in general, you need to think about the specifics of the situation. There’s no magic oracle to consult. What you can do, as I show in the book, is to learn what good traders think about, how they think, and how they go about improving their thinking over time. It’s not the rosy future of flying robot cars, but it’s one you can actually invest in.
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