The IPO Deluge: Gold Rush Or Fool’s Rush?
Sir Issac Newton once said , "I can calculate the movement of the stars, but not the madness of men".
This was in 1722 on the bursting of the South Sea bubble – one of the greatest and all pervasive bubble in the UK which engulfed aristocrats, peasants, the chancellor of the exchequer, ministers, the government, the parliament, the bank of England….. and even the King ! Newton had personally lost GBP 20,000 which in today’s terms would be $ 7 mln !
Capitalism inevitably creates speculative bubbles in some asset class or another, and which create significant impact on society once it bursts. Economic history is replete with such examples : from the Tulip mania in the 17th century to the South Sea bubble few decades later, the Great Depression in 1930s, the Japanese real estate bubble in late 1980s, the Asian financial crisis of 1997, the dot com bust in 2001 and the Global Financial crisis in 2008.
One of the tricky things about bubbles, though, is that they become evident only in hindsight after they burst. As an example from recent memory, the Nasdaq rose from 1000 to 5000 between 1995-2000 and then crashed by 75% in 2001-02 post the dot come bust. However, there are some characteristics of such bubbles which have withstood the test of time and worth reminding ourselves as we witness perhaps one of the greatest bubbles of all time.
The Benefit Of Hindsight From Economic History
I will take the example of the South Sea bubble of 1711 -1720 to make the point that though times change and the actors are different, the broad principles remain the same. Even as way back in 1700s the South Sea bubble was predicated on the interplay of expectations of profits ( not profits themselves), a new world paradigm, loose credit, high trading volume, rapid rise of prices and word of mouth dissemination of the investment thesis to the general public. Essentially the bubble was created using rising stock prices of the South Sea Company to issue equity to the investors to refinance unserviceable treasury debt of a bankrupt government. The business model of the company to generate cash to finance the government was made by providing monopoly rights to The South Sea company in slave trading to Hispanic America ( the new El Doroado ) ! In reality, the slave trade ran at a loss year after year and the company raised finances through the gullible public to finance the Government debt. At one point they had 22% of Government debt against the Bank of England which had only 7% ! The key to the survival was rising stock prices by talking up the business model, regular floatation to the frenzied public at progressively higher prices, building an aura of legitimacy by inducting marquee investors and extension of loose credit by none other than the King himself !
I do not think it requires too much imagination to contextualize the present times we live in with the example above with the modus operandi ; and with the Fed and central governments replacing the King of England of yore ! PE funds, unprofitable unicorns and pedigreed institutional investors make up for the rest of the ensemble which play for the benefit of the retail investor – the ultimate sucker over the ages !
Appreciation of financial history, thus, offer an useful perspective to contextualize and decipher the present times by understanding the past as, at the end of it all, it is human behavior which characterizes market movements. As Rose Bertin said “There is nothing new except what is forgotten.” And anything we believe about the present depends on what we know and believe of the past.
Decomposing The IPO Deluge
The IPO deluge we are currently witnessing across the world, and in India, needs to be evaluated in this perspective. According to publicly available data, IPOs have reached a crescendo in the US with as many as 401 issuances last year in the digital economy space. In India too we are witnessing intense activity and post the successful Zomato listing many more will follow. However, not all IPOs come to the market with a similar intent and it is important to understand the different categories of such IPOs we are seeing in India.
Broadly, I would classify them under four heads : a) For growth capital b) Exits by PEs c) Transfer of corporate control d) Frenzy of grabbing capital when it is available. Each has its own dynamics and has wide ranging profound implications on markets, governance, wealth transfer and retail investors.
Growth Capital
That there is a genuine need for growth capital is undisputed for a capital starved country like India. It is also a fact that the digital infrastructure created since the advent of the Aadhaar backbone along with data networks through mobile penetration and the Jan Dhan program for financial inclusion has created a digital highway which is unique in many ways. Technology icons like Nandan Nilekani envisioned the transformation of India through digital tech in his seminal book Reimagining India in 2004 and the Government of India provided the opportunity to translate it into reality. The distinctive feature of the Indian digital architecture is that it’s population level characteristics have been designed for inclusion across all strata of society. Furthermore, the digital stack is created on open architecture, and hence multiple services are being built on top of the platform by our tech savvy entrepreneurs through tech led disruption platforms and API enabled ecosystems. For example, use cases of Aadhaar itself are ubiquitous today from e kyc for instant opening of bank accounts to driving license renewal and digi lockers to name a few. NCPI handles 1 billion transactions per day, and with the UPI backbone multiple front end competitive payment systems ( Google pay, Phonepe, etc) have come into being effortlessly. Hence, capital which is raised for innovation and growth is more than welcome.
Exits By PE Funds
The scenario gets slightly muddled when this is combined with the exit of PEs from many consumer tech ventures seeded to essentially organize the market and drive efficiencies where there were obvious market failures. As I wrote in Economic Times and Hindustan Times editorials recently, though it is tempting to contextualize the current phase in India with that of the West in late 90s- where the concurrent rise of mobile, internet and ecommerce enabled the likes of Amazon, Yahoo and Google - we must realize that these companies had a massive IP content and intellectual resources. Our companies cannot boast of such IPs with the only moat being huge access to capital to shut out competition ( starved, killed or acquired), and good execution capability in building scale, brand and intelligent data banks with demographically copacetic market dynamics. Though these attributes are valuable, the business model risk, at these asking valuations without a definitive, proven (or forecasted) path to profitability through sound unit economics, cannot be ignored. In this context it is important to question whether driving market efficiencies are as valuable as having core IPs which drive structural innovation and sustainable productivity improvements.
This issue assumes relevance as the fact is that such humungous “value creation” of these PE funded consumer plays would have been impossible without a closed clique of inter se investments by foreign PE funds. As global liquidity continues with near negative interest rates, this can potentially be construed as an ingenious play to generate mega returns by inflating asset prices through “investor subsidized business models”. In privately held companies, creating the illusion of ephemeral valuations with co-investments by different PE funds in subsequent rounds of fund raising is fairly simple. It is ultimately the same small group of PE funds like Softbank, Tiger Global and Seqouia who lead a cozy club of friendly competitors for both large scale capital and mega deal flows. With the energy and exuberance of youthful entrepreneurs in abundance, India, with massive virgin markets, is indeed providentially placed in this cycle of fate and fortune. Powerful investor communication in a narrative where huge operating losses are worn as a badge of honour, with icons like Amazon and Google to showcase, allows for a potboiler of an offering. The new Gold Rush of the 19th century revisited ! Or a fool’s rush ?
Transfer Of Corporate Control
The third category of the current spate of IPOs relates to the transfer of corporate control where the incumbent promoter exits the asset and the control passes onto a dominant group of institutional shareholders who appoint, or support, a management to drive the company forward. Management buyouts and buyins are a sub set of this category which has been virtually unheard of in India. Interestingly, over the last 4 years this trend has been only amplifying, and in 2021 we have witnessed 21 transactions till May as against 44 in the pandemic hit 2020. Apart from having a shorter term horizon for business decisions predicated on the life of the fund - rather than the inter generational view which promoters have - such moves would also drive wealth transfer to the new generation of entrepreneurial professionals if promoters utilize the post exit funds for creating family investment offices. This trend of promoter exits can also have unintended consequences for the markets. Given the shorter term horizon of such institutional investors, their impending exits will always be a permanent feature on the markets as will be the risk of inadequate capital if the macro investment climate changes for the worse in India.
Grabbing Capital
The fourth category is of companies grabbing capital whilst it still available. This is the obvious category of IPOs which are foretold to go bad over time with history being a witness to the likes of DSQ Software, Pentafour Software, Kusum Ingots, Pasari Spinning, Camson Bio and Vikas WSP to name a few which had rapturous market debuts on “stories” during similar phases of market exuberance over the last two decades, but only to disappear soon thereafter.
Contrasting Narratives
IPOs are a critical part of the overall investment process in public markets. And investing is all about making decisions, and ultimately definitive choices, which emerge from the interplay of contrasting views regarding the core narrative in the markets at any given point in time. As of now there are two contrasting narratives. The first one is about a tech enabled future which will potentially uplift millions by providing universal access to the digital highway intersecting with the basics of life like financial services, healthcare and education. We are surely on the cusp of this revolution. Also, as Yuval Noah Harari postulates, globally the next decades will about the power shifting from humans to algorithms . This is as fundamental a transformation as when the power shifted from the Church to humans with the advent of humanistic thinking few centuries ago. In such a scenario, the convergence of biotech and infotech with the help of AI, big data and analytics will rule the next many decades very much like railroads, automobiles and power ruled with the advent of the industrial revolution.
Technology, though, is never deterministic as it can be used to create societies as different as democracies and communist social orders with the same basic technology more than 100 years ago. And therein lies the problem.
Such a compelling view, thus, needs to be balanced by the historical understanding of the five stages of a bubble whilst it is being created. First, displacement is created in the market. This has been led by technology or interest rates in the past. This time it is both – massive technological changes along with near negative interest rates. Second, the boom phase is led typically by the FOMO ( fear of missing out ) syndrome, attracting new class of investors, talking up markets by word of mouth, teleprinters, radio and TV. Now with ubiquitous social media such (mis)information is instantaneous, all pervasive. 12 million new demat accounts were opened during the last one year in India as against 4 million in FY 20. In US, the Robinhood phenomenon where individual investors beat hedge funds in their own game by cornering stocks is a recent example of frenzied activity by this new class of investors. Third, asset prices tend to sky rocket with new theories advanced for justifying dizzying valuations. In 1989 the Japanese real estate bubble saw Tokyo properties selling at $ 139k per sft and P/Es of 80…..and justified by pundits, analysts and TV anchors of that era ! Just 20 years ago, the internet- dotcom bubble in 1999-2000 saw esoteric valuations at P/E of 200 in the US , frenzy of IPOs by multitude of companies ( 457 at the peak in 1999 ) which went bankrupt by 2002. eToys, pets.com, webfan.com, globe.com are some examples of the $ 1.8 Trillion rout in 6 months from March 2000 when the bubble burst. For context Zomato quotes at 50x of revenue today as against Door Dash ( the world’s largest food tech company in the US) at 20x and our largest, most profitable companies at 4x or so. Fourth, profit taking by smart investors like BNP Paribas did in Aug 2007 - one full year before the housing mortgage crisis blew up in 2008. Finally, the panic stage arrives where some event causes the bubble to be pricked followed by margin calls, stampede to exit and a collapse of asset prices. Generally these events are to do withdrawal of liquidity through raising interest rate, or change in sentiment due to macro economic events such as recession or defaults.
The Reality Of Leveraged Bubbles
Oscar Jorda, policy advisor to the Fed, released his seminal research paper in 2015 which studied bubbles across 17 countries over 140 years to establish the nexus between credit, asset prices and economic outcomes since 1870. He empirically proves that leveraged bubbles funded by loose credit cause the most significant financial risks, and thereby the maximum damage to the economy followed by deeper, longer recessions post collapse. Thus, how big is the bubble and how it is financed are critical determinants to the risks faced due to extended mispricing of financial assets.
Based on these contrasting views, market participants will have to decide for themselves where we are in the cycle and the role of IPOs in that continuum of public investments in asset markets. It is worth remembering that e Toys ( with a market capitalization of $ 9B post IPO in late 1999 ) started selling off in March 2000 when insiders commenced divesting their holdings post the lock in period of their IPO. It finally declared bankruptcy and was delisted from Nasdaq in 2001. Zomato’s IPO saw unprecedented oversubscription from 3.2 million retail investors but the employee quota was under subscribed ! Mega trends discussed above which create structural efficiencies and step function, sustainable productivity improvements happen only due to rich IP deployment like we are presently witnessing in Europe in biotech, and in the US in AI and bio informatics. Do we have any such core disruptive IPs in India amongst the unicorns seeking listing in the equity markets ?
Cognitive Dissonance And Lurking Gray Rhinos
I will close this piece by alluding to the issue of cognitive dissonance in decision making where we only accept information which confirms what we already believe in and ignore evidence to the contrary. Nobel laureate Robert Schiller wrote “irrational exuberance is the psychological basis of a speculative bubble” where “mere news of price increases spurs investor enthusiasm and which spreads by psychological contagion and brings in larger and larger class of investors who, despite doubts, are drawn to invest partly by envy of others’ successes and partly through a gamblers’ excitement”. Michele Wucker, in her seminal work The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore enunciates the decision making biases which makes us view things more optimistically, and deny things which are scary, due to our psychological make up. It is this “escapist bias” which creates gray rhinos which are highly probable, high impact yet neglected threats. Gray rhinos are precepts which are openly discussed, but not acted upon.
The economy, and the markets, in general is in this phase and we can’t ignore that the deluge of IPOs reflect this reality too.
The author is a Sloan Fellow of the London Business School, non executive director, and an advisor to chairmen, of corporate boards.
