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November 19, 2015 - One of the more anticipated initial public offerings (“IPOs”) is Square, run by Twitter founder and current CEO Jack Dorsey, which just filed a prospectus to go public.  Square is best known for its electronic payment solutions to process credit card and Apple Pay transactions and represents the next generation of technology companies that have raised considerable private funding.  First coined by the New York Times, these unicorn companies possess “wonderful and magical” value propositions that warrant private market valuations north of $1 billion.  Pinterest (digital scrapbooking), Airbnb (room rental sites competing with traditional lodging), and Uber (ride-sharing service competing with taxicabs) command valuations north of $10 billion.  The NY Times article notes how many traditional mutual fund complexes such as Fidelity, T. Rowe Price, and BlackRock have participated in private market fundraising for many of these unicorns which are held across mutual fund portfolios, even though such holdings make up a small percentage of overall fund assets. 

However, cracks are appearing in unicorn valuations as market observers noted that Square’s offering price of $11-13/share implies a valuation of ~$3.9 billion which is well below the $6 billion implied valuation based on the last private fundraising round.   The Wall Street Journal published a front-page article discussing increased scrutiny by federal securities regulators over the procedures for pricing shares of private technology companies.  The article noted that five of the biggest fund firms have “participated in funding rounds worth a combined $8.3 billion this year as of Sept 30, up from $1 billion for [2011]…” The article also refers to an earlier Journal article discussing the difficulty mutual fund firms are facing valuing these startups as they frequently report different prices for the same company.  Finally, the Journal published an article in mid-October highlighting how some of these sky-high valuations are coming in with high profile data file sharer Dropbox seeing a 25% cut in valuation by BlackRock.  However, unlike the 1999-2002 Internet Bubble/Collapse period, this pullback in unicorn valuations appears to be more self-contained among the private equity financiers, even if they include prominent mutual fund companies.  It is also worth noting that ETF vehicles generally do not hold private market securities, unlike several open-ended mutual funds. 

 

Of course, tech startups are but one component of a much broader IPO market where there have been some successes, many of them in the healthcare space but also a handful of banks (First Northwest) and restaurants (Shake Shack).  One of the market indices we monitor as an indicator of investor risk appetite is FTSE/Renaissance US IPO Index whose top constituents include Alibaba, Citizens Financial, Hilton, Twitter, and Ally Financial.  Exhibit 1 shows the YTD performance (through 11/16/2015) of the IPO index versus the S&P 500 (large caps) and S&P 600 (small caps). 

Exhibit 1: YTD Performance (through 11/16/2015) of S&P 500, S&P 600, and FTSE/Renaissance US IPO

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Source: Bloomberg

The index did outperform the broader indices in the October rally, returning 13.0% vs 8.4% for the S&P 500 and 6.1% for the S&P 600.  However, it continues to underperform the broader indices this year.  A faltering IPO market could serve as further indication of deterioration happening within the broader market along with other indicators such as the underperformance of small versus large caps and weakness in the fixed income credit markets.  Poor performance of the index also calls into question the quality of companies coming to the market and/or the valuations being placed by the issuers.  Indeed, Twitter (TWTR) is now trading below its first day of pricing (Exhibit 2).

Exhibit 2: Twitter Stock Price (Since Inception)

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Source: Wall Street Journal

So why do we want to root for the unicorns?  It is not about justifying the private market valuations being afforded to these companies based on “magical” metrics.  It is more about rooting for the overall health of the IPO market.  Investors need a properly, functioning system for pricing market assets.  IPOs represent the more dynamic elements of the market economy, either as disruptors to existing business models, product/service innovators, or as clean slates resulting from a spin-off or from a private equity fund that had taken the company private a while back.  If investors are souring on issues coming to market, it suggests something is not functioning properly, either the quality of the companies or the valuations being sought.  IPOs represent the next generation of companies whose earnings growth should drive further market advances.  Otherwise, the U.S. market becomes sclerotic and loses its dynamism that has historically attracted global investor capital.  


 

The opinions expressed are those of the 3D Asset Management, Inc. investment team (“3D”).  Nothing herein should be construed as investment advice or a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.  Any references to performance statistics, investment or market data or any other statistics presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

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Index returns include the reinvestment of income and dividends. The returns for these unmanaged indexes do not include any transaction costs, management fees or other costs. It is not possible to make an investment directly in any index.

The Renaissance US IPO Index is designed to represent the US IPO market while avoiding turnover. The index reflects approximately the top 80% of newly public companies based on full market capitalization, is weighted by free float capitalization, and imposes a 10% cap on large constituents. Companies are removed two years after their initial trade date, when they become seasoned equities.

The S&P 500 Index measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. stock market capitalization.

The S&P SmallCap 600® measures the small-cap segment of the U.S. equity market. The index is designed to track the smallest 600 stocks within the S&P 1500 which is also comprised of the S&P 500 (large companies) and the S&P 400 (mid-size companies).