IPOs are booming with the help of SPACs
On the back of a few years, with a limited number of IPOs, 2020 turned out to be one of the best years in recent history for the IPO market, and 2021 proved to be even better. As of mid-December, the U.S had already surpassed the previous record set for IPOs in the 1990s, with almost 1,000 companies coming to the market raising $315 billion.
Special purpose acquisition companies, or SPACs as they are commonly referred to, played an important role in this development by helping many young companies go public. Some of the most notable market debuts in 2021 include Roblox Corp (NYSE:RBLX), Coinbase Global (NASDAQ:COIN), Rivian Automotive (NASDAQ:RIVN) and Robinhood Markets (NASDAQ:HOOD).
Exhibit 1: IPOs reached a record in 2021
There are several underlying assumptions as to why many companies are going public today in comparison to previous years. The attractive valuation level of the market is one of the major reasons behind this IPO boom, as elevated price-to-earnings multiples (denoted from the blue line in Exhibit 1) are helping young companies raise better-than-expected capital in the market.
Zero-commission trading introduced by major stockbrokers is another reason behind this IPO boom as cost-effective investment solutions have prompted many new investors to buy stocks for the first time.
The next factor is the rise of special-purpose acquisition companies, denoted by the yellow in the above chart. As per Morningstar, more than 700 SPACs went public in 2021, which is 5 times the number from the year before.
Exhibit 2: the surge in SPAC listings
SPACs, also known as blank check companies, have no commercial operations and stated targets and are formed solely for the purpose of raising capital through an initial public offering to invest in another company later. These companies are capable of facilitating private companies to go public faster while allowing public investors access to markets previously only available to accredited investors, and SPACs have become increasingly popular in recent years.
In 2019 alone, SPACs raised a staggering $13.6 billion, which was four times the $3.2 billion raised in 2016. The popularity of SPACs reached new highs in the last couple of years. In 2020, 247 SPACs raised $80 billion from investors, and in the first quarter of 2021 itself, a record $96 billion was raised by 295 newly formed SPACs.
Understanding the key economic factors relevant to IPO investors in 2022
As noticeable from Exhibit 1, there have been a large number of companies going public in the 1990s, which was a period marked by low inflation around 3% while the real interests rates were positive at around 6%, and this was the period leading to the tech bubble.
Exhibit 3: Low rates support current valuations better than the ‘90s
The real interest rates were negative at the start of 2021 with the 10-year yield remaining below 2% even as inflation started to soar towards the end of the year. When plotting the PE ratios against interest rates, it is noticeable that lower rates have historically supported higher valuations, which is exactly the driving force of valuations today amid ultra-low interest rates.
Towards the end of 2021, and as of today, U.S. inflation is on the rise, and the Federal Reserve has already signaled for multiple rate hikes this year, which suggests the ultra-low interest rate environment is finally poised to come to an end this year. This, in turn, suggests the stock market valuations might receive a reality check this year, and companies planning for IPOs this year might not attract the same enthusiasm from investors as they did in the last couple of years.
IPO investors, therefore, should conduct thorough due diligence to identify young companies that are well-positioned to perform despite these looming challenges.
On the bright side, recent earnings data of U.S companies indicate robust profit growth, which in turn should support higher stock prices and valuations.
Exhibit 4: Stellar earnings growth supporting higher stock prices
In conclusion, valuations are bound to take a hit this year, which is not music in the ear for IPO investors and companies planning to raise capital. The continued growth in earnings, however, will neutralize some of the negative effects of a valuation pullback. Overall, IPO investors may be in for a challenging year, but there is an abundance of opportunities in certain sectors of the market.
The long-term success of IPOs
According to the findings of Jay Ritter, identifying a good IPO investment comes down to sales growth and the absolute value of annual revenue at the time of a company’s market debut. Empirical evidence suggests investors should always choose the company with the highest reported revenue if they were given a choice to invest in a group of IPO companies with varying levels of revenue.
In any case, investors should prepare to stomach some volatility if they are planning to reap the rewards of investing in a young and fast-growing company. Even in 2021, the stock prices of some of the high-flying market debutants such as Coinbase and Robinhood plummeted, highlighting the importance of picking the right IPO to invest in.
Historical data shows that most of the new IPO companies are unprofitable at the time of their market debut. What would be more surprising to know is unprofitable companies, on average, have had a better start in the market in comparison to their profitable peers.
Exhibit 5: First-day return of profitable and unprofitable IPOs
Research conducted by FactSet reveals that most of the IPOs end up delivering lackluster investment returns in the long run, which might not be encouraging news for investors looking forward to the IPO market this year.
Exhibit 6: IPO returns by time frame
The companies that have gone on to deliver positive returns in the long run, however, have beaten the market hand over fist, and this is why investors still need to look for opportunities in IPOs to identify the small number of big winners that could potentially drive portfolio returns to unfathomable highs in the long run.
Exhibit 7: IPO returns by decile group
Source: FactSet/NASDAQ
The data presented in this segment of the analysis highlights that investing in IPOs does not guarantee positive returns in the long run, but carefully investing in young companies that are poised to change the world will help investors bag lucrative returns in the future. With this understanding, let’s look at 5 IPOs (including SPAC deals) to look out for this year.
IPOs to look out for in 2022
The social media app Discord is a highly anticipated but yet unconfirmed IPO that could take place in 2022. Discord is one of the favorite apps among gamers and cryptocurrency projects. During the pandemic in 2020, the company doubled its users and almost tripled its revenue as its popularity surged with the majority of the global population confined indoors.
The failed acquisition by Microsoft Corporation (NASDAQ:MSFT) for $12 billion, which occurred due to Discord turning the deal down, in April 2021 brought accidental luck for the company. In September, the private company raised $500 million in new funding at a valuation of $15 billion, which suggests the company is on track to attract a much higher valuation in the market when it decides to take itself public, which is likely to happen this year according to industry experts.
Reddit, the social media platform behind the meme stock mania in 2021, is another company to look out for this year as it prepares for a spectacular debut in the market. The company’s valuation rose from $3 billion in 2020 to an impressive $10 billion in August 2021 amid the surging popularity of some of its forums.
At the beginning of 2021, Reddit had 52 million daily active users and in the second quarter, the company earned $100 million in advertising revenue which almost tripled compared to the same period the previous year. Reddit is likely to seek a valuation of at least $15 billion in the market amid favorable macroeconomic conditions for the social media industry.
Instacart, a booming grocery delivery company, was one of the most awaited public debuts of 2021, but the company did not go through with the plans, and the anticipation continues in 2022. The grocery delivery giant has backing from Kleiner Perkins, Andreessen Horowitz, and Sequoia Capital, and some of these investors might be seeking an exit at the time of the company’s planned IPO.
The revenue of the company tripled in 2020 to $1.5 billion, and the company continues to enjoy double-digit growth. The reasons for last year's postponement of the IPO were the increased focus on battling competition from the likes of Amazon.com (NASDAQ:AMZN) and Uber Technologies (NYSE:UBER), as well as expanding its digital advertising services. The company is expected to attract a market valuation of as high as $39 billion, which would pin Instacart among the most valuable companies to go public in the United States.
The fintech company Chime Financial Inc., which has grown rapidly in the recent past, is another IPO to look out for in 2022. The company is operating in a competitive ecosystem with companies, such as, Block (NYSE:SQ), PayPal Holdings (NASDAQ:PYPL), and Affirm Holdings (AFRM) are fighting for market share in this fast-growing payment industry.
Chime recently denied predatory fees that disproportionately affect the poor and financially illiterate consumers, and the company management continues to focus on making a positive impact on society alongside improving the financial performance of the company.
In October 2020, Chime was valued at $15 billion in a private investment round, but its valuation has since then increased to $25 billion as of August 2021. The company is targeting a valuation between $35 billion to $45 billion in the planned IPO.
The confidential computing company, Hub Security Ltd, recently announced a SPAC deal to up-list to NASDAQ, and the deal is expected to be closed in the second quarter of 2022. Established in 2017 by veterans of the 8200 and 81 elite intelligence units of the Israeli Defense Forces, Hub Security operates in 4 distinct product categories with 3 of them aimed at the enterprise and government sector and one product at the IoT sector in over 30 countries.
The company’s cybersecurity products encapsulate both software and hardware solutions and its clients include Boeing Co (NYSE:BA), Visa (NYSE:V) Lockheed Martin (NYSE:LMT), Siemens AG (OTC:SIEGY), Johnson & Johnson (NYSE:JNJ), Pentagon Global Solutions, the Israeli Ministry of Defense, Motorola Solutions (NYSE:MSI), and many other prominent business and government agencies.
According to a recent announcement, the SPAC has over $150 million in cash and together with Hub, they will raise more capital through private investment in public equity subscriptions. The company’s investment bank, A-Labs, is estimating that the value of the company will grow 240% within 24 months post-SPAC deal.
Investors should carefully look for the legal structure of the company, the securities laws of Israel and the USA, and the possible tax implications of this deal. In any case, Hub Security is an IPO to look out for this year as the company has already made steady progress in landing high-value clients, which in return would help the company turn consistent profits.
Takeaway
Investing in the right IPOs could help investors book handsome profits in the long run, and 2022 could be another banner year for the IPO market as many private companies are gearing up to go public to raise capital. It would be reasonable to conclude that the 5 companies introduced in this article deserve a place on the watchlist of any growth investor looking to invest in young, fast-growing companies.