IPOs and SPACs: Recent Developments

The review article, IPOs and SPACs: Recent Developments, forthcoming in the Annual Review of Financial Economics, examines recent developments in the IPO market. The paper discusses three alternative mechanisms for going public, including traditional bookbuilt initial public offerings (IPOs), direct listings, and mergers with special purpose acquisition companies (SPACs), and provides a review of recent evidence on the processes, pricing, and consequences of IPOs.

A traditional bookbuilt IPO uses one or more underwriters to help the issuing firm conduct a roadshow (marketing campaigns aimed at institutional investors) and survey investor demand before pricing and allocating shares. These IPOs have faced criticism for leaving too much money on the table, defined as the difference between the market value of the shares sold and the issue proceeds. Underwriters have discretion in the allocation of shares and thus have incentives to set an offer price that allows them to allocate underpriced shares to favored clients. In auction IPOs and direct listings, investment banks do not have such discretion.

Direct listings appear to be a replacement for auction IPOs, which have not been used since 2013. In a direct listing, a private company lists its common stock on an exchange directly, with the opening price determined by market demand and supply. In April 2018, Spotify Technology was the first company in the U.S. to go public via a direct listing. Since then, 11 other companies have followed suit. None of the direct listings involved newly issued shares, likely due to a listing rule limiting a company’s capital raise to the range stated on its registration statement. In December 2022, the Securities and Exchange Commission (SEC) approved stock exchange proposals to ease the rule, making direct listings with a capital raise more attractive than they used to be.

A SPAC raises capital via an IPO and then seeks a merger with a private operating company, in the process bringing the private target company public. In the U.S., only 86 SPAC IPOs listed on the major exchanges from 1997 to 2009, but there were 1,157 SPAC IPOs from 2010 to 2022, of which 248 and 613 occurred, respectively, in 2020 and 2021. Recent research shows that, for investors in the shares of the merged company, the post-merger returns tend to be very negative. Although post-merger returns have been low, SPAC sponsors are often criticized for receiving very lucrative returns. Investors who buy the SPAC units at the offer price and sell at the time of the merger or liquidation also earn high returns. From a private operating company’s point of view, on average it is more expensive to merge with a SPAC than to go public via a traditional bookbuilt IPO. We discuss the criticisms that have been leveled at SPACs, and also discuss how some of the features of SPACs are designed to deal with agency problems that would otherwise be more severe.

The number of IPOs in the U.S. has been much lower since 2000 than in the preceding two decades. The number of publicly listed domestic operating companies on the major U.S. exchanges dropped from almost 8,000 in 1997 to below 4,000 in each year from 2012 to 2020. Although 2021 saw a surge in IPO activity, with 613 SPAC IPOs and 311 operating company IPOs, the number of IPOs in 2022 collapsed, with a meager 86 SPACs and 38 operating companies going public.

There are three main explanations for the drop in the number of listed companies since 1997. The first explanation attributes the drop to heavy-handed regulation of public companies. Although the conventional wisdom emphasizes regulatory burdens for hindering capital formation, there has been little reliable evidence that Reg FD in 2000, the Sarbanes-Oxley Act of 2002, and the 2003 Global Settlement caused the decline in IPO activity. Recent research has focused on the effect, or lack thereof, of the 2012 Jumpstart Our Business Startups (JOBS) Act on IPO volume. The JOBS Act allowed reduced information disclosure for Emerging Growth Companies (EGCs) going public, defined as firms with gross revenues of less than $1 billion during the most recently completed fiscal year. The JOBS Act also permitted EGCs to confidentially file a draft registration statement (essentially the preliminary prospectus) for the SEC staff to review. Moreover, EGCs and their investment banks were allowed to engage in testing the waters communications with institutional investors to assess market demand. Further changes in the regulations since the JOBS Act now allow all IPO firms to use confidential filings and testing the waters.

A second explanation for the drop in the number of listed operating companies is that economies of scale and scope have also contributed to the slow IPO activity in the U.S. From a cash flow perspective, small firms in many industries face disadvantages due to the increased importance of economies of scale and scope driven by technology. A private firm can choose to grow organically, or merge with a larger organization to become bigger faster, with the acquirer’s established platform allowing the private target to bring a product to market more quickly. Recent research finds that a private firm in a more globalized industry is more likely to merge with an established partner instead of doing an IPO.

A third explanation for the drop in the number of listed companies is that the increased availability of private equity capital has enabled private firms to stay private longer. The increased supply of capital to private companies over time is partly due to the deregulation of some securities laws. Even without the regulatory changes, however, venture capitalists would have received more funding for other reasons. The success of the “Yale model” has resulted in many university endowments and pension funds allocating a significant fraction of their assets to illiquid investments such as venture capital. Furthermore, a bizarre rule that allows government pensions to calculate the present value of their liabilities at the expected return on their assets, regardless of the risk and maturity of the assets, has incentivized these pension funds to place a larger fraction of assets in opaque and illiquid assets such as VC funds.

Institutional investors that traditionally focused on public companies (e.g., mutual funds, hedge funds, and, to a lesser degree, pension funds) have also substantially increased investments in private companies in recent decades.

IPO underpricing is of continuing interest. In 2020, the average first-day return in the U.S. was 41.6% on an equally weighted basis, and an even higher 47.9% on a proceeds-weighted basis. Information asymmetry-based theories help explain underpricing, although only if the average underpricing is modest. But theories based on agency problems, underwriter power, and issuer complacency better explain the high average underpricing of 19.0% of U.S. IPOs from 1980 to 2022, as well as the severe average underpricing of over 50% for large subsamples that can be identified ex ante.

In the three years after going public, for the 8,775 IPOs from 1980 to 2020, the average IPO underperforms the market by -17.1% on an equally weighted basis, measured from the first closing market price. The underperformance of IPOs is largely being driven by small, unprofitable companies.

The full paper is available for download here.