Siren Songs: IPOs & SPACs

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Visualizing History

The Evolution of Markets: United States Sectors 1800 to 2018

(Source: Global Financial Data)

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From the Archives

Successful Stock Speculation (1922)

The author’s advice on buying at the IPO: Don’t.

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Sunday Reads

The Investor Amnesia History Course

Let me just say that if you’re interested in learning more about previous IPO booms, and the long history of going public, make sure to check out the online financial history course I launched last month. Over 250 students have enrolled, and there are multiple lectures discussing historical IPO manias. The screenshots below show snippets from Professor John Turner’s lecture on the 1890s “Brewery Bubble” that saw 300 breweries IPO in a matter of years. In addition, Turner covers the Bicycle Mania of the same decade that witnessed 671 Bicycle Companies go public in 2.5 years.

PREVIEW THE COURSE HERE

You will also get detailed lectures on IPO shenanigans in the 1690s and 1990s from Professor Anne Murphy (left) and Jim Chanos (right).

Back from the Dead

Reports on the death of IPO’s deaths have been greatly exaggerated (for now). I mean, what a week, eh?

Before diving further into these past few days, however, let’s get some context. The chart below portrays the long and steady decline of IPOs since peaking in the 1990s:

Even worse, when high-profile private companies of recent years did go public they often opted for non-traditional routes. Spotify’s decision in 2018 to go public through a Direct Listing, for example, was a pivotal moment in determining how future private tech companies would enter the public sphere. Along with Slack in 2019, Palantir and Asana are two more recent examples of direct listings.

SPAC Attack

While Direct Listings have gained popularity, 2020 is the year of the SPAC (Special Purpose Acquisition Companies). Otherwise known as “blank-check companies”, SPACs are companies (in the loosest sense of the word) that go public to raise capital from public market investors with the intent to acquire a private company and bring it public.

As I wrote previously, I believe much of the retail fervor for SPACs stems from their inability to access the rewarding private market investments enjoyed by accredited / institutional investors.

“The non-accredited individual investor received the short end of the stick due to their inability to access these same private market investments with more attractive expected returns. They were left to fish from the diminishing supply of public stocks in a market that was still dominated by institutional ownership, despite their increased private market allocations.

In addition, the attractive companies that many of the individual investors would want to invest in were now electing to stay private longer before going public.

To me, the points outlined above help explain the behavioral drivers behind the recent speculative boom in SPACs, EV startups, and everything else. For decades, the non-accredited individual investor has been unable to reap the benefits of private market investments offered through either Private Equity, VC, etc.

When these individual investors finally get the chance to invest in exciting names like Facebook or Uber, it is only after significant wealth creation has occurred in the private markets. Now, it is worth mentioning that there have obviously been countless examples of wealth destruction in private markets that individual investors have been shielded from (WeWork). However, I think we’d all agree that the individual investor is probably more aware of the private market ‘winners’ that they have been unable to access in the exciting and sexy world of venture investing / private equity…

While SPACs are nothing new, their resurgence as an alternative to the traditional IPO route have made them very enticing to the individual investor because they can provide the experience that they have long desired: the thrill of VC investing and opportunity to access private market companies.

Clearly, there is a laundry list of differences between VC funds and SPACs. However, I think the reason for SPACs booming popularity this year partially due to the psychological component of individual investors feeling like they can finally access an area of the market that institutions and accredited investors have benefited from for so long.”

And wow have SPACs been popular. If you squint really closely you can probably see an uptick in the number / size of SPAC IPOs this year…

As with many “thrills” in life, however, they often turn out poorly.

IPOs Are BACK, Baby!

Although SPACs received all of the attention this year, the good ol’ fashioned IPO is enjoying a notable resurgence as of late. The stellar public market debuts of Doordash (+86%) and Airbnb (+143%) proved that IPOs still offer investors’ some SPAC-levels of excitement. In fact, Airbnb marked the 19th company in 2020 to double their shares on IPO day:

Even outside of these individual IPOs there were signs of excess in ETFs as the Renaissance IPO ETF experienced record weekly inflows:

So without any more delay, let’s dive in to the history of IPOs, financing private enterprise, and venture capital!

Venture Capital During the Second Industrial Revolution (1870-1920)

No discussion on the history of IPOs would be complete without covering Venture Capital and the financing of private companies. While today we think of innovation and technological breakthroughs only occurring in coastal cities like San Francisco and New York, this paper looks at the original Silicon Valley: 19th century Cleveland. I’m serious.

“During the Second Industrial Revolution of the late nineteenth and early twentieth centuries, Midwestern cities were important centers of innovation. Cleveland, the focus of this study, led in the development of a number of key industries, including electric light and power, steel, petroleum, chemicals, and automobiles, and was a hotbed of high-tech startups, much like Silicon Valley today.

In an era when production and invention were increasingly capital-intensive, technologically creative individuals and firms required greater access to funds than ever before. This paper explores how Cleveland’s leading inventors and technologically innovative firms obtained financing. We find that formal financial institutions, such as banks and securities markets, were of only limited significance. Instead our research highlights the vital role played by a small number of successful local enterprises that both exemplified the wealth-creation possibilities of the new technologies and served as hubs of overlapping networks of inventors and financiers. We conclude by suggesting that such nodal firms have spawned important clusters of innovative enterprises in other places and times as well.”

Cleveland: The Original Silicon Valley

“The continued growth both of local brokerage houses and of trading in local securities resulted in 1900 in the formal organization of the Cleveland Stock Exchange….

As was the case for other exchanges at that time, railroads initially dominated the listings. Compared to the New York Stock Exchange, however, the Cleveland market from the beginning handled the securities of a more diverse set of firms. For example, 52 percent of the firms listed on the New York Stock Exchange in 1900 were railroads, and in 1910 the figure was still 48 percent. By contrast, railroads accounted for only 40 percent of the listings on the Cleveland exchange in 1903, and by 1910 the share had fallen to 15 percent. This decline in the relative position of railroads on the CSE owed mainly to the listing of new banks, trust companies and utilities, including several local electric light companies and nine local telephone companies. Between 1910 and 1914, however, the number of manufacturing firms on the CSE more than doubled. The newly listed manufacturers included some of the most successful of the innovative firms formed over the previous several decades (American Multigraph; the Bishop-Babcock-Becker Company; Brown Hoisting Machine; National Carbon; Wellman-Seaver-Morgan, and the White Company).

The important point to underscore, however, is that these firms did not turn to the CSE to raise capital. Nor did their largest shareholders use the market to increase the liquidity of their investments. Trading in the equities of these manufacturing firms was at best light, and it seems that the listings were mainly useful to local brokers who from time to time had small lots of these securities to offer the public. Although venture capitalists today often make their profits by taking firms public and then cashing out their investments, that does not seem to have been the practice in the early twentieth century. To the contrary, investors in start-up enterprises appear to have planned to receive their profits over the long run in the form of dividends on their shareholdings.“

The Brush Electric Company

“Looking for a dramatic way to publicize Brush’s invention, Stockly and his associates negotiated a contract with the city of Cleveland to light Monumental Park (now Public Square). Advance publicity brought out a large crowd the evening of April 29, 1879, when Cleveland officials threw a switch, and twelve strategically placed arc lamps flooded the park with light. News of the event spread quickly throughout the country, generating a rush of interest in this new type of street lighting, followed by orders for installations. The successful demonstration also helped the officers of Telegraph Supply line up investors, and the next year the firm was reorganized as the Brush Electric Company with an authorized capital of $3 million, an enormous amount for the time.

Brush Electric installed about eighty percent of the nation’s arc-lighting systems during the early 1880s and made the business people who initially bought its stock rich. As Jacob D. Cox, founder of the Cleveland Twist Drill Company, later regretfully noted: “The original holders made immense sums of money but, as I had no funds to invest, I missed this rare opportunity”. Brush himself became a wealthy man, earning royalties on his patents in excess of $200,000 a year during 1882 and 1883. Indeed, his royalty account accumulated so quickly that the company fell behind on its payments, and to settle the debt, Brush agreed in 1886 to take $500,000 in stock. By the second half of the decade, however, the company was losing ground to new competitors, and Brush, Stockly, and the other major shareholders sold out to the Thomson Houston Electric Company at what appears to have been a handsome price. According to a report in the New York Times, the controlling shareholders (Stockly, Tracy, Leggett, Brush, and Stockly’s sister) owned 30,000 of the company’s 40,000 outstanding shares and sold them for $75 each. The par value of the stock was $50, and its market price was estimated at that time to be $35.”

The Theranos of 19th Century Cleveland

Just like Silicon Valley today, Cleveland had its fair share of enterprising frauds. One particular example is reminiscent of Elizabeth Holmes and Theranos attempts to raise money without actually possessing a viable product. The excerpt below describes the electric light industry’s “wild cat” companies that manufactured no products, but still pumped and dump stock with gullible investors by stealing legitimate company’s products and using them in pitches as if they were the company’s. This passage comes from an 1881 issue of the New York Times:

The Role of Financial Institutions

In short, the role of financial institutions was actually very small, even non-existent at times. What is particularly interesting about this historical parallel for Silicon Valley and VCs today is that these original “Venture Capitalists” were more interested in obtaining a return on their investments through long-term growth and dividends as opposed to seeking exits through an IPO or buyout (as is the case today).

“The wealthy Clevelanders who bought shares in these new high-tech enterprises seem to have been motivated by the returns they expected to earn from owning and holding them rather than by the profits they could reap by selling them off after an initial run-up in price. Although a few investors cashed out their investments relatively early (as Lawrence did when he sold off his Brush stock), this practice seems to have been quite uncommon. A search of Cleveland newspapers indicates, for example, that from the time of the formation of the Brush Electric Company until the late 1880s, when the idea of selling or merging the firm was beginning to be discussed, the only mention of Brush shares available on the market occurred around the time Lawrence was selling out. Before the formation of the Cleveland Stock Exchange in 1900, the only firms associated with the Brush hub for which share prices were quoted in the Cleveland papers were Brush Electric itself and the Walker Manufacturing Company. Even after the formation of the exchange, we do not see much trading in the equities of concerns associated with this hub.“

IPO Underpricing Over the Very Long Run

For investors, the “first day pop” when shares begin trading is an eagerly anticipated moment of the IPO process. This “pop” has led to greater debate around the persistent underpricing of IPOs to ensure this first day pop occurs. Legendary venture capitalist Bill Gurley has written and talked about this at length, and you can watch him discuss the issue below:

This article aims to provide historical context for this very same issue, with data stretching back to 1917.

“A central measure of the efficiency of the Initial Public Offering (IPO) market is the extent to which issues are underpriced. We present new and comprehensive evidence covering British IPOs since World War I. During the period from 1917 to 1945, public offers were underpriced by an average of only 3.80%, as compared to 9.15% in the period from 1946 to 1986, and even more after the U.K. stock market was deregulated in 1986. The post WWII rise in underpricing cannot be attributed to changes in firm composition, and occurred in spite of improvements in regulation, disclosure, and the prestige of IPO underwriters.”

The table below shows how this first day pop and related underpricing evolved over time:

Happy Hour Followed by Hangover: Financing the UK Brewery Industry 1880-1913

If you really want to talk about IPO booms, get a load of this:

“The brewing industry enjoyed a ‘happy hour’ in the last 15 years of the 19th century, with a 25-fold increase in brewery listings and an 82-fold increase in brewery capitalization.”

Madness! Now, I like to think that I have read a decent amount of financial history articles / books, and I have to say that this piece and story has long been one of my favorites. This article covers a “Brewery Bubble” that broke out in the years following Guinness’ IPO in 1886.

“The majority of the companies which floated on the London and provincial stock markets prior to the 1880s were companies which floated from scratch i.e., the founders sought finance from the capital markets right from the company’s inception. However, in the last two decades of the nineteenth century, there was an increasing number of companies which were viewed as ‘conversions’ i.e., long-established private companies or partnerships which went public by raising capital. The brewing industry was one of the largest conversion industries. Beginning with the flotation of Guinness in 1886, there were two brewery flotation booms before the end of the century. Why did breweries need to raise capital from public markets?”

“In 1885 there were only 12 incorporated breweries with securities traded on a stock market with a total paid-up capital of about £2 million, but by 1900, there were 308 breweries, with a total paid-up capital of over £165 million.”

The two booms were not necessarily similar, however.

“The first expansion phase was mainly financed by equity capital, whereas the 1894-9 boom was financed more by debt than equity finance. Indeed, the mean debt-to-equity ratio in 1900 meant that for every £100 of equity finance, breweries carried £86 of debt – these were highly-leveraged companies.“

The authors give four reasons for why studying this period is interesting for investors and historians today:

1. Measuring the relationship between family ownership and share performance.
2. Previously, most of the companies going public in Britain were new ventures, but in the case of Breweries, most of them were existing private companies ‘converting’ to public ones. “Thus, the brewery industry was a central defining influence at the genesis of the modern-day initial public offering.”
3. “The brewing industry presents us with a case study of the role of credit in sustaining asset price booms.”
4. The brewer industry is also a fascinating look at the impact of social movements and regulation on stock prices (the temperance movement).

Regulation

One very interesting reason that may have caused brewers to go public was…

“It ensured the spread of ownership in a controversial industry – tens of thousands of small investors had a stake rather than a small number of prosperous brewers. This may have helped influence public support for the industry and at the same time made it more difficult for politicians to attack it. Notably, shareholders were encouraged to lobby MPs and to vote against pro-temperance candidates in general elections.”

Corporate Profiles

The paper states that there were essentially three types of brewery companies:

• (A) Breweries which were closely held and 40 per cent or more of their capital structure was debt;
• (b) Breweries which had relatively diffuse ownership and very little in the way of debenture finance; and
• (c) Breweries with relatively diffuse ownership and which had a capital structure consisting of circa 40 per cent debentures.

The author’s argue that most companies fell into the first category.

Investor Returns

“If an investor had held a weighted portfolio of brewery ordinary shares from 1878 to 1913, the total return they would have earned would have narrowly underperformed the overall market. However, the weighted total returns are being driven by Guinness, the largest and most successful brewery of the era; when Guinness is excluded, the terminal point of the index of ordinary brewery shares is 1.59 rather than 4.36. The performance of the breweries relative to the market was poor given the greater riskiness of brewery ordinary shares as manifested in higher standard deviations of returns on brewery ordinary shares than on the market. Notably, the equally-weighted (or unweighted) total returns in Figure 5 reveal that the overall market outperformed the brewery sector and, as can be seen from the standard deviations in Table 4, was also less risky.”

But what caused the hangover?

“Beer consumption fell every year from 1899 to 1909 and by close to 14 per cent over the decade. This largely reflected pressures on working-class standards of living as well as a decline in the popularity of public houses due to the rise of alternative sources of working-class entertainment. In addition, the development of tram networks resulted in a growth of suburbs and a concomitant decline in use of central London pubs.”

However, like a college kid looking to beat a hangover, we can’t forget about the ‘the hair of the dog‘, as shares shirked their hangover, and rebounded in 1910:

“Notably, when the standard of living improved for the working classes after 1909, there was a revival in beer consumption, with consumption increasing by the not insubstantial amount of three million barrels between 1909 and 1913. This increase in consumption is associated with the improvement in the performance of brewery ordinary and preference shares between 1910 and 1913.”

Why Wait? A Century of Life Before IPO

“Firms that entered the stock market in the 1990s were younger than any earlier cohort since World War I. Surprisingly, however, firms that IPO’d at the close of the 19th century were just as young as the companies that are entering today. We argue here that the electrification-era and the IT-era firms came in young because the technologies that they brought in were too productive to be kept out very long. The model assumes that the stage before IPO is a learning period during which the firm refines the idea before committing to it at the IPO stage. The better the idea, the higher is the opportunity cost of a delay in its implementation, and the earlier the firm will have its IPO.”

One of the most common explanations for why SPACs have become so popular is that they represent a more enticing option for private companies looking to go public. SPAC’s provide private companies a lower cost and faster path to public markets that endures less scrutiny than a traditional IPO, since they are going public via an acquisition or merger instead of an independent IPO.

Bearing that in mind, this article looks at the long history of IPOs, and the decisions driving entrepreneurs to list their shares on the public markets. For example, the popular narrative today is that companies are staying private longer, but what has this trend looked like historically?

Financial Innovation & Growth: Listings & IPOs from 1880 to World War II in the Athens Stock Exchange

 

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