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Struggling to Explain Sluggish IPO Volume

Colleen Marie O'Connor (colleen.oconnor@sourcemedia.com)

April 17, 2006

So far this year, the US IPO market has been sending out rather mixed signals. While most of the IPOs completed during the first quarter performed well in the aftermarket, an air of dissatisfaction lingers in the underwriting community. That's because fewer deals were completed than ECM bankers had hoped, and dollar volume was down significantly from the same period last year.

Companies raised $8.9 billion in the US IPO market in the first quarter, a 17.6% decline from the same period last year. That is even though the number of deals, 44, was essentially flat with the 45 done a year ago.

Bolstering underwriters' expectations was the significant backlog that accumulated by the end of 2005--some 102 deals, according to investment bank Canaccord Adams. Oddly enough, few real negatives have surfaced to explain why the backlog did not dwindle during the first quarter, as has historically occurred. In fact, IPO volume dipped despite a robust stock market, with the Nasdaq hitting new highs, and strong equity follow-on volume (see "Promising Q1 for Capital Markets Desks," IDD, Apr. 10, 2006).

As of April 10, Canaccord Adams said the backlog remained at about 92 IPOs, worth approximately $13 billion.

"The greater measuring point is the number of deals, not the dollar volume," said Michael Kollender, director of middle-market investment banking at Ryan Beck. He suggests that valuation pressure may have played some role in the volume decline.

That valuation pressure continues into the second quarter. Last week, Deutsche Bank and Pacific Growth Equities pushed biopharmaceuticals maker Targacept out of the gate at $9 per share and raised $60 million, but the deal priced lower than the company's $11-13 filing range. The same occurred with JPMorgan's lead-managed offering for Vanda Pharmaceuticals, another biopharma maker, which raised $57.5 million at $10 per share, less than its $12-14 filing range.

"The IPO calendar is light for the next few weeks. But on the other hand, IPOs were mostly up in the first quarter," said Francis Gaskins, president of IPOdesktop, an independent research firm. "I think it's just a matter of underwriters packaging and bringing merchandise to the market at prices that interest institutions."

VCs opting out

In addition to valuation pressure, several underwriting sources mentioned two other reasons for the drop-off in dollar volume: smaller IPO deal sizes and a lack of participation by venture capitalists in the market.

"The decrease in dollar volume just means we are looking at both smaller companies coming to the public markets and fewer large transactions," said Kollender.

The average IPO deal size in 2005 was $313 million, according to Canaccord Adams, while the average size this year has dwindled to $168 million. And the deals in the backlog are even smaller, at an average of $140 million.

"A sign of strengthening in the IPO market is the number of smaller companies coming out--it's an indication that investors are considering smaller companies in the realm of the public markets," said John Tesoro, head of capital markets at Canaccord Adams.

Kollender agreed. "We're starting to see that every IPO doesn't have to be a minimum of $75 million or $100 million of gross proceeds to happen," he said. "Slightly smaller but good growth companies are beginning once again to capitalize on the public markets."

That said, ECM bankers are more focused on the Silicon Valley factor. Although the private equity community is still bringing companies public, so far venture-backed offerings haven't made it off the endangered species list. The National Venture Capital Association and Thomson Financial found that just 10 venture-backed companies went public last quarter, raising $540.8 million. In Q1 2005, 10 VC companies went public and raised $720.7 million. The average VC-backed deal size this year has been $54.1 million versus $72.1 million last year.

Many ECM sources believe the reason is that VCs are still looking to M&A for their exits, so IPOs remain on the backburner for the time being. VC-related M&A deals totaled $45.1 billion in 2005, up from $23.9 billion in 2004, according to Thomson. And M&A activity in the first quarter of 2006 was far busier than the same period last year. Thomson data show 134 M&A deals from VC-backed companies worth $17.2 billion in Q1 '06, nearly triple the Q1 '05 volume of $6.4 billion.

One reason M&A is more attractive to VCs is the current robust environment for fundraising. "To be successful at raising their next funds, they need to show they have returned money on the last," said Tesoro. "Rather than going through the time and pain of going pubic, and then waiting nearly a year to get themselves cashed out after the lock-up, the alternative is to sell to a buyer today."

Moreover, for those VCs that do go for an IPO, the London AIM market, which has been aggressively courting their business, may be siphoning off some deals.

Nonetheless, most sources seemed positive about the overall health of the US IPO market. "We are cautiously optimistic," said Kollender. "I'm seeing a reasonably good pipeline, and many corporate executives and financial sponsors are talking about financings and liquidity events through the pubic equity markets, more so than I saw 12 months ago."

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