In 2004, a technology startup looking to raise capital through an Initial Public Offering (IPO) decided to forgo the traditional route, instead using a novel method colloquially known as the “Dutch auction”. Here, investors bid for the stock to dictate the price of the initial offering. The company priced at $85 per share, well shy of the $135 share price the tech giant desired—raising a mere $1.67 billion with a $23 billion valuation.

Today, that company—Google—is worth well over $700 billion.

Startup founders look toward the widely-regarded failure of Google’s unconventional IPO route as affirmation to not challenge the system. A “conventional” IPO takes place when companies wish to raise money from the market. A “lock up”’ period of 90 to 180 days prevents principle shareholders from selling stock into the market initially. Underwriters from investment banks set the price and support it in case the stock begins to crash. This traditional method reduces volatility in the price and allows for a company to raise capital for future investments and expansion.

However, Spotify, which went public in April 2018, made waves as the largest company to ever pursue a Direct Public Offering (DPO). A more decentralized process, this kind of listing allows existing investors or employees to directly sell shares to the public. The company being listed also does not issue any new shares. The most widely reported difference between the DPO and IPO was the elimination of the middle man, the underwriter. Headlines across the country surmised the doom of the investment banks as more technology companies would pursue direct listing to save on underwriting fees. In reality, Spotify’s choice to pursue a DPO was nuanced and done with advice from some of the world’s best financial advisors.

The ensuing concerns about what this would mean for the investment banking industry is understandable–IPOs are incredibly important to the entire industry. Equity underwriting is one of the most lucrative fields on Wall Street. This is especially apparent during the underwriting of an IPO, when banks receive roughly seven percent of capital raised. In 2017, the United States’ five largest investment banks made over $20 billion in equity underwriting. Large companies vying for the largest pool of expertise and research often employ five to seven different underwriters. For this reason, the elimination of IPO underwriting could easily have drastic effects on the industry as a whole.

Had Spotify pursued a traditional IPO, each of their Wall Street underwriters would have earned tens of millions of dollars in fees. In reality, the banks were not entirely removed from the equation. In the company prospectus, Spotify disclosed that advisory fees of $35 million would be shared between Allen & Co, Goldman Sachs, and Morgan Stanley. This price did not include the underwriting fees that total 13 to 15 percent of bank revenue.

Many concerns over Spotify’s use of direct listing came from beliefs that the technology sector would follow suit. Over the next two years, a new wave of some of the decade’s most notable startups will go public, raising billions of dollars for their businesses. According to Dealogic, 2018 tech public offerings have already raised more than all of 2016 and 2017, combined.

Investor consensus is on pace to make a sharp turn in 2018 with both Spotify and Dropbox holding their prices after going public, while Snap and Blue Apron’s 2017 IPOs saw price collapses. This bullish attitude towards the market is urging big names to go public. Uber’s CEO has made clear plans to go public in 2019. Lyft began posturing for a public offering after speaking with investment banks. In what is likely preparation for a future IPO, Airbnb executives began adding independent directors to their board.

Technology IPOs are critical for the innovation landscape. Money raised upon floating shares to the public can be returned to employees who start new companies. Some capital is returned to venture capitalists, who use it to invest in the companies formed by ex-employees. Public offerings in the technology sector are so critical for this very reason.

Given the critical nature of tech IPOs, companies within the sector spend a significant amount of time preparing for their listings. Spotify’s choice to pursue a direct listing was a calculated move tailored to the company’s strengths. Most companies listing shares publicly do so in an effort to raise interest-free capital for future investments and acquisitions. Spotify, on the other hand, did not issue shares and raise new funds in an effort to keep existing stakes at their value. The company, instead, allowed existing shares to be traded. This situation is impossible under an IPO, where companies float new shares on the market. Raising capital is the principal reason for the vast majority of companies going public, a barrier to the direct listing process.

While Spotify’s DPO circumvented underwriters and reduced cost, it also removed many of the tasks that are key for soon-to-be-public companies. During an IPO, bankers and executives travel around the country visiting institutional investors and advertising the company they represent. Underwriters also speak with their firms’ largest trading partners, agreeing to buy and sell the shares at a price that earns these partners profits. These services don’t occur for a DPO. Spotify was able to eliminate this process due to publicity. Spotify is unique in its incredible brand recognition across the world. The company had no need to gather the support and guarantee of institutional investors to pick up the stock price due to its prominence throughout households. Other companies potentially going public in 2019—including Slack and WeWork—simply lack the appeal and prominence of Spotify, giving value to the underwriters in their public listings. Spotify’s ability to eliminate underwriters was unique given its incredible brand recognition.

Spotify’s unconventional motivation was another factor that distinguishes it from other technology companies. As previously mentioned, the company did not intend to raise capital from this round. Instead, Spotify wished to increase liquidity and reduce volatility for its investors.  As a result, the DPO investors and employees alike had the opportunity to immediately sell their shares. On the first day of trading, there were few sellers and buyers. Over time, groups became more comfortable with the listing, and the initial volatility of the stock price fell dramatically as more investors and employees sold. In the scope of a traditional IPO, this would appear to be a failure: large blocks of shares were not moved to institutional investors, and the price was volatile in early hours of trading. Yet, in Spotify’s scope, this IPO was ideal. The company’s share price increased from $48.93 to $132.50 privately to between $136.51 and $169 publicly. In just two days of public trading, over 600 percent more Spotify shares traded hands than after ten weeks of private trading.  Spotify increased investor and employee liquidity through this move, which was in line with the company’s motivation for the public offering.

Since the birth of the IPO, companies have been characterized as successful based on whether they ticked a series of checkboxes—none of which Spotify touted during its public listing. Within the technology and banking sectors, IPOs play a critical role. The introduction and success of Spotify’s DPO resulted in some reactions that the tech industry would shift to this new model, cutting out the underwriters. The reality is that the number of private companies with name recognition, no need to raise money, and a desire to give investors liquidity can be counted on one hand. Spotify’s path to public trading was a unique event tailor-made for its situation. Those worried about the downfall of Wall Street equity underwriting should not fear–Dropbox’s pursuit of a traditional IPO in March of 2018 resulted in shares trading up 40 percent. Evidence of a resurgence of tech public offerings is abound, and–thankfully for the banking industry–the DPO is no substitute for an IPO.

This article was written by Jake Goodman, Brown ’20. It is one of two Intercollegiate Finance Journal (IFJ) articles co-published this fall under a new partnership between the DBJ and the IFJ. To find out more about the IFJ and the partnership, please click on the author profile below.

Spotting Investors

From its early roots in Stockholm, Sweden, Spotify AB (Spotify Inc. in the United States) has grown to become a tectonic force in the music industry — a true market disruptor in the way it transformed the consumption of music. Since its inception, the firm has managed to dramatically increase its paid-membership service, as opposed to its free service rife with advertisements. Daniel Ek, the company’s CEO, recently tweeted that “40 is the new 30. Million.”, referring to the streaming service’s recent milestone of 40 million paid users, compared to 30 million in March 2016. The firm has 100 million total users, both free and paid. Spotify’s largest competitor, Apple Music, lags behind with a mere 17 million users.

As Spotify grows, it is increasingly under pressure to file for an initial public offering, which is the first time a private company’s stock is opened to the public to purchase. According to Bloomberg Businessweek, the company plans to go public in the second half of 2017 with a valuation of $8 billion. The pressure to go public largely stems from a recent round of financing — $1 billion in convertible debt, which is a debt security that can be converted into the underlying company’s equity at the financiers’ discretion.

This new round of debt was issued by a group consisting of the private equity-firm TPG, the hedge fund Dragoneer Investment Group, and Goldman Sachs. The Wall Street Journal reports that the debt’s interest rate will increase the longer Spotify waits for an IPO, and investors are entitled to a 20 percent discount on shares if they decide to convert their debt into equity. Yet, to improve its margins before an IPO, Spotify will have to grapple with its net loss of $200 million last years despite revenue doubling to more than $2 billion, and the firm thinks it has found a solution.

A Music Industry Super Brawl

As Spotify anticipates its IPO, its chief focus is on restructuring its music rights. According to public filings, Spotify’s commissions to the music industry totaled $1.8 billion last year, with 55 percent of its currently paid to record labels and artists and an additional 15 percent to music publishers and songwriters. The major record labels — namely Universal Music Group, Sony Music Entertainment, and Warner Music Group — each hold undisclosed minority stakes, forming a conflict of interest as CEO Daniel Eks attempts to lower the labels’ checks to around 50 percent. Lower sales to labels would encourage Spotify’s chances of profitability with an IPO on its horizon.

Spotify currently operates on a short-term month-to-month basis with the labels. With long-term negotiations underway, there is insight into the positions of both sides of the table. On Spotify’s side, the streaming service has a couple advantages. Additionally, Spotify has offered additional data and promotion to artists and has hinted at the possibility of a limitation on the length of time one can remain a free user for. As the labels all hold minority stakes in Spotify, they have a vested interest in seeing the streaming service succeed. Spotify also has some special treats it can offer the labels. The labels, and notably artists such as Adele and Taylor Swift, have taken issue with Spotify’s availability of its complete catalog to free users. There has been discussion about giving the labels the ability to restrict certain new releases to the paid tier. However, Spotify is concerned that doing this will drive consumers to free platforms, such as YouTube.

Finally, Spotify holds a key position as a mainstream consumption platform and a major source of revenue for record companies — the largest source of sales for recorded music in 2015. After struggling from declining sales of CDs and digital downloads, US record companies, posting revenues of $3.4 billion in the first half of 2016, are increasingly pivoting toward streaming services, giving Spotify greater leverage in negotiations.

The record labels also maintain a certain edge over Spotify. Online streaming services have tended to create losses for corporate parents, as evidenced by the struggling Pandora, which went public in 2011. Spotify also faces competitive pressure from its rivals in the industry: Apple Music, Amazon Prime Music, YouTube. Whereas these other services can lean on their respective corporate parent, Spotify does not enjoy such a luxury. Ultimately, with discussions centering on amending Spotify’s free service aspects, compromises will have to be made, and Daniel Ek and his team will have to balance the firm’s need for increased profit margins with its relationships with record labels and artists.

The Times They Are A-Changin’

Whatever happens with Spotify, it is clear that consumers can expect changes in the months before an IPO. Spotify seems to be increasingly ambitious in its projects. Spotify’s recent partnership with Tinder, integrating a user’s music taste into their dating profile, is a recent example. A single song, dubbed an ‘anthem’, is chosen to represent one’s personality on the dating app. Spotify has also worked with another dating app, Bumble, to work on a similar idea, displaying what users have been streaming. These recent developments are part of Spotify’s goal to provide a broader experience to users. The company spent $250 million on research and development last year, including the purchase of a dozen original music-based TV series. It’s evident that Spotify does not envision itself as part of the general trend in the music industry — to soar and plummet fast — rather seeks the means to ensure its survival.

However, with the pressure on, this series of negotiations seems to be a key test for Spotify’s leadership and for its future on Wall Street. Despite this pressure, Spotify has other options besides Wall Street. A possible acquisition by Facebook is not even off the table, according to the investment firm GP Bullhound, a partial owner. Overall, an $8 billion dollar valuation is hard to live up to, especially in an industry notorious for its lack of profitability, but Spotify seems to have the drive to forge a permanent position in the music industry. Hopefully for Daniel Ek and the rest of his team, Wall Street feels the same way.

Background

Private equity (PE) and venture capital (VC) firms generally view the initial public offering (IPO) as the most desirable exit scenario by which to realize their returns, sparking keen interest in the risk-return profile of these stocks as compared to the overall market.

In his seminal work on IPOs, Ritter (1991) first drew attention to the significant underperformance of newly issued stocks during their first three years in the aftermarket. Interestingly, subsequent literature has found evidence that private-equity-backed (PE-backed) IPOs defy this trend. For example, studies by Degeorge and Zeckhouser (1993) and Holthausen and Larcker (1996) show that leveraged buyouts (LBOs) returning to the public markets outperform other newly listed stocks. In the case of venture capital, a study by Brav and Gompers (1997) establishes that venture-capital-backed (VC-backed) IPOs significantly outperform non-VC-backed IPOs.

Previous studies have sought to identify risk and return characteristics that might explain the differential performance of PE-backed IPOs. Most relevant to this paper is a study authored by Levis (2011) that uses Fama and French’s three-factor model to analyze a sample of PE-backed, VC-backed and other non-backed IPOs. Levis finds that PE-backed IPOs have larger market capitalizations and are more profitable than their non-sponsored counterparts. In examining the aftermarket performance of these IPOs, he also finds that the three-factor alphas of VC-backed IPOs are poorer than those of PE-backed IPOs, but that both of these groups generate higher returns than non-backed IPOs.

Although the three-factor profiles of private equity IPOs has been well established in the financial literature, such studies have yet to incorporate the factors from Fama and French’s most recent five-factor model (2014). In addition to the traditional factors for market risk (MKTRF for “market return over risk free rate”), size (SMB for “small minus big”) and value (HML for “high minus low”), this model includes two new factors: operating profitability (RMW for “robust minus weak”) and investment (CMA for “conservative minus aggressive”).

RMW is particularly relevant to the private equity industry in two respects. First, operational improvement is one of the primary means by which sponsoring funds seek to create value in their portfolio companies, with operating multiples such as EV/EBITDA serving as key metrics for evaluating investment performance (Axelson et. al, 2010). Additionally, expectations for operational profitability differ significantly by fund strategy. For example, a paper on private equity performance by Ljungvist and Richardson (2003) finds that venture capital investments tend to be significantly less profitable than private equity investments.

The investment factor was first introduced by Zhang et. al (2008) in response to the apparent underperformance of equity and debt issuers as compared to matched non-issuers. The authors propose that the reduced cost of capital from issuing securities incentivizes firms to increase investment, which in turn lowers average returns. They find that the new factor does indeed explain a significant part of the new issues puzzle, reducing 80 percent of IPO underperformance.

Fama and French (2014) find that positive exposures to RMW and CMA capture the high average returns associated with low market betas and conservative investing, whereas negative exposures explain the low average returns characteristic of unprofitable firms that invest aggressively. Given the differing return characteristics of PE and VC investments, it is likely that the loadings on these two factors would differ based on the stage of an investment’s sponsoring fund, although no research has been conducted on this topic to date.

In addition to five-factor analyses, there is also a notable lack of research on the specific risk and return characteristics of distressed stage funds. This gap in the literature is surprising, as distressed deals have become more popular over time, accounting for 3.2 percent of all LBO transactions from 2001-2007 versus 1.2 percent from 1970-2000 (Stromberg 2007); moreover, the most recent financial crisis in 2008 sparked further opportunities for distressed strategies. Research into the characteristics of distressed investing has potentially interesting implications, given the highly differentiated platform of such funds. For example, Stromberg (2007) establishes that distressed investments are the most risky form of LBO deals, with bankruptcy rates that are twice as high as other deal types.

The purpose of my analysis is two fold. First, I apply Fama and French’s most recently published five-factor model to establish the risk and return characteristics of IPOs backed by buyout, venture and distressed stage funds. I then proceed to parse out significant differences in the alphas and betas of IPOs based on each of the three types of sponsor in my dataset. My analysis is one of the first to apply the new five-factor terms for operating profitability and investment to the private equity industry, as well as one of few papers to give specific attention to distressed stage investments.

Analysis

The main dataset on private equity IPOs is from Thompson One, which covers all private equity exits since 1970. I filtered this data to focus on companies that were backed by either venture-, buyout- or distressed-stage funds and exited via IPO. The sample I obtained from Thompson One only includes IPOs that took place from 1970 to 2014 on the New York Stock Exchange, NASDAQ Stock Market or American Stock Exchange. Of the 4,131 total IPOs in the dataset, venture-backed firms comprise over half of the sample with 2,729 IPOs; the 1,329 buyout- and 73 distressed-backed firms account for the remaining observations. Table 1 provides summary statistics for the price, shares issued and proceeds of IPOs based on sponsor stage.

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Table 1

Table 2 shows the output from the five-factor regressions. Results are broken down by each of the five time intervals following a firm’s IPO date: 1 month, 6 months, 12 months, 24 months and 36 months. These panels are further subdivided according to the stage of the firm’s sponsoring fund—venture, buyout or distressed.

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Table 2

The findings indicate that the five-factor model has significant descriptive power for sponsored IPOs. Venture-, buyout- and distressed-backed firms are similarly characterized by greater volatility, smaller market capitalizations, lower book-to-market values, lower operational profitability, higher levels of investment and some degree of abnormal returns in the first month following an IPO.

While these initial results hint at differences in alphas and risk factor loadings between sponsor stages, they do not establish whether such differences are statistically significant. To follow up on this point, I conducted a second analysis adding interaction terms to the five-factor model to test for IPO performance differentials based on sponsor stage.

Thus, in addition to the original five factors, the regressions shown in Table 3 include dummy variables for buyout and distressed sponsorship, plus interaction terms between these dummies and each of the five factors. Because the base case is venture, the constant and all five uninteracted factors in this table are identical to the coefficients from the venture regressions for the corresponding periods in Table 2.

Table 3
Table 3

Although there were no consistently significant differential effects for distressed terms, the analysis does reveal a few points of significant difference in the performance attribution of venture- and buyout-backed IPOs. Buyout sponsored firms are less volatile than venture sponsored firms during the first six to twelve months following an IPO. Consistent with previous studies, buyout-backed firms also tend to be larger and more value-oriented than venture-backed firms.

While there are significant differential effects for the original three Fama-French factors, no such differences appear to exist for RMW or CMA. Consistent differences in abnormal returns are also lacking, although the end-period alpha differential for buyout-backed IPOs is significant and negative with respect to venture-backed IPOs.

Conclusions

My results generally confirm findings from previous studies based on the original three Fama-French factors—market risk, SMB and HML. Regardless of sponsor stage, I show that all firms backed by private equity funds tend to be smaller and more growth-oriented than other public companies, even generating some degree of excess returns in the first month following their IPO date. Furthermore, venture-backed IPOs are more volatile than the market, as to be expected from the riskier strategies that characterize venture capital industry. Differential analyses for the three factors are also consistent with preceding financial literature; buyout-backed IPOs are less volatile, larger and more value-oriented than their venture-backed counterparts.

The new RMW and CMA factors shed light on previously unexplored aspects of private equity performance attribution. My results show that sponsored IPOs as a whole exhibit lower operating profitability and higher levels of investment during their first 36 months on the public markets. These results are consistent with Fama and French’s five-factor correlations (2014), which show that RMA and CMA vary positively with book-to-market value. Unlike the first three Fama-French factors, however, I find no evidence of differential effects for RMW or CMA by sponsor stage.

This paper set out to profile the risk and return characteristics of private-equity-backed IPOs based on the stage of their sponsoring fund. In addition to confirming previously established findings, the analysis also contributes new insights to the performance attribution of private-backed-IPOs via the five-factor model. These findings lay the groundwork for future research on the value-add of private equity funds in managing their portfolio companies.

This article is an excerpt from Ms. Eubank’s paper for her finance class at Dartmouth.