This article was first published in the Globe and Mail on November 30, 2024. It is being republished with permission.

by Tom Bradley

Stock markets are booming and there seems to be an unquenchable thirst for risk, but there is one area of the capital markets that’s in the doldrums. The market for initial public offerings or IPOs is dead.

It’s clink, clink, clunk. Company valuations are on the high side of normal, and in some sectors, investors are willing to pay well above historical levels. Clink. There is a backlog of companies that need to be sold by private equity (PE) funds. Clink.

But then the clunk. Very few companies are being brought to market.

Industry veterans like me remember a time when there were multiple IPOs every month. There was a regular flow of interesting companies that had outgrown their family roots and/or needed to raise capital. But that has changed to the point where Craig Coben of the Financial Times described the IPO market this way: “With these meagre volumes, many international IPO markets aren’t mere backwaters; they’re fast becoming parched riverbeds, cracked and barren where once capital flowed freely.”

There are several reasons for the slowdown. One is the severe hangover investors are experiencing since the bust of the 2020-21 IPO boom. Most of those stocks are still trading below issue price.

The trend toward passive investing hasn’t helped either. Index funds don’t buy IPOs (the companies aren’t yet in an index) and there are fewer active funds that do. And with the continual consolidation of the asset management industry, most active funds are now too big to consider investing in a new issue.

But the biggest factor by far is the growth of private markets. Well-capitalized private equity funds now give potential IPO candidates another option. They can stay private, for which there are many advantages. It avoids the high cost of being public and lessens quarterly-earnings pressures and ESG (environmental, social and governance) scrutiny. Management is able to restructure and invest in businesses away from the shareholder and media spotlight, and can fund it using liberal amounts of debt, which in turn, reduces taxes.

The question is, what happens when PE funds get near the end of term and are required to return capital to unitholders (most have a 10-year life with the option of two or three one-year extensions). They must sell companies in their portfolios using one of three channels. They can take them public, sell to a strategic buyer, or sell to another fund (which is known as passing the package).

Strategics, as they’re called, are other companies that operate in the same business and want to expand through acquisition (i.e. a tool maker buys another tool maker to broaden its product line or expand into new markets). These sales, as well as IPOs, are the ultimate arbiters of price. The value of the company and success of the private journey is determined.

When PE managers transact with each other, however, the outcome is less clear. Did the seller get full value for the package, or did the buyer get a great deal? It’s one way or the other, but not both.

Now, back to the moribund IPO market. What’s needed to get it flowing? Would better markets do it? Well, as noted, things are about as good as they can get. Do we need more quality companies to take the plunge? No, the supply of candidates is deep. In North America, there have to be 50-100 companies ready to be public, if not more.

Perversely, the people who are complaining about (and wishing for) an IPO market are the same ones who control the flow. After scooping up most of the companies that might previously have gone public and taking many public companies private, PE managers now control the IPO market. They can turn on the tap in a heartbeat.

The reason they haven’t is simple. It’s a matter of price. PE funds want more for their holdings than public investors are willing to pay. PE sellers want full credit for the growth potential and desperately want to avoid a down round (a price below the last round of private financing). Their returns and future sales depend on it. Unfortunately, public equity buyers want some upside too, as well as a discount that recognizes the risk they’re taking a la 2020-21.

It’s not too late for the IPO market, but if private asset owners are going to hit the public bid, they’d better get started soon while conditions are favourable. The next few months will tell the tale.