The IPO Market

Bausch & Lomb braves the bear market

An IPO tradition: Ringing the bell at the NYSE

This note was initially prepared for students in my Corporate Financial Policy class, and has been slightly edited for posting on B&B. It is pretty basic, so those of you working on the ECM desk at Morgan Stanley can probably skip it.

We did not spend much time on IPOs this term—the topic came up only tangentially in our discussion of the Jet Blue and Goldman Sachs cases-- but IPOs are an important topic that I would like to have covered in greater detail.  So let me make a few comments about IPOs to fill in some of the gaps in our coursework.

To begin, I encourage you to read this recent WSJ article profiling the IPO of Bausch & Lomb Corp (BLCO), which priced its IPO on Thursday. In order to get its deal done in the face of increasingly difficult market conditions, Bausch & Lomb reduced both the number of shares offered and the offering price of the shares. The BLCO shares were priced at $18 raising $630mm for the Company, down substantially from the initially targeted amount of $840mm. But the BLCO shares traded up in the after-market and closed Friday at $20, an almost picture perfect first day performance by traditional IPO standards. (IPOs are typically priced to generate on average a 10% or so “pop” in aftermarket trading. This is “money left on the table” for issuers, but the practice is justified as a way to compensate IPO investors for taking the risk of dud deals. I have never been entirely persuaded by this argument, but this seems to be the way things have been done for decades now and so there must be a good reason.)

I will discuss the BLCO transaction in more detail below, but before I do let’s review a few of the basics of IPOs for those who could use a refresher.

An IPO (Initial Public Offering) is just what the name suggests: the initial public offering of common stock by a business corporation, the shares of which will subsequently trade publicly on a recognized stock exchange. The photo above is of Hilton Corp management ringing the opening bell at the NY Stock Exchange to celebrate the completion of their IPO—a time-honored transaction at the NYSE—and Nasdaq hosts similar celebrations for their IPO issuers.

Companies go public for a number of reasons. Some companies go public to raise new equity capital for investment in the business or to pay down debt, and others go public to provide liquidity for their current (private) owners. But there are other reasons to go public as well. You will recall from class that Goldman Sachs went public in 1998 for three stated reasons: (1) to raise permanent capital, (2) to facilitate broader equity ownership among its employee base, and (3) to create a publicly traded acquisition currency. Prior to going public, Goldman was a privately held partnership, which constrained the amount of equity capital available to the business and created periodic liquidity issues when partners retired and began withdrawing their capital from the firm. In the GS partnership, only partners had direct equity stakes in the business, not other very senior or promising young employees. And Goldman was constrained in making acquisitions because of its private partnership structure, unlike its publicly traded competitors. (Most of the large US investment banks went public before Goldman did, which Goldman may have viewed as a competitive disadvantage.) Not mentioned in the prospectus was valuation, but of course this too was a big factor in Goldman’s decision to go public. Prior to going public, Goldman partners bought into the partnership at a price equal to book value (paid in capital plus retained earnings) and when they retired they sold back their partnership interests to the firm at book value, paid out over time. Goldman’s IPO however was priced at over 3x book value, which delivered a big one-time wealth enhancement to those individuals who were then active partners of the firm. This no doubt created some tension with retired partners and senior non-partner employees, who did not benefit commensurately in the big bump to valuation, as well as with those partners and others who were loath to see Goldman give up its long-standing partnership culture.

Public equity offering transactions take various forms, structured differently to achieve different objectives. You will recall from class that Jet Blue completed its IPO in 2002, two years or so prior to the time of our case. In 2004, Jet Blue completed a subsequent “follow on” offering of shares. In the case of Jet Blue, both the IPO and the follow on offering were “primary” offerings, which means that the shares offered to public investors were newly issued shares being sold by Jet Blue itself, with the public offering proceeds going to the Company to be invested in the business. When growth companies go public, the transactions often take the form of primary offerings, as the young company needs more capital to grow and the main reason it is going public is to access the large pool of equity capital available on the public markets.

[Historically the public equity markets were much deeper than the private equity markets, but this has become less true over the years with the big growth in the amount of capital allocated to VC and PE firms. And so today, young growing companies can stay private longer than in the past and tap the deep pools of private capital available to attractive companies at various stages of development. Some of these companies achieve quite high valuations in the private market, making “unicorns” much more common in the financial world than in the natural world.]

We can contrast a “primary” offering with a “secondary” offering, which is the public sale of shares in a registered offering by existing shareholders rather than by the issuer itself. (‘Follow on’ offerings are often referred to colloquially as ‘secondary’ offerings, but this is not technically correct and students should avoid this lazy terminology.) A secondary offering can take place at any stage of the public offering process, at the IPO or subsequently. In class we saw this with the Goldman Sachs IPO, which included both a primary and a secondary offering component, with money raised both for the issuer (Goldman) and for two institutional shareholders. Follow on offerings can also be structured as secondary offerings, which is often what happens when VC and PE firms decide to cash out on their private equity investments after taking a portfolio company public. These secondary sales can take place either via a registered public offering or via unregistered sales on a public stock exchange, and the SEC has rules which regulate these decisions.

As noted in the Bausch & Lomb article, the IPO market can be volatile. There are periods when IPOs are quite common and raise a lot of money and periods when the IPO market is seemingly dead or at least in deep hibernation. Even more so than the equity market as a whole, the IPO market can quickly shift from “risk on” to ‘risk off”, as we have seen in recent months. And both bull and bear markets can last for years, sometimes a decade or more, as we witnessed in the 1970s (bear market) and in the 1990s (bull market). In hindsight, we can probably characterize the 40-year period from 1982-2021 as largely one giant bull market, driven by the massive secular decline in interest rates (from 20% in the early 1980s to 0% for much of the past decade plus), but of course there were some very big (although relatively short lived) equity market corrections during this period (eg in 1987, 2001, 2008 and 2020).

The composition of IPOs also varies over time, along with the volume of offerings. We tend to think of IPOs as offerings primarily by tech and other high-growth companies, and this is often true. We saw this, for example with the internet “dotcom” boom in the late 1990s and again more recently with social media stocks. But this is not always the case. Many different types of companies go public, for very different reasons, and some companies have gone public more than once! The Bausch & Lomb transaction is a good example of a very different sort of IPO than say Microsoft (1984, $0.07 per share split adjusted), Google (2004, $85 per share), or Facebook (2012, $38 per share, which fell to $16 within 6-months). So let’s dig a bit deeper into the Bausch & Lomb IPO.

The Bausch & Lomb IPO discussed in the WSJ article is referred to as a "spin off" transaction. The new public company, Bausch & Lomb Corp (BLCO), was prior to the IPO a 100% owned subsidiary of another larger publicly-traded company, Bausch Health Companies (BHC). Bausch Health was formerly known as Valeant, a Canadian pharmaceuticals company with a somewhat checkered history on which I and many other much smarter investors lost a lot of money a few years ago. Valeant bought the Bausch & Lomb business in 2013, and it is this business (in its current form) which is now being returned to the public market as BLCO.

In its IPO, Bausch & Lomb Corp is offering to the public newly issued shares and the parent company BHC is not itself selling any shares. The BLCO IPO is an example of a primary offering with no secondary component, which is quite traditional but could have been structured differently if the parties had different objectives. The parent company Bausch Health’s ownership stake in BLCO will be diluted to 90% by virtue of the newly issued shares sold in the IPO. What happens next depends entirely on the parent company’s strategy. Perhaps Bausch Health simply wants to highlight the value of this particular unit for the benefit of its own shareholders (and share price) and intends to retain a large controlling stake. Or perhaps the parent company intends over time to fully separate the ownership of the two companies, and the subsidiary IPO is just the first step in a subsequent spin-off transaction in which the remaining shares are eventually distributed to BHC shareholders in the form of a dividend.. Or perhaps BHC has other motivations, for example providing BLCO with a publicly traded acquisition currency.

Whatever the motivation, until such time as Bausch Health reduces its ownership stake below 50%, BHC will remain the controlling shareholder of BLCO and will continue to report the financial results of BLCO on its own consolidated financial statements. As a new (if not entirely independent) public company, Bausch & Lomb will have its own board of directors (including representatives of BHC), its own management team, its own capital and legal structure and of course its own publicly traded shares. By looking at the market price of BLCO shares, investors will be able to estimate the total value (market cap or enterprise value) of the Bausch & Lomb business, including not just the 10% stake which is traded publicly but also the 90% stake retained by the parent company Bausch Health.

Growth company IPOs and corporate spin-offs are both large and important components of the IPO market, but in recent years the IPO market has been dominated by another form of transaction, the so-called SPAC IPO. SPAC stands for Special Purpose Acquisition Corp, which is a form of "blind pool" investment vehicle. “Blind pool” because at the time of the IPO, the SPAC is just a shell company with no operating business; SPAC investors are basically giving their money to the SPAC sponsor to invest more or less blindly on their behalf in the years following the IPO. (If you want to learn more about the structure of SPACs, and their inherent conflicts of interest, see my various past posts on the subject of SPACs. What follows is just a very short overview.)

So how do SPACs work? Take a financial entrepreneur on the lookout for an acquisition, who does not have his own ready source of risk capital (as would be the case with a PE firm), but who recognizes that he can’t be competitive in the M&A market if his offer will be conditional not only on raising debt but also the equity needed to fund the acquisition. (Not everyone is Elon Musk!) This clever fellow (and it has been mostly men I believe), might set up a SPAC, raise money from gullible (and greedy) investors in an IPO and then go hunting for a company to buy, using as acquisition currency the cash raised in the IPO, the SPAC shares and in some cases more money raised at the time of the acquisition. The target company acquired by the sponsor’s SPAC then merges into the SPAC, and effectively becomes publicly traded as a result, with the SPAC sponsor and the former owners of the target company sharing control of the merged entity. The cash raised in the SPAC IPO is used either as part of the merger consideration or as capital to fund the operations of the target company (now merged into the SPAC), or both. We can view SPAC IPOs as a clever way for the cash poor sponsor to make an acquisition with OPM (Other People’s Money), or as a streamlined way for the target company to go public (bypassing certain SEC IPO regulations), or both. Clever, no?

If SPACs sound fishy to you, there is good reason.  SPACs were quite a clever innovation many years ago, but they never accounted for much of total IPO volume until they came back into vogue in the waning days of the recently deceased bull market, when all kinds of crazy things were happening in the equity markets (think meme stocks!). And SPACs became big business indeed, generating windfall underwriting profits for those investment banking firms that specialized in SPACs. During 2020-21, SPACs accounted for over 50% of total US IPO volume, about on a par with the share of US residential mortgage originations that were sub-prime (or non-prime) in the lead up to the 2008 financial crisis, which is never a good comparison. In 2021 alone, there were over 600 SPAC IPOs, raising almost $150bn in capital. By the end of this period, SPACs had become widely misused and even abused by irresponsible (and greedy) sponsors taking money from gullible (and equally greedy) investors to pursue deals of often questionable investment merit and rife with conflicts of interest.  Suffice it to say that SPACS are a quintessential bull market instrument, and had a big run over the past few years, but you won't see much of them in a "risk off" market environment like the current one.  And from a corporate governance perspective and investor protection perspective, I think that is probably a very good thing.

The IPO market today is not dead, but it may well soon be on life support, in which case only very special deals will get done, most likely at lower valuations and on more attractive terms (for investors). And although the IPO bear market may continue for some time, it will not last forever. We live in a cyclical and volatile world, with unpredictable and rapidly changing market conditions, where what goes up can also go down and vice versa. And although the IPO market today is very quiet, this too can change in a heartbeat.  And when it does watch out. As it says in the WSJ article, we may regret the lack of IPOs now, but we will likely lament the flood when the IPO window opens back up, however far into the future that may be.

In the meantime, be on the lookout for some of the fallout of a closed IPO market. Many companies that had planned to go public are still in need of capital and they will have to get it from somewhere, most likely in the private market. But the private equity market is also contracting, particularly at the VC end, and so we may witness some high profile corporate casualties as a result of the increasingly bearish conditions in the IPO market.

As Warren Buffett likes to say, “it is only when the tide goes out that we see who has been swimming naked”. And this I think is what we have to look forward to in the coming months, however unattractive that picture may be.

Links:

Bausch & Lomb Prices IPO at $18, below Expectations, WSJ May 7, 2022

Bausch & Lomb Announces Pricing of IPO, Company Press Release, May 7, 2022

US IPO Stats and Charts, Stock Analysis