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ArticleOctober 2019

Direct Listings Not A Catch-all Solution to the IPO

Direct Listings Not A Catch-all Solution to the IPO

Direct listings are one of the hot new trends in the capital markets following the high profile decision of companies such as Slack and Spotify to transition from private to public without a traditional IPO process.

Vocal thought leaders in the financial industry have become passionate proponents of this approach. Many VCs now demand that their portfolio companies at least consider a direct listing when making the transition into the public sphere. Some in the media have even heralded the direct listing as the dawn of a new IPO era.

What’s the problem with IPO?

It might be a bit too early to say that the traditional IPO is dead, but direct listings represent a significant shift taking place in the capital markets. This shift has been driven by underlying frustrations with the IPO process, which have been brewing for some time. In other words, direct listings are in response to the flaws inherent in the IPO process that have long been discussed but left unaddressed by an industry hesitant to shake-up the status quo.

The problems of traditional IPO are worth revisiting. Proponents of direct listings argue that IPOs are not only expensive but inefficient because investment banks serve two masters, the sellers (i.e. the corporate issuer and the existing shareholders) and the buyers (institutional investors like mutual funds and hedge funds). As such, they are being blamed for systematically underpricing IPOs to give their buy-side clients embedded gains on Day 1 of trading, at the expense of their sell-side clients.

Investment banks will understandably defend their approach to IPO pricing. They will rightfully argue that new investors need some kind of discount in order to be incentivised to partake in an IPO. Indeed, it is the “discount” that attracts big public investors to look at smaller new companies and make the whole process tick. This is a fair point. But when that discount averages over 20% it is understandable that existing investors and issuers are worried about the money they are leaving on the table.

Moreover, investment banks will argue that the value of their services go beyond maximising IPO proceeds. Investment banks are expected to identify high quality, long term investors, who are preferable to the flighty ones even if the latter are willing to pay a higher price. In a direct listing, the ability to curate and manage the order book goes away.

The debate will continue and one’s point of view will depend on their economic interest. But the complaints are legitimate and investment banks should take some heed. It is equally important to recognise that the direct listing also has some important limitations, which restrict their effectiveness and applicability.

Direct Listings are not the solution.

Direct listings are not a capital formation exercise. They are an exercise in efficient value discovery but they do not help companies raise new capital to grow the business. Most companies making a transition from private to public are doing so precisely because they have hit the critical juncture in their trajectory where they need new outside capital to fund future growth.

The bottom line is that IPOs need to evolve, but direct listings are not the catch-all solution. Instead what needs to happen is that IPOs need to be upgraded, not scrapped. The industry needs to transition to IPO 2.0. This new and improved version needs to address the fundamental problems associated with traditional IPOs.

The obvious answer is to democratise the process and open-up the deal to all investors, just like a direct listing but give the issuer and their advisors control on the allocation process.

A direct consequence of this would be equal access to retail investors who have historically not received their fair shot in these offerings despite being sticky, long term investors.

By opening up to retail investors, investment banks invite additional price tension into the capital formation process. More eyeballs equals more demand for a finite number of shares, which in turn may narrow the discount. At PrimaryBid we are championing this idea. We think Main Street deserves to participate alongside Wall Street in the IPO processes and have a genuine seat at the table.

Everybody loves a sensational 30% IPO pop on Day 1 of trading, but we must create a more inclusive process where the benefits are shared more broadly by the entire ecosystem and not skewed to selected subsets.