Renaissance Capital’s Kathy Smith on When the IPO Pipeline Will Thaw: The Weekend Interview

'The entire investment world is sitting on a Treasury bubble'

Since July, the initial public offering pipeline for all sectors--including the finance industry--has been frozen due to chilly economic conditions and stock market uncertainty.

When will the IPO tap thaw? Soon, says Renaissance Capital Principal Kathleen Shelton Smith, but only after we're fully into the back-to-work fall season and company executives feel more confident about where they're headed in terms of taxes, regulation, and health care.

"When the market shut down this summer, that was the canary in the coal mine," Smith told AdvisorOne.com associate editor Joyce Hanson in a September 7 interview. "It's all about uncertainty. When the Bush tax cuts go away, the marginal rate of taxation could be 40% or even higher. Investors want companies to tell them something about the future, and companies are under the gun."

Data from Renaissance Capital, which is a Greenwich, Connecticut-based IPO research firm, show that since July 8, when Fortune Bank shelved its $360 million IPO, a total of 11 filings in the finance sector have not gone to market. Those 11 filings are just a fraction of the total 168 IPOs that have stalled and are waiting to be priced when market conditions improve. Since June, only six financial companies have actually priced IPOs, including Green Dot (GDOT), Envestnet (ENV)--the accompanying photo shows the Envestnet brain trust ringing the opening bell at the NYSE on July 29--and CBOE Holdings (CBOE).

New Regulation Worries Put Drag on Earnings

But even those companies with successful IPOs are worried, Smith noted.

"How reliable can your earnings be if you're Green Dot or Envestnet, but you don't know what your employees' health costs will be? We don't know now, and there's new regulation that still hasn't come out yet," she said. "When we're in that kind of environment, no wonder investors are sitting on their hands and companies don't know what kind of profits they're going to see. We've got the worst kind of scenario happening right now. The entire investment world is sitting on a Treasury bubble."

In the finance sector, the CBOE Holdings IPO in June started out as the big success story this quarter before it fell off due to regulatory fears. Another success was Green Dot, a leading U.S. provider of reloadable prepaid debit cards, which priced its IPO at $36, above the $32-$35 range. But there's been a lot of bad news in the IPO market. Envestnet's pricing came in at the low end of its range, and Park Sterling Bank's IPO was at $6.50, below the range of $9-$11. Also, Fortune Bank, a recently formed commercial bank led by former HSBC execs, postponed its IPO on July 15 because of poor market conditions.

High-Beta IPOs 'Are Hanging in There With the Market'

During the interview, Smith looked closely at the finance-sector IPOs that have and haven't yet been priced, and she explained why market conditions are preventing them from going through:

AdvisorOne: The average IPO has returned 1.0% from its offer price so far in 2010. Why so low?

Smith: "Remember, year to date, the S&P 500 is down 2.2%. IPOs are not outperforming the market, but they're not underperforming, either. I take a lot of heart that high-beta IPOs are not doing so bad. IPOs are hanging in there with the market."

AdvisorOne: Measured by number of deals, the technology sector comes first and finance comes in second, with 16 deals totaling $2.9 billion and an average first-day return of 8.1%. But then the average total return for the Finance sector is a disappointment: negative 0.1%. Why so different from the first-day return?

Smith: These IPOs started out with strong interest, but they haven't sustained interest beyond the first day of trading. REITs are the lowest performers in the finance sector. The best after-market trading has been in growth companies in the financial segment--Green Dot and Envestnet. They're not a typical yield play. CBOE has really disappointed a lot of investors because of their fears about derivatives regulation.

Fed's Lower Rates Are Good for Finance IPOs

AdvisorOne: A history of the Finance sector shows that over the last 10 years, IPO filings rose steadily from seven in 2000 to a high of 42 deals in 2004. After that, IPOs dropped off slightly to 31 in 2005, 27 in 2006, and 29 in 2007. And then they plummeted to only three deals done in 2008 and 11 in 2009. What do your numbers say about the finance sector's performance over the last decade?

Smith: Financials had been really strong on a relative basis until the meltdown. When the Federal Reserve started lowering rates, such as in the last two years, that tended to be good for financial stocks--banks, insurance companies, and REITs. When the Fed starts lowering rates, it gives financial institutions cheap money.

AdvisorOne:What about CBOE Holdings? Why did that turn out to be such a disappointment?

Smith:There was a lot of enthusiasm for CBOE, and I think investors did not see how the potential financial regulation bill would hurt its business, and it did hurt its volume. That's a specific thing. That was an unusual deal pricing above the range. We have a chart on the price ranges that underwriters and companies place on an IPO, and it's a really important chart. If you look at our pricing chart, we have a category on "offer price discounts," and you'll see that 50% of the IPOs in 2010 have priced below their range.

AdvisorOne:Why?

Smith:Because the IPO market has been trying to find a good clearing price. In 2010, we were in a nice run through March, and then saw a lot of choppy waters in the market. Year to date, we're down. Because of that, every time an IPO gets priced, investors are really, really picky about the price. So companies and the underwriters are coming in with these higher expectations, and the marketplace is saying, "Uh oh, lower those expectations." That's why you've seen discounted pricing, and when they're discounted enough, a good company trades well in the aftermarket trading.

Some companies, especially smaller ones, who see this happening may have filed, and then they say, "Well, if I have to come out at a really low valuation, maybe I shouldn't come out yet." This is part of the repair process that's going on with company pricings and valuations. Investors and new companies don't put in money to lose money. Otherwise, you could invest in an already established company. Why would you look at something new? That is why it's so important to have a positive return in IPOs. So the market is trying to find a level.

Deals Are Only Postponed, not Withdrawn

AdvisorOne: It looks like a lot of announced deals in the finance sector just aren't getting priced. Since July 8, when Fortune Bank shelved its $360 million IPO, a total of 11 IPO filings in the Finance sector have not gone to market. Why is that? [Editor's note: Finance IPOs waiting to price in the pipeline include netSpend, STAG Industrial, Walker & Dunlop, Gladstone Land Corporation, Summit Hotel Properties, The Aveon Group LP, Richmond Honan Medical Properties, Imperial Holdings, ECM Realty Trust, Velocity Commercial, and FXCM.]

Smith: But note that they haven't been pulled off the table. They've been filed. Looking at my list of postponed financial IPOs, I can see that DLC Realty Trust postponed a $500 million REIT filing, and then you have Callahan Capital Properties, another REIT which was going to be big, at $500 million. Fortune Bank, at $360 million, was significant, too. These companies are just saying, "Okay, the white flag's up. I surrender, I can't do it." Investors want to make money, and the REITs haven't traded well, so they don't want a capital loss, so that's the reason for REITs. As for Fortune Bank, it's a $360 million filing--that's significant. So why did they pull that? Well, it's a recently formed company, a blind pool. It's not a business yet; it's a recently formed commercial bank. It's a story stock, meaning there isn't a business to analyze, and we're in a risky market. Why, when there are so many outstanding opportunities, would you invest in something that doesn't have a business underneath it yet?

Let's put it this way: the market has been challenging. However, what you're really getting to is that there are a bunch of IPOs still on file hoping to get priced. There are a lot of companies willing to get done even if they're hard to get and they have to discount the price. They know what's happening, right?

The latest filings in the pipeline show that there are 168 IPOs waiting in the pipeline. That's a lot. The point is, there's a whole lot of momentum built up for companies that want to come out, and they're going to come out at very attractive prices to get done. They are not withdrawing them. We're going to see more discounted deals. We had a really bad stock market in August and part of July. If the market gets through this and becomes a little more stable, we'll start to see the deals getting done. When you look at what's been raised in 2010, $13 billion in the United States, but there's another $57 billion waiting to get done.

Read more about Renaissance Capital's data about the frozen IPO pipelineat AdvisorOne.com.

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