When Evaluating Venture-Backed Initial Public Offerings, Patience Is a Virtue
Published on October 11, 2019
The venture capital industry has created a robust pipeline of new public companies, but in our view discipline is the key to finding the best opportunities.
2019 has been a rough year for the venture capital industry. Multiple high profile IPOs have either fared poorly (e.g., Uber, Lyft, Slack, Peloton) or been postponed (e.g., WeWork), tarnishing the industry’s reputation and triggering a wave of negative press.
Lost amidst the headlines is the significant fact that over 80 venture backed firms have gone public already this year, and another 134 went public last year1. These totals indicate that the VC industry is thriving, which is good news for managers like us. Not only does the creation of new public firms expand our investible universe, but more importantly, VC-backed emerging firms generally exploit the types of secular growth trends that we believe are the true drivers of both revenue growth and returns.
Venture Capital Has Evolved
The venture capital industry has been growing steadily for the past decade and is now a powerful economic force. Venture backed firms impact society in a variety of profound ways, whether or not they’re public. Ridesharing giants Uber and Lyft began transforming how people get around long before their recent IPOs. Likewise, AirBnB has fundamentally changed how people travel, even though it’s still private. And Beyond Meat is having a similar impact on how consumers think about hamburgers and other meat products.
As the chart below demonstrates, over the past ten years domestic VC activity has been steadily increasing across all three major dimensions: fundraising, investing, and exits.
Source: 4Q 2018 PitchBook-NVCA Venture Monitor
The VC industry is not only getting bigger, but it is also becoming more diverse. In the chart below, notice how the share of investment into “other” industries has increased from about 10% in 2011 to a peak of 30% in 2018. Given that $131 billion was invested in 2018 versus just $45 billion in 2011, that means roughly $40 billion was invested in non-traditional sectors in 2018 versus just $5 billion in 2011. In addition, software has fallen from its peak of nearly 40% in 2014 to just above 30% in 2019.
There have been two other significant changes in the industry in the past few years. First, companies are staying private for longer, which not only enables VC investors to capture more pre-IPO value, but also allows startups more runway to prove their business model and solidify their revenues. At the same time, the industry is moving toward more “mega” rounds, which are funding events in excess of $100M. These huge investments have contributed to the proliferation of so-called “unicorns,” venture backed firms valued at more than $1 billion.
In our view, both trends are positive for disciplined investors. We believe the VC industry has absorbed some of the downside risk by letting companies incubate longer. At the same time, these companies have a longer track record once they become publicly traded, so we have more data to work with when we attempt to assess their prospects and compute valuations.
Patience Is a Virtue
We generally prefer to take a patient approach to investing in new public firms, even if we are bullish on the business. In our experience, the first several months following an IPO are a good time to stay on the sidelines as it allows the hype cycle to dissipate.
Perhaps more importantly, if a new stock is doing well after its IPO, we find that market technicals have an outsized impact on the share price relative to the fundamentals. Specifically, IPOs are generally oversubscribed due to limited supply, which artificially boosts prices. At the same time, lockup restrictions placed on company insiders further reduce supply, adding to the inflated prices. The combination distorts the company’s value on a temporary basis, and we prefer to wait till the pressure abates. On the other hand, if a company’s share price is falling after its IPO, we don’t want to invest even if we feel the business is attractive. We’d prefer to wait till the company finds a pricing floor.
Ultimately, our approach to investing in post-IPO companies is identical to the other positions in our portfolio. We only invest in firms that we believe can deliver sustainable secular revenue growth, and we are committed to purchasing these companies at reasonable prices so we can maximize our returns.
Case Studies
Two of our recent post-IPO positions were each purchased about two years after the companies went public. In both cases, we monitored the stocks until we had confidence in each company’s growth prospects and we felt the valuations were reasonable.
Planet Fitness (PLNT)
Planet Fitness is a national chain of budget-friendly health clubs with monthly dues that start at just $10 – a fraction of the cost of a typical boutique club.
The company went public in August of 2015, and for nearly two years following the IPO the stock was essentially flat. During that period, the company was aggressively expanding its footprint, increasing from ~1,000 locations to over 1,500, leading to both higher revenues and increased costs. Despite the company’s rapid growth, the stock was stuck in a holding pattern because the market felt the valuation was too rich (i.e., its earnings multiple was too high).
We liked the company’s growth trajectory, but we agreed about the valuation, so we stayed out of the stock for 18 months. We also liked the company’s approach to expansion – it built many of its new clubs in areas where previous retailers had closed due to online competition, so it was able to negotiate favorable rents in well-trafficked spots.
In April of 2017, we felt the valuation made sense relative to the growth prospects (i.e., the earnings had increased materially while the share price stayed mostly flat), and we decided to enter the position. We continue to hold it in our portfolio.
Etsy (ETSY)
Etsy (ETSY) is an online marketplace that brings together sellers and buyers of handmade arts and crafts. The company went public in April of 2015 and its shares began declining immediately, losing 75% in the first nine months before rallying modestly in 2016.
The company was well-positioned when it went public, as it was the first online marketplace to feature vintage and custom goods, but an inefficient management team prevented the company from achieving its full potential. Growth was lagging and expenses were rising.
In May of 2017, about two years after the IPO, Etsy replaced its CEO, and the company rapidly began to improve. We were personally familiar with the new CEO from his previous stints at eBay and Skype, and we had confidence he would be able to turn the company around. In September of that year, we initiated our position in the company, and we have held it ever since.
Conclusion
The venture capital industry has taken over 200 startups public in the last two years, but very few have been a fit for our portfolio. Some have performed too poorly, a handful of others have been too big (i.e., their market cap has exceeded our maximum threshold), and the rest have not grown fast enough to align with our investment objective. As growth managers we are laser focused on investing only in firms that we believe can sustain strong secular revenue growth and that we can acquire at reasonable prices. Taking a patient approach to venture-backed, post-IPO companies has been an excellent way to add high quality emerging businesses to our portfolio.
1 - “Initial Public Offerings: Updated Statistics,” Jay R. Ritter, University of Florida
James Callinan, CFA
Chief Investment Officer – Emerging Growth
Featuring
James Callinan, CFA
Chief Investment Officer – Emerging Growth
Jim Callinan was the Co-Founder & Chief Investment Officer at RS Investments. He also co-founded the RS Growth Group LLC in 1996 and managed the RS Emerging Growth Fund from 1996 until 2010. In 1999 Mr. Callinan was named Morningstar’s Domestic Stock Manager of the Year.*
He served as portfolio manager for the Putnam OTC Emerging Growth Fund from 1994 to 1996 and began his career at Putnam Investments as an equity research analyst in 1987. He joined Osterweis Capital Management in 2016 and brought with him the Emerging Growth Partners, LP, a concentrated small cap growth strategy he founded at RS in 2006.
Mr. Callinan is a member of the Weatherbie Capital Advisory Board.
He is an equity owner in the firm and the Lead Portfolio Manager for the emerging growth strategy.
Mr. Callinan graduated from Harvard College (B.A. in Economics), New York University (M.S. in Accounting) and Harvard Business School (M.B.A.). Mr. Callinan holds the CFA designation.
*Morningstar Managers of the Year are determined by a combination of qualitative research by Morningstar’s manager research analysts; risk-adjusted medium- to long-term performance track records; and performance in the calendar year.
For more information about this strategy, please send us an email or call us at (800) 700-3316.
Emerging Opportunity Fund Quarter-End Performance (as of 3/31/24)
| Fund | 1 MO | QTD | YTD | 1 YR | 3 YR | 5 YR | 7 YR | 10 YR |
INCEP (10/1/2012) |
|
|---|---|---|---|---|---|---|---|---|---|---|
| OSTGX | 4.46% | 12.10% | 12.10% | 26.31% | -0.87% | 13.72% | 15.68% | 12.93% | 14.65% | |
| Russell 2000 Growth Index | 2.80 | 7.58 | 7.58 | 20.35 | -2.68 | 7.38 | 8.40 | 7.89 | 10.29 | |
Gross/Net expense ratio as of 3/31/23:1.25% / 1.13%. The Adviser has contractually agreed to waive certain fees through June 30, 2024. The net expense ratio is applicable to investors.
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