After spending some time away, our friend asks us: how do megacap IPOs affect us?
Initial public offerings (also known as IPOs) are the processes by which private companies become public, that is, their capital is opened to the general investing public, they begin to trade freely on secondary markets (stock exchanges), and they are subject to the regulation and scrutiny of public companies with access to less sophisticated investors.
Megacap companies are those with valuations above $200 billion[1]. Due to the large capitalization, they tend to be overrepresented in indices that use this variable to determine the relative weights of its components.
We have recently learned that at least three private companies, all of them related to futuristic technologies, have begun their IPO processes.
Our friend is curious, and we sense concern, about the impact this could have on his investments.
If we start from the basis that most individuals have their financial investments in retirement or educational savings accounts and products, and if we accept that most of these accounts and products invest in funds (either mutual, CIT or ETFs), then it is worth asking how and when these new issues would reach these funds and whether this is positive or negative.
In general, mutual funds and ETFs are separated into two, passive or index funds, i.e. funds that faithfully follow a representative index of the market (S&P 500, Russell 1000, Nasdaq 100, etc.) that will serve as its benchmark, and active funds, i.e. those that, although they may have a benchmark index, can invest more or less freely following the directions of those in charge of managing them.
Passive or index funds, by definition, follow or mimic their benchmarks, i.e. the moment their benchmark index changes its composition, the fund also changes it to follow it faithfully. In this sense, index composition rules determine when a new issuer is added. In general, the rules state that a reasonable amount of time must pass since the IPO[2] and, in some cases, that companies must be profitable to be added. We have read about several indices that have decided to shorten the waiting period before onboarding a new issuer. In this sense, it is possible that such inclusions occur a few days after the IPOs and are then followed by the index funds.
Active funds are not required to track an index, but their managers may decide to include the new assets in their portfolios, depending on their analysis and investment policies.
It is important to mention that many indices use methodologies that adjust the target weights by free-float, that is weights depend on the number of shares available to trade freely on the exchange, or said differently, if a considerable number of shares are not available or are restricted for sale, then the relative weight of said issuer will be less than it would be if all the shares were available. We now know that some of the companies that have recently shown interest in going public have a high percentage of shares that will not be initially available for sale, reducing the weight in the indices and in the funds.
In conclusion, retail investors will have exposure to these new issues within days of their IPOs, either because a passive fund makes the changes to follow its index, or because an active fund decides to have them.
Regarding the question of whether it will be positive or negative, we can say the following: these new issuers are going to be part of the investable universe and therefore it makes sense to consider them. On the other hand, this will depend on the investor’s investment horizon. Being futuristic technologies, a good part of their current value comes from what is going to happen in the distant future and not from what is happening right now as it is the case that many of these companies are still young and do not have profits. This entails short-term volatility, given that investors do not have a stable earnings floor on which to base a valuation, and given the possible oversupply of shares from employees and private investors. In the long run, however, performance will depend on the gap between the projections used in the initial valuation and what ultimately turns out to happen.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] Each of the three companies referred to in this article is expected to exceed this threshold at least five times.
[2] This is largely due to the volatility that usually accompanies an IPO. This volatility comes from several aspects unique to IPOs, for example, the market has not had the opportunity to analyze the issuer and establish a target price. Short-term volatility can also come from an excess of supply or demand in the period right after the IPO, exacerbated by the opportunity for investors who previously did not have a secondary market to sell their positions, lock-in gains and reduce exposure.