Sizzle to Fizzle: Relaxed IPO Rules Have No Longer Term Impact

When disclosure regulations for IPOs in the US were relaxed last year, advocates claimed that this would free enterprises from the chains of regulatory overkill, encourage even greater economic activity and increase the number of new jobs.

Opponents worried that fraud and abuse would increase as ruthless speculators would attempt to foist underperforming assets on an unwary public. Cynics simply acknowledged the potential for investment firms to make a bit more in fees.

If two years of experience have taught us anything, as the following article explains, it is that little has changed. In the short term there have been benefits to traders employing the Greater Fool Theory who get in and out fast, but in the longer term, the performance of shares issued under the new regs is almost identical to those issued under the previous regulatory regime.

Transparency invariably comes with a cost in the short term but salutary effects in down the road. The rampant short termism evident in the economy today seems too deeply entrenched to change, but is, in fact, a cyclical phenomenon. Enterprises that want to grow rather than launch and sell are finding that investors want more information not less. Asymmetric distribution of data almost always benefits only those with something to hide. JL

Emily Chasan reports in the Wall Street Journal:

Long-term investors worry that the streamlined filing process and reduced disclosures the law allows will eventually hurt returns."Less information and less transparency are ultimately negative."

It is an increasingly common story: a company makes scaled-backed disclosures about itself before going public and gives investors scant time to digest the information. The shares sizzle in their first weeks of trading but start to fizzle within a year.

Is this the JOBS Act effect? It has been more than two years since Congress passed the Jumpstart Our Business Startups Act, which was designed to make it easier for companies with less than $1 billion in revenue to make initial public offerings.

That it has done. But while short-term investors and venture capitalists are cashing in, long-term investors worry that the streamlined filing process and reduced disclosures the law allows will eventually hurt returns.

"Less information and less transparency are ultimately negative," says Kathleen Smith, a principal at Renaissance Capital LLC, which tracks and invests in IPOs.

At first glance, however, the results look impressive: Nearly 20% of the so-called emerging-growth companies that went public this year started trading above their expected price range, compared with about 10% of big-company IPOs.

In their first three months of post-IPO trading last year, shares in companies with $1 billion or less in revenues gained 38%, versus a 15% average gain from 2000 until the JOBS Act took effect. They also beat last year's average three-month post-IPO gain of about 35% for bigger companies.

Flash forward and the pattern of gains has reverted to the historical trend: Large-company IPOs have turned in better long-term performances, according to Dealogic. To date, last year's larger IPOs have posted average gains of 40%, while returns from smaller companies are hovering near 36%, the same pattern as before the JOBS Act.

An early "pop doesn't mean anything if you can't have follow-through," says Ms. Smith.

Of course, strong stock markets tend to be rocket fuel for IPOs. The broad Russell 3000 stock index returned almost 34% last year—its best performance since 1995—which could explain the short-term gains.

Emerging-growth IPOs now account for more than three-quarters of the U.S. IPO market, according to Dealogic. And most of those companies are in the technology, media, telecommunications and biotech industries, where it is common for IPOs to price above expectations.

"That just means bankers are low-balling companies going public," says Lise Buyer, whose Class V Group LLC in Silicon Valley advises startups on IPOs.

Companies covered by the JOBS Act enjoy many benefits. They can submit their IPO plans to regulators behind closed doors, and they don't have to reveal their plans or any regulatory feedback until 21 days before they start their investor roadshows. They also can disclose just two years of audited financial statements, instead of the standard three, and the pay packages of their three top-paid executives, instead of the standard five.

Almost 80% of emerging-growth companies have used the confidential filing provision, while 90% took advantage of reduced compensation disclosures, and 45% are using the provision that lets them file just two years of audited financial statements, according to a review by accounting firm Ernst & Young.

Those benefits, among other things, make it tough to evaluate a company's executive-pay practices. For its November IPO, Twitter Inc.  TWTR in Your Value Your Change Short position listed the pay of its three top-paid executives. But by April, when it filed its proxy, two of those named executives had dropped out of the top three due to job turnover and pay changes. Twitter never disclosed the full pay package of former Chief Operating Officer Ali Rowghani.

Twitter shares rose 92% in their first three months of trading, similar to the pattern of other JOBS Act IPOs. They have since fallen around 34% from their December peak.

Twitter declined to comment.

Many executives applaud the law, which was passed in the wake of the recession and was aimed at kick-starting the economy. "In Silicon Valley, it has been a very good thing," said Sean Aggarwal, chief financial officer of online real-estate company Trulia Inc.,  TRLA in Your Value Your Change Short position which went public in September 2012.

"It used to be that your competitors would grab your filing documents and the company couldn't say anything, or your employees would get distracted looking at the documents. With confidential filing you can keep all of that under wraps," he said.

Trulia chose the law's confidential filing option, opening its books to investors just three weeks before a roadshow presentation to potential investors. Ultimately, its executives decided to provide as much information as a large company would.

"We did the extra work and spent the extra money," Mr. Aggarwal said. If the company had taken advantage of the JOBS Act's exemptions, "it's quite possible [that] instead of focusing on our story, our path, and our competitive position, investors would have spent a chunk of the roadshow meeting talking about disclosure."

For investors, IPOs that start trading above their expected price range can signal a stock shortage or confusion about demand.

Some also fret about masked risks. "Emerging-growth companies themselves are admitting in their [Securities and Exchange Commission] filings that taking advantage of JOBS Act provisions is a risk factor that may cause investors to view such companies less favorably," says Sen. Jack Reed. (D., R.I.) who voted against the JOBS Act. "That in and of itself should cause some concern."

Another risk for investors is that economic growth and low interest rates fueling the stock market may have obscured the true effects of the JOBS Act.

It could be years before it is clear if the JOBS Act's exemptions were worth it. "The biggest telling will be how have these stocks performed vis-à-vis a rising economy once we get five years down the road," said Lynn Turner, former chief accountant at the SEC. "At the end of the day, when investors have a bit more transparency and see how they are actually doing, that is what will impact returns."