I always found Newton’s cradle to be a fun contraption. You know the one: The metal balls that swing in opposite directions, going back and forth as they hit the stationary balls in the middle.
This little desk toy demonstrates powerful principles of momentum and energy. But here’s the thing: To make it work for long periods of time, you need the right materials. The balls need to be highly elastic, so they conserve more energy. And the density of the balls needs to be the same. Let me put it this way: The specifications matter.
It’s fun to think of the private markets as Newton’s cradle. This is an oversimplification, but money goes in one side into a seed-stage company, it scales, grows, innovates, and—if all goes well—IPOs come out the other end. Returns that were held up during the process are handed back to LPs, then can be reinvested back into the system. In an ideal world, you get worthy, innovative companies that improve hiring rates and make the world a better place, and people make money throughout the process, too. Woo!
But as 2022 has made it abundantly clear, there’s a series of external indicators that heavily influence whether those balls maintain their momentum and keep snapping back and forth—or whether they come to a halt and the whole system gets clogged up. There are things like interest rates, discount rates, regulation, public market performance, economic growth, inflation, etc. All those things have a very real impact on the viability of the IPO market. And the IPO market, in turn, has a very real impact on the trajectory of companies that are aiming for it.
The American IPO market was basically dead last year. Sure, there were a few IPOs here and there, but people weren’t really making much money from them. EY’s 2022 Global IPO Trends Report revealed that, in the Americas, there was a 95% reduction in proceeds from companies that went public in 2022 versus 2021. 95%. There were 76% fewer IPOs in 2022 in the Americas than the year before.
So when will all this pick back up? And which companies are in the cages, waiting for the gates to open?
While no one can pinpoint exactly when the IPO market will reopen, Glen Anderson and Greg Martin, who run the secondary brokerage Rainmaker Securities, where investors can buy shares of private companies outside of formal liquidity events, guess it will be in the third quarter of this year.
“Obviously, I think it relies upon the stabilization of interest rates,” Martin says, adding later. “As long as we’re in an increasing interest rate environment, which we still are right now, I think the markets are going to remain closed, and we're going to still have very choppy equity markets.”
If the Federal Reserve stops raising rates sometime in the second quarter, then the IPO market could start to open back up in the third quarter, Martin says. “The market is looking for stability.”
Bonnie Hyun, U.S. head of capital markets at the New York Stock Exchange, helped explain why the Fed’s decision-making is so influential to IPOs: Interest rates are directly correlated to discount rates, which are used to calculate the present-day value of future cash flow of a company, she explains. When interest rates go up, so do discount rates, which can contribute to a lower valuation of a company.
“I think that in 2021 when you did see companies that had no revenue or limited revenue go public, that was based on the notion of future cash flows,” Hyun says. “I think that whole sentiment has changed.”
Interest rates can also impact LP interest in the venture capital sector, as less-risky asset classes can become more appealing in high-interest-rate environments.
If the IPO market does reopen this year, which companies will go public first? Martin and Anderson tell me that investors continue to show sizable interest in shares for bluechip startups like SpaceX, Stripe, Rubrik, Klarna, Bytedance, and Databricks, among other late-stage tech stocks—making these companies worthy candidates if they decide to go public.
This doesn’t mean that investors are willing to pay the same prices for companies as their last funding rounds may indicate, however. In mid-November of 2021, investors were scooping up shares of Stripe on the secondary market for as much as $83 per share, according to Rainmaker data. At the end of last year, the secondary brokerage was placing orders for between $29-35 per share. Stripe is one of several companies, such as Instacart, to reportedly dock its own valuation amidst the downturn, while Klarna did so as part of a formal fundraising round.
Besides factors like discount rates, part of the reason that shares of late-stage companies have fallen in price is demand. In 2022, family offices, high-net-worth individuals, hedge funds, and mutual funds retreated from the market as the IPO market closed, Martin says. Now those investors are starting to trickle back in. (Private equity investors and VCs have continued to invest, Martin and Anderson say.)
Amid the market volatility and newfound preferences for profitability, some companies no longer appear to be as poised for an IPO as they might have been this time last year. Martin says that there were hundreds of companies getting secondary market traction from investors in 2021.
“Now it's more like 30, 40, 50 that are seen as either a little bit higher quality, or they've come down so much in terms of valuation, they represent bargain opportunities,” Martin says. Anderson pointed out that startups like Discord, Epic Games, Kraken, OpenSea, Udacity and Automation Anywhere—all high-interest companies on the secondary market last year—are no longer garnering the same level of interest in terms of secondary trading activity at Rainmaker. (Spokespersons at those companies had not responded to requests for comment by the time of publication.)
“I think the damage is definitely going to be substantially reduced valuation multiples,” Martin says. “You better have predictable revenue, be profitable, and have great unit economics, and probably a very secure $1.5-$2 billion market cap before any underwriter is going to take you public. And probably more.”
How are you feeling? Term Sheet is partnering with Semaphore again for its 15th annual confidence survey of private equity, venture capital, hedge fund, and other professionals. Did 2022 turn out to be a poor year for both investment returns and the managers/service providers of PE, VC, and hedge funds? Are investors complicit in the downfall of Sam Bankman-Fried and FTX? How could a split Congress influence the private markets? Weigh in, if you like, and share your level of confidence in yourself, the economy, and your business; it’s anonymous and should take you 3-4 minutes. You can take the survey here. Have a look at last year’s results here and here.
One note…I updated Friday’s newsletter online to make it clear that VCs do report the "fair value" of their investments to LPs, but "fair value" can be highly subjective.
See you tomorrow,
Jessica Mathews
Twitter: @jessicakmathews
Email: jessica.mathews@fortune.com
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Jackson Fordyce curated the deals section of today’s newsletter.
