IPOs are being boosted by private equity.

Volumes of initial public offerings (IPOs) are expected to establish a new high in 2021, providing investors with a more significant return potential than market equities but at a higher risk. However, investing in the appropriate IPO is dependent on more than simply geographical location and industry. The volume of global IPOs has already surpassed the total issuance seen in 2020 within the first nine months of 2021, with the Americas and Asia-Pacific (excluding Central Asia) accounting for more than 75 per cent of the total capital raised, with China (29 per cent) and the US (30 per cent) being the main contributors. These estimates are even more impressive when they omit the 2020-2021 SPACs (Special-Purpose Acquisition Company) market surge.

The market's acceleration is unsurprising given the ultra-high equity valuations created by ever-increasing share prices, making the ideal environment for firms to go public. Most IPO-heavy equities sectors (for example, information technology) are presently trading at 20-year high multiples. The Eurozone is now outpacing the US and the global aggregate. Simultaneously, developing economies fail to stay up due to differing economic conditions and China's legislative crackdown.

This historically low-interest-rate environment, high stock multiples, improved macroeconomic outlook, and implicit central bank "whatever it takes" put protection all set the ground for continued IPO growth. However, there are a few risks to be aware of: IPO prospects pay a more significant proportion of their cash flows in the long term rather than in the short time because of their relatively lengthy cash flow duration. IPO candidates are exposed to interest rate variations and remain highly vulnerable to equity market volatility. As a result, if interest rates were to increase rapidly (e.g., owing to a policy error, persistent inflation, etc.); or stock markets were to return from the present bull run (e.g., due to external reasons, shift in risk appetite), IPO markets would close down very quickly.

However, remaining at the aggregate level would be unreasonable because the underlying nature of the IPO business, as well as the relatively low market "liquidity" in comparison to traded equity, means that stock-picking is the critical determinant of future returns, making it more difficult to embark on a broader passive portfolio strategy. When comparing the return distributions of traded equities and IPO businesses, it is clear that while the average return for traditional traded equity is more significant (more appropriate for passive investment), the tails or extremes of the return distribution are broader and denser in the case of IPOs.

How can investors choose a successful IPO? Although the correct location, sector, and size are essential, private equity-backed IPOs are more likely to beat "naked" IPOs. When the IPO market is dissected further, it becomes evident that IPOs follow the success of the equities sector. In other words, like a dog trying to bite its tail, an acceleration in the relative performance of a specific industry versus the broad market tends to trigger a wave of new IPOs within the thriving sector as companies ready to go public take advantage of the window of opportunity to enter the market. With this in mind, the fast acceleration in tech-related IPOs before the Dotcom boom, as well as the acceleration in financials before the subprime crisis, are prominent examples of this self-fulfilling dynamic.

The Covid-19 pandemic caused "stay-at-home" and health-care-related industries to outperform (i.e., technology and healthcare), resulting in a surge in IPOs in those areas. However, current market dynamics indicate that the recent acceleration is unlikely to last much longer, implying a slow and steady return to long-term average returns and issuance levels. As a result, we anticipate that pro-cyclical IPO markets will slow, paving the way for more traditional/defensive sector IPOs. It is important to note that non-IPO-intensive industries flourish in market consolidating situations, with industrials, minerals, and energy demonstrating resilience.

Without a doubt, if picking the correct IPO was a simple operation, it would no longer produce intriguing profits since every player would rush into the market ("A method that becomes common knowledge can no longer be deemed a strategy"). However, when IPOs are treated as a tactical investment (with a 12-month investment horizon) and broken down by location, sector, kind, and size, there are some fascinating parallels among successful IPOs.

We see a definite market pro-cyclicality of the IPO activity when looking at industries. Before the dot-com boom (2000-2001), the technology sector accounted for more than 90% of total IPO performance, but it quickly became a drag following the crisis. Similarly, financials were relatively important in the years preceding the 2008 Great Financial Crisis disaster. Despite this obvious pro-cyclicality, current IPO success is unique in that it cannot be attributed to a particular industry but rather to the whole market. It indicates a healthier and more fundamental market outperformance than a one-time surge in a specific sector. This odd behaviour appears consistent with the broad equities rally after the initial market sell-off in March 2020.

What causes the significant return disparity between naked IPOs and PE-backed IPOs in aggregate? The essential point is that, due to their rigorous business selection, private equity firms do not fully follow the aggregate IPO market behaviour, resulting in significant variances in sector allocation. For example, private equity firms avoided overweighting financials in 2006 and 2008 but in 2014 and 2015. Similarly, private equity firms did not follow the 2020 technology trend but are now, on average, overweighting the sector in 2021. Overall, being more selective in asset selection appears to offer some quantitative and qualitative overlay to the investing process, which aids in differentiating successful from unsuccessful tactical IPO bets.

For institutional investors, the primary driver of their interest in public markets is a potential discount on the share price at the IPO. Stocks of promising firms may rise after the IPO window has closed, making it harder to invest. Furthermore, later-stage and growing enterprises seek investors interested in crossover investments. As a result, institutional investors engaging in both PE and IPOs have become a common occurrence in the market, putting significant pressure on players investing in both.