An Open and Shut Case: The Madness of the IPO window

As biotech companies queue up like lemmings on a cliff top to hurl themselves through the ‘IPO window’ while its open, DrugBaron tried (and failed) to understand the mentality of public market investors who shun biotech assets for years, and then suddenly buy anything (or so it seems).

The trigger for many, if not all, of these companies to go public has not been new data, or any material change in the value of their assets, or indeed anything specific about the company at all.  Instead, it’s simply the opening of the window.

If you have a good team (or even a team that looks good), a viable asset and a swagger, you can raise money on the public markets in 2013.  Last year, similar companies – even the very best companies – had no such opportunity.

Such is the current enthusiasm for biotech stocks, these same public market investors promptly drive the price higher, netting a decent return for the anchor investors.  Such a demand cycle is clearly self-sustaining with bankers and investors eagerly looking for the next trick.

Eventually – and if the current headlong dash to join the IPO queue is sustained, then soon – supply will exceed demand, and since the prices had little to do with the actual underlying enterprise value of the companies prices will drop precipitously.

When that happens, and investors are burned, the binary switch in their brains will flip back to the ‘off’ position and the window will slam shut for a further indefinite period.

Such wild swings of sentiment are bad for the industry, and are driven by unrealistic negative sentiment in the closed periods and unrealistic positive sentiment in the open periods.  What we all need is a healthy – and above all sustained – dose of realism.

Reliable access to the public markets for biotech companies would make a big difference to the business model of drug discovery and development outside of global pharma companies.  But this kind of feast followed by famine is damaging even in the feast phase – because at least some of the companies going public in 2013 will turn out to be duds.  And the number of eventual failures that do make it to market is only increased by the apparent loss of stringency that accompanies a bubble.

Sadly, the behavior of markets in respect of biotech IPOs is only symptomatic of a deeper ill in modern free-market capitalism: the dissociation of stock price from enterprise value.  Almost all the short term fluctuation in stocks is driven by human psychology – its not about what I think a company is worth, but about what I think the other market participants will judge the value to be tomorrow.

More than 90% of all the capital playing the public markets is traded on these short term fluctuations.  Derivatives and ultra high frequency trading are all tools that emphasise the importance of market fluctuations (based on sentiment) rather than on changes in the enterprise value.

The solution is quite simple: a reduced tax on dividend income and an increased cost of trading.  Some economists argue that ideally the cost to trade should be zero, so that prices most accurately reflect the current average perception of value.  But DrugBaron disagrees: low trading costs lead to shorter term, sentiment-based trading at the expense of longer term allocation of capital to more productive (and hence more valuable) users.

Of course, such solutions lie entirely outside the biotech domain – wholesale changes in the way governments regulate public markets are required.  And without them, its hard to see when the madness of an IPO window oscillating between wide open and firmly shut will end.  I guess, as with any bubble, the skill is first recognizing it as a bubble (though I doubt anyone could mis-call that) and then calling the moment when sentiment will turn – and avoid buying just before the peak.

In the meantime, good companies, average companies and even a few bad companies will exploit the feeding frenzy.