Lower Inflation And Federal Reserve Rate Cut Could Revive The IPO Market
The October 2023 Consumer Price Index report showed inflation came in unchanged from the month before, according to the Wall Street Journal. Could the resulting drop in interest rates and soaring stock market foretell a reopening of the initial public offering market?
That would be great for startups. After all, many company founders dream of turning their ideas into a fast growing publicly traded company. About three years ago, the market for IPOs began to shut down —deferring or destroying many such founders’ dreams.
Why did the IPO market shut down? In November 2021, investors suspected the Federal Reserve Bank would raise interest rates significantly for the first time in more than a decade. This expectation sent tech stocks plunging and made the IPO market look much riskier.
This raises many related questions:
- Why did the IPO market shut down?
- How have entrepreneurs been coping?
- What early signals could presage the IPO market’s revival?
The October CPI report could help revive the IPO market — especially if inflation continues to come in below investor expectations for the rest of 2023.
Is Inflation Tamed?
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The Bureau of Labor Statistics reported October inflation was unchanged from the month before, prompting the “likely ending [of] the Federal Reserve’s historic interest-rate increases,” the Journal noted.
October’s inflation results were relatively modest. Overall consumer prices rose at the same rate they did in September — 3.2% compared to the same months in 2022 — and they were abetted by declining gasoline prices.
Excluding volatile food and energy prices, October 2023 core inflation rose 0.2 percentage points compared to September — a 4% increase from October 2022, the Journal wrote.
This outcome was more sanguine than expected. Private-sector forecasters and some Fed officials expected higher core inflation. “The progress is probably going to come in lumps and be bumpy, but we’re making progress,” Fed Chair Jerome Powell said at a news conference earlier this month.
The Fed is aiming for 2% inflation according to a separate measure from the Commerce Department. Powell said reaching that goal “may actually take a longer time,” the Journal noted.
Two economists were optimistic about inflation coming under control. “We may have brought down inflation as fast as it has ever come down, and we did that without starting a recession,” Chicago Fed President Austan Goolsbee told the Journal in an interview last week.
”The sources of inflation are disappearing quickly,” Luke Tilley, Wilmington Trust’s chief economist, told the Journal on Tuesday. “A whole bunch of categories are moving in the direction that we need them to.”
Why The IPO Market Shut Down
What do inflation trends have to do with IPO opportunities? The IPO market shut down because after more than a decade of near-zero interest rates, in November 2021 rumors surfaced of Jerome Powell’s likely reappointment as Fed chair, reported the New York Times NYT .
That appointment would come with a mission to raise interest rates until inflation — until then thought to be a result of temporary factors related to Covid-19 — dropped below 2%.
Fears of rising interest rates sent tech stocks tumbling. Plunging stock prices broadcast a message to investors: When established technology companies lose value, it’s foolish to increase the supply of technology shares by taking private tech companies public.
After a boom in 2021, the IPO market nearly shut down – a trend that has continued for the last three years. With the exit door slammed shut, venture investors told most of their portfolio companies not to expect more cash.
The numbers support this conclusion. Excluding special-purpose acquisition companies, in 2020 and 2021, more than 600 companies went public. Since then, not so much. “In the nearly two years since, there have been fewer than 200,” the Wall Street Journal reported.
Venture capital investments have plunged since 2021. After nearly doubling to $345 billion in that year, such investment in the U.S. fell 57% in 2022 to $241 billion, according to Statista.
That downward trend persisted into 2023. Venture investments in the second quarter of 2023 fell 34% to $29.4 billion from the first quarter’s $44.4 billion, according to E&Y.
How Entrepreneurs Have Been Coping
The shutdown of the IPO market caused a virtual freeze in pre-IPO funding rounds. Moreover, the contraction of software company valuations cut off their flow of venture capital.
Startups scrambled to avoid a down round — raising new capital at a lower valuation than the previous round, according to CNBC.
Since the 2022 IPO market shut down, investors shifted focus from rapid growth alone to higher margins, more sales efficiency, and higher revenues from existing customers, CNBC reported.
This change in investor focus from growth to productivity has significant implications for business leaders. Now CEOs must improve operations by reducing the amount of time it takes sales reps to become productive and increasing the number of salespeople who contribute to meeting a company’s goal for annualized recurring revenue.
Perhaps most importantly, leaders must increase their revenue growth from existing customers – known as dollar-based net retention. In a productivity-obsessed investment climate, this metric is growing more important since “it takes 14 times more money to generate revenue from a new customer than from an existing client,” CNBC wrote.
Many startups have not been able to satisfy investors’ more stringent performance expectations and have either raised capital at much lower valuations or shut down completely.
While I cannot find detailed startup failure statistics by year, a report that tracks startup post-mortems suggests more have failed since 2021.
How so? In 2021, 253 startups failed due to many reasons, including “a faulty business model and poor product-market fit, running out of cash or a lack of passion and perseverance,” according to CB Insights’ startup post-mortem report. By August 2023, that report tracked 463 startup failure post-mortems.
Four Indicators Of A Reviving IPO Market
Here are four early indicators of a possible IPO market revival.
Gains In The Stock Prices Of Recent IPOs
Rising post-IPO stock prices could help revive the overall market. That would reverse the recent trend.
This fall, three big tech companies went public: chip designer Arm Holdings, grocery-delivery company Instacart; and e-commerce firm, Klaviyo. As of November 13, all but Arm traded below their IPO prices.
The disappointing performance “likely shut the [IPO market’s] door for the remainder of 2023,” the Journal reported. ‘
Declining Interest Rates
If the Federal Reserve sees inflation dropping below its 2% target, interest rates could drop and stocks could rise. Expectations of lower rates could send technology stocks soaring.
Steadily Rising Technology Stock Prices
Since late 2021, technology stocks have been whipsawed, the Journal noted. A steady rise in the tech-heavy NASDAQ NDAQ index could create demand for more technology company shares.
IPOs Of Fast-Growing Generative AI Companies
No doubt, business leaders would like to see that demand satisfied by a reopening of the IPO market. The most attractive candidates for IPOs would be soaring Generative AI companies like OpenAI and Anthropic – both of which are enjoying rapid revenue growth.
Risks To This Rosy Scenario
Many things could upend this rosy scenario. The most notable one is persistent high inflation due to the wage increases resulting from the recent settlements of disputes in industries including automobiles and entertainment.
This excludes higher wages for “baristas, national park bus drivers, hotel housekeepers, lawyers, book sellers, locomotive plant workers, sour cream producers and brewery workers,” the Washington Post reported.
Count me among those who hope inflation goes below 2% and stays there. Investors could benefit from a reopening of the IPO market — which should help propel the stock market and keep the economy from tilting into a recession.