How could mega-cap IPOs affect markets?

In the U.S., there are now more than 800 venture-backed private companies valued at over USD 1billion, and a handful of private companies that have raised capital at valuations near USD 1trillion. When these companies eventually go public with their Initial Public Offering (IPO), they could become meaningful components of public stock indices and ordinary investors’ portfolios.

How big a splash could large IPOs make when they first begin trading?

An important point to keep in mind for initial public offerings is that they typically float only a small fraction of the total shares, rather than releasing them all in one go. That helps to facilitate an orderly entry into the trading flow, allowing markets to digest the volume gradually. A large chunk of shares owned by private owners can remain locked up for six months or longer.

That means that a trillion-U.S. dollar IPO is not automatically a trillion-U.S. dollar market event on day one, and the impact on markets can be managed to limit volatility.

When could large IPOs be included in stock indices?

Stock indices are rewriting their rules to adapt to the new phenomenon of mega-cap IPOs. The index providers behind the Nasdaq 100 and the Russell 1000 indices have released commentary around how they would “fast track” the inclusion of large companies in their indices. Based on these announcements, mega-cap companies could join the indices in a matter of weeks or months, rather than taking years as is typically the case with IPOs of smaller companies. The index provider behind the S&P 500 index opted to keep its current inclusion rules in place, which include at least a 12-month seasoning period as a public company, financial profitability and a minimum of 10% of its shares available to the public.

The weighting of companies in indices is typically based on the free float, or the percentage of shares available to public investors. So, during initial trading with a free float of 5% for example, a company that is a mega-cap in terms of total valuation might still make up a relatively small percentage of the index. Some index providers have chosen to apply multipliers to the free float percentage of new IPOs, which could amplify their impact on the index.

Will funds have to sell some stocks to buy new ones?

Not necessarily. Funds that have strong inflows can use capital to preferentially acquire newly minted shares without having to sell existing holdings. Also, managers have some flexibility to manage liquidity in advance, so they are able to deploy it into new listings.

That said, some rebalancing activity is to be expected, which could translate into short-term volatility. Strategies that are actively managed and can allow small deviations from passive benchmarks may be able to better manage volatility and take advantage of timing opportunities than passive strategies.

How will index composition adapt over time?

As more shares are floated, and as lock-up periods expire, the weights of new companies in the indices will grow. The performance of the companies post-IPO, and therefore their valuation, will also determine their ultimate weight in stock indices.

What to expect in early trading?

Freshly floated stocks can be volatile, as investors process new information and form opinions on valuation. The average IPO this decade, for example, popped 32% on the first day of trading, but was down 26% from its offering price after one year, as seen in Exhibit 1. Headlines at the bell-ringing event can create early excitement, but ultimately the fundamentals of company performance determine where stock prices land after the confetti settles.

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