IPOs 2017: Here's why issuers are hoping for a big comeback

After far fewer IPOs went public than expected in 2016, issuers are hoping for a roaring comeback in 2017.

There are reasons to be optimistic:

1) Historic highs in the stock market, which is the main determinant of IPO activity

2) A business-friendly administration with the stated goal of less regulation and lower taxes. IPOs are mostly small-cap companies, and those small-cap companies pay a larger share of taxes and suffer from higher levels of regulation because they lack the lawyers and infrastructure to deal with all the regulations. Any reduction in taxes and regulation would be a major plus for IPOs because it would likely increase the public valuation of the company. One of the reasons many unicorns are electing to stay private is the private valuation is much higher than the public valuation is likely to be.

Several IPO sectors could be especially hot in 2017:

1) The year of the tech unicorn? Tech has been the best performing sector of the IPO market, but over a hundred highly valued big tech names—the so-called unicorns like Snapchat, Spotify, Palantir, Uber and Airbnb, among many—have sat dormant for several years.

This could be the year many finally come into the light. Besides the reasons listed above, there's another critical reason: limited partnerships who have been investing privately in firms—most of them in the Technology space—may be looking for reasons to cash out. Kathleen Smith at Renaissance Capital says there's limits to how long these partnerships can stay invested in companies.

"Many investments are now running on to 10 years old, about the limit for a private equity investment," she said. "Some are going to want to re-allocate at some point soon."

2) Energy. There were only two energy IPOs in 2016. But with oil stabilizing between $50 and $60, there are many shale-based companies that could be profitable in that range. Then there is the likely biggest IPO of all time: Saudi Aramco, with a potentially trillion dollar listing.

"This could be the whale that ate the unicorns," Smith quipped.

3) Small banks and innovative fintech companies. Banks make much of their money on the spread between what they can lend at and how much they have to pay on deposits. That yield curve is steepening. The Bermuda-based Bank of Butterfield (NTB) and First Hawaiian Bank (FHB) were one of the few regional banks that went public last year. SoFi, a peer-to-peer lending platform, is among several other fintech companies mentioned as possible IPO candidates.

It's not all coming up roses, however. One big problem is higher rates in general. That has two effects: a) it makes it more difficult to borrow money, and companies with a lot of floating rate debt who want to go public could have a problem, and b) it lowers interest in yield-oriented vehicles like Master Limited Partnerships (MLPs) or utilities.

Other sectors may suffer from policy uncertainties. Healthcare, for example, may suffer due to uncertainty regarding changes to the healthcare system; no one knows how much of Obamacare will be repealed, or what will replace it.

What could go wrong with this hopeful scenario? David Menlow of IPOFinancial.com is one of several I spoke with who are not sure that public investors are going to suddenly accept higher prices for IPOs after pushing back for more than a year.

"They're not going to say, it was overpriced before, but now that we have we have a business-friendly administration we can suddenly put a sky-high public valuation on these companies," Menlow told me. "People are not going to walk into these offerings and suddenly think they are getting a deal. There are multiple rounds of financing for many of the tech companies. Each time the valuation gets higher, and these venture capital deals get long in the tooth."

So regardless of what goes public, you can be sure investors will continue to be price sensitive. How do we know? Menlow points to what happened in 2016.

For IPOs in 2016, it was, as Kathleen Smith quipped to me, the best of times and the worst of times. It was the worst of times because there were roughly 105 IPOs, more than 35 percent below the 170 IPOs in 2015. That's awful.

But it was a pretty good time if you were an investor in the small number that did go public. Buyers were skeptical, so IPO issuers had to cut the prices. The average price relative to the midpoint of the expected price range was minus 7 percent. In other words, if an IPO was expected to price between $19 and $21, the midpoint was $20. The actual average price was 7 percent below that, or $18.60.

That is quite a haircut!

But that haircut helped the investors in IPOs make money. As of last week, the average return on a 2016 IPO was 26.9 percent, according to Renaissance Capital. And it wasn't all on the first day of trading. The average first-day pop was 11.9 percent, so there were also substantial returns after that first day.

Why did the IPO market dry up in 2016? Kathleen says it's not a mystery: "There was a huge hit in returns in the beginning of the year, and valuations were reset downward. The market didn't gear up again until the middle of the year, then Brexit hit. Then the election hit."

In other words, one whammy after the other.