An initial public offering (IPO) is a very exciting event in the life of a firm. It is the transition from a private entity to a public company listed on one of the various exchanges around the world.
There are various reasons for a firm to embark on such an endeavour. The common ones can be narrowed down to increased ability to raise capital, better visibility and access to talent.
However, there are disadvantages such as the cost itself, increased regulatory oversight, ongoing costs, transparency to competitors and conflicts between shareholders and management (agency problems).
To sum it all up it’s about money.
Two types of IPOs
I feel that the most important part of an IPO prospectus is the section where the company discloses what they intend to do with the funds.
Early stage investors, the founders and other parties already own a large chunk of the shares. Consequently, only a portion of the firm is offered for floatation.
The more favourable option is when a large percentage of the funds are used to increase future profits. Current share price is based on anticipated profit, thus the higher the expectations the higher the price.
However, the future investment can’t be 100% as the current owners and management have to be reimbursed.
Conversely, a large percentage of the funds could be going in the pockets of the owners and the management team. This is less favourable as it raises questions about the future of the firm. An IPO brings a life changing amount of money, in the case of Unity Software $1.3 billion.
I don’t mind people being paid for their hard work, whatever the amount. However, you have to decide if you want to be the one paying them or not. If you do that’s fine and if you don’t that’s also fine.
Access to IPO shares
Investment banks and brokers promote buying them on the first day of trading. This is often the worst way to go about it.
I am not cynical enough to think that a high profile investment bank could possibly entice people to buy shares at an inflated price.
However, we shouldn’t forget that a prominent IPO may be underwritten by several investment banks which are concerned with the share price performance. These institutions have to stabilise the price for a period of time.
Buying on the first day
Companies are different so some may perform really well and may be worth buying on the first day. Nevertheless, official statistics report that a lot of IPOs underperform for years after the IPO.
You’d have plenty of time to buy! Have a look at Spotify, there was a lot of opportunity to get a discount:
Getting an IPO allotment
One of the good ways to buy IPO shares is to get an allotment a few weeks before the listing. The process sounds simple, you find a company, apply, pay the money and you get your shares. The downside is that it is actually very difficult for an individual.
A lot of IPOs are not accessible to the public and even when they are there are restrictions on the amount of shares you can order. You may not receive all the shares requested.
But if you do you can sell them on the first day of trading (unless there are restrictions) and realise an average 10-20% return. In the case of Unity Software the listing price was $52 while the shares traded around $70 on the first day.
Don’t worry if you missed the first two opportunities, there’s always another trade waiting around the corner. The IPO’s publicly available terms include management lock-up periods, usually 6,12 and/or 18 months.
Naturally, insiders are anxious to realise their profits. Some of them will sell their holdings and depress the share price. Therefore, make sure to check when these periods expire and look closely at the price action. You may grab a bargain.
The bundle is a few hundred pages so it is time consuming to go through. On a positive note you will find all the relevant financial data and company information.
A valuation and a target share price are just that. No one said that they are fair. Private companies are difficult to value with popular methods such as discounted cash flow or comparables.
It gets even worse if the company has a unique value proposition as there may be few listed companies to compare it to.
Private company valuations come with a significant informational disadvantage. They are not as transparent as their listed counterparts so insiders may have vital information that you don’t have access to.
Statistics report that buyers overpay as much as 20% in private company acquisition because of this. However, just because a company is listed doesn’t mean that you won’t overpay for the shares so research is important either way.
There is an initial hype during the promotion period of the IPO. The underwriters do their best to create interest among investors.
Sometimes that hype gets overtaken by the next hot stock which leads to underperformance.
IPO Analyst ratings
I never take these seriously but people read them so I usually check the summary. When it comes to an IPO it is important to find out if the analysts work for the investment banks which are underwriting it.
I know that there is a ‘Chinese wall’ in the bank and so forth but it doesn’t hurt to be careful.
Bellring Brands’ submitted their S-1 filing on 11 October 2019 with a proposed offering price of $19 per share. The stock closed at $16.35 on 18 October 2019 and is currently trading around $19.
It has not been an exceptional performer. Let’s see what the analysts have to say:
Not bad, seems like a bargain. Note that some of these ratings were published soon after the IPO. It is interesting to check if any of the analysts work for the underwriters.
You can find them in the S-1 filing: Morgan Stanley, Citigroup, J.P. Morgan, Goldman Sachs & Co. LLC, BofA Merrill Lynch, Barclays, BMO Capital Markets, Credit Suisse, Evercore ISI, Stifel, SunTrust Robinson Humphrey, Wells Fargo Securities, HSBC, Nomura, Rabo Securities, UBS Investment Bank, PNC Capital Markets LLC.
It seems that only 3 of all the ratings (Jefferies, D.A. Davidson and Consumer Edge Research) and only 1 in the last 3 months (Jefferies) came from institutions which were not involved in the IPO.
An IPO can be a great opportunity to buy shares, however, as any other investment all of us need to be careful with our money. Every day offers us an opportunity so missing out on an IPO is not such a big deal.
The first day of trading may not be the best time to buy shares. If in doubt check the post-IPO performance of your favourite companies.
The availability of allotments is poor at the moment both in terms of the amount of IPOs and the quality of the companies. However, products are becoming more and more accessible so I hope that this will change in the future.