Understanding IPO

One of the most seemingly attractive areas of investment is that of initial public offerings (IPOs). Buying shares the first time they are offered to the public has considerable natural appeal, especially in a bull market, tempting investors with potentially phenomenal short-term returns as well as exposure to exciting new companies and industries. And since the early 1980s, privatizations of state-owned enterprises around the world have become an additional source of new issues, providing investors with the opportunity to get low-priced stakes in big, stable businesses, often the dominant incumbents in core sectors of the global economy.

The objective of any new issue is to achieve the highest value for the issuer, while ensuring a buoyant start to secondary trading. Shares are generally offered at a fixed price, set by the sponsors of the issue, and based on multiples, forecasts of likely future profits, or a combination of multiples and forecasts. Alternatively, in countries outside the United States, like the UK, there might be a tender offer, where no price is set in advance, leaving it to the market forces of demand and supply.

Fixed-price IPOs are frequently underpriced, providing opportunities for stags, investors who buy in anticipation of an immediate price rise. Big instant profits may often be made if shares can be purchased at the offer price and sold soon after dealing begins returns in the order of 515% in one day, but with high variance across offerings. Understandably, such offers are often oversubscribed, leaving the sponsors to decide on the appropriate equity allocation: by ballot, by scaling-down large applications, or by giving preferential treatment to certain investors, typically their favored clients though in some cases the private investor. The method varies by country: in some countries, like the United States, it is discretionary; in others, it is mandated equal for equal submissions.
The UK privatization issues of the 1980s and 1990s tended to be markedly underpriced, sometimes coming with incentives for the private investor, and positively discriminating against the institutions in terms of allocation and even price. They have generally been regarded as a success in terms of investor returns, government revenues and improvement in corporate performance. Certainly, the UK program has inspired numerous other governments around the world to begin turning their public-sector companies into publicly quoted ones, though perhaps this is more inspired by the real performance of companies post-IPO than the amount raised at the IPO.

Like privatizations, private sector new issues are often viewed as a route to quick and easy profits, but for every ten or so successes, there is usually one that goes wrong or seriously fails to perform. Indeed, one study of the US market reveals that of nearly 5000 IPOs initiated between May 1988 and July 1998, nearly a third no longer trade their stock and 44% sell at a market price below their original offering price.

So private investors must always show great caution, being careful to study the prospectus, balance sheet and profit and loss account of any potential investment. Investing in IPOs is intrinsically risky and not for the faint of heart. Companies that have recently reported very good results or which are in fashionable industries with their best results at an indeterminate point in the future should be scrutinized especially diligently.

Investors should also note that conflicts of interest and potential abuses are rife in the distribution of new issues. IPOs are inevitably timed to benefit the seller not the buyer, aiming to extract the maximum value from the market. Indeed, several studies indicate that IPOs are usually not good investments, underperforming the market over the longer term. This may be a reflection of companies preparing the numbers for a couple of years, and underwriters overhyping and sales people overselling the shares. Such activities may be particularly prevalent in the late stages of a bull market.