April 3, 2017    4 minute read

Investor Warning: Avoid IPOs

The Other Perspective    April 3, 2017    4 minute read

Investor Warning: Avoid IPOs

In every transaction, there are buyers and sellers. Initial public offerings (IPOs) are no different. Each side has their own objectives to maximise. The company wishing to raise equity capital from investors wants to raise as much as possible; as does the bank underwriting/advising the deal.

The investor, on the other hand, wants to get the stock as cheap as possible in order to benefit from capital appreciation down the track. Somewhere in the process, the stock settles at equilibrium, where the supply matches demand after a great sales pitch from the bank.

So Why Are IPOs a Bad Idea?

It is important to clarify that IPOs are a bad idea for retail investors, while less so for institutions. The banks acting as the lead advisors will attempt to flog the shares to institutions first, i.e. pension funds and various other asset managers, before offering to the public via brokerage accounts. If the stocks eventually get to the stage where they are offered to the public, they are already rejects.

Bear in mind the institutions have already received presentations from the banks on the financials of the new target. If they were not keen, why on earth should a retail investor? In some cases, a portion of the stock has to be offered to the public but assuming this is the case, it still does not make sense to wait in the queue.

Furthermore, if an investment guru said that one should buy a stake in a company even if there is little or no information about its track record, would it make sense to commit capital?

Another reason not to buy into the hype is because the company has a different agenda to the investor. Going public is fiercely expensive. It is not advisory bank fees but the amount of regulation required to protect the public from the directors running off with all their money is costly, to put it mildly. This increase in cost incentivises the owners to get as high a share price as possible; again, not good for the retail investor. In fact, they want the total opposite.

A Few Reasons Against

From an owner’s perspective, going public is also not all roses. Firstly, takeovers or least disruptive voices can occur from some big mouth activist buying a good chunk of the outstanding shares. All of a sudden they can be at board meetings and influence decision-making; Carl Icahn comes to mind. They have the motive to boost the stock price rather than give opinions on long-term growth. In many ways, they have similar objectives to private equity, but private equity firms, many public themselves, have a duty to behave within the boundaries of society.

Second, being public means that all the secrets are available for all to see. This is because they have a fiduciary duty to update shareholders on their internal plans. Moreover, the Sarbanes-Oxley (SOX) Act, means public firms need to report on a whole of issues. The time and energy producing such reports can detract from the original reason for going into business; producing great niche products/services.

The only upside to going public is that if listing on a US exchange, the company gets to ring the bell, be surrounded by confetti and get a few minutes of fame on Bloomberg. After that, it is a massive burden if the workforce is not sizeable or capable.

And One For

Finally, one reason to go into an IPO for an investor is if the strategy is to flip it. ‘Flipping’ is when the investor buys into the IPO then sells it within a few days, particularly if the hype is positive. If the stock did have a good pop in the first week, it would likely decline slightly as the institutions take profits. Even though the idea is that the pension funds are ‘long-term investors’, the fund managers are judged on their quarterly performance. They need returns and have the exact opposite objective of the firm itself.

In the old days, because broadband was non-existent, there was time to flip the IPO and decide if you wanted it or not. These days, brokers would frown at an investor for doing that because the idea is that one should be wanting to hold the stock for the long term, not simply to make a quick buck. Ironic isn’t it when the brokers would rather one’s account went to zero.

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