While Snapchat may have been making waves with its huge $28bn Initial Public Offering (IPO) recently (March 2nd, 2017) at the New York Stock Exchange, IPOs are not always all gold and glitter. Success stories are usually more hyped than failure cases, and this gives the public a false perception of the profitability of cashing in on a hot IPO and causes them to overlook the risks and dangers of such an important move.
Risks for the Investors
First, a quick look into the IPO process will serve one well in better understanding the risks that come with it. Banks (usually investment banks) will first pitch to the private company in question the idea of going public. The selected bank will then oversee the other procedures – due diligence and the finer details of the offering.
Once that is done, a Registration Statement will be filed and a prospectus (sometimes called a “red herring”) will be issued to potential investors. This is where the bank plays a crucial role in sourcing for quality investors (usually institutional investors who have the size to take on a significant stake). During this marketing period, the investment bank will determine a sensible price for the offering based on market demand, before finally releasing the offering to the public stock exchange on the agreed date.
Sounds really good in theory, until one considers the fact that the ten-year survival rate of new listings has declined sharply from 61% in the early 70s to just 37% in the 90s. And a non-failure does not necessarily equate to success; a surviving company may not be thriving, but in fact struggling with losses.
Clearly, there is a risk to investors buying into a company with a weak business model or management, and the company may collapse soon after the IPO. VeraSun and Aventine, for example, declared bankruptcy after raising hundreds of millions of dollars in their IPO. In cases like these, competition and inefficient management may be the root cause; in others, management scandals, industry shocks and corruption.
Going Down 🔽
A less extreme alternative to the scenario above would be a sharp decline (or continuous downward trend) of the stock price after the IPO. Consider first a short-term investor who bought into Snapchat’s IPO when it was first released. Not including large institutional investors, private investors would have bought Snap’s shares at a huge premium ($24 per share). However, the share is trading at $20 and may show signs of further decline.
Thus, the danger of buying into an IPO early is the risk of a major price correction right after the IPO release, due to overbuying of the stock by enthusiastic investors. Note below the massive decline from early March to mid-March: no investor would want to be caught in that downtrend.
Another striking example would be King Digital, whose IPO price was $22.50 but closed its debut day at $18.25. It was since acquired in 2016 by Activision Blizzard.
In the two companies, two different underlying issues give rise to the underperformance of the stock price. In Snap’s case, it might be a problem of market over-optimism, which explains the eventual decline downwards. In King’s case, it would most likely be a case of the share being overpriced, which led to a substantial immediate correction.
Numbers Are Telling
One may mitigate these risks by analysing the fundamental of the company in great detail, such as its profitability ratios, margins, leverage ratios, and cash flow. A company with strong fundamentals is less likely to go bust, and these will also give a good indication of how much the entity is actually worth.
An investor should also look at the qualitative factors of the company such as competition, business model, and barriers to entry or market share to have a better idea of the company’s strength. However, it should be noted that since these companies were previously private, information may be scarce despite the filing regulations and disclosure laws, and there is no guarantee that the reported information is wholly accurate. Firms with high prestige underwriters (like JP Morgan, Morgan Stanley) and with a good history or track record tend to be safer IPO bets than their smaller scale counterparts.
Risks for the Companies
One major concern is the failure of the IPO to even take off, leading to postponement or outright cancellation. Last year, only 111 IPOs actually made it to the market, with 58 other issuers withdrawing. Among the reasons this may happen are a softening global market (making investors less willing to take on risks and buy up the IPO, lowering the offer price), a scandal that damages a company’s reputation, or even a hit to profitability.
In particular, commodities-based companies will be extra vulnerable to fluctuations in commodity price, leading to very volatile fluctuations in offer price valuation.
For example, Saudi Aramco’s IPO planned for next year is very sensitive to oil prices, and they may choose to postpone it should oil prices not rise to $70 per barrel by next year. Given the humongous expenses of preparing for an IPO, cancelling one means a big financial loss to the company.
External pressure from the scrutiny the company is subject to when undergoing an IPO can also affect the company’s performance. Regulatory bodies, stakeholders and potential investors will all have access to the company’s financial data and may pressure management to make decisions they normally would not.
Costly audits and bureaucracy will become a common occurrence, which may eat into company profits and make operations more sluggish. Management now must also answer to shareholders, who may be more short-sighted in terms of profitability. It may damage the company’s potential to grow by constraining senior management to please stakeholders and meet targets.
Generally, IPOs are risky business that even professional investors falter in. True, the success stories are extremely attractive and may inspire optimism in the market, but one should be wary and remember the darker side of IPOs so as not to paint an overly rosy picture of going public, both for investors and the company considering it.
With a softening IPO market, it remains to be seen how 2017 will fare in terms of issuances. Will the market recover and optimism prevail, or will the risks discussed above dominate and the bear be the prevalent mood?