An IPO, or Initial Public Offering, is the first time that shares of a previously privately held company have been sold to the general public through stock markets. As a rule, private companies go public to raise capital through the sale of shares in order to obtain funds for development and growth.
To be clear: private companies have shareholders, but ownership is limited to company founders, key figures and other insiders, as well as selected stakeholders who have had a number of crucial consequences for the creation or growth of the company, such as early stage angel of VC investors. The general public is not allowed to own shares in a private company, leaving individual investors on the sidelines even if they are interested in acquiring ownership in the early stages of promising start-ups that have the obvious potential of future industry to become leaders such as Uber (NYSE 🙂 was a few years ago and AirBnB is today.
It is understandable that when a highly respected company is made public in private, it can generate a lot of attention that arouses excitement among investors, often and especially among private investors. But should a retail investor actually buy in when an IPO occurs?
Evaluating the merits of an IPO can be difficult
Government regulations require listed companies to submit quarterly performance reports, called 10Q & # 39; s. These are also available to the public. Typically, investors interested in a particular company can find years of 10Q applications to investigate and analyze the merits of investing in a particular company. In many cases and comparable companies, data is available from the past decade, if not more.
Doing due diligence at an upcoming IPO is more difficult and often more difficult. The only thing available to private investors is the mandatory pre-IPO S-1 that submits the SEC requirements of companies before approving their offer
Unfortunately, the information in an S-1 application may be limited. Uber, for example, was founded in 2009 and was listed on the stock exchange in early May 2019. Although the company had been in operation for about ten years, submitting S-1 only contains financial data from 2016 and later. As a result, retail investors lost seven years of financial data that could have deepened and improved their analysis.
This not only underlines the difficulty of evaluating a company with only limited data, but also the information asymmetry that exists in the run-up to an IPO between retail investors versus insiders and well-connected institutions that have a lot of money to invest . The insiders and well-connected financial entities receive personal meetings with founders and access to financial information that is not available to the general public. Pre-IPO, retail investors are seriously at a disadvantage.
Also, the roadshow that is often performed prior to an IPO, plus all releases about the upcoming event – and the generated media attention – has only one goal: creating buzz and drum interests in the offer. Many private investors end up being unable to separate the signal from the noise. Strong interest in equities is increasing while risks are hidden.
Access can be difficult
When a company wants IPO, it often employs an underwriter, often a leading investment bank, such as Goldman Sachs or Morgan Stanley, who ensures that all shares available to the public are purchased (the bank buys all float or ordinary shares), which ensures that the intended amount of capital that the company intends to increase is met; they later sell the stock to the market again.
It is also worth noting that a Direct Listing – performing an IPO without using an investment bank – is also possible. Spotify (NYSE 🙂 and Slack (NYSE 🙂 are two prominent examples of companies that have opted for direct listings. This route to public markets can save a company millions of dollars in costs, but opens the shares to more volatility as soon as it starts trading, as participation in the investment bank mitigates the price fluctuations of the share that are often observed during the first days of trading.
Institutions can compete against the offer price, which is determined in advance by the underwriter. This is the stock price that the media often uses before the first trading day starts. Lyft (NASDAQ :), for example, had an IPO of $ 72 per share. But gaining access to the initial price is almost impossible for retail investors, especially when an IPO is long awaited. When institutions receive an allocation of shares at the IPO price for their customers, they are first offered to VIP's and wealthy individuals.
Therefore, the advertised price is almost never what a retail investor will pay, even if they buy shares as soon as the shares start trading. To return to the Lyft example, the shares actually started trading at $ 87, 21% above the IPO price. A company is only as good as the price you pay for it. For small investors there is almost always a premium to get started right away with the IPO promotion.
Initially, Performance Is Uneven … Best
Entering into increased risk and uncertainty must be rewarded with large gains, but the reality is often different. During the past two years, most IPOs have not performed better than the S&P 500.
As mentioned above, retail investors often measure a premium over the IPO. That's why we measure performance based on the first public market price of a share instead of the price of the & # 39; pre-sale & # 39 ;. The table below compares some of the most anticipated IPOs in 2018 and 2019.
IPO Performance versus SPX since the Offering
The top of the table contains the large IPO's of 2018: Spotify, AXA (OTC :), iQIYI (NASDAQ 🙂 and Pinduoduo (NASDAQ :). The bottom highlights the performance of the most anticipated 2019 IPOs to date, including Uber, Lyft, Zoom Technologies (OTC 🙂 and Pinterest (NYSE :).
It is clear that in 2018 and 2019 it was a mixed bag for the cream of the crop. IPO & # 39; s seemed to have done better in the past year than it has so far. But keep in mind that it is also too early to give a definitive opinion on 2019 IPOs.
Remember that compared to the S&P 500, the average overperformance of IPO & # 39; s is 8.61%, while the average underperformance is -23.89%. The IPO of Zoom was the only one that outperformed the broader market by 20%, while three-Spotify, Pinduoduo and Lyft underperformed by more than 20%.
This data does not speak about the feasibility of investing in an IPO in the long term, but it clearly shows that in the short term, IPOs are not magic cash generators for small investors, as market mythology might make you believe. On the contrary, investing in an IPO requires tolerance for volatility, something that retail investors often shy away from.
Conclusion
It is clear that the decision to introduce an IPO is entirely up to an investor. However, it is clear that in the short term the risks are greater than the poor performance. The good news: over time, more information becomes available, real price development takes place and all investors can make smarter decisions.
