Before quoting, a painter asked if this was our ‘forever house’ or if we were selling.
“What difference does it make?” I asked naively. “If it’s your forever house, we’ll fix the cracks in the wall and make it perfect,” the painter replied. “If you’re selling, we’ll do a quick job and charge less.” We chose the thorough job.
This anecdote reminds me of the Initial Public Offerings (IPO) market. Like property, an IPO seller has more information than the buyer.
Often, investors buy shares in an IPO, believing prospectus hype that the company is in excellent shape. Within a few years, cracks emerge.
Information asymmetry is a key challenge with IPO investing – and a reason why extra care is needed when investing in new listings.
Investors haven’t had to worry much about IPOs in recent years. The local market has been quiet due to heightened volatility in global equity markets. IPO volumes typically rise when markets are strong and risk appetite returns.
Only six companies had applied to list on ASX in late January 2024. Each was small and some floats might not proceed, unable to raise enough capital to meet their minimum subscription or attract enough shareholders.
But IPO conditions can change quickly. There could be a rush of IPOs this year – probably in the fourth quarter – as companies dust off shelved prospectuses. The last quarter is traditionally the strongest for IPOs as companies race to list before Christmas (and IPO advisers seek a bigger end-of-year bonus!).
Two factors support an IPO recovery. First, market conditions, particularly for small-cap equities, should be stronger in the fourth quarter. By then, falling interest rates will lift risk appetite, support higher equity valuations, and provide better conditions for companies to list on exchanges.
Second, there is huge pent-up demand for IPOs from companies and advisers (who make fees from IPOs). When the IPO window finally opens, companies will rush to take advantage of it, encouraged by corporate advisers.
Don’t expect boom IPO conditions. Some large, mooted IPOs (think Chemist Warehouse) have chosen alternative listing options. Other rumoured large IPOs (think Virgin) did not proceed. History shows a blockbuster IPO can unlock the float window for other companies, but there are few mega-cap IPO candidates right now.
Much of the IPO action could be in mid- and small-cap companies that take advantage of better market conditions to raise equity capital. If small-caps finally outperform, interest in small-cap IPOs will rise.
That means now is a good time to keep a closer eye on the IPO market and sharpen IPO investing skills.
Over the years, I’ve preferred newly listed companies (1-2 years after listing) over IPOs. Newly listed companies have more information and history as a listed entity. The information asymmetry between sellers and buyers reduces.
Also, many small-cap IPOs are often cheaper two years after listing (compared to their issue price) as the market loses interest and float hype fades.
I like to follow IPOs, having covered hundreds of them for the Australian Financial Review, in a previous weekly column over many years. I interviewed more CEOs of IPOs – and heard more IPO sales pitches – than I care to remember.
Here are my eight top tips with IPO investing:
- Know the odds
If it’s a high-quality IPO, most retail investors won’t get stock in it or will have their allocation scaled back. That’s the truth. Most stock in the best IPOs goes to institutional investors or higher new worth clients of brokers who advise on the float.
That’s not to say retail investors can’t invest in the good floats – or find opportunities in IPOs that don’t attract cornerstone investors, such as small-cap equity funds. But institutions and clients of larger full-service brokers have a big head start in IPO investing.
- Be realistic
I recall when speculators clamoured for IPO stock, knowing many new listings spiked higher on their first trading day. They sold soon after listing, pocketing a 5-10% ‘stag gain’. Some IPOs were a sure-fire way to make fast money.
That is no longer the case. Yes, some IPOs still ‘pop’ on debut, but there’s more price discovery these days before companies list (particularly for large floats).
If you want to trade, there are better ways to do so than the IPO market. Floats that disappoint on listing can be hammered as IPO stock is dumped.
- Know who is selling
Many retail investors have fond memories of the IPO market due to the success of government privatisations such as the Commonwealth Bank and CSL.
These days, more floats are vended by private equity firms. IPO assets often stay privately owned for longer and are sometimes traded between private equity firms before coming to market. Professional sellers aren’t fond of leaving too much on the table (if anything at all) for other investors in IPOs.
To be fair, there have been some terrific IPOs vended by private equity firms (think JB Hi-Fi). There have also been overpriced duds (think Myer Holdings).
As a rough rule of thumb, use extra care with floats if private equity is bringing the asset to market during buoyant conditions, taking the IPO proceeds and moving on to the next deal.
- Why is the seller selling?
Is the vendor selling all or part of their stake in the IPO? Are IPO proceeds being reinvested in the business to quicken its growth? Does it make sense for the company to raise equity capital at this stage of its journey? Are IPO proceeds going to vendors who will no longer be involved in the business?
Companies go public for many reasons. For some, an exchange listing provides fresh capital, a higher profile, price discovery and liquidity. An IPO is a natural step in their evolution. For others, an IPO is a chance to raise opportunistic capital in bull markets or offload lower-quality assets to new buyers (think divestments).
- Alignment
Arguably the best protection in the IPO is knowing the interests of a majority shareholder and management team are aligned with other investors.
Consider an entrepreneur who sells 40% of their stock through an IPO. Namely, 30% goes to institutions and other investors, and 10% is offered to the firm’s staff. The entrepreneur’s wealth is still heavily invested in the IPO’s fortunes and staff are incentivised to grow the company.
That’s no guarantee the company will prosper, but IPO investors at least know their interests are aligned with management and founding shareholders. If investors lose money, so do key shareholders and staff.
- Years one and two
The first two years are a vital period for small-cap IPOs. That’s when escrow provisions lift, and restricted securities can be sold (after the IPO’s first or second anniversary). It’s also when some options and other executive incentive plans begin to vest, leading to more stock issuance.
News flow is vital in those years. Too many IPOs sink without a trace after listing because they lack news flow or struggle with investor relations.
Consider the company’s likely news flow after listing. Are there near-term milestones (such as a feasibility study for a miner or potential drug approval for a biotech? Are there acquisitions in the pipeline that could be announced?
Over the years, I’ve seen too many CEOs go back to their ‘day job’ after raising capital through an IPO. Having secured the money, they spend less time with investors to promote their company. In this market, small-cap IPOs need a lot of news flow and investor relations to maintain and build market interest.
- Valuation
Valuation is the foundation for all share investing, including IPOs. When assessing an IPO’s valuation relative to similar companies, ask whether there is a sufficient discount to reflect the higher risks and information asymmetry in an IPO.
If an IPO has a valuation multiple similar to that of a well-established listed company, ask why. If there is a valuation discount, consider if it sufficiently compensates investors for the higher risks with IPO investing.
- Be sceptical
All investors should have a healthy dose of scepticism. Enough to be on guard for opportunistic stock and fund promotion, but not so much that you become blind to opportunity or unwilling to invest in new opportunities.
The IPO market has provided many fantastic investments over the years. Consider the original investors in JB Hi-Fi and Commonwealth Bank (who still hold their stocks) and how fortunes have been made through some IPOs.
But there is also a long list of IPOs that ended up in the small-cap graveyard, unable to live up to prospectus hype or deliver as a listed company.
IPOs have an extra layer of risk. That’s the nature of investing in a company that is not yet proven as a listed entity. Some also have vendors who are happy to ‘paint over the cracks’ to maximise the sale price, meaning extra care is needed.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation, and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 31 January 2024.
