Sunday, 12 April 2015

Thinking of "investing" in the next IPO?

Back when the markets were going hot in 2006 - 2007, just before the Lehman Brothers and Bear Stearns collapse took centre stage, the common water cooler topic was whether you managed to get allotments for shares in the latest IPO on the SGX. It seemed like the gravy train was running full speed ahead on wards to nirvana for retail investors. Not a bad move isn't it, getting some allotments and then selling onto the market, after all in a red hot market the only way is up up and away. It certainly was, till the music stopped and most investors found themselves without the proverbial chair. 

Maybe if you had a better understanding of the IPO process, you probably would have stayed clear of the entire she-bang, so perhaps I can provide you with some insight of what an IPO process is all about, after working in investment banking for a good number of years. Maybe you would then have a better understanding of whether subscribing to allotments in the future would make sense. 

Rationale for an IPO

The IPO exists as a method for either one or a combination or two things. Firstly, to raise new equity for the incumbent shareholder - typically the incumbent tries to tap the equity capital markets for US$[ ]m in exchange for a [ ]% of his company through the issuance of new shares, called a primary issuance. The enlarged company would then be worth US$[ ]m plus the additional US$[ ]m raised through the primary issuance. 

Secondly, to raise proceeds for the incumbent shareholder - typically the incumbent tries to sell down a portion of his shareholding in his company through the equity capital markets, called a secondary issuance. The incumbent sells [ ]% of his company through the exchange of his existing shares for cash. There is no enlargement of anything but the incumbent shareholders' wallet. Sometimes this is called cashing out (exiting) or raising liquidity for the incumbent investor. 

Now... an IPO is most likely a combination of both a primary and secondary issuance, on the pretext of raising capital for expansion (growth story anyone?) and providing the current shareholders with some liquidity as well. There might be many reasons for an IPO, from government privatization exercises to a form of exit for big boys (private equity investors), to a more genuine form of capital raising for expansion purposes by normal businesses. 

Do think about it in more detail though, equity is the most costly form of investment as opposed to debt, so if you are raising capital for expansion through an equity issuance such as an IPO, it probably means that you are tapped out on your leverage and your capital structure really needs some equity. Common sense would dictate that is hardly a good sign... but then again common sense is not really common is it? 

The Investment Banks and your interest do not go hand in hand

The sole job of the investment banks underwriting the IPO is to maximize value for their clients through selling the share issuance. A small technical point is that these days, banks seldom fully underwrite (meaning the banks take the entire risk of the IPO on their books and then tries to sell down in the public market later) IPOs, they do them on a best efforts basis. 

The key word is "selling". And when you sell shit, you want to maximize value for what you get, so there is nil chance of something being fairly valued, or even under-valued. Nil. Donut. Kosong. And that is totally aligned with the investment banker's thoughts, as he wants to maximize deal size in order to generate more fees. Typically these guys are paid 2 - 4% of the total proceeds brought in. 

Ah yes, one small caveat is that if you want recurring customers in the form of institutional investors, you might price down your share issuance a little to provide some "perceived value" so that there is some money left on the table and every one gets rich. But that to me, is pretty much gambling. From a retail investor's perspective, you are betting on the next dude in line bidding your price up as you unload. 

You surely don't get anything at a discount to value, because the sole job of the investment banks are to maximize price for their clients. So if you are thinking of "investing" the next IPO, maybe you should just go play blackjack at MBS, might be a more exciting way of "investing" since you are gambling anyway :) Huat ah! 


  1. Thumbs up!
    Eloquently worded

  2. Thank you for sharing the 'behind-the-scene' of IPOs. Insightful.