What do I need to know before buying into an IPO?

February 24 2017
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While many investors dream of making a fortune by buying into a floated company and selling down the track for a tidy profit, it’s important to remember most IPOs aren’t the runaway successes we’d like to think.

With the avalanche of new listings in the market, should you invest in any IPOs or are there risks on the horizon?

When it comes to investing, we all aspire to be Warren Buffett, and yet at times investors act more like Gordon Gekko, the fictional character portrayed by Michael Douglas in the 1987 film Wall Street. This is how it seems with the love affair investors have with IPOs.

Every investor’s dream, of course, is to buy into a float and sell day one for a handsome profit, otherwise known as a ‘stag’.

We acknowledge how easy it is to fall in love with a new IPO. After all, the prospectuses produced usually come complete with stunning pictures of celebrities such as Jennifer Hawkins who made the Myer prospectus worth flicking through. When Pacific Brands pitched to investors the images of Pat Rafter and others in their underwear, it may have been visually appealing, but it was certainly not instructive.

Aside from the pictures, the prospectus almost always outlines a rosy outlook for the business.

The first question you should ask is whether you want to have this in your portfolio in five years’ time? If the answer is a clear no, we would suggest extreme caution.

Other than the normal set of investment factors – such as price, management, gearing etc – you would consider, there are additional points to think about.

1. Investors need to understand who the vendor of the IPO is. Private equity funds have established a poor reputation for taking over businesses, loading them up with debt after stripping the company of other assets before selling them back to unsuspecting investors via an IPO. Dick Smith comes to mind as a perfect example. We are not opposed to buying from private equity funds as such, but you must understand that the vendors in an IPO have a far greater understanding of the business than the investor can gather from reading the prospectus, which puts the vendor at a significant advantage. Conversely the history of government IPOs has been a little friendlier for investors, other than of course Telstra II, which is still significantly under water from its $7 plus offer price.

2. Once an adviser and their client have established who the vendor is, it is important to also understand whether the vendor is retaining any part of the company or if it is a full sale. If the vendor is retaining part of the business, advisers need to understand if there are any time limitations around this ownership. It is also crucial to understand what the IPO proceeds are being used for. Is the IPO simply to reduce debt? Or are the proceeds being used to grow the business?

3. Brokers are remunerated for selling the IPO. While this may sound obvious, it reminds us of the phrase ‘never ask a barber whether you need a haircut’. Brokers have to sell their services to the IPO vendor, which results in a research blackout on the IPO company. This simply means that it is virtually impossible to obtain unbiased investment research from the broking firm that is handling the IPO. As experienced brokers will tell you, “the best IPOs you can never get enough of and the IPO that you receive your full allocation for is generally the one you don’t want”.

4. One of the best pages of the prospectus is the ‘investment risks’ section. In our experience, few investors read much in a prospectus at all, and in particular do not read or understand the investment risks section. If advisers only read one section of a prospectus, it should be this section.

Should you invest in IPOs? Our view is that while some IPOs offer good opportunity, greater caution should be exercised by investors when considering IPOs due to the lower level of information usually available.

Mark Draper, adviser, GEM Capital

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