Seven top tips for buying an IPO

Not all initial public offerings (IPOs) are created equal. If you’re going to put your hard earned cash into the public float of a company, what are the markers of a good investment?

Below are eight suggested tests that you should subject any new issue to, which will hopefully put you on the plus side of the ledger when the shares actually list on the ASX.

As a general rule, investing in IPOs is a high-growth equity strategy. In fact, the odds of a positive return on an IPO investment were much better than average; last year, 59 per cent of IPOs finished the year at a price higher than their listing price, while 6 per cent held their ground.

Indeed, if you had invested in every IPO on the ASX last year, you would have made 23 per cent by the year’s end. The following eight tips will help guide you to a decent return.

1. Is private equity behind the sale?

After the Dick Smith disaster, investors will be expecting private equity sellers to retain a larger equity stake (and to hold on for longer) than in the past to insure against a ‘take the money and run’ scenario. So, if the IPO is from private equity, ask how much of a stake they are retaining in the company. If they are selling off the whole lot, as in Dick Smith, it might pay to be wary.

What is revealing is the performance data from the IPOs of private equity-owned companies for the past 10 years. The data shows that when private equity retains greater than 25 per cent of the company the IPO significantly outperforms IPOs where no private equity ownership is retained.

2. Is the offer a privatisation?

Some of the most successful floats have been the government privatisations. If the government is a seller, investors often take a measure of comfort that the claims in the prospectus will be borne out. Medibank Private, for example, floated in late 2014 and retail investors paid $2 a share. Its shares are now trading at just over $3, representing a 50-plus per cent gain. However, government floats are often oversubscribed, so bear this in mind when you are deciding how much to invest. Your initial investment may well be scaled back. So it might pay to ask for more, rather than less.

3. What is the management’s track record?

It is vital to investigate the people shown in the prospectus as directors and managers. Do they have prior experience in the industry? How long have they been with the company? How much are they being paid? And, critically – do they have ‘skin in the game’? That is, is their financial success tied to the company’s? If so, that’s usually a good sign that management is motivated to do well.

Keep an eye out for the less obvious. For example, some small companies combine chief executive and executive chairman roles, which saves money but leaves a lot of power with one person. Do your due diligence on them, including a Google search and search ASIC’s registers for any suspect characters. One piece of negative press may be a blip or a misunderstanding but several negative articles should be a red flag.

4. How will the money be used by the company?

One of the most important questions you should ask is how the company will generate or expand revenues to increase the value of the shares you are buying. There should be a clear statement in the prospectus about how the money raised in the IPO will be used. Importantly, keep a lookout for anything that will benefit third parties, such as excessive fees being paid out to advisers, as occurs in some floats.

5. Do you understand the product?

Investment guru Warren Buffett always says if you can’t work out what a company is doing, stay away, as lots of other people will have the same problem. He’s right. Companies should be clear in the prospectus about what their product or service is and why it matters. It is simple yet integral advice, and something to keep a close eye on when investing. The lesson here is that if you don’t understand the produce or service, then remember – it’s not you, it’s the company failing to adequately define and explain why their product matters.

6. How big is the market for the product?

The size of the opportunity and the company’s ability to capture market share can make all the difference when it comes to growth and shareholder returns. Keep in mind that the size of the market is only an estimate based on many assumptions. These assumptions need to pass the common sense test.

For instance, say a company is selling widgets and is targeting high-income households. Consider how likely high-income households are likely to buy widgets before accepting that the market size is equal to the number of high-income households. Ask yourself, are there substitutes for their widgets? Is it a need or a want? Would the product be better off as a Main Street or High Street product? Do existing trends support the assumption that high-income households will want to buy widgets or not? Estimating the size of the market is a ‘best endeavours’ sort of thing but if you don’t understand it or it doesn’t sit right, think twice.

7. How is the offer structured?

If the size of the market looks promising, the management is experienced, and the fees paid to advisers are reasonable, then it may look like a great opportunity all round.

But if the offer is structured so that options, convertible notes or performance shares will automatically be issued to the seller at a future date, this may dilute your shareholding. Remember, each share you buy represents your piece of ownership of the company. The more shares there are on issue, the less value each one represents. So it’s something you should investigate when deciding whether or not to invest in the company.

Tim Eisenhauer, managing director, OnMarket BookBuilds

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