Initial Public Offerings
IPO’s (initial public offerings) are probably some of the most coveted investment opportunities on the markets. IPO’s are events where a company lists their shares to be sold to the public for the 1st time. Companies usually go public when their private equity investors want to sell their shares and/or when company insiders want to sell their shares.
So, why are IPO’s so popular? There’s a couple reasons why IPO’s are so popular and the simplest one is probably that investors are uber (no pun intended) excited about the prospects on investing in some of the industry’s hottest stars. Take the DropBox IPO or AliBaba and Snapchat that all went public in the last little while. All of these companies are high-flying names that people have followed for many years. For many consumers, the IPO represents the first time people get to put their money into companies
The second reason why investors are interested in IPO’s is also because it gives investors a chance to gain some exposure to emerging trends in the market. Although any company can elect to go public - many of times it will be a company that is very popular at the current time (to maximize value). This can be seen by looking at the IPO order book and seeing if the issue if over-subscribed or not. Remember, during an IPO there is a limited number of shares to go around. If the order book is over subscribed your original allotment will be prorated and you will definitely receive.
What’s the catch?
I am sure by now, you have probably heard that IPO’s are pretty risky (not neccessarily cause of the underlying security) but the volume of trading.
Given risk that the Investment Bank faces in trying to sell a new issue for which the true price is unknown it is not surprising to find on average the initial selling price is set lower on average and the price increases tremendously during the 1st day. The percentage between the closing and opening price is the degree of underpricing.
Investment banks are always looking at their book building which is the process of finding subscribers for the shares. Many of times as part of the underwriting offering , the bank is responsbible for purchasing the remaining shares at the negotiated offering price. So Many of times, investment banks will purposefully lower the price of the shares so it will be easier to sell in the secondary markets when the issue ultimately goes public.
This is why IPO’s are dangerous. Many retail investors cannot gain access to shares in an IPO unless they meet minimum requirements (Questrade for example requires $5K for IPO). By the time investors can get in on the action the market has gotten to the “true price” of the shares and any remaining gains will be due to the volume and trade prospects. Investment banks also want to ensure that order books are over-subscribed as this indicates a very large interest in the issue and means that the investment bank does not need to put up any of their own equity to purchase the issue.
Disclaimer: All of the above information is my own personal opinion - it should not be used as investment advice. Please consult with a licensed representative when making any investment decision. Examples listed are for learning purposes only.
Thumbnail Image: Deccan Chronicle