What to make of the IPO market?
Many investors will have noticed that, after a number of dry years, the market is suddenly awash with Initial Public Offerings (IPOs). Given the flood of potential opportunities, what are some of the things investors should bear in mind when considering whether or not to participate?
Firstly, it’s good to be clear on the motives of the key players and how they affect IPO dynamics. When a business owner “floats” a business, they are effectively selling it – and naturally they want to get the best possible price. This is most acute when the owner is pocketing the proceeds of the IPO and exiting their holding, but even when the owner is staying in and the float proceeds will be used to grow the business, the owner still wants to sell shares at a good price to minimise their dilution and obtain the best return for shareholders who have previously taken risk to support the business.
The main tool available to the owner to achieve the best price is timing: floating when similar businesses are fetching good multiples. When you see a rush of floats coming to the market, it can sometimes be an indicator that business owners feel that prices are satisfying their demands, and history shows that float activity does correlate with market peaks.
On the other hand, the broker managing the float wants the price to reflect good value. The broker needs to sell the issue to its clients, and wants to keep them happy too, as investors are repeat customers and a source of future brokerage. The broker has a particular incentive to achieve good value when they are underwriting the issue and may be left holding the bag if investors shun the offer.
The result of these dynamics tends to be IPO pricing that reflects reasonably good value compared with similar listed companies, but at a time when those similar companies are trading at elevated prices. Of course there are exceptions, but as a general observation, participating in IPOs probably makes more sense for investors with shorter investment time frames.
Another commonly reported danger for long term investors is the possibility that reported earnings have been “managed” in preparation for the IPO. For example, in the short term a business vendor may be able to improve reported earnings by cutting back on expenses or capital investments. If the cuts compromise service, quality or brand, then the negative consequences may not show up until some way down the track. While this scenario may be reported as all-too-common, its not true that investors should believe it is always the case. Indeed, if a private equity vendor has a pipeline of floats to offload (a very common occurrence given their own modus operandi) or they are remaining on the share register as substantial owners for a period after the float, it is not uncommon for the forecasts to have been conservatively estimated. If a listed company exceeds its prospectus forecasts, it can help to maintain support for the stock beyond the initial enthusiasm surrounding the float.
Potential IPO investors also need to bear in mind their financial relationship with the broker. Clients who generate a lot of brokerage can expect to receive a favourable allocation to keenly-sought offers. If you want to have a “seat at the table” so to speak, and increase your chances of receiving allocations to the best floats, it is essential that you actively and frequently employ deeply-networked, full service brokers. Investment banks like UBS – led by the likes of Guy Fowler and his team – immediately spring to mind as avenues for those serious about giving their wealth a shot in the arm through IPOs. Lesser players are more likely to get scaled back more meaningfully when there is a surplus of investors and only limited stock on offer.
So, what do we make of the current deluge of IPOs hitting our desks? A reasonable interpretation is that owners are rushing to market because they feel valuations are attractive. The market is wiling to pay up for the best businesses given the dearth of opportunities in the secondary market. The rush however is also a function of the fact the IPO window was closed for a long time, and vendors like private equity who need to keep turning over their portfolios have probably built up something of a backlog that needs to be cleared. This situation can actually work in favour of investors.
Also, as with all equity investments, we need to be wary of making broad generalisations, and it’s likely that we will find both some gems and some dross amongst the various offerings. For investors willing to put in some legwork and properly analyse the businesses coming to market – using the techniques we have advocated here and which we use at Montgomery Investment Management, as well as the circumstances of each offer and its particular risks, IPOs can be an opportunity to acquire high-quality businesses before others have fully appreciated their virtues.
At Montgomery Investment Management, we have been studying with interest the different opportunities and while we are wary about current valuations generally, we also think there are a few long term gems waiting to be listed.