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Ground rules for IPOs

New arrivals to market generate a huge amount of interest but they don't always pan out for investors. Robin Hardy outlines what investors should bear in mind
Ground rules for IPOs

There have been a large number of IPOs on the London Stock Exchange (LSE) in the past two years – 31 in 2020 and 45 in H12021 with 20 in Q1 alone, the highest quarterly level since 2007. 

These flotations or initial public offerings (IPOs) are when ownership changes from a single or small collective of shareholders to a wide array of new investors, to institutional investors (such as pension funds) typically owning more than 90 per cent of the available shares and private investors large in number but holding only a small fraction of the equity. 

In an IPO, owners do not have to put all of the shares into the market. For a listing on the UK’s junior market, Aim, there is no minimum number of shares (although in practice c10 per cent would be needed to attract investors’ interest) and for the main market it is (currently) 25 per cent. Shares made available to investors are known as the ‘free float’ and if the free float is too small, this can harm the valuation. 

There are many reasons why a company might be brought to the market. It might be government policy and this would typically be a privatisation for businesses such as BT (BT.), British Gas, Rolls-Royce (RR.), British Steel, water companies and power companies. The UK has been the global leader here with £107bn of funds raised between 2004 and 2017. The rationale is that public ownership is less efficient than private enterprise. 

It could also be to unlock investments. Successful private companies may attract a high valuation but this can be hard to unlock. Entrepreneurs can have millions of their net worth in illiquid, private company shares, which a public listing unlocks. Beware of large sell-downs by existing shareholders – investors want to see owners and managers keeping some (ideally a lot of) skin in the game so their interests align with external investors’. These can be the best IPOs to pursue especially if the founders are still in charge. 

Another reason is to raise capital today. This is usually a mechanism to reduce debt but where the issuer wishes to generate funds for a debt-funded takeover already undertaken while a private company. It can also be where a strong business has expanded using only bank debt and wishes, quite rightly, to have a more permanent equity base. However, it may also be that a business needs capital to continue expanding and is unable to secure sufficient debt capital because lenders are wary of, say, the business reaching profitability and positive cash flow. This is often the case in earlier-stage technology or biotech businesses where any funds raised in the IPO are used up in ‘cash burn’ and there is near-certainty that there will be one or more additional calls for equity funding. 

To create future access to capital. A key reason businesses go public is to have access to capital for expansion. Private companies can issue new shares for cash but this can be problematic and buying a business using private company shares is equally difficult. Using publicly traded shares, both processes are made substantially easier. While most IPOs raise new money, this is not always the case: Dr Martens (DOCS) floated in 2021 with a market value of £3.7bn but raised no new funds. 

A private equity (PE) exit. Previously-PE-backed businesses typically have a lot of debt when they come to market. The IPO is undertaken to: a) reduce the debt and b) allow the PE investor to bank their (often significant) returns. Investors need to be wary of this type of IPO: 1) the high debt; 2) limited new money for growth; 3) there are less likely still to be founders/entrepreneurs on board; 4) there is a good chance that the best of the value has already been wrung out. 

 

The pitfalls of being quoted

While becoming a quoted company is more typically a positive step, there are factors that can be a drain or be more damaging. There will be months of work ahead of the float that risk distracting from running the business. This will continue after the IPO as directors have to undertake investor relations. 

The IPO is likely to cost around 4-5 per cent of the value of the floatation, but this will be harvested from IPO proceeds. There are substantial ongoing Plc costs.

Passive loss of control is another issue. While a founder/driver of a business may retain control post-IPO, they can lose control by dilution. This may be in a crisis where emergency funding is needed, where shares are issued for a takeover and the founder cannot afford to invest, or where they need to sell shares to fund an external event (ie divorce or a large tax bill) and cede control in the process. 

Other pitfalls include volatility. Share prices can be very volatile, more so for newer companies and those where the free float is small. Even a relatively minor piece of cautious news or a negative comment by an investment bank analyst can easily wipe more than 10 per cent off a company’s valuation in an instant. 

If a private company misses completing a project or making a disposal by a couple of months, there is little or no consequence. For a quoted company, this is deemed a failing and the share price can slump.

 

Positive examples

An IPO might be seen as successful if the share price rises in the early days, but that is not entirely correct. The purpose of the IPO is to list the shares and to access new funds. Regardless of the share price (unless calamitously bad) the IPO has achieved its objectives. However, in most investors’ minds and in the eyes of the media an IPO has been a success if the share price rises, and there have been plenty of good examples. 

On a long-term view, Asos (ASC) has been a spectacular success, starting in 2001 at the equivalent of c16p and peaking at 7,750p in 2018, although the share price has since more than halved. The price is still up c200-fold.

The IPO class of 2021 has been generally successful with an average price rise post-IPO of around 20-25 per cent with three more than doubling (Caerus Mineral Resources (CMRS), Cornish Metals (CUSN) and Nightcap (NGHT)) with a further three exceeding a 50 per cent increase (Auction Technology (ATG), MGC Pharmaceuticals (MXC) and Trellus Health (TRLS)). Bigger-name issues (Dr Martens, Moonpig (MOON), Trustpilot (TRST) and Virgin Wines (VINO)) have all seen more than a 20 per cent increase. 

From the 2020 IPO class, again two sets of three strong performers with Critical Metals (CRTM), Verici DX (VRCI) and Kistos (KIST) all having tripled and Elixirr International (ELIX), Calnex Solutions (CLX) and Inspecs Group (SPEC) have doubled. 

 

Weaker examples

Early or initial share price weakness is not automatically a failed IPO. Facebook (US:FB) halved after IPO and has since risen 20-fold and ‘glamour stocks’ can have a tough time losing value as the hype wears off, ie Uber (US:UBER) and Peloton (PTON), albeit the latter has since doubled and the former has crawled back to the IPO price. WeWork famously failed even to get to IPO in an emperor's new clothes moment when it became clear that this was nothing more than a fancy commercial landlord wrapped in hype. The $47bn price tag was unsupportable being 10 times that of IWG (IWG) (Regus as was) which was both larger and profitable. Stocks like these are known as ‘unicorns’ and value often turns out to be, like their namesake, mythical: health tech company Theranos is another example.

In recent UK IPOs, the stand-out disappointment has to be Deliveroo (ROO), dubbed by the Financial Times as the “worst IPO in London’s history”. An overhyped issue that fell 21 per cent in three weeks did recover to the IPO price but is tumbling again. Deliveroo loses money on every delivery and a lot of questions remain about how profitability can be achieved. 

Other recent strugglers include readymeals manufacturer Parsley Box (MEAL), which has halved since IPO as losses increased; Cizzle Biotechnology (CIZ), a ‘shell’ reversal IPO that halved after float; Alphawave IP (AWE), a Canadian semiconductor maker hit by a tech sell-off and chip market problems that dropped 21 per cent immediately on IPO; and Supply@me (SYME), a ‘fintech’ for funding business inventory – another ‘shell’ reversal IPO that looks to be running out of cash. 

 

Hurdles

In general, it is difficult for private investors to become involved at the IPO stage, other than higher-net-worth investors. Stockopedia reports that in more than 350 IPOs between 2017 and 2020 only 24 included private investors. 

Ground rules for appraising IPO stocks:

Wait: Around nine in 10 companies making an IPO see their share price above the issue price in early trades, making it appear that private investors have missed out. There is often an opportunity some months later to buy the shares at below the issue price. However, only do so if the news flowing from the company has been broadly positive and things promised pre-IPO have been delivered. 

Think contrarily: While some shares rebound after an IPO slump, many do not. If looking at a ‘bargain’ share price in such cases, really do your homework on the market, the management and the model. It is better to be thinking 180 degrees different – buy a stock that has risen well post-IPO. The business is likely to be delivering and should continue to do so, but again probe into the story. A sharp rise after IPO can also indicate massive, unsatisfied investor demand which again can highlight a quality story in which many investors will still want to participate.

Avoid glamour stocks: The best-performing IPOs tend to be for small, fast-growing, under-the-radar companies and this has largely been the case with UK IPOs in 2020 and 2021.

Go tangential: Investors can participate in IPOs indirectly using the likes of contracts for difference (CFDs) (but only for higher-net-worths), exchange traded funds (ETFs), spread bets (always ensuring that stop-losses are used), certain funds that may be known to be inclined to invest in IPOs and some platforms (such as Interactive Investor) can offer collective access to new issues. 

Overall, IPOs for good businesses are not priced as bargain issues and gains are certainly not guaranteed. Often businesses raising capital in this way will be set to deliver good long-term growth via better-funded expansion or product development which can make the shares more attractive than well-established, more mature businesses. However, this does mean higher risk and as is more typical with smaller and newer businesses there will be no dividend to enhance returns. Looking to trade in this part of the market will always require greater diligence, spread/diversity is always advisable, don’t make your first foray into investment an IPO and it is a bad idea only ever to buy newly floated businesses.