Chasing The Fabled “IPO Pop”
If your financial advisor promised you two to three years of S&P 500 returns in one day, would you believe him? Me neither, and yet according to Jay Ritter, finance professor at the University of Florence, the average first day returns for IPOs (or Initial Public Offerings) in 2020 exceeded 40%1.
What’s more, these impressive returns are nothing new. Ritter’s data shows that first day IPO pops have generated +18.4% on average since 1980. A consistent practice of issuing stock to investors at a significant discount has driven strong interest from institutional investors in recent years.
Although the hype has cooled somewhat in 2021, there’s been a regular stream of big tech companies coming to market with large first day IPO pops. In April, we saw Coinbase’s share price hit a first day intraday high of 71.8% premium to IPO price. In June of this year SentinelOne’s share price had a first day intraday high of 32.9% premium to IPO price, and back in July, Couchbase achieved 38.5% premium to IPO price.
The Traditional IPO Process
The usual way for institutional investors to get involved in IPOs is via a process called “book building”. This is where a company seeks to raise additional capital right before a stock’s ticker starts trading on an exchange. The typical process looks like this:
The underwriters, who will be a consortium of investment banks, reach out to their institutional clients.
They then determine the offer price based on investor demand and the prices institutional investors are willing to pay for the IPO.
All investors are allocated stock in the IPO at this price. In the case of popular IPOs, investors may receive a smaller quantity than their original order.
The next day the stock begins trading on the exchange. The general public are now able to purchase shares. The listing exchange determines the stock’s first trade price.
Institutional investors bank on strong interest in the IPO to drive up first day prices, and in recent years that bet seems to have paid off most of the time. On average from 2008 to 2020 an impressive 69% of IPOs have closed above the IPO price2.
How Can Retail Investors Get Involved?
The question you’re probably asking now is how can retail investors actually secure an allocation, especially for the hottest IPOs?
Traditionally there have been two main paths open to retail investors. The first is to apply for shares in the public tranche, which is akin to a lottery. Even if you are fortunate enough to be allocated shares, it will likely be a very small allocation. The second option is to access the institutional tranche through private banks. The caveat with this is that you’ll need to be an ultra-HNW to receive an attractive allocation.
Getting In Before Others At The Pre-IPO Stage
Fortunately for smaller investors, the emerging fintech scene is continually creating new solutions to democratize financial access for the rest of us. Tech platforms allow investors to purchase secondary shares of private technology companies. So, instead of having to fight with others for a seat at the table when it comes to IPO shares, you now have the chance to purchase at the pre-IPO stage.
We’ll dig deeper into these options later in this article, but before you call your bank manager, let’s first weigh up the possible risks and rewards of pre-IPO investment for the retail investor.
There are two key risks to be aware of when investing at a late or pre-IPO stage. The first is that you cannot easily exit or that the company fails before you can exit. Looking at Preqin data on over 80 companies which raised a Series E or F round in 2015, the probability of this happening seems very low. Only 2-3% of these companies went on to fail, with almost 60% either going public or subject to acquisitions by the end of 2020. Consider that there is some liquidity risk, as you would have to wait around three years for a liquidity event to happen.
A further issue is that the IPO price or the first day trading price opens below the pre-IPO price that you paid, leaving you with a dip in your investment right off the bat. The best way to mitigate this risk is to invest in top performing or larger companies. Looking at the ten largest US IPOs over the past three years (see table below), all have shown a positive return from the offering date. In 70% of these companies, that return exceeded 100% with top performer BioNTech returning a massive 1477%.
Fig 1: Top US IPOs By Market Capitalization, 2018-2021
Source: Factset
Purchasing Secondary Shares Of Tech Companies
For retail investors looking to go down the pre-IPO route, there are several platforms that allow you to purchase secondary shares of private technology companies. These include Forge Global, Equity Zen, iCapital Network and Carta.
These platforms work by charging different tiers of fees depending on the seller and their business model. In general you can expect to pay a one-time access fee. You may also need to pay an annual management fee and performance fee in some cases, especially if it’s a long play.
Be aware that these platforms do sometimes list popular names where they may not yet have supply. This is a common practice to build a buyer list of aggregated demand so that they can act fast when supply becomes available. Hot shares are snapped up incredibly quickly!
Alternative Routes For Retail Investors
There are a few alternative options like having access to merchant banks and other brokers or intermediaries, having connections to employees in the company, or investing in dedicated pre-IPO/IPO funds. Generally these options are pretty similar to the traditional channels in that you need a large amount of capital or the right connections to get a seat at the table.
It’s highly likely that this space will be further democratized in the near future as illiquid assets can be tokenized and be more easily transacted amongst investors on a secondary market.
How Do You Select A Promising IPO?
There are a few general criteria which can be helpful when evaluating IPO opportunities:
The first and most important is the investor base. Are there brand name VCs on the cap table, and have they been leading the rounds?
The second is valuation. This can be difficult to assess as private companies seldom share much information, especially with secondary share buyers. You would probably only be able to do some basic peer comparables and estimates at this stage.
The third is the business fundamentals of a company. As mentioned, private companies are rather opaque and you may not have much information to go on. Besides the business model, what is important is to determine whether a company has potential to become a unicorn. These are the companies which are more likely to receive further rounds of funding.
The fourth is the industry. Is it large and growing fast? What is the competitive landscape like?
Finally, remember to evaluate the terms and conditions and understand the type of share that you are buying.
What Are The Big Names To Look Out For?
We have already seen many prominent technology companies come to market in 2021, including the likes of Robinhood, Roblox, Coupang, Marqeta, UiPath, Coinbase, Coursera, and Bumble. Still left on the table are a roster of high profile names which have yet to go public, such as Instacart, Flipkart, Databricks, Udemy, Discord, GitLab and many, many more.
If you’re feeling adventurous, you can look outside the US as well. Globally, the Indian market looks ripe for a wave of tech IPOs in the next 6-24 months. In July the share price of Zomato, a food delivery company, shot up 70% on the first day of trading.
Bear in mind, though, that it’s difficult for non-locals to get access and you will have to bear an extra currency risk. Novice investors are probably better off sticking to the domestic market until they’ve got a few successful IPOs under their belt.
Disclosure: Investing involves risk and past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Delphia) will match historic results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client’s investment portfolio.
Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed in this material.
Jay Ritter, “Monthly Number of IPOs and the average first-day return”
Nasqaq, “ Trends in IPO Pops”