Institutional investors often include risky investments like distressed debt and initial public offerings (IPOs) in their portfolios. High-risk investments such as these come with the possibility of large returns. At the same time, investors should keep in mind that they could lose these investments completely, which is why the riskiest assets are typically reserved for institutional investors with very large portfolios.
As with any investment, IPOs are never guaranteed. Even successful companies, like Blue Apron, have had IPOs completely fail. While IPOs can earn you a lot of money, it is best to be cautious before you invest. The following are some key points to consider before participating in an IPO:
- A strong broker is a good sign.
As you consider a company about to undergo an IPO, pay close attention to the underwriters of these transactions. Companies that work with any of the larger investment banks are generally safer bets. While these large investment banks have certainly helped launch failures in the past, quality brokerages signal a certain level of trust in the company’s success. Smaller brokerages may underwrite any company, so their backing does not mean nearly as much as a company that is underwritten by Goldman Sachs, for example.
Note that large brokerage firms typically will not allow you to participate in an IPO as your first investment. IPOs are generally only available to established investors with high net worth. However, this is not always true with smaller boutique brokers, so that could be a way in if you do not have an established history.
2. Objective data is hard to find.
You will want to get as much objective data on companies about to go public as possible. However, private companies typically do not have a lot of analysts combing through their finances, so this information can be difficult to find. The prospectus will have a lot of financial information about the company, but this document is ultimately written by the company itself and thus not an unbiased source of information.
Turn to the Internet to see if you can find any more objective data about the company and its competitors. You should also do some research about the target company’s industry. Even if objective information is nearly impossible to find, every little bit provides critical insight and will help you make the best investment decision. You may be surprised by how quickly you find out that a company’s prospects have been exaggerated.
3. The end of the lock-up period is telling.
The underwriters of the IPO and company insiders enter a legally binding contract called the lock-up period, which prevents trade for a period of three to 24 months. Investors often wait until the end of the lock-up period to act on their IPO stock. If you notice that none of the insiders sell their stock when the period ends, you should take this as a sign of stability for the investment and the company itself.
Unfortunately, there is no way to tell if insiders would rather sell during the lock-up period since they are legally prohibited from doing so. Waiting for the period to end is a good strategy since, in the end, a worthy investment will remain so after this timeframe expires.
4. The prospectus is a necessary read.
The prospectus for a company needs to be read with a critical eye since it is written from a biased standpoint. However, this does not mean that you should ignore the prospectus altogether. While the document itself is dry reading, it will help you frame the risks and opportunities presented by the IPO as well as understand what the company plans to do with the money raised by the IPO.
As a general rule, using IPO money to repay loans or buy equity from private investors is a bad sign since it indicates that the company cannot pay debts without issuing stock. However, if the money is going toward research, marketing, or company expansion, that indicates a healthier place for the company and the potential for increased profits in the future. Also, pay close attention to the earnings outlook. If a company overpromises, that is a bad sign.
5. Be skeptical before investing.
Because IPOs generally do not provide much reliable information, you should always approach an IPO with a generous amount of caution, especially if it is being pitched to you by a broker. While brokers may try to push an IPO as a great deal, always ask questions. For instance, why is there an excess of stock if the deal is so great?
Also, it is important to keep in mind that individual investors only rarely get access to shares of an IPO for a highly respected company. Brokers tend to save these stocks for their star clients, making it difficult for anyone else to access them. Even if you do get access to an IPO from a respectable company, remember that this still comes with many risks that the average stock does not have.