An investment bank differs from a traditional bank that accepts deposits, pools those deposits together, and sells loans at a higher interest rate. These banks assist companies in raising funds in the capital markets, advise on mergers & acquisitions, and complete other complex financial transactions.
One of these is selling shares of private companies through an Initial Public Offering (IPO). This process is often called “taking a company public” because that company’s stock becomes tradable on public stock exchanges.
The media loves IPOs because the opportunity for fast money generates a lot of buzz. For example, when Alibaba went public in 2014, the deal size was the largest in the history of the New York Stock Exchange. Demand for stock in this fast-growing internet giant was so high that there were more than ten willing buyers for every share available1.
British microchip designer Arm Holdings is preparing to go public this month in the largest IPO of the year. It’s attracted interest from more than just institutional investors. Apple, Nvidia, AMD, and Samsung are among the companies that plan to buy shares in the IPO, according to the filing2.
But that doesn’t mean individual investors will be invited to the party. Getting in on “hot IPOs” is often next to impossible. Although this may frustrate some, let’s explain how the IPO process works to see why this may not be so bad.
Under the hood
The first step to going public usually involves hiring an investment bank to facilitate the sale of their stock. Think of investment bankers as the middlemen between the company (the seller) and big investors (the buyers). These banks have deep relationships with money managers, so most sellers would rather pay a bank than try to sell its stock on their own.
This is no different than using a real estate agent to sell a house. An agent is not required, but they can make the process smoother and offer advice on how to get the best price.
Bankers target large investors because they can buy big blocks of stock and tend to be long-term holders. They also bring their best relationships because good customers of an investment bank expect exclusive access to deals like these.
Over several weeks, the bankers travel with the management team to meet prospective buyers. This process is called the “roadshow.” Its goal is to educate investors on the company and future growth prospects and gauge demand for the stock.
A few days before the sale, bankers solicit orders. If a money manager is interested, they tell the bank how much stock they want and the price they are willing to pay. The bank then compiles the orders to see how the overall demand compares to the amount of stock being sold.
This process helps the bankers determine where to price the stock. Setting the listing price can be more an art than a science, and the bankers will often adjust the price more than once before it begins trading as they get a better sense of the overall demand.
Bankers walk a fine line because the seller hired them to get the best price for their stock. But they cannot price too high and risk damaging relationships with buyers who may feel they got a bad deal.
A good rule of thumb for bankers is to price the stock at a level where it will open roughly 10% higher. If a bank priced an IPO at $20, the bankers aim for the stock to open around $22.
Therefore, management does not feel like they are leaving money on the table, and investors now own a stock that they paid $20 but could sell immediately for $22. However, this rarely happens because pricing newly issued stock is complicated. For example, Alibaba was priced in the mid $60s but opened in the low $90s1.
Simply put, individual investors and smaller institutions rarely get an allocation because bankers prefer to put stock in the hands of those with the most money to spend.
Let’s assume that after a bank completes a roadshow, they realize that demand is lower than expected. This scenario occasionally happens due to a less optimistic view of the company’s prospects or the stock's initial price range is too high.
Bankers are hired to sell this stock, and since the big buyers are not biting, they must resort to other channels. This is pretty much the only time when smaller investors get a look.
For example, the Facebook roadshow did not garner enough interest from large investors. The bankers filled the gap by offering stock to smaller institutions, high-net-worth individuals, and the mass affluent through financial advisors and brokers at the banks involved in the IPO3.
However, when bankers courted smaller investors, they most likely didn’t pitch it as a failure on their part to convince tier-one clients. They probably marketed it as exclusive access to one of the biggest IPOs in U.S. history.
But these investors did not get to meet with Mark Zuckerberg to discuss his vision for the future of the company. Nor did they employ trained analysts to create financial models and comb through SEC filings to assess the risk in the offering.
Most likely, the only analyses made available to them were the research reports published by the banks hired to take Facebook public, which are little more than glorified sales brochures.
The bottom line
Stocks can be volatile for months after an IPO. The mix of emotions and uncertainty of whether management will deliver on their projections often make for too wild of a ride for some. Many professional investors will wait a year or longer before buying to watch how a stock trades while they conduct due diligence. Therefore, if you miss out on a hot IPO but still want to get in, the professionals take their time to do the job right, so it’s best to do the same.
If you cannot resist the temptation to buy closer to the debut, a good rule of thumb is to only allocate what you are comfortable losing. This strategy will likely preserve your sanity if a stock falls flat on its face, which is often the case in the world of IPOs.
The bottom line is that most investors will never get to participate in a hot IPO. For those offered, keep in mind that you are only getting the opportunity because larger and more sophisticated investors did not like the deal and chose to pass.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.