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25-09-2020 | Insight

IPOs – the lottery everyone wins?

  • Steef  Bergakker
    Steef
    Bergakker
    Senior Portfolio Manager

Following the pandemic, IPOs initially slowed down to a trickle. This comes as no surprise as falling stock prices are not exactly ideal when trying to attract investor money. The stock market’s strong rebound, however, has ensured IPOs are picking up steam again. Tech companies in particular have been successful in this regard and have gotten investors to open up their wallets.

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Source: Professor Jay R. Ritter, University of Florida

While most businesses saw a decline in demand for their products and services due to the Covid-19 crisis, tech companies generated excellent returns and strong corporate earnings growth. Lockdowns accelerated the digitalization of the economy, giving tech companies a unique opportunity to capitalize on their growth prospects by going public.

There have been plenty of new issues in the past few weeks by companies such as nCino, BigCommerce and Snowflake. In fact, Chinese e-commerce giant Alibaba will see its finance arm, Ant, issue its first IPO very soon. This may well turn out to be one of the biggest IPO deals in the history of the stock market.

From a nobody to a champion in one giant leap

Snowflake made front pages after its first day of trading, opening with USD 120 per share and ending the day with a bang at USD 255.45 per share. Yet it wasn’t so much this phenomenal price increase that garnered such huge interest – it was the fact that the company racked up a valuation of more than USD 70 billion after its first day of trading. This is more than Colgate, Deere or Bayer – to mention but a few respected names with a long and rich history.

Snowflake operates in data-warehousing and analytics – a market that is obviously more imaginative and exciting than toothpaste, agricultural machinery or aspirin. Analysts expect explosive growth from the company in the coming years. There is only, of course, the minor detail that Snowflake has as yet to generate any profit and only made USD 265 million in revenue last year. Who said investors only possess short-term horizons and never look beyond the next quarterly results?

IPO Bonanza

Snowflake was not the only company to go public and generate huge first-day price gains for investors. For instance, the aforementioned nCino and BigCommerce shot up 195% and 201% respectively. Of course, these are examples of major outliers. But as Professor Jay Ritter, the undisputed expert when it comes to IPOs in the US, points out, the average price gains this year for all US IPOs comprised a respectable 42% on the first day of trading.

In fact, the graph reveals average first trading day gains were only significantly higher in the late 90s. It is striking that average first trading day gains have been positive over the past years, not just in the US but worldwide. All in all, it is hard to imagine getting burned as an investor in an IPO. Does this mean IPOs are a lottery everyone wins?

A complex game benefiting everyone

It is almost always the case that if the title of a text poses a question, the answer tends to either be ‘no’ or ‘not quite’. This text is no exception to this rule. Most investors want in on an IPO as they know the price will typically go up. The underwriting syndicate, however, deliberately limits the number of stocks investors can subscribe to – meaning less than 25% of stocks are often available for purchase.

This, in turn, ensures demand outstrips supply. Investors therefore frequently only receive a portion of the shares they had wanted to purchase. This may amount to no more than a fraction if the IPO turns out to be ‘hot’. If investors then want more shares, they will have to purchase them on the stock market, at higher market prices, of course.

On balance, then, investors tend not to earn huge amounts, in absolute terms, through IPOs. The exceptions are, of course, those investors whom underwriters consider valued clients and who are therefore allotted a relatively large part of the emission. This is then more than offset by the fees these valued clients are charged for other services the bank provides. After all, a valued client is a client who generates money for the bank – one way or another.

Everything happens for a reason

Some might wonder why companies are content to forego a considerable portion of the proceeds by settling for a lower asking price. This often means missing out on billions of dollars. But, here too, compensating factors are at play. One advantage of offering a limited amount of stock for sale is that insiders’ stock will implicitly increase in value once the market price has gone up.

In fact, most IPOs ensure various insiders join the ranks of millionaires or, even, billionaires – at least on paper. Of course, if they then want to convert their paper wealth into cash, they will need to sell their stocks once again to outside investors. It then helps if the IPO left an overall positive impression on investors. Thus, ensuring everything comes full circle.

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