Are IPOs a Good Investment Opportunity?
An Acceler8now.com Investing Education Resource July, 2007
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The recent massive capital-raising activities of the financial services sector (in particular, banks and insurance companies) included a significant dose of IPOs and, in the process, made the term fairly popular. IPO stands for initial public offering, a first-time share offer to the public by a company, to raise equity capital from the capital market. An IPO will therefore necessarily be a share offer by a previously private company, which is now ready to go public. Usually, the company is pursuing some growth plans and goes public to attract equity capital from the wider investing public. For most banks that staged IPOs in the Nigerian stock market during the bank consolidation period, the primary drive was to raise capital to meet the minimum requirement of N25 billion set for the sector. The money so raised has clearly helped them to boost their operation. Dangote Sugar Refinery was, prior to its IPO of 2006, a privately held company. Now, with its IPO, it has become a public company with the tag 'plc' and has many shareholders from across the nation.
In a serious sense, IPOs are very important to the economy as they provide a platform to nurture large companies that provide goods and services, generate employment and help to grow the economy. By mobilising funds from the investing public, a good business concept can be developed into a vibrant large-scale operation, with the resources to compete in the market and generate wealth for individual investors. Funding constraints can limit growth for an otherwise sound business idea. An IPO will liberate the business from this impediment and, at the same time, provide an opportunity for other people to participate in the ownership of a profitable business. That is only one side of the coin, however. Not every IPO will realise this objective. Not all business models succeed, just because more capital is injected. If a business model fails to survive in the market place in spite of adequate capital injection, that will spell a major loss for investors who bought into the IPO. That was the case with Onwuka Hi-Tek Plc, for instance. For the potential investor, that raises the basic question: "are IPOs a good investment opportunity?"
It's good to note that all publicly quoted companies on the stock exchange today once staged an IPO. That was the initiation ceremony for each to become a 'plc'. So, it could be argued that a lot of IPOs have been successful. Unfortunately, as stated, success is not a guaranteed outcome. The company could turn out a huge disappointment, a drain on investors purses. What are the land-mines?
- No Performance History
Being previously a private company, the statutory reporting requirements and openness expected of public companies did not apply to it. The corporate governance responsibilities borne by public companies have limited relevance to private companies. In effect, you are dealing with a company that its operational history is not available. Yes the prospectus provides some insight, but remember that this is packaged for the sole purpose of marketing the offer. While it should be largely factual, it is still a marketing document, requiring close scrutiny. So, you are dealing with an 'unknown quantity' here. An investment appraisal with sufficient information is still difficult, meaning that one done for an IPO is even more murky.
- Marketing Hype
Because of the need to succeed, given the challenge as a new entrant, an IPO is likely to be heavily marketed, presented as a one-in-a-lifetime opportunity to join a company that is breaking into the big league. It may well turn out to be, but sifting through the noise to make a clear-headed investment decision is a challenge you must handle effectively.
In effect, there is no band-wagon position as to whether IPOs are a good investment or not. It has to be based on an evaluation of each offer. To worsen matters, you have a higher burden in deciding whether this is a good investment opportunity or not, because you will lack a historical framework to support your evaluation. How can you approach this to minimise the opportunity for an investment error? Pay attention to the following:
- Check the Prospectus Carefully
This document becomes even more important, in spite of any inherent limitations, since it may be your most far-reaching source of information. If the regulators have done a good job in screening the offer before approval, information should be available in the prospectus showing clearly the business model of the company, how the funds being raised will be applied, the business and other risks that apply to the business, the assumptions that underlie projections, as well as the projection of performance results, going forward. You need to review these carefully to make judgement on the viability of the business and how reasonable an investment it would be for you. Beyond the hype, look for the solid indicators.
- Management and Board Appraisal
The resources the company is targeting to mobilise will be managed by a company management team. What do you know about them? Find out as much as possible and make a judgement as to the quality of the team. It's easy to fritter away money, if in the custody of bad managers. Be satisfied about this team before you invest. The quality of the board of directors adds to this scrutiny. Who are the members and what are their antecedents? Are they men of integrity and of such business exposure as to bring some experience to bear on the performance of this company?
- Check other fundamentals
For instance, the economy and the prospects for the kind of business this company is going into. It's competition and what competitive advantage it can boast of. Get all the information you can on the company and weigh their import.
 - What Key Parties Are Involved
If an offer is underwritten by a major underwriting institution or a consortium of them, it is indicative of some level of approval by a top-grade institution(s), even if not conclusive proof of good investment. Check what parties are involved as underwriter(s), issuing house(s), Accountant, etc, as this gives some insight into what quality of third parties are willing to associate with the offer.
- Have a Clear Investment Strategy
You need to define your strategy for any investment you want to make. One option is to aim for a quick exit, where you are hoping to ride the price gains that immediately follow the listing of the stock, usually. Such gains may continue until many shareholders have received their share certificates (most companies still issue certificates), when some will begin to sell, possibly depressing the price. If this is your intention, you better strive to secure your share certificate early, before the price moves against you. Another option is to dig in for the long-term performance of the company, which will be a good idea if you see the long-term prospects as good. Bottom-line: decide your entry strategy.
While investing in IPOs is, at the end of the day, an investment in company stock and should be properly evaluated like any stock purchase, the onus is higher because of a more risky outlook. You do not have a comfortable basis to judge a company that was previously very private, accounting only to its owner(s) and providing no public information on its operations. The transition from 'small' to 'big' is also additional business risk since growth needs proper management. Projecting its future is more challenge than for a public company tracked by many analysts and investors, with a lot of public information to draw from. What all this says is that , while an IPO could prove a good investment if its objectives are realised, you need every caution. Scrutinise the offer carefully. At the end, it must be a convincing business model with strong potentials of success and reasonably priced, for you to invest.
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