Initial public offering
Amid a bull run on the stock markets, the initial public offering (IPO) market, or primary market, is again in the spotlight.
At a time when companies are lining up to raise funds from the market amid high valuations in the market, one needs to consider several things before investing their money in an IPO.
Also known as stock market launch is a type of public offering in which shares of a company are sold to institutional investors and usually also retail (individual) investors.
- An IPO is underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges.
- Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company.
- Initial public offerings can be used to raise new equity capital for companies, to monetize the investments of private shareholders such as company founders or private equity investors, and to enable easy trading of existing holdings or future capital raising by becoming publicly traded.
- After the IPO, shares are traded freely in the open market at what is known as the free float.
- Stock exchanges stipulate a minimum free float both in absolute terms (the total value as determined by the share price multiplied by the number of shares sold to the public) and as a proportion of the total share capital (i.e., the number of shares sold to the public divided by the total shares outstanding).
- Although IPO offers many benefits, there are also significant costs involved, chiefly those associated with the process such as banking and legal fees, and the ongoing requirement to disclose important and sometimes sensitive information.
- Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus.
- Most companies undertake an IPO with the assistance of an investment banking firm acting in the capacity of an underwriter.
- Underwriters provide several services, including help with correctly assessing the value of shares (share price) and establishing a public market for shares (initial sale).
- Alternative methods such as the Dutch auction have also been explored and applied for several IPOs.
- Enlarging and diversifying equity base
- Enabling cheaper access to capital
- Increasing exposure, prestige, and public image
- Attracting and retaining better management and employees through liquid equity participation
- Facilitating acquisitions (potentially in return for shares of stock)
- Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans, etc.
- Significant legal, accounting and marketing costs, many of which are ongoing.
- Requirement to disclose financial and business information.
- Meaningful time, effort and attention required of management.
- Risk that required funding will not be raised.
- Public dissemination of information which may be useful to competitors, suppliers and customers.
- Loss of control and stronger agency problems due to new shareholders.
- Increased risk of litigation, including private securities class actions and shareholder derivative actions.
How have IPOs performed?
- Most of the IPOs that raised funds this year have performed well. Rossari Biotech (issue price Rs 425) has gained 13.34% to Rs 841 from the listing day price on July 23.
- Route Mobile (issue price Rs 350) gained 83,25% at Rs 1,193 from Rs 651 on September 21. Eleven companies have raised funds from the IPO market in 2019-20 so far, and all of them were quoting above the issue price as on December 8, 2020.
- This performance is over a short period (3-4 months) and it has been supported by a sharp rally in the large, mid and small-cap indices.
- By and large, unlike in earlier years, only companies with good promoters and governance base are venturing to the primary market, and it has also been a result of stringent regulation.
- It is important to take a careful look at the company before you invest. Besides the finances of the company (at least three years), prospective investors must also look at the quality and stability of the management, and the promoters and their credibility.
- A good peer review is a must: Investors must study other listed companies in the sector and compare their growth and compare their PE ratio (market price to earnings per share). If the company is demanding a higher valuation, investors can choose to skip the issue.
- Many experts, however, feel that retail investors should stay away from IPOs. “IPOs are one of the riskiest asset classes to invest in, and ideally retail investors should stay away.
- Unlike listed companies where there is higher disclosure and information available in public, very little is known about an unlisted about-to-IPO company, in comparison.
- However, if someone is very keen on investing, then besides studying the company and promoters’ track record, one must also look at existing institutional investors such as private equity and venture capital investors in the company.
Why are companies lining up for IPOs?
- The IPO market is expected to witness some interesting names, including the mother of all IPOs, Life Insurance Corporation, and the NSE, in the coming months.
- Others include Kalyan Jewellers, Esaf Small Finance Bank and Barbeque Nation.
- The biggest factor driving companies to the IPO market is the bull run in the stock markets, which has taken the Sensex to an all-time high of 46,000.
- A strong market means a good company can get a good valuation for its shares.
- It has also enabled several venture and private equity funds’ exit from companies that they funded through the IPO.
- Market regulator Sebi has fine-tuned the primary market norms, enabling the issuers to float an IPO and list shares in a short period, thus cutting costs.
- The success of IPOs has prompted many potential issuers to look at the primary market for fund raising and listing as investor sentiment is positive.
IPOs importance for stock markets:
- While IPOs may not be an ideal option for retail investors, they are very important for the broadening and depth of the market.
- A higher number of good-quality listed entities offer more options for investors in the secondary market and provide stability and increase liquidity.
- Consider: If a large sum of investor money chases few quality stocks, they will all turn very expensive and push the stock much ahead of its fundamentals.
- However, if the same money chases a higher number of good-quality stocks, they are more evenly priced and risk levels are lower.