So, You Want To Buy An Ipo, Eh?

Selling shares of stock to the public through an Initial Public Offering (IPO) is a tried and true way for a company to raise money by expanding its ownership base. Going public involves many steps, several entities and considerable expenses. (For a good explanation of the process read Guide to going public in Canada: EY https://www.ey.com/Publication/vwLUAssets/EY-Guide-to-going-public-in-Canada/$FILE/EY-Guide-to-going-public-in-Canada.pdf). In a best efforts underwriting, the underwriters are obligated to use their reasonable best efforts to sell the company’s securities on behalf of the company. At no time do the underwriters obligate themselves to purchase the securities, as they do in a firm commitment underwriting.

There are many rules and regulations that the company needs to comply with. In Canada, each province has its own securities legislation, although the requirements are generally consistent across the country. In an effort to coordinate the regulation of the markets, the provinces work together through the Canadian Securities Administrators (CSA). The CSA has been developing uniform rules and guidelines, coordinating approval processes, developing national electronic filing systems and coordinating compliance and enforcement activities. CSA’s online system, System for Electronic Document Analysis and Retrieval (SEDAR), whereby prospectuses and continuous disclosure documents can be filed with the various securities commissions and viewed by the public, provides access to all Canadian public company filings on its website (www.sedar.com) under applicable securities laws. The CSA also has an online system for insider reporting filings, the System for Electronic Disclosure by Insiders (SEDI www.sedi.ca).

In most cases, you won’t pay a direct commission to buy an IPO. That’s because the company issuing the IPO engages underwriters to price and market the new stock. Their fees are built into the initial offering price of the stock—the dealer gets a share of that embedded fee which can range from 4-7 % or more. The dealer then pays its employees, often called “advisors” from this fee for overseeing the placement of these new shares into client accounts. The Annual Report on fees and charges for your account will show the portion of the embedded fee that relates to the distribution of the new issue to clients (the “commission portion”) as a third-party payment.

An IPO comes with a regulator vetted prospectus, a legal document that sets out the full, true and plain facts you need to know about a security. Unfortunately, most retail investors ignore the prospectuses and don’t read them, which is a big mistake.

While an IPO may appear like any other transaction an investor might execute on a stock exchange, it is a decidedly different animal. Unlike other trades where existing shareholders sell their shares in exchange for money from a new investor, in a treasury offering, typically the company is raising money to fund growth plans and the new investor buys shares directly from the company. The company’s management team and board of directors will engage one or more investment banks to manage the IPO. Investment banks compete to win an IPO mandate as underwriters—the fees can be very lucrative—lower for well established companies seeking additional capital but often much higher for higher risk, new, largely unknown companies.

A roadshow, a two- to six-week marketing effort, is done by the underwriters to determine the demand/interest in the new issue. Investor interest, in terms of the quantity and price at which investors are willing to buy, is then recorded in an order book. Based on the investor interest/demand, the underwriters will determine the quantity and pricing of the shares that will be issued. The initial terms will be adjusted according to the investor demand on the new shares. In an IPO, selling shareholders will always prefer a higher valuation and a higher IPO price. Typically, the presentation to the company’s board that makes the most appealing valuation/demand case for the issue price will win the underwriting mandate. It is therefore not unreasonable for the retail investor to assume over-pricing of IPOs is the norm in light of conflicts of interest and monetary incentives.

A CIRANO research paper Three Decades of IPO Markets in Canada: Evolution, Risk and Return concluded: “On average, these IPOs generate three-year negative abnormal returns, and more than 70% report negative abnormal returns. Large issuers reporting profits constitute the only subsample that provides fair returns, but they account for less than 5% of IPOs. We observe a high level of skewness of abnormal returns, consistent with the behavioral finance proposition that investors are often unduly optimistic when valuing lottery stocks. The lemon market characteristics of the Canadian IPO market can probably explain why it is vanishing”. (Source: https://www.cirano.qc.ca/files/publications/2018s-04.pdf). So, the odds of finding a ten bagger aren’t high.

An International Organization of Securities Commissions (IOSCO) Report identified a number of risks associated with an IPO. “Conflicts of interest and associated conduct risks during the equity capital raising process reveals that the issuance of shares in a new company can be rife with conflicts of interests.”

The following are some of the key risks that have been identified:

• Conflicts of interest and pressures on related party analysts during the formation of their views on an issuer in the pre-offering phase of a capital raising.
• The prominence of conflicted related party research during investor “education” and price formation in equity IPOs.
• Conflicts of interest during the allocation of securities.
• Management of underwriting risk by firms managing the offering and associated conflicts of interest in the pricing of securities.

(Source:https://www.iosco.org/library/pubdocs/pdf/IOSCOPD612.pdf)

Consider the allocation of securities. In principle, investment bankers should not differentiate between investor groups. In practice however, the retail investor is totally out gunned by institutional investors: mutual funds (may be a related party), pension funds, hedge funds, venture capitalists and private equity. These folks are aggressive about using their influence in insisting for a disproportionate share of “hot IPOs”. After all, they pay the investment banks millions of dollars in commissions and fees every year. Institutional investors thus crowd out smaller investors on popular new issues. In effect, a retail investor may readily access shares of an unattractive, higher risk undersubscribed company, but may get a very limited opportunity to participate in a high quality IPO.

With an IPO company there is a situation where the seller is much better informed about the value of the company than the buyer. The original shareholders have a body of information that an outsider cannot match. The founders know the firm’s competitive position, they know market demand and opportunities, they understand the business risks, and a multitude of other relevant information. A retail IPO investor has a more limited basis for making an informed purchase decision as to valuation.

No one can predict how the price of an IPO will change once it goes on sale. Before you decide, read the prospectus. It contains information about the company or mutual fund selling the security, its management team, products and services, business plans and risks. from the company issuing the IPO. The prospectus describes the business plan and notes important risk factors. As part of its story, the company will need to clearly explain the intended use of proceeds of the IPO and disclose whether the proceeds will be sufficient for that stated purpose. Check whether the company is making money or when it expects to become profitable. Be wary if you’re told that you don’t need a copy of the prospectus to decide, or to ignore the prospectus or certain information in it.

You should assume that the investment banks choose the timing of the IPO very carefully. A company going public should have a favourable financial history and outlook, with a clear argument on why its securities are an attractive investment at IPO time. The timing for an IPO is also subject to a variety of external market factors. For instance, in a general or sector-specific market downturn, underwriters will often recommend delaying an IPO. Conversely, when the sector is hot, the IPO will be brought to market. In other words, IPO’s are sold under the most favourable conditions for the seller. Retail investors should be aware of this timing factor to avoid overpaying or even deciding to purchase the IPO at all.

Underwriters typically require that key existing shareholders agree to continue to hold their shares for a certain period of time following completion of the IPO. This ensures that the key shareholders of the company will—along with the new investors—continue to support the company and remain exposed to changes in the company’s prospects for a period of time following the IPO. The duration of this “lockup period” is subject to negotiation with the underwriters, but typically it lasts 180 days. In principle, this shows good faith, as new investors don’t want to see original shareholders cash out immediately after they’ve just bought shares. That would drive the price down below the issuing price. In reality, the market knows when the lock-ups expire and this can create a cloud over the company’s shares until the expiry of the lockup period. This is an important point to consider when considering a purchase of an IPO.

In some cases, a company may want to reserve control rights for its founding investors when executing an IPO and will create two classes of common equity, with the founders holding multiple voting shares and the public investors holding subordinate voting shares. Alternatively, the founders may hold voting shares and the public will be offered non-voting shares. Proponents of these dual class shares believe that they protect founders from short-sighted investor demands. However, critics argue that this sort of share structure gives founders “unchecked power”. If a compelling reason exists for accepting a more complex structure, the dual class structure may not be inappropriate. Just be sure you understand what you’re buying.

Common shares aren’t the only securities offered via an IPO. IPOs are also available for preferred shares, bonds and the Closed-end Fund (CEF). A CEF is a collective investment model based on issuing a fixed number of shares which are not redeemable from the fund. Unlike open-end mutual funds, new shares in a closed-end fund are not created by managers to meet demand from investors. CEF shares trade on the TSX like common shares with bid/ask price spreads.

Buying an IPO in a CEF can cost you money via fees, specifically the cost of paying the bankers, brokers, accountants and lawyers who put the deals together. If a fund raises say $150 million, they’ll collectively might receive more than $7 or $8 million of your money, money that does not stay in the fund. So right from the start, you’re in a loss position. Think twice before investing in a CEF IPO. (See Closed-end Fund IPOs: Sold, Not Bought https://site.warrington.ufl.edu/ritter/files/2018/06/CEF_IPOs_June15_2018.pdf)

Once issued, a new IPO begins to trade on the public markets such as the Toronto Stock Exchange (TSX). It is at this point that investment dealer analysts initiate research on the stock. Investors should be critical about the objectivity in these reports if they are published by dealers affiliated with the investment bank who created the IPO. Independent analysts should not be reluctant to expose company operations to critical analysis. The post-IPO market is where you can begin to see if company management are able to deliver on the optimistic outlook indicated in the prospectus. Some savvy investors buy into the stock only when there is convincing evidence of positive performance. That is, after the IPO.

As Canada’s banks control underwriting, investment dealers and mutual funds, it is possible you might be investing in a great IPO without knowing it. It could be subsumed in a mutual fund. On the other hand, the bank may decide to dump a weak IPO into one of its mutual funds due to lack of sales. Of course, there are rules regarding mutual fund governance, but U.S. research shows that banks use their powerful position to optimize their profitability. (See Nepotism in IPOs: consequences for issuers and investors. http://ewfs.org/wp-content/uploads/2018/02/Degeorge_Pratobevera_Nepotism-in-IPOs.pdf). The researchers found a strong positive association between IPO underpricing and affiliated allocations, which strengthens when nepotism incentives are stronger.

And then there are the investment dealers who distribute the new shares.

The person selling you the IPO may use the title “advisor”, but the correct term would be “Registered Representative”, since that is the title associated with the license registration. In general, Registered Reps are not required to act in your best interests. Reps are not fiduciaries. They need only meet the low suitability advice standard prescribed by regulators and address conflicts of interest. Basically, as long as the security is not unsuitable, it can be sold to you. It need not be the best, lowest cost or least risky.

If an advisor thinks an issue will be “hot” they would make an expression of interest early, in hopes of getting a good allotment from the dealer. Sometimes in the course of the build-up to the deal it becomes apparent that the issue is not going to get the interest that was hoped for. This can result with the advisor being saddled with an issue and having to find a way to cover it. An advisor facing pressure to distribute his allocation may try to unload it on clients even if it may not be suitable for them. That could certainly be a source of conflict of interest, placing clients in harm’s way. Caveat emptor.

Be aware also that even if you buy an IPO in a fee-based account, the dealer and advisor will collect commissions.

In summary, investing in IPOs is full of bear traps for unsuspecting retail investors. Sure, you may uncover the next Facebook, Netflix or a Shopify but you might also end up in an Eaton’s, Bre-X, Sino Forest or other fiascos. Consider investing in IPOs as risky; consider them for that portion of your portfolio labelled above average risk.

Ken Kivenko, PEng, President, Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com