Fleshing out our take on IPOs

Livewire Markets included some commentary from Equitable Investors in its IPO round-up - which you can find here - and we thought we would take he opportunity to flesh things out here.

Discipline creeping in?

Our footnote to the description of a buoyant 2020 for IPOs (as we set out for Livewire) was that the market appeared to take a more discerning approach in the last few weeks. Several IPOs slated for the ASX were cancelled and ready-made meals company YouFoodz got its listing away but then fell 25% on its first day. 

We would like to think that there was more than just investor fatigue at work. A common structure to fund companies preparing to IPO has been to conduct a "pre-IPO" raising where investors commit capital that will be converted to shares at a discount to the IPO price. Quite often that discount is around the 20% mark. It was probably a healthy sign pre-Christmas that the market did not support a proposed IPO with convertible notes on issue that were to be converted to ordinary shares at a 50% discount to the IPO price.

We don't need to invest in IPOs...

Equitable Investors did not participate in a single new IPO in calendar 2020, an outcome we would not have predicted at the beginning of the year (we did invest in one Reverse Takeover or "RTO"). We found great opportunities to provide new capital to companies we already knew well and we prioritised these opportunities over new listings.

... but we are expecting continued demand

Low interest rates would certainly continue to force investors to look at equities, including IPOs. As CY2020 came to a close, equities were trading at a spread of about 4% on government bonds, if you use the sharemarket's earnings yield. So even if interest rates increased a little, the overall equity market would remain relatively attractive on that basis - remembering that the earnings yield used to trade on par with interest rates before the GFC ushered in the era of low interest rates. Takeover activity also appears to have heated up and if it continues on into 2021, it will put cash back into the hands of investors looking for opportunities to redeploy it. 

Some of Equitable Investors' considerations when reviewing an IPO:

  • Motivations: It is extremely important to understand the motivations of the company for listing. If it is about vendors taking money off the table, then more caution is appropriate. The sellers know exactly what it is they are selling and have had time to package it up to look as attractive as possible. The prospectus and pitch deck are part of that packaging. 
  • Pricing: In general, given the knowledge imbalance between the pre-IPO owners and IPO participants, we expect an IPO to be priced at a discount to its listed peers. This doesn't mean it has to be priced like a deep value play. A fast growing company with market power or strategic value should be priced against other companies with those characteristics. 
  • Structuring: We've touched on setups where investors who came in before the IPO are guaranteed a significant discount to the IPO price and how that can undermine the price of the stock once it lists. But there are a number of other things to watch out for. A classic is the provision of a significant "free carry" where the promoters are issued with free shares and claim that this creates alignment - the truth is that the stock price can halve and the promoters may have done very well for themselves. Sometimes you see IPOs where the intellectual property or other important components of the business are ring-fenced in an entity that will remain private and won't be owned by the listed entity. The bottom line is that you need to read the prospectus, including its footnotes, with eyes wide open. 
  • Ownership: Who your fellow shareholders are is also relevant. We want to see founders, board and management holding reasonable investments. We do think about whether an IPO is attracting flighty day traders or patient capital. It does worry us whether fellow owners understand what they are holding.
  • Potential: Ultimately we are looking for a business that we expect in the future, based on our understanding of its economics, can generate future earnings that will drive a valuation that makes the issue price look like a bargain today - or have strategic value to other industry players. Revenue multiples have become increasingly popular in comparing IPOs with their peers. We think this can be a valid approach but, as is the case with other valuation benchmarks, you need to have an understanding of what the scale of the opportunity, margins, growth, cost structure and risks in the business are like or could look like in time. 

Popular posts from this blog

10k Words | August 2022

Feel the Cash Burn as Profit Season Closes (or "In memory of Pocketmail")

Where was the EPS uplift?

Disclaimer

Nothing in this blog constitutes investment advice - or advice in any other field. Neither the information, commentary or any opinion contained in this blog constitutes a solicitation or offer by Equitable Investors Pty Ltd (Equitable Investors) or its affiliates to buy or sell any securities or other financial instruments. Nor shall any such security be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.

The content of this blog should not be relied upon in making investment decisions.Any decisions based on information contained on this blog are the sole responsibility of the visitor. In exchange for using this blog, the visitor agree to indemnify Equitable Investors and hold Equitable Investors, its officers, directors, employees, affiliates, agents, licensors and suppliers harmless against any and all claims, losses, liability, costs and expenses (including but not limited to legal fees) arising from your use of this blog, from your violation of these Terms or from any decisions that the visitor makes based on such information.

This blog is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The information on this blog does not constitute a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Although this material is based upon information that Equitable Investors considers reliable and endeavours to keep current, Equitable Investors does not assure that this material is accurate, current or complete, and it should not be relied upon as such. Any opinions expressed on this blog may change as subsequent conditions vary.

Equitable Investors does not warrant, either expressly or implied, the accuracy or completeness of the information, text, graphics, links or other items contained on this blog and does not warrant that the functions contained in this blog will be uninterrupted or error-free, that defects will be corrected, or that the blog will be free of viruses or other harmful components.Equitable Investors expressly disclaims all liability for errors and omissions in the materials on this blog and for the use or interpretation by others of information contained on the blog.