The open IPO channel

January 15, 2015

Fundamentals of finance, Investments

A lot of new firms listed on the Australian Securities Exchange (ASX) for the first time in 2014. Over $16 billion of shares were sold in 60 initial public offerings of shares (IPOs). This high value and high number of IPOs represented a re-opening of that market. The well known graph below is taken from the RBA chart pack. It shows that in the six years from 2008Q1 through to 2013Q4 there was only one good quarter for IPOs — in 2009Q4 when Myer was refloated on the ASX.

The second part of the graph (the orange bars) show the volume of SEOs (seasoned equity offerings). SEOs are share issues by firms that are already listed on the ASX. The red bars at bottom show the buy-backs of shares, which are the opposite of SEOs. Let’s leave SEOs and buy-backs for another day.

Why did the IPO market reopen in 2014 and not before?

Capital markets are fickle. There are periods when firms with relatively low credit ratings can issue large volumes of bonds into the fixed income markets, but in other periods that channel for raising capital is closed. Sometimes firms can issue new shares at close to their current share price to raise new capital, other times a large discount to the current price is needed to get an issue of shares away. The least fickle channel for corporate capital raising is the bank loan channel. The bank channel is, overall, the most reliable source of external capital for most firms.

The IPO market is especially fickle. There is always a pipeline of private (unlisted) firms that want to go public (list on the ASX). But they cannot always get a reasonable valuation for their shares.

It is the ECM (equity capital market) groups of investment banks that help private firms to go public (for fees of up to 7% of the value of shares sold). ECM groups are always testing the appetite of institutional investors for IPO shares. When institutional investors see value in IPOs, and the IPO channel then opens up, the ECM groups try to get as many of the firms in the pipeline through as possible before institutional investors lose their appetite.

It is hard to know whether the channel will stay open in 2015. The signs are promising and there is certainly a big pipeline after the long years of the channel being closed.

First day pop

The salient features of IPO returns on global stock markets is that on average the share price rises by 12-18% on the first day. Some firms rise and some fall on their first day on the stock market, but on average there is a first day pop that makes money for investors who can flip (sell) their allocation of shares. After the first day the story is reversed. The newly listed firms deliver lower returns to shareholders than comparable established firms — underperforming by 5-7% per year over the first 3 years after listing.

Why do IPOs have a first day pop in price; that is, why are they underpriced? It suits both the investment bank and the listing firm for there to be more demand for the IPO shares than supply. The main concern of the listing firm is avoiding the debacle of a failed listing. Underpricing minimizes that risk. In any case, it is often only 20-25% of the firm’s shares that are being sold. The rest can be sold down after a year or two at their full price, so long as the IPO goes well.

Investment banks love underpriced IPOs because it allows them to do a favour for their most profitable institutional and private wealth clients by allocating those clients shares in IPOs that will enrich the client.

Participation in IPOs

Did you participate in any of the 60 IPOs in Australia last year? Did your portfolio get an allocation of shares that rose in price on the first day and which you may have sold shortly after to realise a profit?

If you have a financial advisor, then it is worth asking yourself what your financial advisor did to help you benefit from the reopening of the IPO market. Unless your financial advisor is connected to one of the big investment banks that took firms public, then you should not have very high expectations about getting direct allocations to IPOs.

But what about the $5.6 billion Medibank Private IPO? Anyone could apply for an allocation — 440,000 retail investors did just that. Did your financial advisor speak to you about Medibank Private? Retail investors paid $2.00 per share and they listed at $2.22.

Dr. Sam Wylie

Director, Windlestone Education
Principal Fellow, Melbourne Business School