Why Are IPOs Riskier For Private Investors?

Despite the covid-19 pandemic and subsequent lockdowns, London has seen one of the strongest periods of Initial Public Offerings (IPOs) in years.

Last year, there was a record-breaking number of technology companies launching on the public market. According to GlobalData, tech IPOs were up by 26% globally, reaching 771 as the covid-19 pandemic triggered a major digital shift. Additionally, in the United Kingdom, there were even more flotations in the first half of 2021 than there were throughout 2020 as several leading tech startups, as well as other big-name brands, opted to list in the English capital with sky-high valuations. Amongst those making their debut were Darktrace, Dr Martens, Deliveroo, and Moonpig. 

IPOs can be highly alluring to investors. Companies that go public are frequently in industries of significant interest to investors at the time and IPO companies tend to sell products that have rapidly become household names, with IPOs serving as a means of raising cash to sustain this rapid growth. However, despite their allure, IPOs are generally considered riskier investments. This is because they:

  • Are generally young companies

Smaller companies experiencing rapid growth are typically the ones that decide to go public. Unfortunately for investors, these companies usually have limited operating histories, less experienced management teams, and a limited product range.

  • Lack a stock-trading history

Because an IPO isn’t yet trading, it’s impossible to assess how the stock has behaved over the years before deciding to invest. 

  • They sell their shares first to large institutional investors

IPOs are generally first sold to large investors at the offering price while other investors are free to bid on those shares above or below the offering price once the stock begins trading. 

In fact, recent analysis by online research platform Stockopedia suggests that the odds are rather heavily stacked against private investors when it comes to investing in new company IPOs. 

Structural Bias Puts Private Investors At A Disadvantage 

Stockopedia analysed thousands of data points for 258 IPOs listed in the UK between January 2016 and May 2021. The research platform’s new IPO Survival Guide shows structural bias in the current system that leaves private investors with the odds stacked against them. This is partly because, as mentioned, large pre-IPO purchases are marketed with institutional clients before a company is floated on the London Stock Exchange and this makes it close to impossible for private investors to purchase shares at the issue price. According to Stockopedia, 89% of IPOs open higher and, on top of this, the average price “pop” from the issue price to the first day opening price is nearly 10%. 

Private Investors Can Lack Knowledge And Understanding

Stockopedia’s analysis draws attention to the uneven performance distribution of IPOs and where private investors can potentially gain, and lose, the most. On average, a timeframe of 3 to 6 months appears to be best for holding IPOs in the short term. However, in the long term, IPOs tend to perform poorly

For the 258 UK IPOs studied, Stockopedia’s researchers found a negative median compound annual growth rate of -4.3% across five years. Small-cap IPOs that are typically under-researched and less anticipated by the market outperform mid and large-cap IPOs on nearly all metrics assessed. Throughout the last five years, the average performance of small caps sat at 85%, while large caps saw a negative performance of -20% one to two years after the IPO. 

Interestingly, in a joint survey of 1,2000 private investors conducted by Stockopedia and Interactive Investor, 33% of respondents said they had or would invest at an IPO for long-term growth, while 23% said they would invest for medium-term growth. Just 16% of respondents said they would invest to make a short-term profit. 

Although companies that float can vary widely, based on Stockopedia’s research, it appears that many private investors are putting their capital at risk through a lack of IPO knowledge and understanding. 

Final Thoughts

While plenty of private investors have successfully bought into IPOs, it’s important for any private investor, new or old, to thoroughly research the risks involved and keep in mind that the odds are more heavily stacked against them as an individual. 

You’d want to be careful that you’re not just chasing a story or hype,” warns certified financial planner Douglas Boneparth in conversation with CNBC. “Don’t let excitement get in the way of making sure the investment you’re making is a smart one.”

This article does not constitute financial advice. The author and Universal Media Ltd. are not qualified financial advisers. All investments are made at the reader’s own risk.

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