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This is why you should make growth investments before the IPO

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It is more rule than an exception: Initial public offerings (IPO, when a company goes public and floats its shares on a stock exchange) are disappointing to retail investors. 

Not in the sense that participating in IPOs would not be profitable – historically they have, in fact, been very profitable – but that retail investors usually only get a fraction of the shares they want. This is due to tactics utilized by the investment banks advising companies on going public. It pays off to keep the public hungry.

I argue that investors looking for high-growth investments should not always wait for the IPO. The examples I will present herein are from the Finnish market, and there may be some differences across markets.

 

The Portfolio Premise

The premise of the matter is the search for the elusive ‘balanced investment portfolio’. Theory states that the best favour an investor can do for him or herself is to diversify their investment collection, also called the investment portfolio. This is because the values of securities go up and down, and in a diverse enough portfolio one investment will generally be up when another is down.

A diverse portfolio should have defensive and aggressive investments. The latter are what shares of most growth companies, ie ones that are growing rapidly but may not yet be profitable, would be classified as. Growth investments are the ones that can yield the biggest returns, but on the flipside also have the biggest risks. In many cases, a well-placed growth investment can have a disproportionately large effect on the return of a portfolio.

Often when a company does an IPO and lists on a stock exchange, it is already a well-established player in its domain and probably has considerable backing from professional private equity investors. At this point, much of the value has already been created and professional investment funds have the firm in their grasps. At this point, what’s left for the retail investor are crumbs on the table.

 

The Thrilling, Frustrating IPO

An important reason that companies choose to list on stock exchanges is the visibility, brand awareness and credibility they generate in so doing. There is much on the line when a company chooses to IPO, especially image-wise. So what investment bankers and other IPO advisors generally advise are tactics that result in the share price ‘popping’ in the first days of trading, because it sends a strong message to the public. One of these tactics is to aim for an oversubscription.

An oversubscription is a situation in which demand exceeds supply, ie the total numer of share subscriptions received exceeds the maximum number of shares on offer. It sends a strong message to the market. One way of accomplishing an oversubscription is to divide the shares being issued into so called tranches; for example one for institutional investors (such as pension funds and other large investment funds) and one for the public (retail investors, ie normal people and companies investing for themselves).

The problem for the retail investor is that the tranches are almost never of equal sizes: on average 90% of the shares are allocated to institutional investors and only 10% to the public. With the institutions investments are agreed on mostly behind closed doors, while the public has to make do with what they are given.

This results in IPOs where it is not uncommon for an investor to put in €5,000, and once the results of the IPO are announced, the investor hears that he has only been allocated shares worth €600.

It is very difficult to make IPO investments that would provide a considerable absolute return if you’re throwing money at the companies and they won’t take it. For them, it’s better to keep the public hungry, because it supports their shares’ price development.

 

The Solution? Invest Earlier

It would seem that it is generally smart to invest in IPOs, but that it is also difficult to fill your portfolio’s growth investment quota with them. Therefore, the solution is to invest when there are no advisors looking to make you go hungry. This is what so called business angels (private individuals investing their own money in early-stage companies) have been doing for ages.

Research on US angel investing by Robert Wiltbank has shown that the average annual return on investment (IRR, internalized rate of return, not adjusted for inflation) for angel investors in 2001–2016 was 22%. For comparison, the S&P500 index yielded 5.3% in the same period, even assuming that all dividends are reinvested. On average the US angel investor exits his or her investment with a 2.5 multiple after 4.5 years of holding it. This means that an investment of $10,000 would have yielded an exit of $25,000 ie a profit of $15,000 upon divestment.

Angel investing returns

It must be emphasized that these are very high risks investments and that 70% of angel investments produce an exit multiple of <1, meaning they fail. Indeed, the median investment returns loss, however the mean is an exit of 2.5x. What this translates into is that the distribution is highly skewed and it’s the home runs that make the real returns. Here, too, diversification is key. On average, the investments shown on eg Invesdor.com are in later and thus less risky growth stages than the ones business angels invest in, but I feel that the same rules apply.

Nowadays it is possible for almost anyone to become a mini-angel and invest in private businesses because it no longer requires contacs and hundreds of thousands in investable capital; the average minimum investment on Invesdor is only €500. 

In conclusion, the numbers show that it can be smart for retail investors able to take on some risk to consider unlisted investments. Just remember: diversify, diversify, diversify.

 

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Tagged: Tips & Tricks

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Mikko Savolainen

Written by Mikko Savolainen

Mikko is the marketing and comms manager at Invesdor. Having been with Invesdor since 2013, Mikko has a knack for incisive analysis and wordsmithery.