There are two kinds of Initial Public Offering (IPO) –

1). Fresh Issue where new shares are issued and money raised goes to the company which can be used for growth or retire debt and

2). Offer for Sale where existing investors (promoters and private equity) sell their shares and money goes to them rather than the company.

Unlike earlier times when most IPOs were a fresh issue in order to raise growth capital, now most issues these days are Offer for Sale. During rapid growth phase companies go to private equity firms for capital and after achieving reasonable scale comes up with an IPO at rich valuations, leaving hardly anything on the table for new investors, to offer an exit to private equity.

IPO is a seller’s market, they time it in order to suck maximum value out of it, they indeed understand ‘One should raise money when it is available rather than when it is needed’. Invariably you would see a slew of IPOs during a bull market. Why? That’s the time when they have comparable listed peers trading at rich multiples and by showing a lame relative valuation investment bankers are able to price it richly. Bull markets are flushed with liquidity and hence sailing through an IPO despite unreasonably high valuations is an easy task.

Consider this:

1. The sellers (promoters/private equity) know about the company and its future prospects much better than you do.
2. There is not much information on corporate governance standards of the company.
3. No idea on how they would treat minority.
4. Without any trading history, there isn’t much information on how the market would value this business across cycles.

But its all about listing gains!

Participating in IPOs for listing gains invariably becomes popular in every bull market; seems like easy money after all. Its always the same argument- when for a Rs 500 Cr. issue the applications are for Rs 50,000 Cr., many of those who wouldn’t get any allotment would want to pay up even 20-30% on the listing, giving effortless gains to those who get the allotment.

What are the chances of allotment? There is a regulation that each retail investor (those applying for less than Rs 2 lacs) should get at least one lot during IPO. However, when an issue gets oversubscribed 100x, it is not possible to give one lot to everyone which is why only a few “lucky” ones get allotment which based on a random draw. Those who get the allotment just get one lot. Is it then worth the effort?

Ideally, any sensible investment operation needs an understanding of the business, management quality, valuation and 100s of factors that affect those. In case of an IPO, one needs to read the prospectus, a long document with 400-500 pages containing all critical information about the history of the business and promoters, key risks etc. Its unlikely those investing for “listing gains” would be wasting their time doing this silly thing, and if you read prospectus you would anyways tend to avoid 9 out of 10 IPOs.

Other than for an individual whose portfolio is under Rs 5 lacs, 20-25% returns on that one lot wouldn’t make any meaningful difference, its simply not enough to even move the needle in larger portfolios. Either way, it’s a speculative activity and the bet is to be able to find a ‘bigger fool’, which doesn’t end nicely ever. One bad outcome can wipe out gains of many prior gainful exits. Remember ‘Reliance Power’ IPO? Those who do not know history are doomed to repeat it, if you weren’t around during RPower IPO, strongly recommend talking to people who did. The IPO was to raise Rs 11,790 Cr. and got offers for Rs 8.13 lac Cr., a whopping 69 times oversubscription. The shares were allotted at Rs 450 a piece and closed 17% lower on listing day. Suddenly many of those who bought for listing gains turned into long-term investors talking about strong potential in India’s power sector, unfortunately, the stock eventually lost 90% of the value.

Occasionally there could be an attractive IPO, however, base rates are absolutely stacked against investors.

End of the day it’s important to remind ourselves that we only need 15-25 quality businesses in our portfolio and there are already 5,000+ listed businesses to chose from, all with decades of track record in public domain, why then risk our hard earned money with unknowns?

What veterans say about IPOs:

“ IPOs are one of the surest ways of losing money in the long run.” – Prof. Sanjay Bakshi

Benjamin Graham in Intelligent Investor – IPO stands for Initial Public Offering but some more reflective full forms are: 1). It’s Probably Overpriced 2). Imaginary Profits Only 3). Insiders’ Private Opportunity.

“ Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues[IPO] have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.” – Benjamin Graham

“ It is entirely possible that you could use our mental models to find good IPOs to buy. There are countless IPOs every year, and I’m sure that there are a few cinches that you could jump on. But the average person is going to get creamed. So if you’re talented, good luck.” – Charlie Munger

“ An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.” – Warren Buffet

“ Never buy what is being sold by promoters” – Mohnish Pabrai (His views on IPOs 05:40 onwards)