- The sizzling initial-public-offering market of 2019 continues with five companies valued at over $US1 billion already having gone public this year.
- While the majority of these companies have soared in their debut, retail investors have mostly struggled to benefit from the upside.
- Markets Insider walks through the challenges that retail investors face getting pre-IPO shares and also the risks.
- Read more stories at MarketsInsider.com
The initial-public-offering market has been red-hot in 2019 with several tech “unicorns” going public and cementing their multi-billion dollar status. Tradeweb,PagerDuty,Pinterest, and Zoom have all gone public with shares rising significantly in their trading debuts.
All of these stocks shot up by at least 25% in their initial trade. Zoom topped the list with an 81% gain. The ride-hailing unicorn Lyft has proved to be a notable exception, with shares eeking out a small gain on the first day of trading before tumbling 20% below its IPO price.
Despite the volatility, the IPO market remains red-hot with more companies to follow, including the mega-unicorn Uber which may seek a valuation as high as $US100 billion.
Despite this activity, many small investors will struggle to get a piece of the pre-IPO action. Investing in initial public offerings is far more complicated than placing a trade to buy stock, as explained by Fidelity.
First off, IPOs are run by investment banks such as Goldman Sachs, Morgan Stanley, and Bank of America. Typically, a bank allocates 90% of the available shares to institutional investors, such as pension funds and hedge funds. Retail investors who who have brokerage accounts with the firm are typically allotted 10%.
All retail investors seeking to get in pre-IPO must meet brokerage requirements of minimum investable assets as well as answer Financial Industry Regulatory Authority (FINRA) questions about investment style and risk tolerance.
Once those requirements are met, retail investors must review the company’s prospectus, which lays out the risks of the investment, and indicate the maximum amount of shares they wish to purchase. The day before an IPO begins trading, investors are given confirmation of their share allocations as well as pricing of the issue.
IPOs with strong demand are over-subscribed and investors usually only receive a part of their maximum indication, sometimes as low as 10-20%, with the brokerage firm deciding the exact amount each investor receives.
“Typically, customers with significant, long-term relationships with their brokerage firm will receive higher priority than those with smaller or new relationships,” according to Fidelity’s website. In other words, the rich get richer while smaller investors may receive no shares at all despite their request.
To the extent that brokerage firms do allocate IPO shares to smaller investors, this is usually a sign that there is limited demand for the IPO which may result in weak trading.
“Historically if my broker called me up and tried to sell me on an IPO, I would say, ‘This is not a good idea,’ and take a pass,” Timothy Loughran, a finance professor at the University of Notre Dame told US News & World Report. “The only time they were going to go down to someone like me is if the IPO is having trouble and they’re having trouble placing the shares.”
Despite these challenges, some companies have made an effort to broaden the allocation to retail investors. Most notably, Facebook added E-trade as one of the 33 underwriters to its IPO. E-trade then offered shares to its nearly 3 million retail accounts.
With demand outstripping supply, however, E-trade noted that shares would be allocated in a process where “asset levels” and trading history would be taken into account. Similar to the bulge-bracket brokerage houses, larger clients received a preference.
Despite the craze for shares, IPOs carry real risks for investors. IPO investors who held onto shares of Facebook lost almost 50% of their money within two months of its stock-market debut as the social-media company suffered doubts about its valuation and growth prospects.
The shares ultimately recovered, and is up nearly 10 fold from its post-IPO low of $US20.10 in August 2012. More recently, Lyft’s 20% post-IPO plunge is a reminder that IPO investing is not for the faint of heart.
Retail investors still looking for IPO allocations may not have a shot at the next Zoom, but will have more luck with sectors that attract less buzz and attention. These can include public offerings of Real Estate Investment Trusts or energy stocks which often trade as partnership structures for tax reasons. These securities are generally less suited to institutional investors, opening up the opportunity for retail investors to participate.
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