By: Zachary D. Scheidt, Swing Trader, Fund Manager, Financial Analyst, Scheidt Capital Management LLC

March 29, 2010 10:39 pm EDT

We understand that bringing up the subject of IPOs in the current challenging economy may seem antithetical. But in our conversations with the Core Compass community, IPOs seems to be a topic of recurring interest. For many, they simply want a better grounding in the investment class. Others are already active investors in these newly issued shares. Thus, we asked Zachary Scheidt to provide an initial overview as a start to anchor our periodic discussions on IPOs going forward.

Resurging IPO Market Adds Liquidity for Businesses and Owners

As the market trends higher and investors gain more confidence, business owners and private equity firms are increasingly tapping into the available market liquidity. The opportunity at this point is for businesses to raise capital through an IPO transaction, selling shares of the company to the general public. Private equity firms which own and manage individual companies are also cashing in. A market of willing buyers allows the private equity managers to sell portions of these companies (or the entire company) and often realize healthy profits on their initial investment.

But how exactly does this process work? As a fund manager who focuses on new issues, I have seen hundreds and participated in dozens of these transactions. While there are often many moving parts and more than a little “slight of hand,” the IPO transaction is a fairly simple concept to grasp. And whether you are a business owner or an investor, you should be aware of and understand the basic building blocks of this type of transaction.

The Cast of Participants

In order for a company to start trading on the public exchanges, there are basically three parties who are instrumental in the process. The seller is the party distributing the shares and receiving the capital. The underwriter facilitates the transaction much like a broker would facilitate a real estate transaction. Finally, the buyers actually pay for the newly issued shares for the company.

So let’s look at each of these parties a bit more carefully.

Sellers Seeking to Raise Capital

When I look at an IPO transaction from an investor perspective, one of the most important questions I ask is who is selling the shares?

Usually, I am most excited about participating in the IPO when the shares are primary or being sold by the company. This means that the capital that I pay for the stock goes largely back into the company which allows for growth. The capital can be used to expand the sales force and pay their salaries, it can be used to expand a plant or facility that allows for better production, or it can be to pay down debt to make the financial foundation more stable.

The more specific a company can be about what they are doing with the capital, the more confident I can be that the money raised will be put to good work. Too many times a selling firm will announce that the capital will be used “for general corporate purposes. That simply means the management team is asking for a blank check to spend however they see fit. Not exactly a great way to instill confidence.

Other sellers can include the company’s founders, a private equity firm, or a wealthy individual or trust who has previously owned all or a large portion of the business. While I understand that these parties need to sell at some point to monetize their investment, I’m instinctively uncomfortable with a current investor selling shares to the public. Since in this case the seller knows more about the inner-workings of the company than I could hope to learn in a few weeks time, I’m curious whether he or she sees a problem and that is motivating them to liquidate.

Whether a private equity firm or an individual investor is selling shares in the transaction, there are a couple of things that can be done to make the deal a little more appealing. If the seller retains a large portion of their investment, then I can feel confident that they still believe in the future of the business – but they just want to begin collecting capital from their success in building the company. I understand this need and if they still stand to benefit or lose from the ongoing success or failure of the company, then I am a more willing buyer.

A second way for sellers to make the deal more appealing would be to issue a mix of primary and secondary shares. This way the company is still receiving part of the money from the transaction and the sellers are liquidating a portion of their holdings as well. This way there is still a reason to expect the company to benefit from my investment and the selling parties receive an opportunity to monetize their investment as well.

Underwriters Introduce Buyers and Sellers to Each Other

Underwriting firms are usually well known brokerages such as Goldman Sachs, Merrill Lynch (now a division of Bank of America), Morgan Stanley and similar firms. In recent years, the number of top tiered underwriting firms have decreased as a result of the financial crisis. But there are still plenty of niche boutiques which also have the ability to act as underwriters for IPO transactions.

The underwriter is responsible for putting together the prospectus which is an offering document with all of the pertinent information that investors need to make an educated decision as to whether to invest or not. Typically, underwriters are part of a brokerage firm which will service a number of institutional and retail investment accounts – thus bringing the buyers into the picture.

After performing due diligence on the company, the underwriter will determine a “fair market” price range for the IPO. This is based on their assessment of the profitability of the business, its risks and growth expectations, and the price at which similar investments are trading for in the open market.

Once an acceptable price range has been established, the underwriters will then turn to the buyers to place the stock with willing investors.

Usually there is more than one underwriter working on a deal. The LEAD underwriter is usually the firm responsible for performing the due diligence and determining the acceptable price range. Secondary underwriters are simply brought in to help place the deal. Since it is important to have a broad number of investors in the stock, underwriters usually work in teams to distribute the stock to a wide assortment of investors.

The underwriting firms are typically paid very well for their assistance in getting the stock distributed to investors. Typically the underwriting fees are between 6% and 10% of the stock price, so if a company is selling 30 million shares at $14.00 per share, the underwriters could split between $25 million and $38 million. Underwriting fees can often make up a large portion of revenue for a company like Morgan Stanley.

Buyers Invest In an Unproven Vehicle

You’ve probably heard that the average investment return is highly correlated with the risk taken. While I don’t think that’s an absolute truth, there is a certain amount of return an IPO investors should expect due to the risk he is taking. After all, there has never been a market for this stock before and the buyer is being asked to trust the underwriter’s “fair market” valuation of the company.

Since as a buyer, I am putting my investors capital at risk on an unproven stock, I expect the deal to be profitable immediately. Underwriters understand this dynamic and so they are constantly trying to please both their buyers and sellers. After all, they need both parties in order to generate their fees.

So IPO transactions are usually priced with the expectation of being a bit below the expected market price. That way buyers are pleased with their transaction and are willing to come back the next time the underwriter has a new IPO to pitch. But if the IPO pricing was TOO low and the stock jumps 50% or 100% from the pricing immediately, the sellers could become angry because they could have received a better price for their stock. So there is a fine line, but the pricing of the transaction usually favors the buyer.

Buyers of IPOs are typically institutional investors, although it’s not impossible for retail accounts to participate in many of these transactions. Underwriters typically approach the buyers with information about the stock, the expected price range, and maybe some color as to how much demand there is for the stock. Buyers will then offer an IOI or Indication of Interest, stating how much stock they would like to buy when the transaction is completed.

When indicating for a particular stock, I am always interested to know how much stock the underwriter believes he can get for me. There is a bit of reverse psychology at play here because if the underwriter says “this is a great stock and the best news is that I can get you all the shares you want!”then I quickly become nervous that the demand is very low. However, if the story is “We don’t have much of this one available,” then I am much more interested because it is likely that demand will drive the price higher once the stock begins trading.

After the Process Is Complete

You might think that once the sellers have received their capital, the underwriters have collected their fees, and the buyers begin trading the stock, that the process is over. However, just like a baby, the newly issued stock still needs some care to survive to maturity.

Underwriters have a definite incentive to make sure IPO transactions work and the stock remains a viable investment vehicle. After all, they want to make sure that sellers look them up when they have a company to sell to the market, and the only way buyers will stay interested is if the IPO continues to trade in a positive manner.

So it’s a loosely guarded secret that many underwriting firms “support” the stock in the first few months of trading. That simply means that when and if the stock trades back towards the offering price, the underwriter very well may place large buy orders in the market to keep the stock from falling below the IPO price. If you look through the charts of a dozen recent IPOs, you will probably see 6 or 8 of these stocks which trade right down to the IPO price and then mysteriously find support.

Another issue is the research process. Since many investors are hesitant to invest in a stock without receiving a few second opinions from analysts, it is important for these stocks to catch the eye of research departments in various investment firms. Ironically, the underwriters usually know the most about these companies because of their due diligence process, and yet the underwriters are restricted from offering analysis for a period of time after the offering.

But once that “quiet period” is over, you will often see several underwriting firms issue reports on the newly issued stock. More often than not, the analysts will have a “buy” rating on the stock which helps to attract more buying interest and once again beef up the stock.

A word of caution here: If an IPO breaks below the offering price, the risk immediately becomes exponentially higher. At this point every investor in the IPO transaction is now under water. There are exceptions, but usually a break below the IPO price leads to massive distribution which can take days, weeks, or even months to run its course. This is where the risk comes in and while it may be frustrating to sell an IPO at a loss within the first few days, there is a very real risk that the loss will get much worse.

Opportunities and Risk

So IPO transactions offer investors exceptional opportunities along with material risks. The transaction can also offer a business owner an efficient and rewarding way to capitalize on his time and energy investment. For buyers and sellers, it is important to have a strong relationship with an underwriting firm (or several underwriters if your account size or business is large enough).

There is opportunity to participate in many of the gains just by investing in IPOs after they have begun trading. These stocks are usually very dynamic with wide swings and attractive trading opportunities. But remember to keep your trades sized smaller than a typical established stock because of the large swings associated with unstable supply and demand dynamics.

IPO transactions can be an excellent way for traders to generate returns provided appropriate risk controls are in place.

The views and opinions expressed herein are those of the author(s). Core Compass’s Terms Of Use applies.

About the author

Zachary D. Scheidt, CFA, is a swing trader with a global macro perspective. He is actively engaged trading US equities, ETFs, options and currencies.

IPOinitial public offeringprivate equity firms
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