The Dangers of Investing In IPOs

Credit: Simon Cunningham

It can be exciting to invest in IPOs, or initial public offerings.

The thought of being one of the first investors in a newly-listed company, and the idea of being able to get onto the “train to riches” early, can be great motivating factors for an investor to participate in IPOs.

But, IPOs may not be the best investments around. In fact, investing in an IPO can be a much riskier endeavor as compared to investing in companies that have a long tenure as publicly-listed entities. Here’s why.

Lack of data about management

One of the main reasons we should be wary about an IPO is the lack of information about the company’s management team.

I’m not talking about things like the personal information and résumé details of a company’s management team and board of directors – I’m talking about information on how they will treat the company’s shareholders.

Management plays a very important role in the eventual success or failure of a company and it thus follows that their interests need to be aligned with that of shareholders.

However, for a company that’s just listed, there is still little indication on how the management team will behave when running the company. Will they eventually take home oversized compensation packages that are not tied to the performance of the company’s business? Will they make decisions that are beneficial only for themselves at the expense of shareholders?

All these details can only be obtained by observing the management team’s behaviour after the company is listed for a while. Thus, investing without such knowledge can be quite risky.

History is of course not a perfect indicator of the future, but it can still give us a base to understand what can happen next.

Why are they selling?

Investors often associate an IPO as a time for them to invest in a company. But for some companies, it is actually a critical time for their existing investors to have an exit opportunity. In fact, IPOs are one of the key strategies that private equity funds use to “realise” their investment gains in a private company prior to its listing.

In this sense, shouldn’t we exercise a little caution if we are buying shares in a company where existing shareholders are eager to sell? After all, logically speaking, sellers would almost always want the best price for their produce, and it may not be in the best interests of buyers.

So, investors who are interested in IPOs need to understand why a company would like to list its shares.

Is the company raising money simply to clear financial obligations which they’re struggling to meet? Or is the company just finding an opportunity to allow its existing shareholders to cash out completely or in a significant manner? These are not the best reasons for a company to list its shares.

One other important thing to note here is that a company’s “hope to share the firm’s future upside potential with new shareholders” is not a valid reason for an IPO. Running a public company is a business, not a charity. Be careful when management appears to be too altruistic.

On the flip side, a firm that’s raising capital so that they can expand their business can be a good sign.

Foolish Summary

With all that said, a newly-listed company can still be a great investment if we are able to select the right companies to invest in. What’s important is to recognise and cater for the possibility that investing in IPOs can involve much higher risks than investing in shares that have already been listed for a long time.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.