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Essay 2

“Investing in IPOs is an easy way to lose money” (FT,08/11/2019).

Review the empirical evidence on whether IPOs have historically been
good for investors. What are the main indicators of a successful IPO for
companies, investors, sponsors and the market? Are they a good
investment now?

Name: Sugeetha Sattiyan

Student ID: H00339422

Word count: 2005 words

Submission Date: 2nd March 2023

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Introduction …………………………………………………………………………………….. 3
Body ……………………………………………………………………………………………. 4
IPO historical evidence …..……………………………………………………………….. 4
Main indicators of successful IPOs ………………...…………………………………….. 7
Are IPOs a good investment now? ………………………………………………………10
Conclusion …………………………………………………………………………………….. 11
References ………………………………………………………………………………………13

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1.0 Introduction

A corporate entity may issue new shares to the public for the first time through a process known

as an Initial Public Offering (IPO). It marks a significant turning point in an organisation's

development since it enables it to generate capital by issuing and selling securities to the public.

Generally, companies go public in order to increase their equity funding as well as to establish a

public market where their owners and other stockholders might potentially transform part of their

equity into cash at a later time, (Ritter & Welch, 2002). Ultimately, an IPO could be an

important milestone for the business and its stakeholders as it may give investors access to funds

and boost their transparency and liquidity.

Historical IPO trends will be reviewed in this essay. In addition, this essay will cover IPO

success indicators. Finally, IPOs' investment prospects are discussed.

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2.0 IPO historical evidence

The previous literature on initial public offerings (IPOs) has emphasised two fundamental

abnormalities underlying IPO concerns: underpricing of IPOs (Ritter and Welch, 2002) and long-

run underperformance of IPO equities (Ritter, 1991). The term "IPO underpricing" refers to the

occurrence in which an IPO stock closes at a higher price than the initial offer price at the end of

the first day of trading. It is the first primary market issue documented by (Ibbotson, 1975),

which reported positive abnormal initial return in the U.S. IPO market. The first-day

underpricing of IPO shares appears to be pervasive across global capital markets (Engelen and

Essen, 2010). Their study indicates a wide range of underpricing for 2,290 entities across 21

nations, ranging from 2.20% in Mexico, to 25.98% in Finland and 21.14% in the United States.

Loughran et al. (1994) compared 25 countries with average initial return from 1960 to 1992 and

found that IPOs are underpriced in all countries. They addressed the various stages of

underpricing across all the countries based on country mechanism and organisational

characteristics. They also claimed that countries with high initial returns have weak institutions.

Jordan, Saudi Arabia, China, India, and Malaysia have initial returns of 149%, 239%, 118.40%,

88.5%, and 56.20%, respectively. Canada, France, and the Netherlands have low initial returns

below 10.0% due to strong institutional and firm characteristics.

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On the other hand, long-run underperformance suggests that succeeding share prices are

frequently lower than the first trading day prices, resulting in negative abnormal returns for

investors over time. In the long-term performance realm, (Ritter, 1991) discovered that 1526 US

IPOs (issued between 1975 and 1984) underperformed their market benchmarks by

approximately 34.47% in the 3-year period, whereas (Ritter and Welch,2002) evidenced that 3-

year holding-period returns for an investor purchasing at the listing price may substantially

underperform the market.

The associated literature on European countries' long-term IPO performance is summarised in

Table 1. According to the studies presented, IPOs in developed nations typically exhibit a

considerable underperformance relative to a selected benchmark for a variety of sample sizes,

timeframes, and observation periods. As it can be seen in Table 1, in Cyprus and Greece, the

authors investigated the short- and long-term performance of a sample of 75 and 144 IPOs

respectively issued during 1999-2004. Both authors reported that Cyprian IPOs underperform by

-4.96% and Greek IPOs underperform by -6.4% in a three year period.

Surprisingly, IPOs in Sweden were found to have a long-run overperformance rather than

negative long-term returns. Laughran et al. (1994) found a positive overperformance equal to

1.2%. (Giudici & Paleari, 2001) and (Alvarez & Gonzales, 2005) used market index as a

benchmark to illustrate long-term underperformance of IPOs in Italy and Spain respectively.

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(Merikas & Gaunopaulos, 2009) analysed the short and long-term performance of worldwide

shipping IPOs listed between 1984 and 2007, and found that after a five-month holding period,

Shipping IPOs began to underperform. They showed that investors who purchase shares shortly

after listing and hold them for three years incur a 15.72% loss. This indicates that the majority of

the world, and not just Europe, exhibit long-term underperformance of IPOs.

In general, the IPO literature quotes the following theories for explaining observed long-run

underperformance. (Ritter, 1991) reveals that firms that undertake IPOs have lower long-run

returns than firms that do not pursue IPOs. When several companies in a given industry go

public at once, as Ritter says they do, the long-term returns of IPOs suffer. This, he argues, is

because investors are occasionally over-optimistic about the prospective profitability of new

firms.

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3.0 Main indicators of successful IPOs

There are several hallmarks of successful initial public offering (IPO) for companies, investors,

sponsors and the market. This includes several factors such as underwriter reputation, valuation

and allocation of shares will be discussed in the following section.

Underwriter reputation

Credible underwriters are crucial to the success of an initial public offering (IPO). Underwriters

are investment banks that help companies execute the IPO process by pricing the offering,

marketing the shares to investors, and providing continuing support, (Sec.gov, n.d.). A competent

underwriting staff can assist in ensuring that the firm is appropriately priced and that the stock is

efficiently marketed. If the offering is priced too high, it may fail to attract enough investors,

while if it is priced too low, the company is essentially 'leaving money on the table'. Similarly,

(Carter & Manaster, 1990) demonstrate that the issuer's choice of underwriter repute is

negatively associated with short-run underpricing of IPOs.

Besides that, by leveraging off of a strong underwriter, the IPO firm will be able generate

interests of potential investors in the IPO since they will be able to instil a level of confidence in

potential investors. This can improve the odds of a successful IPO debut and promising

aftermarket results.

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Valuation

Secondly, share price valuation is crucial to the success of an initial public offering (IPO)

because it specifies the price at which the company's shares will be offered to the general public.

It is essential to set a reasonable valuation for the firm at the time of the IPO while also alluring

to potential investors. Bookbuilding is a practice adopted by firms as well as their underwriters to

gauge the appropriate pricing of their shares. Underwriters and the issuers engage in roadshows

to estimate demand by garnering "expressions of interest" from prospective investors. If demand

is high, the underwriter will raise the offer price. Yet, if prospective investors are aware that

expressing a desire to pay a high price will result in a higher offer price, these investors must be

compensated. (Ritter & Welch, 2002) ’

If the share price is set too high, it may repel potential investors, and if it is set too low, the

company may miss out on revenue opportunities. Hence, a well-priced IPO can attract

institutional investors and retail investors, which can enhance demand for the shares and

subsequently result in a successful IPO.

Allocation of shares

The distribution of shares in an initial public offering (IPO) might indicate the success of the

IPO. A successful IPO is often distinguished by significant investor demand and positive investor

sentiment, resulting in oversubscription, which implies that the number of shares demanded by

investors exceeds the number of shares available for sale. A substantial percentage of the IPO

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shares are often allotted to institutional investors such as mutual funds and hedge funds. If a

significant portion of the shares are allotted to institutional investors, it may imply that the entity

has attracted sophisticated investors who have confidence in the organisation's ultimate

prospects. In contrast, retail investors are often offered a lesser fraction of the shares in an IPO. If

the IPO is a success, individual investors may receive a larger share allocation. This could

signify that the firm has a successful reputation and a substantial retail presence.

Consequently due to the reasons mentioned above, if an IPO is oversubscribed, it shows that

there is a large demand for the company's shares due to the confidence or even overconfidence of

investors, which might be indicative of a successful IPO. Oversubscription can result in a greater

distribution of shares to investors, which can lead to significant price appreciation of the prospect

IPO firm once trading commences.

As for the firm, strong demand from institutional and retail investors can indicate a successful

IPO. Furthermore, the price of a successful IPO accurately reflects the company's value and is

neither overpriced nor underpriced. For sponsors, the ability to successfully exit their investment

and realise a return is a crucial indicator of a successful IPO, indicating that the company has

performed well to the point where it has a good valuation. A successful IPO for investors is

frequently characterised by a reputable underwriter managing the offering, as investors are more

likely to trust and invest in a company. A successful IPO can generate positive investor

sentiment, which can have a ripple effect throughout the market.

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4.0 Are IPOs a good investment now?

After a slowdown in the IPO market due to the COVID-19 pandemic, the initial public offering

markets around the world are working towards recovering or have recovered to pre-pandemic

levels. The Financial Times wrote the contentious statement, "Investing in IPOs are a smart way

to lose money," in the context of Uber's challenges as an illustration of a poor IPO investment.

The same situation can be extended to most of the other IPOs around the world.

Uber and Saudi Aramco both went public in 2019, but Saudi Aramco's share price has remained

significantly higher than its IPO price. Uber, on the other hand, has always incurred significant

losses and has never turned profit. As it can be observed from Table 1, although Saudi Aramco

experienced some negative returns in its third year since going public, they were not as severe as

the losses Uber suffered in its third year, when it posted a staggering loss of -47.40%. In 2019,

CNN Business interviewed Carter Mack, the co-founder of JMK, one of Uber’s underwriters. He

mentioned that, ‘The lesson of Uber and Lyft IPOs is that investors are looking for a clearer path

to profitability’. Mack further went on to say that the failure of the Uber IPO has dampened

investors' enthusiasm in IPO, (CNN Business, 2019).

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While each IPO is different, as are the market conditions, it is possible to make broad

generalisations based on previous IPO listings as to whether IPOs are now a sound investment.

Only a few IPOs have performed well in the long run in recent years, with the majority

underperforming.

5.0 Conclusion

The argument that "Investing in IPOs is an easy way to lose money" is not always accurate in

every situation. IPOs success can vary depending on the various factors present. The objective of

this article was to investigate the return on IPO investments and conclude that, in the short run,

IPO returns are fairly average and may be influenced by market speculative forces due to

information asymmetry and a lack of historical data. If the firm has a successful launch and

growth trajectory, IPOs can eventually provide significant returns to investors. Nevertheless,

there are inherent risks, and investing in IPOs can be highly speculative, as the stock price may

be influenced by the ‘hype’ and investor sentiment.

While the majority of IPO investors can profit instantaneously from the first day's "pop," long-

term profitable investments have been exceptionally rare. As of their initial public offerings, even

the most well-known names have lagged their respective stock market index. Investors are

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doomed to lose money as they buy into perceived underpricing and take risks they ordinarily

wouldn't because there are few reliable indicators for success.

Investing in IPOs can be a lucrative method to generate revenue, but it is not without risk.

Investors should also be mindful of possible risks such as market fluctuations, illiquidity, and

absence of historical performance data. It is essential to analyse the factors that can influence the

success of an IPO and to approach any investment with prudence and a thorough grasp of the

risks involved.

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6.0 Reference

Álvarez, S., & Gonzalez, V. M. (2005). Signalling and the long run performance of Spanish
initial public offerings (IPOs). Journal of Business Finance & Accounting, 32(1 2), 325-350.
Available at: Signalling and the long run performance of Spanish initial public offerings (IPOs)
Accessed on: (13 February 2023).

Arosio, R., Paleari, S., & Giudici, G. (2001). The market performance of Italian IPOs in the
long-run. Available at: The market performance of Italian IPOs in the long-run (Accessed on: 13
February 2023).

Carter, R., & Manaster, S. (1990). Initial public offerings and underwriter reputation. The
Journal of Finance, 45(4), 1045-1067.
Available at: https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1990.tb02426.x
(Accessed on: 19 February 2023).

Drobetz, W., Kammermann, M., & Wälchli, U. (2005). Long-run performance of initial public
offerings: The evidence for Switzerland. Schmalenbach Business Review, 57, 253-275. Available
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13 February 2023).

Merikas, A., Gounopoulos, D., & Nounis, C. (2009). Global shipping IPOs performance.
Maritime Policy & Management, 36(6), 481-505. Available at: https://www.tandfonline.com/
doi/abs/10.1080/03088830903346053 (Accessed on: 19 February 2023).

Egan, M (2019). Banker gives an inside look at why Uber and Lyft IPOs failed to live up to the
hype. CNN Business. Available at:
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on: 27 February 2023).

Engelen, P. J., & Van Essen, M. (2010). Underpricing of IPOs: Firm-, issue-and country-specific
characteristics. Journal of Banking & Finance, 34(8), 1958-1969. Available at: Underpricing of
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Ibbotson, R. G. (1975). Price performance of common stock new issues. Journal of financial
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4 6 ( 1 ) , 3 - 2 7 . Av a i l a b l e a t : h t t p : / / w w w - 2 . r o t m a n . u t o r o n t o . c a / ~ k a n / 3 0 3 2 / p d f /
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SEC.GOV (n.d.) Investing in an IPO. Investor Bulletin. Available at: https://www.sec.gov/files/

ipo-investorbulletin.pdf (Accessed on: 19 February 2023).

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