RIYADH, 11 October 2004 — An initial public offering, IPO, is a procedure that private companies follow when they want to go public and in the process sell some of their shares and generate funds that they needs to expand their business. An IPO is a very important event to any organization, and if successful can provide an excellent return to its owners. Before embarking on an IPO, companies invest a lot in planning the event and marketing the product — shares in their company. When an organization decides to go public, it selects an underwriter, i.e. one or more investment bank to manage the process. The main activities required are to dress up the business concern and market its shares to selected prospects, pricing the shares for optimum return, and get early commitment from specific buyers.
Investment bankers have an incentive to get the deals done, regardless of the particular company real prospects. Research analysts are rewarded for selling the company on the idea of going public, while brokers have a clear imperative, “move the merchandise.” The investment bankers are interested in the spread, which is 5 percent to 7 percent of the IPO proceeds that underwriters typically keep. Roughly half the spread goes to the “lead” underwriter, the firm that arranges the deal, prices the stock and sells the largest percentage of shares. The relationship between the new company, IPO, and the underwriter is a win-win proposition. The company wants to raise the price as much as possible, and the bankers know that the higher the valuation the bigger the fee.
For IPOs that are properly marketed, client demands far exceeds available shares. This passes direct control to the rules of supply and demand and explains the rocketing prices at the first day of trading for oversold shares, sometimes more than nine times their initial price. A real example is the IPOs of the “Linux operating system” companies, Corel, Redhat and VA Linux, whose share prices went up 10, 20 and 20 folds, in the initial 5 months, 6 months and one day respectively. Since all of this high valuation was based on a new idea transformed into a “super business plan,” the energy needed to keep the share prices high eventually vanished leaving few winners and many unhappy investors.
Although there were few winners like Cisco, Microsoft and AOL however most IPOs have resulted in busted stocks, disappointed investors and in the process made good money for investment banks that arranged the deals. Many people dream of getting rich through a hot IPO, but picking up the next Cisco out of a crowd of unproven companies at their initial offering is an extremely low percentage bet. Of the nearly 5,000 companies that have gone public between 1993 and end 2,000 in the US, more than eighty percent were below their offering price at the beginning of 2001 and much more today.
IPO most fertile ground is the US, basically due to the attributes and behavior of American investors. The IPO market saw huge swings in the last 20 years of the past century. From few billion dollars that IPOs generated per year in the nineteen-eighties up to $40 billion in 2000. The present size of the IPO market is much smaller but more mature compared to what happened in the late nineties. With the burst of the “New Economy” bubble in early 2001, suspicion crept into the IPO process. The few hundred percent gains, from the offering price, of the top performers during the first day of an IPO disappeared and was replaced with top performers that gained around 50 percent.
One the successful IPOs that took center stage recently was that of Google, the Internet search engine company. After initial confusion, its IPO share price was fixed at $100 around mid August. Less than six weeks later, the share price increased by 35 percent.
In Saudi Arabia STC — Saudi Telecom, IPO earlier this year was very successful and generated a good profit for those who bought the shares at the initial offering price. Ettihad Etisalat whose IPO is targeted to start on Oct. 16, is backed by Etisalat business experience in the UAE, limited supply of shares, and high investors’ interest due to the recent STC performance. Accordingly it has all the ingredients to be profitable for the early investors.
The initial share price increase in IPOs is dependent on supply and demand, proper market timing and active marketing. Eventually control is transferred to the company financial performance. The share price of an IPO which is marketed properly tends to increase initially only to drop few days or weeks later. A prudent investor can benefit from buying and selling IPO shares during this short window.
(Salim J Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)
