INVESTMENT QUESTION OF THE MONTH: Should I invest in an Initial Public Offering (IPO)?

Through November 16th of this year, we saw 223 companies[1] make the transition from private to public through way of IPOs, the most since 2014. And we could potentially see over $100 billion raised in IPOs by the end of 2020. Momentum may continue in 2021 with potential IPOs for notable companies like Airbnb, DoorDash and Instacart.

Headlining the year so far is Snowflake, the largest IPO so far in 2020 and the largest ever for a U.S. software company. While there is much excitement that comes with the opportunity of early ownership and the allure of getting in on the initial action, investors should proceed with caution when considering investing in IPOs.

Accessing First Day Returns

While Warren Buffet’s Berkshire Hathaway may have been able to purchase $250 million in Snowflake stock prior to the IPO, most investors were not afforded this opportunity. IPOs are often associated with strong returns on the first day the shares become available, however, accessing these first-day returns requires an allocation from the underwriting banks. Researchers[2] have documented an adverse selection problem associated with IPO share allocations and find that allocations to IPOs having poor first-day returns have generally been easier to obtain, while allocations to IPOs with good first‑day returns have usually been reserved for certain clients of the underwriting banks.[3]

Snowflake’s recent IPO illustrates the difficulty for main street investors to capitalize on first-day returns. Snowflake sold 28 million shares at an offering price of $120 apiece. Shares opened to the public the following day at $245 and ended up closing at $254. For investors like Buffet who had the opportunity to get in at the offering price, they were able to make a pretty penny. However, the average investor did not enjoy nearly the same return.

IPO Restrictions

Generally, a large portion (typically 50% or more)[4] of the IPO shares are held by insiders and subject to lockup periods that prevent such insiders from selling on the open market for a specified time frame. Once the lockup restrictions expire, typically 180 days after the initial offering, these shares may be sold in the market. Studies show that lockup covenants not only limit the liquidity in the first few months after an IPO, but also contribute to downward pressure on the stock price after expiration, as many of the insiders flood the market creating a liquidation event. Dimensional Funds found that these restrictions contribute to underwhelming medium-term IPO performance, as most IPOs underperformed industry benchmarks in their first year.

IPO Performance

Looking out at longer term performance, Dimensional’s Research team conducted a study of 6,632 US IPOs that occurred from 1991 to 2018. The period is broken into two subperiods. The period from 1991 to 2000 is characterized by a relatively high IPO frequency rate of 420 per year. During the 2001-2018 period the IPO rate fell to 120 IPOs on average per year. Despite the average number of IPOs declining from the 1990’s, the average IPO offering size is almost three times larger over the most recent period, as compared to the initial 10 years in the sample.

Exhibit 1 compares the returns of the IPOs to the returns of the Russell 2000 (an index of small cap stocks) and Russell 3000 (an index of predominately large cap stocks) indices over the full sample period as well as two subperiods. The data shows that IPOs underperformed the Russell 3000 by more than 2% in the full sample period as well as in both subperiods. In comparison to the Russell 2000 Index, IPOs underperformed in the overall period and the sub-period from 2001-2018.

Exhibit 1: IPO Return Analysis, 1992-2018

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

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Index Definitions

The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market.

[1] Renaissance Capital

[2] Ritter, Jay. 1987. “The Costs of Going Public.”

[3] Reuter, Jonathan. 2006. “Are IPO Allocations for Sale? Evidence from Mutual Funds.”; Jenkinson, Tim, Howard Jones, and Felix Suntheim. 2018. “Quid Pro Quo? What Factors Influence IPO Allocations to Investors?”

[4] Green, Kevin. Black, Stanley. 2019. “What to Know About an IPO.” Dimensional Fund Advisors