Factors to consider before investing in an IPO…

We are in the midst of the season of IPOs. During the last fiscal year, nearly $2 billion was raised through IPOs. This fiscal year, the markets have raised nearly $5 billion already through the IPO route and could end the year with nearly $8 billion. The story of IPOs in the last 2 years has been one of competitive pricing and attractive post-listing performance. Marquee names like Alkem, Shankara Building Products, D-Mart, ICICI Pru Life, SBI Life and GIC Reinsurance have all contributed towards the credibility of the IPO market. The big question in front of investors is how they should evaluate an IPO. There are 8 key factors…

  1. Does the company have a clear vision of the future? This can be quite subjective but there are a variety of sub-factors to consider. You must first understand how the industry overall is being disrupted and how the company is preparing for the disruption. Secondly, you need to be clear that the company has a vision to attain leadership in the particular niche in which they are operating. Also-ran companies can never create long term value; the company must aspire for leadership.
  1. Focus on the background of the promoters. Value creation in equities is all about intangible factors like corporate governance, transparency, standards of disclosure etc. Check the background of the promoters and their past track record in the business. Check the contingent liabilities section to understand if there are major legal cases pending against the promoters. It is possible to check the background of the promoters through the MCA website. Do this basic homework before investing in an IPO.
  1. It does boil down to valuation. Valuation is measured by the P/E but it is not just about P/E ratio alone. For example, D-Mart was supposed to be expensive when it came out with an IPO earlier this year but it has still managed to generate over 200% returns post listing. More than the P/E ratio, the growth prospects matter for valuations. Be wary of companies that try to use the IPO as a means of taking exit at rich valuations.
  1. How are the funds raised through the IPO being utilized? If it is a manufacturing company and the company is using the IPO funds to expand its scale then it is a good idea as long as the prospects of the business are good. Secondly, be wary of companies that are likely to use the proceeds of the IPO for investing in real estate and office space. Thirdly, repaying high cost loans with IPO proceeds is understandable but equity has a higher cost compared to debt. Lastly, be wary of companies that are likely to use IPO proceeds to finance working capital gaps. These are companies that are classic test cases for an eventual maturity mismatch.
  1. Of course, you need to take care of the fine print because small legal cases, corporate governance problems, business challenges; risk factors are all hidden in the fine print. If you are going to commit your money to the IPO then it makes a lot of sense for you to dwell in detail on the finer aspects of the issue. You may end up unearthing a lot of hidden wisdom in these pages.
  1. A typical question is why investors should worry about the promoter holding post the IPO. Remember, lot or promoters will be looking to monetize part of their stake as part of the IPO. This is true of companies promoted by large institutions as well as by entrepreneurs. But be wary of companies where promoters have been trying to consistently dilute their stake in the company. The historic evidence has been that when promoters are themselves not too committed to the company that the performance is likely to falter sooner rather than later.
  1. Debt has always been a four letter word for business and always will be. There is financial risk in debt and that is where most mid-cap and large cap companies falter. If you look at the outperformers in the last 5 years, they have all been companies with lower levels of debt. On the other hand, companies belonging to the Jaypee, GMR, GVK and ADAG groups have faltered as the debt has pushed them down. For a growing company, too much of debt is never a great idea.
  1. Lastly, check out the names of anchor investors in the company. The anchor investors are normally large institutional investors who have participated in the equity of the company even before the IPO. A greater share of quality anchor investors shows the degree of faith reposed by institutional investors in the issue. Normally, these anchor investors provide stability and credibility to the company and it is favourable for valuations.

The bottom-line is that it will eventually boil down to how the company performs post listing. A quick check of the above 8 factors will ensure that you do not become a victim of slick marketing. IPOs have created value for shareholders but they also tend to participate in market excesses. That is what you need to be wary of!

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