Investing in an IPO is an exciting venture for investors. Nowadays, popular brands launch their IPOs, becoming oversubscribed in a matter of hours. The craze behind IPOs is not just about buying shares and the profits they may bring. It is also about bragging rights for investors to receive allotments in a highly competitive IPO.
However, amidst the high-intensity bidding and waiting for allotments, the risks involved with IPOs often go unnoticed. Before you invest in an IPO, it should be clear that IPO allotments do not guarantee the successful market performance of the shares you purchase. There are various other risks associated with IPO investments. In this article, we will discuss the different risks of investing in IPO and explain how you can mitigate these risks.
India has a rich history of IPO successes and failures. Considering the lessons learned from previous IPO mishaps, here are some of the most important risks associated with IPO investment.
When IPO shares are listed in the stock market for the first time, they can experience severe fluctuations in the market price during the initial trading days. There are various reasons for these fluctuations, including market demand for shares, prevailing market conditions, and early investors redeeming their investments. Whatever the underlying reasons may be, you must understand the risks involved. Sometimes, early investors redeeming their investments can cause the market share prices to fall significantly, causing capital losses.
When you invest in a company that has been trading publicly for some time, you are well aware of its profitability, growth potential, and overall stability. However, for IPOs, no matter the brand, the absence of historical data showcasing financial performance makes IPO investments no less than a leap of faith for investors. But why do we say that? Don’t companies provide a DRHP (Draft Red Herring Prospectus) and an RHP (Red Herring Prospectus) detailing the company's financial performance?
Underpricing can increase the chances of IPO oversubscription, and companies are well aware of that. Here, underpricing means the practice of issuing fund shares at a price lower than their actual value to attract investors and ensure a successful IPO launch. And IPO oversubscription occurs when investor demand for fund shares exceeds the number of shares available.
Have you, as an investor, ever wondered why even companies that you may have never heard of get oversubscribed IPOs ever so often? While it is important to note this is not the only reason, still, sometimes, the chances of IPO oversubscription are manipulated by underpricing the offers.
This benefits companies as they can see the price of shares surge when they start trading. However, this can be quite a nightmare for retail investors looking for an investment opportunity. Firstly, they cannot avail of the shares at the IPO cost. Secondly, even if they pay a premium to get the shares, there’s no guarantee that the shares will continue to perform at that level. This puts the investor’s capital at a greater risk. So, beware of lowball IPO offers before investing.
A lack of information regarding a company's financials is not all you need to worry about. As an investor, you must also be very clear about a company's functioning, future prospects, and business dynamics. While a business is launching an IPO, all this information is hard for retail investors to come by.
Retail investors often get sucked into the hype regarding an IPO without fully understanding the business they are investing in. Due to the unavailability of information, it is harder for retail investors to formulate strategic investment decisions, increasing their risk understanding when they invest in an IPO.
Company owners, early investors, and private equity investors are subject to lock-up or lock-in periods. These investors are not allowed to sell their stake in the company during this period. However, once this period is over, the redemption of these significant investments in the secondary share market can lead to substantial market price volatility for the share. After all, an IPO is an exit strategy for early-stage investors. This can put the capital of retail investors at risk, who may not be thoroughly aware of the lock-in periods associated with the IPO they’re investing in.
Market sentiment refers to how investors feel about a share. Human emotions are unpredictable, and often, market sentiment can determine how a share performs in the stock market. If there’s a positive market sentiment or buzz regarding a stock, it can positively impact its market price. Conversely, a negative market sentiment surrounding any share can negatively affect the market price. As a retail investor, you should try to be aware of the market sentiment regarding the shares you’re invested in to protect your capital.
Several risk factors are involved with investing in IPO, which need to be understood before you proceed with an application. The Red Herring Prospectus issued by the company outlines some of these risks of investing in their IPO. If you are interested in investing in the company, please study the RHP before investing. It will help you protect your interests as a retail investor. To help you stay ahead of the curve, here are some of the common IPO risk factors often listed in RHPs.
How will it impact the company if there are significant regulatory changes in its industry in the future? What happens if there are newer technological inventions in the company’s industry? Will it make the company obsolete? These are some of the questions that the company tries to answer in their Red Herring Prospectus (RHP). However, as the future is uncertain, no guarantees made anywhere can ensure these risks are nonexistent. So, research thoroughly before investing. [1]
Certain risks in business are unique to every business, like reliance on its best-selling product/service, intellectual property disputes, or litigation. These risks can damage the company’s performance from the inside out, leading to volatility in its market performance. However, these business-specific risks also include management conflicts. Given that RHPs are developed by the company, they may not be able to shed light on all the risks undertaken by an investor before investing in an IPO.
Studying the RHPs will help you understand the financials of the company to a certain extent. These documents contain information about debt obligations and cash flow maintenance. Before investing in an IPO, study this data to understand how the company aims to meet its debt obligations and still be profitable for investors.
It is true that companies present these documents (DRHP and RHP) to be eligible for IPO listings. And while these documents have financial reports of the listing company, there’s a catch. These documents only detail the financial performance of a company for a few years before the IPO listing. The long-term profitability of the business is not well understood from these documents. The real-life performance in various economic conditions and markets is not detailed in these documents. Even the data that is presented may have a touch of bias since the company itself develops these documents. DRHPs are not required to have independent agencies vet the data presented in them. So, optimistic projections and a lack of practical data can still make IPO investments a matter of significant risk for investors.
There are two sides to everything. The fun and excitement that IPOs bring also come with their fair share of risks. It is not wrong to be excited about IPOs and participate in them. However, doing so without fully understanding the risks isn’t in your best interests as an investor. So, now that you know the most important risks associated with investing in IPOs, make sure you use your newfound knowledge and invest safely!
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