Why Investing In IPOs Is A Foolish Move
So far 2014 has been the year of IPOs.
According to Renaissance Capital, "In terms of proceeds, 2014 is now the biggest year for the IPO market since 2000, when 406 companies raised $97 billion."
To give you an idea of just how big this year has been, look at the Alibaba (NYSE: BABA) IPO from last month.
On September 19th, Alibaba broke records, raising $25 billion -- making it the largest IPO in history.
So with the world's biggest IPO last month and the most IPO activity in dollar terms since the tech boom, many investors may be wondering, "should I buy into the next hot IPO?"
Put simply, investing in IPOs is a loser's game. Whenever a hot IPO is being pushed onto the public, I generally don't partake, because typically the money has already been made.
Let me explain...
First, a quick rundown on what it takes for a company to go public. Most companies looking to go public bring in underwriters to help navigate the company through the entire process -- in Alibaba's case they had six underwriters: Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Citigroup.
The underwriters help form the preliminary prospectus, often referred to as the "red herring." This outlines the company's financials, use of proceeds, vision, and market research, among other things to present in front of potential investors. (I always found it humorous that it was called a "red herring," because the idiom often refers to something that misleads or distracts from important issues.)
They then use this red herring to generate interest and attract buyers. Most of the time, companies will do what is called a "road show" where they host events to pitch their company to the big institutional investors: investment banks, private-equity firms and hedge funds.
In exchange for investing in the company looking to go public, the investors get an equity stake in the company and/or options to purchase shares at a specified price... And this is where most of the money is made.
These early investors get the best deals, and by the time the company goes public, they will have often doubled even tripled their original investment.
Take Alibaba for example. Two multibillion-dollar hedge fund firms in Hong Kong were able to buy preferred shares for $18.50 each that automatically converted to common shares at the IPO offering.
If they sold their shares at yesterday's closing price of $87.06 per share, then these firms will make a hefty 370% return...
But that's also where this turns into a sucker's game for individual investors purchasing IPOs.
If you look at it from the hedge funds' standpoint, your thought process might be "Okay, I invested millions of dollars into this company at $18.50 per share and now it's worth $87.06 per share... I think now is a good time to take some profit and sell."
To put it simply, when the smart money is unloading shares, I don't want to be buying them.
If you recall the hype surrounding the Facebook (Nasdaq: FB) IPO. The day after it went public, shares plummeted 10% and they would subsequently fall nearly 50% from its initial offering price of around $38 per share.
It's a common occurrence with IPOs. Institutional investors like to cash in their big profits at the little guy's expense.
Beyond institutional investors cashing in, insiders are bound to unload their shares too.
Just today, there was a major surprise for shareholders of GoPro (Nasdaq: GPRO). The CEO found a way to skirt what is known as the lock-up period -- a period of time where insiders can't sell their personal shares.
The lock-up period wasn't set to end until December 22nd. Now, because of a loophole, 5.8% of the outstanding shares will legally be allowed to be sold starting today.
For the reasons outlined above, I will wait until the dust settles before I make a decision to invest in any IPO. There is far too much smart money just itching to sell their shares to individual investors clamoring to buy the next hot stock.
So if you're not a hedge fund, investment bank or a CEO how can you get in on the ground floor of some of the hottest new companies? The key is to own them before they go public and my colleague, Nathan Slaughter of High-Yield Investing, has found a way to do this by investing in venture-capital like firms. He's collecting yields north of 12% from these under-the-radar investments.To get access to his latest research on these special investments, go here.
This article was originally published on StreetAuthority.com: Why Investing In IPOs Is A Foolish Move