Last week, Robinhood Markets, the brokerage app that everyone loves to hate announced
that they are beginning the roll out of IPO Access, a new product that they say will give
their customers the opportunity to buy shares of companies at the IPO price, before they
trade on public exchanges.
With IPO Access, Robinhood claims that retail investors can now participate in upcoming
IPOs with no account minimums.
Today, most IPO shares go to institutions or high net worth investors at the offer price.
Smaller institutions and retail investors have to wait till the shares are trading on
the exchange, where they often end up buying them at a premium to the IPO price.
Lets use the recent Airbnb IPO as an example.
If you got an allocation, you would have bought Airbnb at $68 per share.
The first trade on the exchange was at $146 per share (115% above the IPO price) the stock
closed that day at $145.
Although the news touted a 113% gain, investors who bought at the opening price were actually
down by the close of business.
(At the time of this recording, Air BNB is trading at $143.)
Robinhood are saying that they will allow everyday investors the chance to get in at
the IPO price (so at the $68 level in that example, rather than at $145 price).
It is worth noting though, that Robinhood will not be an underwriter for companies going
public, they will instead try to get an allocation of shares from the investment banks and pass
those on to their customers.
The traditional IPO process has been criticized for a long time as being broken, with investment
banks allotting the shares to big clients who capture the instant first-day gains.
Some people claim that SPACS are a means to avoid that problem, but if you have watched
my prior videos on SPACS (which I will link to at the end), you’ll have seen that the
public typically does worse with SPACS, and the real winner in that deal is the SPAC sponsor.
Primary direct listings, are a new means of going public on the New York Stock Exchange
and that approach has combated some of the criticisms of SPACS and the IPO process.
Let’s quickly look at the data of how IPO’s typically perform, some of the theories as
to why they behave the way they do, and at the end of the video we will discuss whether
this move by Robinhood is good for retail investors or not.
When trying to understand the IPO market we are very lucky, as there are academics who
have devoted their entire careers to studying IPO’s and IPO underpricing.
The IPO pop is not just annoying to retail investors who don’t get an allocation, it
also enrages the companies who sell stock at one price and see it trading hours later
at a much higher price.
In cases where a stock pops a lot, it is seen as a missed opportunity on the part of the
issuing company who feel they sold their company much too cheap.
Google famously decided to go public in 2004 using a Dutch auction process to avoid leaving
money on the table, this was quite a big deal at the time but it didn’t end up working
out for them.
The IPO was priced at $85 through the Dutch Auction and then opened at $100, delivering
an immediate pop of 17 percent to investors who had gotten an allocation.
This was roughly in line with what would have been expected in a traditional IPO.
Studies have found that I.P.O. underpricing is ubiquitous, and the average IPO pops around
18% on the first day of trading.
The frothier the stock market, the more the shares seem to pop.
In 1999 IPOs averaged a 60% increase on the first trading day.
In 2020 we saw an average first-day return for newly listed IPOs (excluding SPACs), of
38%.
When we analyze the last ten years of data, we find that average IPO pops were greater
if the market had rallied in the 3-weeks prior to the IPO than if it went public in a flat
or down market.
The data shows that first-day returns for tech companies tend to be higher than for
non-tech IPOs.
Over the last 40 years tech IPOs popped 31% versus 11% for all other sectors.
People like to point out that many tech companies are unprofitable when they go public.
Interestingly, IPOs without earnings have experienced an average first-day return higher
than for those with positive earnings.
This investor optimism might reflect the stronger growth prospects for new high growth technology
companies, it is worth noting that many of the largest companies in the world today were
once one of those tech companies that went public with negative earnings.
IPO underpricing is not just an American issue, it appears to be a worldwide phenomenon.
In China, IPO underpricing has been extreme, averaging 137 percent from 1990 through to
2010.
This compares with 16 percent in the United Kingdom.
In most other countries, I.P.O. underpricing averages around 20 percent.
OK, so to understand this underpricing, lets first look at how the traditional IPO process
works.
The process usually involves a company raising additional capital from institutional investors
the day before the stock’s new ticker starts trading on an exchange.
Typically, a group of investment banks will run a process known as “book building,”
where they reach out to their biggest clients and assemble a book of orders at different
prices that institutional investors are willing to pay for the IPO.
These investors are shown a list of possible prices and asked to submit how many shares
they are willing to take at the different price points.
Generally, being involved in this process is by invitation only to big clients of the
investment banks.
Generally, securities laws require additional disclosure requirements if the issue is to
be offered to retail investors, this requirement is the main reason why retail investors are
usually not involved at this stage.
The way book building works is that the investment bank invites large investors and fund managers,
to submit bids on the number of shares that they are interested in buying and the prices
that they would be willing to pay.
They bid the number of shares that they are willing to buy at the various price levels.
To price the issue, the underwriter uses the weighted-average method to arrive at the final
price for the shares.
Stock exchanges around world usually require that the banks make the details of the bids
public after the IPO in the interests of transparency.
Regulators are often entitled to verify the bid applications if they feel it is necessary.
The price where the underwriters feel that demand adequately covers the issuers’ supply
is known as the offer price.
The idea is that this is the price at which all of the shares will be taken up.
All investors are allocated stock in the IPO at that price, even if they said that they
were willing to pay more for their shares,they still get filled at this price.
With a really hot IPO, investors often only receive a fraction of the shares they put
in for.
The day after the shares have been placed, the listing exchange opens the stock for trading,
and the shares can now be purchased by the general public.
The first opening auction runs like all other exchange opening auctions, reaching a price
where demand and supply are equal.
That auction forms the stock’s first opening price.
There can be some complexity to how these deals work, where the underwriter might agree
to stabilize or support the price of the offering for the initial trading period with a greenshoe
(or over-allotment) option.
If demand remains strong for the IPO, the opening trading price will be higher than
the offer price.
But that’s not always the case.
An average gain of 18% on day-one makes IPO investing sound like a very attractive opportunity.
However, 31% of IPOs actually fall on their first day of trading rather than popping.
Additionally, nearly half of IPOs fall on their second day of trading (versus their
first day close).
Some of the high returns relate to the volatility that investors face.
Investors often get only a partial fill on the deals that go well and get a full allocation
on the ones that fail, thus they don’t usually achieve that 18% average return.
So, what are the theories for why IPO’s are so frequently underpriced?
The most common explanation and the one with the most empirical support is that IPO underpricing
occurs because of informational asymmetry.
This theory was put forth by Kevin Rock in 1986.
He theorized that uninformed investors bid without regard to the quality of the IPO – they
just want access to any IPO.
Informed investors on the other hand bid only on the offerings that they have analyzed and
that they think will provide superior returns.
In an IPO that is overpriced, only uninformed investors will bid and they will then lose
money.
If they get burned a few times like this, they eventually leave the IPO market for good.
The investment banks don’t want this to happen as they need the uninformed investors
to also be involved as there just aren’t enough informed investors to take all IPO
shares.
To solve this problem, the underwriter prices the IPO to attract these investors making
sure that uninformed investors are also involved in the process.
The consequence of this is a general underpricing of IPO shares.
Another theory as to why underpricing persists is the investment bank conflict theory, which
argues that investment banks arrange for underpricing as a way to benefit themselves and their big
clients.
There is some mixed evidence to support this argument, but this incentive is mostly offset
by the fact that if an investment bank is known for underpricing IPO’s, companies
won’t hire them for future IPO’s, and IPO’s are very lucrative business for investment
banks.
Investment bankers fees (and thus their bonuses) are based on the size of the deal, so overall
they are well incentivized to raise as much money for their customers as possible.
Next up is the managerial conflict theory which argues that company management deliberately
cause the underpricing.
The idea being that management creates excessive demand for I.P.O. shares in order to ensure
that they can sell their holdings after the legally required 180-day lockup period for
a higher price.
There is not much evidence to support that theory.
Another Theory is that the underpricing is caused by American securities laws that impose
strict liability on the issuer and on the underwriter for material misstatements and
omissions made in connection with the I.P.O.
According to this theory, the underwriter deliberately underprices the I.P.O. to ensure
that even if there is a misstatement or omission the IPO investors don’t have a claim since
these failures were priced in the I.P.O.
This theory hasn’t found much support either as we see underpricing in other countries
with lax securities regulation.
Last up we have liquidity theories that make a lot of sense to me.
When a company goes public, let’s say they sell a million shares for $100 a share.
A lot of the big institutions who get an allocation will just hold their shares for the long term.
Maybe only ten percent (or a hundred thousand) of those shares get sold by these big investors,
and that hundred thousand shares are actively bought and sold repeatedly in the first few
days of trading.
If the shares end the day up 20% at $120.
It doesn’t mean that the entire million shares could have been placed 20% higher by
the investment bank, raising 20% more capital for the company.
It might actually mean that you could only have placed the entire million shares at the
weighted average of those prices($102), which is 2% higher than the IPO price.
So where does this leave us with Robinhood and IPO access?
Well, buying IPO shares is a bit of a lottery for two reasons, one, the company you are
investing in is new and untested, and two - you don’t know how many shares you’ll
get.
Robinhood says that their customers will get an equal shot at shares regardless of their
order size or account value.
One of the problems with getting involved here is that you are faced with what is known
as ‘the winners curse’.
If you are allocated a lot of shares, that means that there was not much demand, and
you probably don’t want them.
Robinhood won’t be an underwriter for the companies going public but will instead apply
for shares as an institutional investor and will fight to get an allocation of shares
from the investment banks.
They will then pass these shares on to their customers.
This is great marketing for Robinhood, and ties in nicely with their claim to be democratizing
finance.
I imagine that pretty much every retail brokerage would like to be able to allocate hot IPO
shares to customers.
Robinhood brought down the cost of trading for all retail investors, simply because the
other brokers had to compete with them on price.
It is quite possible that this could change the way that investors get access to IPO’s
going forward.
Whether you like them or not, Robinhood have been an innovative brokerage firm.
They gamified investing on their app, which is probably not good for their customers,
they brought about commission free trading, but of course accept payment for order flow
at a higher rate than many of their competitors.
But often outside firms change the way industries operate.
Traditional brokers would happily stick with the way business has always been done, but
they must change in order to compete with new entrants.
It is probably good for retail investors that brokers are competing for their business.
To a certain extent Robinhood can pitch to the investment banks that their customers
will buy stock in every IPO with no price sensitivity, allowing the bankers to price
and size the deal more aggressively than if it was just allocated to more sophisticated
investors.
The companies going public will most likely be happy to hear this as they might raise
more capital through allocating to Robinhood than to large institutions.
Companies would probably prefer to have a diverse shareholder base of robinhood investors
rather than a few big investors who might agitate for change if they disagree with how
the company is being managed.
If the investment banks don’t give an allocation to Robinhood, retail investors will simply
buy stock the day after the IPO as they always have done, and if the price pops too much,
the issuers will be angry at the banks for leaving money on the table.
That doesn’t really work for the banks.
It is worth remembering that if you want to get involved in trading IPO’s that for every
high-profile IPO that doubles on its first day, there are many more that disappoint investors.
In fact, the long-term performance of IPOs is underwhelming.
About half produce negative returns in their first five years as public companies.
Over the last thirty years a portfolio of IPOs issued over the prior 12 months, weighted
by market value and rebalanced monthly, posted annualized returns of around 7% per year.
The Russell 3000 stock index, that tracks both large-company and small-cap stocks returned
around 9% a year over the same period.
This doesn’t mean that you shouldn’t invest in IPO’s, as obviously there is a lot of
opportunity there, it just means that you should do your research before diving in.
The world of finance is always moving forward and finding new efficiencies, and that is
good for the investing public.
While most of the new trading apps are not really the best brokerage firms out there,
the ‘all-in’ cost of trading is a lot lower today than it was in the past.
There are definitely issues with these trading apps going down in volatile markets, but when
I started out trading you quickly realized that market makers wouldn’t answer their
phones in volatile markets, the same problem with different technology.
Retail investors are more informed today than at any point in history.
Financial education is available for free on YouTube and elsewhere online, something
investors couldn’t have dreamt of thirty years ago.
The IPO process is not the only way that companies can issue securities to the public, check
out my content on SPACs and on Primary Direct Listings to see other ways that companies
can go public and to learn the pros and cons of those approaches.
Like, Subscribe, Have a great Week, and I’ll see you soon.
Bye.