With the much anticipated (and relatively successful) pricing of
Groupon Inc. (
, attention is once again turning to the IPO market.
A number of investors have noted serious fundamental concerns
with GRPN (
), and yet the stock opened sharply above the offering price -
netting investors lucky enough to get in on the deal a handsome
Ironically, when it comes to the success of an IPO - especially
a widely publicized IPO like Groupon - the initial success is much
less about the fundamental quality of the stock, and much more
how the IPO transaction is managed
. For the first few days of a stock's public life, the price is
determined largely by how well underwriters drum up demand from
institutional investors, and how much stock they actually offer on
Whenever a high-profile IPO like Groupon is priced and initially
gaps higher, there is a general outcry that the shares were
allocated to "preferred clients" while the majority of individual
investors were unable to participate. To be quite honest,
this is a relatively accurate assessment
… As an individual investor, your chances of bagging shares of a
hot IPO are slim.
But at the same time, institutional investors who receive
allocations of hot IPOs aren't always as lucky as you may think.
There are usually politics, restrictions, and significant risks
that come along with IPO allocations - and in order to take those
risks, managers must have a good shot at capturing profits when
they agree to accept IPO shares.
In a former life,
I managed a fund that focused exclusively on IPOs and
. The IPO game is challenging. It requires a lot of research,
attentiveness to both buy side and sell side psychology, and a
Rolodex full of contacts - but if you can develop skill in this
business, IPOs can add significant incremental value to your fund
The Untold Risks of IPOs
Let's get one thing straight to begin with …
IPOs are risky animals
. During the first few months of a stock's existence, price trends
are fickle, traders are hyper, and there are plenty of games being
played behind the scenes. If you decide to manage a basket of IPOs
as part of a hedge fund strategy, just know that you can't turn
your back on these stocks for a moment.
But with volatility and risk comes profit … or maybe I should
re-phrase that …
With volatility and risk comes the
… much better.
The IPO game is rigged to offer participating managers a profit.
be that way!
If I wasn't compensated for taking the risk of owning a brand new
stock that had no trading history and significantly less liquidity,
then I would never participate in an IPO transaction.
If managers decide that the potential returns in participating
in the IPO market aren't worth the risk, they simply won't deal.
IPOs won't get priced, and that means smaller companies won't get
access to capital - leading to slower economic growth, less job
creation, and a more difficult recovery. So we actually WANT IPO
transactions to be profitable for managers - this keeps the wheels
of finance turning and allows companies to access capital
Ok, I'm stepping off my soap box now. Let's take a look at a
couple of high-profile IPOs from the past decade.
Vonage Holdings Corp. (
issued their IPO on May 24, 2006. I remember the deal well as I
received a boatload of stock on that deal (
more on allocations later
). There was a lot of hype surrounding this deal because Vonage was
the leading firm offering
Voice Over Internet Protocol
- or VOIP. The expectation was that Vonage would take over the
telecom world and everyone would be using their service instead of
a local telephone line.
Of course, the flaw in this logic was that other companies could
offer VOIP too - including cable companies that already had
relationships (and installed lines) with a majority of customers.
The IPO hype was soon hit by the cold-hard reality of
In the first few minutes of trading, VG appeared to be ok. The
stock briefly traded slightly above $17. But then the sellers
emerged and VG was history. On the first day of trading, VG lost
15%. On the second day, it closed 24% below the offering price. And
a year after the IPO, VG had lost more than 80% of its value.
Below is a 60 minute chart of the first few days of trading. As
you can see, IPOs can offer sensational risks as well as
(Click to enlarge)
On the positive side of the ledger,
Chipotle Mexican Grill (
comes to mind as an exceptionally profitable IPO. The Chipotle
transaction was particularly memorable for me because of my lack of
I distinctly remember driving to a meeting the morning the stock
debuted - yelling at "Dave" who only came up with a few dozen
shares for our account. This after "playing the game" for months
and directing plenty of business his way.
And that's the rub when it comes to IPO transactions.
You never get enough of the good ones, and you tend to load
the boat when a deal is busted
. That's the nature of this market and the challenge for any
manager taking allocations in these tricky securities.
CMG came out of the gate strong. The offer price was $22, and by
the end of the day, the stock had doubled in value. Great news for
the few blue-chip funds that received their full allocations - but
disappointing for mid-tier funds that couldn't strong-arm their
investment banker contacts.
(Click to enlarge)
Chipotle would eventually make a run to $150 - a move that my
fund caught a big piece of. So the profits were still attractive,
but the example goes to show how hard the IPO business can be -
even when it's working the way it should …
Still interested in trading the IPO market? Well there are a
few key principles you need to apply:
Getting A Shot At IPO Allocations
The first thing you need to know if you want to get involved
with IPOs like Groupon or Chipotle is that
you take every deal that comes down the pike
That's right …
You take the boring ones, the IPOs with hair all over, the ones you
know will turn out to be duds - just so you can get your hands on
the gems when they are available. We'll talk about how to hedge
your bets and protect your capital in a minute. But just know that
if you're not willing to take a hit with Vonage, you're never going
to see a single share of the really good IPOs.
Here's the reason: Investment banks have a business to run.
Their job is to bring companies public and collect fees for finding
investors. If they have a reputation for "getting deals done," then
they can continue to court new clients. However, if they fail to
find homes for the mid-tier IPO companies, they're not likely to
get a shot at participating
when Groupon decides to sell shares to the public.
So as a manager, you develop a reputation with the underwriter
as a "team player." You tell him that you will scratch his back
when he needs a home for some busted IPO dog - but that you want to
participate when the deals are good too. Underwriters LOVE clients
like you. It's still a hard business, but you're well on your way
to getting some decent allocations.
Second key concept:
Hold the IPO stock for at least 30 days
. This may seem like a suicide mission, but it's important for your
relationships. You see, Dave (your broker with Morgan Stanley or
Credit Suisse) has to play his own political games to get stock for
his clients. And the underwriting department needs to know that
Dave is placing his allocations in "strong hands." They want to
know that you will help them support this deal in the first few
weeks of trading.
The worst thing in the world for you at this point is to be
tagged a "flipper."
A "flipper" is someone who takes a hot IPO and flips it out at a
profit in the first few days of trading.
Don't be one
. You'll never see a good IPO again. In fact, you can really help
your chances by calling Dave up after the deal has priced and
buying MORE stock in the aftermarket. Now Dave gets to go to the
underwriting department and brag on his client who is actively
supporting the stock.
Now you're a hero!
Third thing to keep in mind:
Participate in Multiple Lines of Business
. Remember, Dave has to present YOU to the underwriting department
as a valuable client. If you're providing revenue to their company
from multiple sources, you become more valuable.
Other lines of business can include margin loans, fixed income
commissions, equity transaction commissions, structured products
etc. Of course you are always protecting your capital, but if you
can find a way to work in additional revenue lines, you'll be
Tricks of the Trade - Managing Allocations
Up to this point we've talked exclusively about how to GET
allocations to IPOs. But what happens when you have an account full
of new stocks that may or may not be moving in the right
One important factor is to have a GOOD prime broker where the
majority of your funds positions are held. (
TradeStation Prime Services
as our prime broker and they are a sponsor of our site.)
There are many important issues to consider when picking a prime
broker including margin rates, commission rates, access to seed
capital etc. In terms of an IPO strategy, we also need to have a
prime broker with a strong short desk - making it possible to short
IPOs within a few days of the offering.
Once you have a good prime broker, you need to start pressuring
your broker to give you some stock in a DVP account (Delivery
Versus Purchase). This basically means that instead of receiving
your IPO allocation in a Morgan Stanley account, at least some of
the shares are delivered to your prime broker.
Now you can sell part of your IPO immediately - without Dave
knowing that you didn't hold it for an entire 30 or 60 days.
Meanwhile, you're still holding half of your allocation in the
account at Morgan Stanley - like a good little client. You're
banking brownie points for the next IPO that you want to
If you're truly worried about an IPO -
say Vonage is breaking down and you've got 30,000 shares left
at Morgan Stanley
you might have success shorting the stock at your prime broker.
Imagine being short 50k shares at TradeStation Prime Services,
while holding 30,000 shares long at Morgan Stanley.
You can call Dave up and yell at him because the deal is
tanking. You can explain exactly
you are still holding the stock (out of respect for him and your
"gentleman's agreement"). And you can remind him that the next time
you ask for shares of a Chipotle or Groupon -
he had better come through!
Meanwhile, you're booking a solid profit on the short side of
your book and your investors are loving your returns.
A variation of this strategy is possible with secondary
offerings (when a publicly traded stock raises more capital by
offering new shares). Nearly all of these deals price "in the hole"
- or below the previous close. And usually you have a day or two of
warning between the announcement and the actual transaction.
You can typically short the stock ahead of the deal, and then
get Dave to give you an allocation in the secondary offering. You
can't "cover a short with deal stock," but if you close out both
positions later at a similar price, you can usually book the
difference between your short price and the deal stock you bought
"in the hole."
Tracking the Calendar
There are periods where IPO and secondary offerings are scarce
and deal flow is very slow. And then of course there are periods
where up to a dozen deals (IPOs and secondary offerings) price each
During the high-volume periods, following the deal calendar can
be a full time job. In fact, you might consider allocating a
full-time analyst to this area with a mandate to track the deal
flow, manage exposure and risk, and maintain a healthy relationship
with multiple underwriting firms.
As the IPO calendar heats up, new opportunities are arising for
professional and semi-professional traders, IPO transactions can
yield healthy returns - while still managing the material risks of
these type transactions. The key is developing relationships and
playing by the rules of the game. Over time, you can build your
reputation and increase your influence with the underwriters.
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