IPOs: What you need to know

2018 is shaping up to be another strong year for initial public offerings (IPOs). Momentum appears to have carried over from last year, when IPO activity picked back up from the multiyear low set in 2016. Among the contributing factors to the improving IPO market have been healthy stock market returns that have attracted companies to go public and, until recently, persistently low volatility.

The number of deals year-to-date for 2018 is tracking just ahead of last year, while proceeds raised from those deals is well ahead of 2017’s pace. Overall, Renaissance Capital, an IPO investment management company, is forecasting 160 to 180 IPO offerings in 2018, up from 160 in 2017, raising anticipated proceeds in the range of $40 to $60 billion, up from $35.5 billion in 2017. Renaissance Capital manages the Renaissance IPO ETF (IPO), which is up 7% year to date.

The largest IPOs thus far this year include US life insurance firm AXA Equitable (EQH), Argentina-based airport operator America Airports (CAAP), fracking services company FTS International (FTSI), casino operator REIT VICI Properties (VICI), storage services REIT Americold Realty Trust (COLD), and airport concession stand operator Hudson (HUD).

Possible IPOs for the remainder of the year include rental network Airbnb, music service Spotify, social photo sharing website Pinterest, mobile application transportation operator Lyft, web-based cloud storage provider Dropbox, security services firm ADT, and genealogy website Ancestry.com.

2017 in review

Last year, both the number of IPOs and total proceeds climbed dramatically compared with 2016. In 2017, the top 10 IPOs by size were:

• Multimedia messaging app company Snap (SNAP)
• Cable television provider Altice USA (ATUS)
• Home rental company Invitation Homes (INVH)
• Online consumer credit company Qudian (QD)
• Forensic consulting services provider Sea (SE)
• Midstream energy asset operator Antero Midstream (AMGP)
• Cement, concrete, and lime maker Loma Negra (LOMA)
• Pump equipment manufacturer Gardner Denver Holdings (GDI)
• Midstream energy asset operator BP Midstream Partners (BPMP)
• Search engine company Sogou (SOGO)

Alibaba’s (BABA) $22 billion IPO in 2014 remains the global benchmark for deal size. In terms of performance, investors were generally rewarded by IPOs in 2017. The average total return of all IPOs was up 21% from the offer price, down slightly from 2016 (see US IPO return statistics table). This was due in part to the largest IPOs by deal size underperforming relative to other IPOs, according to Renaissance Capital.

Caution is warranted

IPOs can generate buzz among investors, particularly for so-called “hot issues” that garner a lot of interest. But beware of getting caught up in the hype. IPO investing can be complex, and may be suitable only for experienced investors. Be sure to consider any opportunities within the constraints of your unique investment goals and risk tolerance.

There are unique considerations to keep in mind when it comes to investing in IPOs. For instance, the stock of an IPO can be particularly unpredictable on its first day—and also the first few months—of trading. For every AT&T (T), Google (GOOG), and Visa (V) that had successful IPOs and are now entrenched leaders in their respective industries, there is a long history of initial public offerings that have not performed well.

Moreover, extracting long-term value out of IPOs, even successful ones, can be tricky for a retail investor. For example, suppose you identify an IPO that you find attractive as a long-term investment, and the price at which it begins trading on the IPO date is $20. If you were to buy the shares at around this price, and by the end of the IPO day the stock price had risen to $30, you might think, "I've hit the jackpot!"

But take a step back. This means that the company and its underwriters (a financial group, typically a bank that is responsible for determining the market price of an IPO) underestimated demand for the company's stock. Therefore, the company lost out on the opportunity to raise more money to grow its business, because the IPO was mispriced (i.e., instead of receiving let's say $30 a share from the public, it will have received only $20 a share).

In this scenario, if you were looking for short-term profits, great. If you are a long-term investor, however, a mispriced IPO may not be in your best interest.

Do your homework

Like any other investment, before making a decision regarding an IPO, you should review your investment goals and conduct a thorough analysis of the company, along with its growth prospects. Beyond the general risks associated with an individual investment opportunity, there are distinctive risks associated with IPO investing—each IPO is unique, and it needs to be evaluated independently to determine its investment potential.

For example, one of the primary difficulties that some investors face when it comes to researching companies that have not yet become public is the extent to which there is access to information. Publicly traded companies in the US, for example, are required by the Securities and Exchange Commission to disseminate financial information quarterly. Private companies are not required to do the same. Consequently, for those investors who do not have access to this information, it can be hard to fully assess the company's merits as a sound investment. A key source of information for an IPO is the prospectus.

One way that you might be able to navigate the intricate IPO waters is to consider an actively managed fund. Most investment management companies have the research capabilities and resources needed to conduct this analysis, which many individual investors are not able to do.

If you are considering investing in an IPO, know the risks and be sure to do your homework.