Risks Associated with Investing in IPOs

Initial Public Offerings (IPOs) often capture investors’ attention with the promise of impressive returns and the excitement of getting in early on a company’s growth journey. While IPOs can indeed be lucrative, it’s essential to understand that they come with significant risks some of which aren’t always openly discussed. Before you invest in any IPO, it’s vital to look beyond the hype and examine the potential downsides carefully.

Let’s take a closer look at the risks associated with IPO investing and what you should keep in mind as a smart investor.

What is an IPO?

An IPO, or Initial Public Offering, is when a private company offers its shares to the public for the first time. This move allows the company to raise funds for various purposes such as business expansion, paying off debts, or boosting brand presence.

For instance, imagine a D2C eyewear brand going public. By launching an IPO, the company can raise capital to open new stores, invest in product development, and scale its marketing. Once the shares are listed, the ownership of the company extends beyond founders and early investors to public shareholders like you.

But while the company gains exposure and capital, as an investor, your role is to evaluate whether buying into that IPO is a wise financial move especially considering the associated risks.

Key Risks Investors Must Be Aware Of

1. Over-Valuation Issues

One of the most common risks with IPOs is over-valuation. Sometimes, companies set their IPO price based on market excitement or aggressive future projections. This can result in inflated valuations that do not match the company’s actual financial health. If the stock is overvalued, investors who buy in early may face losses once the price adjusts to more realistic levels post-listing.

2. No Guarantee of Allotment

Even if you apply for shares in an IPO, there’s no assurance you’ll receive them. In cases of oversubscription when more people apply than there are shares available many retail investors end up without any allotment at all. This can be frustrating, especially if you were hoping to benefit from potential listing gains.

3. Lack of Historical Data

Many companies entering the public market are relatively new or haven’t previously shared detailed financials with the public. This limited availability of data makes it difficult to assess the company’s long-term prospects. Without a proper track record, you’re making an investment based more on projections than on proven performance.

4. Market Hype and Misleading Promotions

IPOs are often promoted with extensive media coverage and advertising, creating a buzz that can sway even seasoned investors. However, these promotions may present only the upside while ignoring potential downsides. It’s important to avoid being influenced by hype and to conduct your own research before making any investment decisions.

5. Risks of Investing on Leverage

Some investors use borrowed money to invest in IPOs, especially when they anticipate strong listing gains. This strategy can backfire badly if the IPO underperforms. Not only could you lose your capital, but you’d still need to repay the borrowed amount with interest turning a bad investment into an even more costly mistake.

6. Competitive and Industry Risks

The company launching the IPO may be entering a highly competitive industry, or it may not yet have a proven edge over its competitors. It’s important to evaluate the company’s position in the market, its growth strategy, and whether it has a sustainable advantage.

7. Unclear Financial Health

Before investing, it’s essential to study the company’s financial statements. Look for profitability, revenue trends, and debt levels. If these figures raise red flags, or if the IPO price appears too high compared to similar companies, it may be best to wait.

8. Reputation of Underwriters

The underwriters or investment banks managing the IPO play a critical role. Reputable underwriters lend credibility to the offering and are more likely to have conducted thorough due diligence. If an IPO is backed by lesser-known or unproven underwriters, you may want to proceed with extra caution.

How to Invest Wisely in IPOs

Despite the risks, IPOs can still be a part of a balanced investment strategy if approached correctly. Here are a few steps to help you make better choices:

• Read the Prospectus Thoroughly: The draft red herring prospectus (DRHP) contains essential information about the company’s operations, financials, and future plans. Understanding this document can help you evaluate whether the company aligns with your investment goals.
• Avoid Emotional Decisions: Don’t invest just because everyone else is. Media buzz and social media opinions often lead to herd behaviour, which can result in poor investment decisions.
• Know Your Risk Tolerance: Consider your own financial goals and ability to handle risk. IPOs can be volatile, and they may not be suitable for all investors, particularly those with a low risk appetite.
• Compare with Industry Peers: Look at how the IPO valuation stacks up against other listed companies in the same sector. This gives you a more realistic perspective.
• Be Cautious of Leverage: Avoid borrowing money for IPO investments. Market behaviour is unpredictable, and taking on debt can amplify your losses.
• Monitor Post-Listing Performance: Even if you miss the IPO allotment, it can be wise to wait and observe how the stock performs once listed. This post-listing phase often gives a clearer picture of the company’s actual market strength.

Conclusion

While IPOs offer exciting investment opportunities and a chance to get in early with promising companies, they are not without their risks. By being aware of overvaluation, lack of data, media hype, and financial uncertainty, you can approach IPO investing with greater caution and strategy. Make sure you evaluate the company carefully, understand your financial goals, and don’t rush into decisions.