Sharpening the IPO Double-Edged Sword

For a brief, giddy moment, it seemed like an IPO — any IPO — was a prepunched ticket to instant riches for companies and individual investors alike. But the technology- and Internet-stock tumble have made the risks of IPOs all too apparent. As companies sift through the wreckage, the question emerges: How can the risks of IPO stocks be predicted and managed?

Three new research studies explain why some IPO stocks plummet in price while others outperform the market. According to all three, information available prior to the opening trading day of an IPO company is critical. Executives and individual investors should consider the following factors in assessing risk and potential payoffs:

• Who is the underwriter? IPOs underwritten by top-tier investment banks turn in stronger performances after three to five years in the public marketplace.
• How much has the offering price changed? The greater the increase in price from the day the stock was announced until its offering day, the better the stock will do over the long term.
• Has the underwriter used pricing tactics such as the overallotment option? Use of tactics such as the overallotment option, which allows the investment banker to issue up to 15% more shares of the stock, indicates investor demand, which leads to better stock performance over the long haul.
• How much information about the IPO company is leaking out? The more information about a company that comes out before opening day, the more likely the price of the stock on opening day will be what the market will bear — and the more likely the stock will hold its price or increase in the future.
• How much cash and debt does the company have? Because IPO stocks typically have lower debt and higher liquidity, they are considered lower-risk investments, and that helps them outperform the stock of more seasoned companies.

Those factors work in a number of ways. According to a recent working paper, “Busted IPOs and Windows of Misopportunity,” top-tier underwriters qualify their public offerings through a stricter screening and certification process than do their lesser counterparts. (Unfortunately, hot markets are an exception to that rule, because IPO fever taxes the research resources of all levels of banks.)

The paper's authors traced 1,955 issuers that went public between 1988 and 1995.