Understanding the motivation behind the IPO provides context to the S-1 (IPO prospectus). Because motivation is qualitative, understanding it gives you, the nimble investor, comparative advantage over quantitative market participants.
The big question behind every IPO is why isn't this company being financed with cheaper capital? (Refresher from Finance 101: Equity is the most expensive source of capital) The three most common answers are:
1. No sane loan officer would finance this venture.
2. This IPO is not about raising money.
3. This IPO is about raising equity capital
IPOs motivated by the first reason are not attractive to risk-averse value investors. These are the classic IPOs of growth companies raising growth capital. A small plucky company, with the 'next big thing', needs more capital for growth than can be raised from angel investors and venture capitalists. Loan officers tend to be very finicky about lending on hopes and dreams - hence the need for equity investors to invest in hopes and dreams.
Companies raising growth capital tend to be in the biotech and technology sectors. All very risky. IPOs of junior energy and natural resource companies are a notable exception. If you have a good understanding of the underlying business and its possibilities, there is a real chance of getting in on the ground floor.
The second class of companies raising capital for this reason are the overleveraged zombies tossed out by private equity investors. These companies would not be speculative if it weren't for the fact they carry an overwhelming burden of debt. IPO proceeds end up being used to repay debt. Often the company remains undercapitalized after the IPO.
Speculative IPOs can be very profitable, but only the price-sensitive survive. A later chapter in this series will discuss what to look for when investing in speculative companies.
Some IPOs are not really about raising fresh capital. Sure, money is nice, but sometimes liquidity is better than money. This is almost always the case with IPOs of spinouts. Companies want to monetize subsidiaries that can get a greater valuation outside the company than inside of it.
Spinouts are especially interesting for value investors because they involve real companies with a successful underlying businesses. If the parent company expects to retain substantial control after the IPO, the NewCo typically pays a decent dividend.
The main danger is that companies tend to spin out subsidiaries which are currently hot and trendy. These stocks are likely to be overvalued from the get-go. The most recent example of this is the spinout of Mueller Water Products (MWA) from Walter Industries (WLT). Making water pipes and valves is hot; being part of Walter Industries is not. Spinout and liquidity IPOs often have complex motivations which will be explored later in this series.
This is what REIT, Business Development Company [BDC's], Bank and Insurance IPOs do. These IPOs seek to raise equity capital that will be invested and leveraged in financial businesses that require a certain amount equity capital to start with.
These IPOs are a bet on the management and its proposed strategy. Bank strategy is fairly simple: attract deposits and make profitable loans. Insurance strategy is also simple: raise cash, invest the capital and write profitable insurance. Most new insurance companies tend to trip up on the last part. Failure to write profitable insurance always ends badly. Insurance IPOs are no place for the unwary and inexperienced.
Business Development Company strategy is somewhat more complex, because BDCs make equity and debt investments in small private companies. The final outcome is very dependent on the BDC's target investments and investment style (capital gains or current income).
REITs' strategy can be very complex or very simple, depending on what the REIT plans to invest in. REITs are supposed to invest in property and mortgages. However, many newer REITs (especially those with external management) take advantage of tax loopholes to also invest in other things, ranging from bank loans to aircraft leases. All property and mortgages are not alike. It really pays to do your own due diligence
IPOs that are about raising equity capital for a known, robust business plan, rather than raising capital for an unknown business plan, have the best chance for profit.