What Is the Risk of Investing in an IPO

  • 31 Jul 2023
  • Read 9 mins read

Risk of Investing in an IPO

Over the last 25 years, the IPO issue and management process has become substantially simpler. The experience has been that generally, investors have made profits in a majority of the IPOs, although a handful of IPOs do end up giving negative returns. Normally, investors scan details on the website like the Current IPO details and the Upcoming IPO 2022 details before deciding on IPO investments. When you make an IPO application, it is not just the process risk that you run but also the investment risk in committing your hard earned money to that IPO investment.

In the good old days of IPO yore, it would take more than a month to even know the status of IPO application. Thanks to demat and demat settlement, we have come a long way, especially with online IPO application and online allotment status checks. Here we not look at the concept of what is IPO in stock  market, as well as touch upon the aspect of risk. After all, IPO, like any investment entails risk, and that risk cannot be wished away.

Here are some very critical risk factors that are part and parcel of any IPO investment.

Most people can tell you the benefits of an IPO by rote. That is the easier part. But, did you know that IPOs entail a good deal of risk which is not understood by many. Here look at some of these risk factors surrounding the IPOs.

  1. While the initial public offers or the IPOs look like an attractive avenue, there is no guarantee of getting allotment of shares. This problem gets a lot more acute and challenging when the subscription levels go up exponentially. When an IPO gets subscribed around 100 times, your chances of getting IPO allotment is quite low and that would reflect in the low level of quota allotment that you would get. This is more like a IPO market risk and there is not much that you can do about it.
  2. We can extend the above argument with special focus on IPO funding, which entails taking a loan and investing in an IPO. If you take funding to invest in the IPO, the listing premium has to be large enough to cover the cost of funding and the sunk cost of oversubscription. Normally, that is where more investors tend to face a problem since returns are rarely enough to cover cost of funds in bullish times.
  3. IPO markets have been rather inconsistent and it has been like 2 years of market enthusiasm followed by 2 years of market indifference. That has been a standard problem in the past. For instance, IPO markets were giving positive returns till about October 2021, but after the slew of digital IPOs gave negative returns, the entire market became very inconsistent. IPOs like Paytm and LIC only made things worse here.
  4. IPO market can, often times, be rather speculative and one of the best reflections of this is the grey market, which is the unofficial market to trade IPOs prior to listing. Most investors in the retail and HNI category use the IPO market as an “exit on listing strategy” and this creates a lot of pressure on the price. It is only the anchor investors and the pre-IPO investors who are locked into the company. In addition, the expiry of the 30 days and 90 days anchor lock in period also induces a lot of volatility in the IPO stock prices and makes the market a lot more speculative for the investors.
  5. Quite often the interests of the issuer of the shares, the investment bankers and the investors tend to be at cross purposes and that has been a common problem in a growing market like India. For instance, the issuer will want to maximize the price realized so as to enhance valuation since that would give them a good base. The investment banker tries to make the issue as big as possible to enable a larger fee share. The investor wants something left on the table and quite often these 3 come into conflict. In between, analysts and traders also add to their view as stake holders.
  6. There is a major downside when the IPO is a fresh issue of shares. While it is true that fresh funds come into the company, these fresh issue IPOs tend to dilute the capital and the EPS of the issuing company. This is like distributing the same profit over more share capital leading to dilution of EPS. It has been commonly seen that companies use equity funds to repay debt or for working capital, which is not a very efficient and smart way to do things. When you repay debt, it is like saying that the cost of equity is lower than the cost of debt, which is not the case here. In the case of an offer for sale or OFS issue, there is no dilution of equity but it does raise question about the possible reasons for the promoters or early investors want to exit the company.
  7. In terms of risk, there are several external influences, outside the control and purview of the investor. We have seen these so frequently in 2022 when the Fed policy, US inflation, Russia / Ukraine war and China lockdowns were the major global overhang for the IPO markets. There are several other triggers too. For instance, global markets may crash, interest rates may go up, the rupee may fall against the dollar or the inflation may spike. All these can negatively impact the IPO listing and diminish the wealth of the IPO investor.
  8. Unlike secondary markets, where the churn time is just 2 days, the lock-in of funds is longer in an IPO ranging from 8 days to around 11 days for the finalization of allotment and that also is dependent on the number of holidays in between. This prevents the investor from using the fund for other purposes since even in ASBA, the funds are under lock-in, so the funds cannot be used for any other purpose. This remains a major risk in primary market, although we must say that primary markets are not as risky as they were 20 years back, when allotments would take close to a month.
  9. Finally, there is the value diminution due to unrelated factors. For example, the fall in digital stocks on the NASDAQ has had a huge spill-over effect on Indian digital stocks and that could be attributed as the reason, stocks like Paytm, Policybazaar and Nykaa have underperformed the markets. This often happens in companies that have global since such global events tend to have a bearing on the risk of the IPO.

To sum it up, IPO markets also have their own share of risks. Investors need to factor these risks while taking an IPO investment decision.