Risks of Investing in an IPO: What You Need to Know Before Applying

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. When you make an IPO application, it is not just the process risk that you run but also the IPO investment risks in committing your hard-earned money to that IPO investment. Let us understand the risks of investing in an IPO.

Quick IPO Allotment and Risks of Investing in IPO in India

In the early days of IPO, it would take more than a month to know the status of IPO application. Because of Demat account and Demat settlement, we have come a long way, especially with online IPO application and online allotment status check. Here we not only look at the concept of what is IPO in stock market, as well as touch upon the IPO investment risks. After all, IPO, like any investment, entails risk, and that risk cannot be wished away.

Table of Contents

1. Quick IPO Allotment and Risks of Investing in IPO in India
2. Market Risk and Potential Losses from IPO Investments
3. IPO Funding Risks and Why IPOs Are Not Always Profitable

Market Risk and Potential Losses from IPO Investments

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 an IPO market risk and there is not much that you can do about it.

IPO Funding Risks and Why IPOs Are Not Always Profitable

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.

Also Read: 5 Crucial Factors to Consider While Investing in an IPO

Speculative Behaviour in IPO Market

IPO market can, often times, be rather speculative and one of the reflections of this is the grey market, which is the unofficial market to trade IPOs prior to listing. Many 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, making it one of the risks of investing in an IPO. 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.

Conflicting Interests Between Stakeholders

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 stakeholders.

Dilution of Equity and Other Risks of Investing in an IPO

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.

External Factors Affecting IPO Performance

In terms of IPO investment risks, there are several external influences, outside the control and purview of the investor. 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.

Lock-in Period and Fund Liquidity Risk

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 depends on the number of holidays in between. This prevents the investor from using the fund for other purposes since even in ASBA (Application Supported by Blocked Amount), the funds are under lock-in, so the funds cannot be used for any other purpose. This remains a major risk in primary market.

Global Market Influence and Value Diminution

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 some stocks have underperformed the markets. This often happens in companies that have global exposure since such global events tend to have a bearing on the risks of investing in IPO in India.

Conclusion

To sum it up, there are several risks of investing in an IPO. Investors need to factor these risk factors in IPO investment decisions, keeping in mind that potential losses from IPO investments are possible and IPOs are not always profitable.