When a bull market starts getting longer in the tooth and investors believe markets only go up, news about initial public offerings begins to dominate business headlines. The flood starts off with quality companies, but as IPO successes pile up, a frenzy for hot issues inevitably draws out shady operators. Even the most reputable investment banks are tempted to squeeze in a few subpar deals as they contemplate the almost inevitable bear market to follow.
Pricing an IPO is a complex undertaking. Investment bankers face the challenge of estimating market demand along with the difficulty of putting a price on a private company. They may also have to juggle competing interests. The issuer (the company going public) and the original investors want to receive as much money as possible for the ownership stakes they’re selling, but they’re often willing to sell at a little less than full value to create an active market for shares they may eventually want to sell later.
Brokers selling the IPO (known as the “syndicate”) receive a significant portion of the proceeds in exchange for managing and marketing the deal and thus are presumed to be working for the benefit of the issuing company. Some investment banks, however, in the past have been accused of grossly underpricing issues and using the ready-made profits to pursue new business or reward their other big clients.
An IPO becomes “hot” when investor demand for the shares substantially exceeds supply before the stock even begins to trade on an exchange. This is likely to happen when the company is well-known, is in a thriving industry or the offering is occurring in a frenzied market. When the stock starts trading, the strong demand at the open will make the stock price jump immediately, leading to a juicy and very quick profit for those lucky clients who are allocated shares and choose to “flip” the stock at the market open.
As glamorous as a one-day profit of 50 percent may look in the headlines, a flipped IPO doesn’t benefit the issuing company. It’s actually unfortunate; the issuer could have received more money for the shares it sold.