 "IPO investors are better off without a safety net")
Most retail investors want safety of their investments, especially in these troubled times. One of the ways in which they look for safety is through the price at which a share bought through an Initial Public Offer (IPO) trades in the market. There have been several IPOs that have delivered extremely poor returns with investors' capital getting eroded in many cases. This has given rise to a view that there has to be a safety net present for investors, especially retail investors, when they invest in IPOs. This, they feel will attract more investors to the IPO market and could lead to better growth and development of the IPO market. However, the nature of the safety net and the way in which it is constructed could itself render it irrelevant for many investors.
Features of safety net
The safety net usually consists of a buyback of the shares issued in the IPO at a certain price. The price that is determined for the purchase constitutes an important part of the entire analysis. This is usually the price at which the issue or the IPO is offered to investors. This would mean that the investor would find some entity, in some cases it could be the promoter, which would be willing to buy out the shares that they have subscribed to, at the level at which they were offered. The way in which the investor is supposed to look at the situation is that they would not suffer any capital loss in case the shares do not rise after the IPO. If there is a fall then they would at least be able to recover the amount that they have invested in the issue. There have been a few IPOs over a period of time which have offered such a floor price safety net for small investors.
The other key aspect of the safety net is the time period for which it will be in force. It is usually for a specific period of time after the issue is complete and could be something like three or six months. Once this time period is over there would be no protection available and market forces would once again be at play. There could also be some other conditions like what kind of investors are eligible for the safety net. Typically, only investors who have investment up to a certain would be allowed, so that big investors are actually excluded from the process.
Once these features are clear, then investors must evaluate whether the safety net actually makes when they invest in equities.
Matching of time periods
The first point to evaluate is the time of operation of the safety net. A long-term investor in equities would actually want to ensure that there is significant appreciation of capital over the long term. This could even stretch into years. Hence, they look to pick up good companies for their portfolio by identifying them early so that over a longer time period there is a multiplication in the value of the shares. This gives far higher returns.
The safety net is present only for a short period of time and, hence, when it comes to the actual reasons for looking at IPOs then the relevance of this route is diminished. If the investment does not work out as expected over the long term then this is a setback, but that is the nature of the entire investment. The presence of the net, thus, does not help the investor who is looking for capital appreciation.
Selecting the stock
Since safety net promises protection of capital, it can actually have a negative impact on decision making of investors. When investors put their money into an investment knowing that they cannot lose money, there is a chance that they might not be very diligent with their analysis and homework. This could lead to sub optimum choice of investments just due to the presence of the safety net as a comfort factor. This, ideally should be avoided.
Asset allocation decision
Equity investing, especially direct equity investment, is meant to ensure that there is accumulation of wealth over a period of time. Here, safety of the investment is not the key concern. To address the issue of safety of the investment, investors must look at debt options. Proper asset allocation will help to balance long-term wealth accumulation and safety of the portfolio. The presence of the safety net would actually mix up the different requirements and impact the final balance of the investors portfolio. This is dangerous from the asset allocation point-of-view because there has to be a clear distinction between the various investments and what they actually seek to achieve.
Returns impact
The final impact of the safety net process on the investor could be actually negative and this is something they must watch out for. On the face of it, there may no gain or loss because investors will be able to recover what they have paid for the investment. But there is another angle to think about. This is the transaction cost that the entire action will bring about and also the fact that there could be an opportunity cost that will be incurred. Hence, the net figure might not be flat, but actually negative at the end of the day.
WHY A SAFETY NET MAY NOT BE RELEVANT
* It is not present over the long-term which is what equity investors look at
* Its availability could affect investor's decision while selecting which stock to invest in
* Asset allocation decisions could be changed due to the safety net
* The returns would be negative after transaction costs
Features of safety net
The safety net usually consists of a buyback of the shares issued in the IPO at a certain price. The price that is determined for the purchase constitutes an important part of the entire analysis. This is usually the price at which the issue or the IPO is offered to investors. This would mean that the investor would find some entity, in some cases it could be the promoter, which would be willing to buy out the shares that they have subscribed to, at the level at which they were offered. The way in which the investor is supposed to look at the situation is that they would not suffer any capital loss in case the shares do not rise after the IPO. If there is a fall then they would at least be able to recover the amount that they have invested in the issue. There have been a few IPOs over a period of time which have offered such a floor price safety net for small investors.
The other key aspect of the safety net is the time period for which it will be in force. It is usually for a specific period of time after the issue is complete and could be something like three or six months. Once this time period is over there would be no protection available and market forces would once again be at play. There could also be some other conditions like what kind of investors are eligible for the safety net. Typically, only investors who have investment up to a certain would be allowed, so that big investors are actually excluded from the process.
Once these features are clear, then investors must evaluate whether the safety net actually makes when they invest in equities.
Matching of time periods
The first point to evaluate is the time of operation of the safety net. A long-term investor in equities would actually want to ensure that there is significant appreciation of capital over the long term. This could even stretch into years. Hence, they look to pick up good companies for their portfolio by identifying them early so that over a longer time period there is a multiplication in the value of the shares. This gives far higher returns.
The safety net is present only for a short period of time and, hence, when it comes to the actual reasons for looking at IPOs then the relevance of this route is diminished. If the investment does not work out as expected over the long term then this is a setback, but that is the nature of the entire investment. The presence of the net, thus, does not help the investor who is looking for capital appreciation.
Selecting the stock
Since safety net promises protection of capital, it can actually have a negative impact on decision making of investors. When investors put their money into an investment knowing that they cannot lose money, there is a chance that they might not be very diligent with their analysis and homework. This could lead to sub optimum choice of investments just due to the presence of the safety net as a comfort factor. This, ideally should be avoided.
Asset allocation decision
Equity investing, especially direct equity investment, is meant to ensure that there is accumulation of wealth over a period of time. Here, safety of the investment is not the key concern. To address the issue of safety of the investment, investors must look at debt options. Proper asset allocation will help to balance long-term wealth accumulation and safety of the portfolio. The presence of the safety net would actually mix up the different requirements and impact the final balance of the investors portfolio. This is dangerous from the asset allocation point-of-view because there has to be a clear distinction between the various investments and what they actually seek to achieve.
Returns impact
The final impact of the safety net process on the investor could be actually negative and this is something they must watch out for. On the face of it, there may no gain or loss because investors will be able to recover what they have paid for the investment. But there is another angle to think about. This is the transaction cost that the entire action will bring about and also the fact that there could be an opportunity cost that will be incurred. Hence, the net figure might not be flat, but actually negative at the end of the day.
WHY A SAFETY NET MAY NOT BE RELEVANT
* It is not present over the long-term which is what equity investors look at
* Its availability could affect investor's decision while selecting which stock to invest in
* Asset allocation decisions could be changed due to the safety net
* The returns would be negative after transaction costs
The author is a Certified Financial Planner