The opportunity in IPOs

The number of initial public offerings (IPOs) has got off to a flying start this year but, with many opportunistically fundraising after benefiting in the pandemic, small-cap fund managers are divided on whether they will participate.

One of the benefits of investing in small-cap funds is the ability for them to back early-stage companies which might lead to future growth. Successful IPOs in recent years have included Afterpay, CSL and Tyro Payments. As well as Australian listings, the Australian Securities Exchange (ASX) is also a fertile ground for smaller overseas companies to list such as ResMed, Life360 and Auckland International Airport.

According to the latest HLB Mann Judd IPO report, there were only 74 IPOs in 2020 with 84% taking place in the second half of the year and they raised a total of $4.9 billion. This was down from $6.9 billion raised in the previous year.

But, in 2021, the first half of the year alone had seen 61 IPOs taking place which raised $2.9 billion compared to $132 million in the first half of 2020, just 3% of the annual total. A further 42 were proposed for the rest of the year seeking to raise $1.25 billion.

The small-cap end of the market, those under $100 million, was particularly active with 48 new entrants which raised $462 million. The main contributor to this was the materials sector which had 26 small-cap listing take place in the six-month period.

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“IPO activity to date in 2021 has been driven by favourable macroeconomic and capital market conditions, combined with strong investor sentiment,” said Marcus Ohm, partner at HLB Mann Judd. 

One reason for the increased volume of small-cap listings was that the ASX had a far smaller market cap needed to list, which made it more favourable than global exchanges. To list on the ASX 300, a company only needed a market capital of $446 million.

An ASX IPO investor update said: “A technology company with a minimum market capitalisation of $120 million will gain entry to the S&P All Technology index. The S&P/ASX 300 index requires a minimum market capitalisation of $446 million and the S&P/ASX 200 index requires $1.6 billion.

“By contrast, a company needs a minimum size of $7 billion to be included in the FTSE 100 index in the United Kingdom. Or $21.8 billion for inclusion in the S&P 500 index and $31.1 billion for inclusion in the NASDAQ 100 index in the United States.

“The result is small and mid-cap listings in Australia have greater opportunity for index inclusion compared to larger offshore exchanges.”

But while the small-cap space was particularly active, small-cap fund managers were divided in whether they were a good idea to support. Some felt it was an opportunity to get in on a great stock at an early date while others felt they were too risky and wanted to watch their progress first to see if they met their targets.

Richard Ivers, portfolio manager of the Prime Value Emerging Opportunities fund, said the firm regularly looked at IPOs and thought they were a “great opportunity”.

“We regularly look at them. You can find some great businesses especially if they are looking to raise money for growth, it can be a great opportunity to accelerate that business,” Ivers said. 

But Victor Gomes, senior portfolio manager of the Eiger Australian Small Companies fund, said the lack of track record for these type of stocks meant he shied away from investing in them, despite any potential early gains.

“We rarely tend to do IPOs as there are so many small-caps stocks in the universe which have a long track record and they are much lower risk than the new entrants,” Gomes said.

“You find you are only told the good news but not the bad and they don’t have a track record. We shy away from them unless it looks particularly compelling, we are very cautious.

“We prefer to see them trade for at least six months, even a year, before we look at them even if that means giving away the initial outperformance in the early days as that is the riskiest stage. By waiting longer, we are able to assess their track record and see if they have met their targets.”

He said the one major IPO that the fund had backed was of WiseTech, which listed in April 2016 and raised around $168 million. At the time, the software firm was described as a being a “rare standout” as it was already a global and profitable business. Since IPO, the firm had returned 1,102% compared to returns of 87% by the ASX 200.

The reason, Gomes said, that Eiger made an exception for this stock was that it was listing in order to raise capital to increase its credibility and acquire other companies. 

While Ivers was optimistic about the opportunity for IPOs, he did agree with Gomes that due diligence was needed. 

“The time is compressed with an IPO so we look for businesses that we already know and where we can speak to people and make a decision quickly,” Ivers said. 

“It needs to be an attractive price, you need to be able to see the financials in detail as there can be tricks in how they phrase things, talk to customers and suppliers, it is a good sign if the owner isn’t selling equity. They can be high risk and need more due diligence but the price you pay should reflect that.”

Andrew Mitchell, senior portfolio manager at Ophir Asset Management, said: “IPOs are subject to the same investment process that we put every company through. This sees a strong focus on earnings and its sustainability. 

“We particularly look at the business model, the industry structure, its returns on capital, as well as how clean the balance sheet is and the quality of its management team.”

COVID-19 IMPACT

The reason behind a company choosing to list was a big factor in fund managers’ decision whether to back an IPO as there were some companies which had been listing opportunistically, particularly in the aftermath of the pandemic. 

Ivers said: “There have been a lot more IPOs this year but some have been listing based on short-term factors because of COVID-19 so you would have to look at the sustainability of earnings there”.

Two examples of this would be online cosmetics company Adore Beauty and food manufacturer YouFoodz which had benefitted from the stay-at-home rules during the pandemic and subsequently listed in October 2020 and December 2020 respectively. 

YouFoodz, which listed at $1.50 per share, never reached those highs again and eventually received a takeover bid from HelloFresh in July. Meanwhile, Adore Beauty began trading at $6.92 per share when it listed in October 2020 but had fallen 30% since then (Chart 1). 

“These companies experienced extraordinary growth through COVID as they had a captive audience but to be successful, they would need a repeat customer base not just one-off customers during a pandemic. They were priced to perfection and never got off their IPO price,” said Andrew Mouchacca, portfolio manager of the Flinders Emerging Companies fund.

A good reason for a company to list would be if they were trying to access capital to grow their business and Mouchacca said the firm had participated in four IPOs in 2021.

“Small caps are an aspirational asset class, these are companies which are trying to access capital in order to grow their business and become large caps. Those are the ones we want to identify early in order to get the best returns,” he said. 

“There are some which might list in order to access liquidity and those are less attractive to us.”

ADVISING CLIENTS

Marshall Brentnall, director and financial adviser at Evalesco Financial Advisers, said he relied on the asset managers to make the decision about IPOs rather than investigate them himself which left him free to focus on the financial advice.

“We have had some who invested in IPOs such as Medibank and Telstra or because they’ve heard about it through their work. 

“But we want to implement long-term strategies that are repeatable in order to give clients a consistent outcome so we don’t do many tactical, opportunistic trades.”

If he was choosing a small-cap fund, he avoided those which invested in particularly small companies as it could be hard for the manager to get out and meant there was limited liquidity.

Other problems could also arise if a small-cap fund participated in seed funding. 

“Some funds will participate in seed funding ahead of a company’s IPO, and if they then encounter redemptions then those unlisted assets can end up becoming a much larger part of the fund than they expected,” Mouchacca said.

“Seed funding increases the risk as you can’t control when they list, at least with an IPO then we don’t have to be an activist investor and aren’t stuck in an investment where we can’t get out.”  

FIVE IPO TIPS FROM OPHIR ASSET MANAGEMENT

• Who is the vendor? Do your due diligence on the directors and see how much is being sold down by the owners.
• Who is the broker? Do they have experience in the IPO market and how much ‘skin in the game’ do they have?
• Who are the buyers? Is there strong demand for the listing or is it funded by overseas hedge funds?
• When is the IPO? Is it taking place when the market valuation is at a cyclical high?
• How much is it? Does the valuation model indicate you might be overpaying and have you checked their financial performance and future targets?