IPOs, or new issues, can arise after venture capital financing, but these investments can lead to even lower returns

Venture capital investors often only expect to make money on perhaps one in 10 of the companies they invest in. That’s because they mostly invest in early-stage companies that are just starting out, and these companies have a high mortality rate. However, when things go as hoped, that one success could overwhelm the losses of the unsuccessful nine, and leave a healthy profit.

To realize the profits from those successes, and after perhaps a few rounds of financing, venture capitalists often aim to cash in with an IPO (Initial Public Offering, otherwise known as a new issue). This lets them sell shares of their venture capital-backed investment, both to place a market value on the company, and to recoup at least some of their investment.

But overall investors in new issues, including venture capitalist opportunities, most often earn a low rate of return in relation to the risk they are exposed. And that can be especially true with venture capital IPOs, because the original investors may have already captured the bulk of the growth phase of a company.

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Venture capital financing and the growth of new issues

We rarely, if ever, recommend,  investing in new issues—venture capital-originated or otherwise. That’s because they come to market when it’s a good time for the company or its insiders to sell. That may not be, and often isn’t, a good time for you to buy.

New issue offerings often have a turbulent start on the stock market. Stakeholders often sell a portion of their shares to recoup their investment during the first weeks and months the stock begins trading.

Some new issues pay off from their first day of trading, and these are the ones you read about. But underwriters reserve these “hot new issues” for favoured clients such as major financial institutions, hedge funds, big individual traders, friends of insiders at the new company, and so on. This arrangement creates a filtering mechanism that works against outside investors.

Sometimes venture capital financing involves well-packaged IPOs

Venture capital financing institutions know how to package an IPO to make it seem like a great deal. This tends to raise the price that you pay for an IPO, compared to a stock that is already trading in the market. In addition, the underwriting process adds costs for commissions (usually 5% to 7% of the funds raised), plus legal and accounting expenses.

Furthermore, some organizations package venture capital investments into a variety of investment products that they can sell to the general investing public. Some of these products resemble mutual funds. Others are more complex. They may come with partial capital guarantees, income streams, options on future investment opportunities and so on. However, the underlying assets that go into these products expose you to the same risks that you face in any venture capital investment.

Long-term studies show that, on average, IPOs tend to do worse than comparable stocks over a variety of time periods.

Professor Jay R. Ritter of the University of Florida has updated his long-time study of more than 7,000 IPOs that came on the market in the U.S. from 1980 through 2013. He studied returns on the IPOs for the first five years after issue, in two ways.

The average yearly return for the IPOs over five years was 3.1% below the return on existing stocks with the same market capitalization, or “market cap,” (the value of all stock each company had outstanding). When Professor Ritter matched the IPOs with existing stocks that had comparable ratios of book value to market value, the IPO’s performance shortfall shrank to 2.0%.

Both comparisons in the study show that IPOs actually beat existing shares in the first six months of trading. That’s when “hot IPOs” (new IPOs that shoot up in price the moment they come on the market) have their biggest impact, and bring up the average new issue performance. However, hot IPOs are generally unavailable to the average investor.

Bonus tip: An exception to our IPO and new issues rule

IPOs are more attractive and often easier to obtain when they are part of a privatization effort—when a government sells a government-owned enterprise to investors.

With privatization, governments often price an IPO at an attractive level that almost ensures that buyers will make money. That’s because governments are less concerned than a private seller would be about getting a good price in a privatization. Instead, they are more concerned about maintaining the goodwill of buyers, for political reasons. Rather than try to get the best price, they may sell a privatization at a good price to a wide range of individual buyers, to win goodwill and votes in the next election.

Have you ever invested in an IPO that was controversial due to the company’s mission, and what was the outcome?

Hot new IPOs are hard for average investors to get. Is there an IPO you wanted, but couldn’t get immediate access to? What happened with the stock?