Hedge Funds' Secret Weapon
Opportunities for asymmetric payoffs even in today’s tougher markets
I met a young fund manager in Omaha who asked how I found good ideas. He expected me to talk about expert calls or satellite data. Instead, I said: IPOs.
When I was at the hedge funds, the environment was rather different from today:
I was able to take advantage of sell-side relationships as we paid large commissions and there were high quality sector specialists then.
There wasn’t the sheer volume of information there is today – an individual analyst could cover a lot more ground.
Expert transcript libraries like that of AlphaSense didn’t exist so you either used expert call from firms like GLG which were expensive or you built your own relationships through attendance at industry conferences etc.
There were fewer possibilities to acquire secondary data, for example credit card data is very popular now, but it and web scraping tools and similar didn’t really exist then, unless you did the scraping manually (which I used to do frequently, although on a small scale).
My young friend was surprised when I suggested that IPOs were a fruitful area of research. Clearly, there are fewer companies coming to the market today and a lower level of market cap in flotations, especially in the US, but I think there may still be opportunity today, particularly for the global investor. Let me explain, but first let’s look at the state of the IPO markets.
Before doing that, a quick question from me. I shall restart my zoom-based Forensic Analysis Course cohort in September (email me to get on the waiting list) and I have mentioned my one-day Forensic Analysis Workshop in New York on Thursday July 24.
A few professional analysts have asked me to run a course on how to pitch a stock to their PM, and a few investors have asked me to run a course on how to analyse a company more effectively. I am thinking of running a cohort over Zoom in the autumn/fall, say 6 weeks with sessions of 60-90 minutes each, at 18.00 London time. If you are interested in developing your analytical skills, please email me at info@behindthebalancesheet.com and tell me your particular interests. I shall then develop the curriculum and give priority to those respondents. Thanks.
The IPO Opportunity
There are fewer IPOs in the US today and the long-term trend is certainly down:
US IPOs
Source: Jay Ritter Warrington College of Business, University of Florida, excludes smaller stocks
Homing in on the more recent picture, the opportunity is clearly less attractive than say, 15 years ago, especially in the context of the much larger market capitalisation today:
Recent US IPO Trend
Source: Jay Ritter Warrington College of Business, University of Florida, excludes smaller stocks
The average raised in this period was $43bn in 125 issues but ex 2021, notable for the number of SPAC deals, the averages come down to $28bn in 88 deals. There must still be the odd opportunity, but I would be hunting in the rest of the world.
Global IPOs
Source: EY, Dealogic
There were over 100 IPOs per month last year, not far off the 1450 10-year annual average. They raised $123bn last year, which is c.$10bn/month, so not an insignificant sum, although I haven’t investigated how much of this is hot tech IPOs where allocations are impossible. But there must be a few good opportunities.
The Attraction of IPOs
At the hedge funds, I trawled IPOs looking for the occasional buying opportunity and I found lots of good shorts over the years. There were two reasons I was attracted to IPOs. First, there is an opportunity to make decent incremental returns, often with little effort and limited risk. As a big fund, you could pressure an investment bank to allocate stock in a hot IPO and make some “easy money. If it’s massively over-subscribed, you are unlikely to lose money. You won’t make much either, as you won’t get much stock, but it’s easier than finding the next investment idea.
Capital velocity is high – you can be out on the day. Note that this isn’t compatible with a low turnover fund, as you are unlikely to trade 0.5% of the fund weekly. But if you do that say once a month, and make a 20% turn 80% of the time, you add 1% to performance. In good IPO markets, that’s quite feasible and not that difficult.
Second and more important was my lack of knowledge. I had transitioned from being a buyside analyst with deep sectoral expertise to being a global special situations investor. My job was to go anywhere, across any sector I chose, and find stocks with a highly skewed risk-reward ratio and limited downside. We weren’t seeking 5-baggers, although this occasionally happened, but to make 50% in 1, 2 or perhaps 3 years.
When I went into a stock, I was usually buying it from someone who had owned it for years and presumably knew it much better than I did. Of course, we could have different views on the future and it was possible that they were selling it for portfolio reasons or because they couldn’t bear any more pain; I was often catching falling knives - stocks which had been in decline for some time - where I had spotted an upcoming change in their fortunes. And I wasn’t trying to catch the bottom, as our position size forced us to be early.
The problem with this strategy is that I am not that smart - how likely was it that an experienced investor who had owned the stock for years would have missed the opportunity that I had identified? Far more likely, they too had spotted the opportunity and had dismissed its impact on the perceptions of the stock. Of course, I was often right (or lucky), but my structural disadvantage always made me uncomfortable.
This attracted me to IPOs. Because when a new company comes to the market, particularly if it’s an unfamiliar sector, there is no information disadvantage – none of the market players know the stock in any detail. Of course, especially today with larger private markets and funds investing in both public and private, there will be occasions when a sector analyst knows the company. But in general, it’s a level playing field and one in which I felt the smart and diligent analyst could create an information advantage. Hence I used to spend a decent portion of my time on IPOs.
This wasn’t something unfamiliar to me – when I started in the City, I sat in the research department but was paid by corporate finance. I did a lot of the work on upcoming IPOs, especially where we didn’t have an analyst or where the analyst was too busy.
I became an expert in privatisations which were/are often given away at a wide discount to intrinsic value as the goal is mainly wider share ownership; governments are less bothered with maximising proceeds and more worried about a flop. Management are incentivised to talk the price down, as are the selling banks. Such issues are often bargains, although it can be hard to acquire a decent position as a large fund.
My Approach
First, I should introduce the concept of the IPO cycle. There are times when you can sell bad companies at inflated prices – think 2021 – and times when you can barely sell anything – think post the GFC in 2008/9. That sets the context for your research. In times like 2021, you only want to look for shorts. In times like 2008/9, you can find real bargains.
Shorting is more difficult in IPOs because you have to get the borrow and in many jurisdictions this can take some time to be available. In India, which was one of my favourite hunting grounds, unfortunately the stock has to be registered and this can take weeks. This was disappointing as there were some classic cases of massively over-hyped IPOs.
I recall one flotation, where as a valued client, we were “privileged” to get access to the analyst. This was an issue from a bank with a particularly weak quality control in Equity Capital Markets, and it was soon obvious that the analyst was clueless about the profit potential and hence the correct valuation of the business. Our meeting lasted about 15 minutes, as when I asked him about one valuation measure, I was convinced that the issue was pure hype. So it transpired – a massive over-subscription and a big gain on the day, but there was little follow through; once the excitement subsided and the first set of results created a reality check, the stock ended up halving fairly quickly and then continuing to decline.
Long opportunities are rarer. Many IPOs are sold at too high a price and it’s rare that a vendor will be willing to give up equity at a bargain valuation. The owner knows how much the company is worth and will only sell at a discount if they really need the money. In those cases, there can be a real opportunity, especially in the lean part of the cycle.
Of course there is a risk in doing a lot of work that you may not get much stock, but there is always a risk that a quoted stock may run away from you. You can stack the odds in your favour by targeting stocks institutions avoid:
The nature of the business: I wrote about OnlyFans last week, which got a lot of attention, not all the right kind. I perhaps wasn’t sufficiently loud in my disapproval, as several women unsubscribed. And one reader sent the article to my wife who made her views clear. And that’s the point – you are more likely to get a bargain in something unpleasant or awkward. One of the students in my online school sold his fish processing business. He had started in university and made a lot of money as the conditions are unpleasant - night work, smelly and uncomfortable; he continued and made a fortune. Nobody wants to go on that type of company visit so those types of IPOs are more likely to be priced to sell.
Management have some associated stigma. I wrote in my book about Teddy Sagi who floated Playtech in London in 2006. He had been convicted in Israel for fraud and bribery ten years earlier, and was sentenced to nine months in prison, but was released after serving five months. Institutional investors are not queueing up to invest in founder CEOs with prison records. Investing in such a company might be highly profitable, but leaves the professional investor with no defence if it turns out to be a fraud, or underperforms significantly; their superiors or their investors will have little sympathy if they incur losses in a company which has such an obvious black mark, so why take the risk? These are ideal setups. I remember one former convict founder, not involved in the day to day management, being positively scary – he didn’t smile and was really intimidating. We made huge returns on that issue.
The attraction is that you can often make good money quickly. If you just flip in a day, you have not really tied up any of your scarce capital. Even if you hold the stock for a few months, you can make annualised returns of over 100%; a 40% gain in a 1% position in a few months comes in quite handy and doesn’t use much of your scarce resources - capital and analyst time.
And even if you do the work and are unable to get enough stock at a good enough price, you now have some expertise in a stock which is not widely understood and that can pay off at a later date if there is a mis-step, or if the price races up too quickly.
It’s important to scrutinise closely the rationale for the sale. My ideal setup is a company coming at a bad point in the market cycle which really needs the capital to invest in new capacity. A new product or geographic expansion are also good reasons but are riskier. What I look for is a founder CEO who really doesn’t want to issue shares at this price, but is compelled to, in order to increase market share, because demand for his product is greater than can be satisfied from his existing capacity.
This type of IPO can get you in on the ground floor and you can enjoy the ride for years after. The founder will be grateful to you for your support and you will enjoy a close relationship. You will know much more than the average investor because you start with an advantage and your involvement with the stock means you can widen that knowledge gap over time. On one occasion, that advantage meant that I was the only investor to twig that our investee company was uniquely advantaged, as its competitors in one business were all about to suffer a rise in input costs.
I increased my profit forecast two and three years out – doubling and trebling them - and none of the sellside had even spotted the opportunity, let alone the buyside. This was a multi billion company. You don’t often get setups like that, but we made a fortune on that one trade – more money than most funds manage. And it wasn’t that I was super smart, it just came from being involved in a business from the start, when it wasn’t on most investors’ radar. Such opportunities are doubtless rarer today as the investing field has become more competitive, but recent IPOs are likely still a good hunting ground for this type of opportunity.
Conversely, beware of the private equity seller – often they will have shopped the business around potential acquirers in the industry, around all the other p-e funds, exhausted the continuation fund options and have chosen an IPO as the last resort. My good friend Al is one of the sharpest investors I know; when he ran his hedge fund, he used to short every p-e sponsored IPO that came to the market. He didn’t even care what they did. He had a very high hit rate.
Sometimes, the initial work is a waste of time as the IPO does not proceed. A case in point was WeWork in 2019 – here was a company which some of the biggest and most respected US investment banks valued at $50–100bn. It failed at $20bn and at $10bn, as investors did not believe the more ambitious valuations. In my view, it was never a tech stock and that was the primary reason the flotation did not proceed.
It’s also worthwhile looking at the IPOs of competitors to any investee companies you own. Often, information is given away in the process and you can glean a new perspective on something you own. That can come from the analyst IPO research and roadshow or from the company’s own IPO roadshow, although those are generally tightly managed by the sponsoring banks.
I had a different approach to those meetings. Sometimes we would be brought in at the start of the process as they tried to secure a cornerstone investment. More normally, management would have had quite a bit of practice and by the time they came to see us, they had answered all possible questions and of course, they had the obligatory slick PowerPoint. I would not listen to their presentation, but would scan the pitch deck silently (often you were not allowed to keep this, so I might take a few notes). I could usually process the deck quite quickly and would then interrupt the presentation and start asking questions.
My first question was always, “Can we please start by your explaining why you want our money and why we should give it to you?” This innocuous question can trap a surprising number of CEOs. Going off-script like this can create some amusing incidents. The chairman of one Indian IPO was the son of the founder and clearly knew little about the business.
When I started this questioning, he was totally lost, and the highly experienced CEO (and large supporting team) refused to say anything, presumably because they were more scared of making their boss look bad than they were interested in the success of the issue. I have found this technique, of forcing the company to abandon the script and answer real questions, to be really effective.
Not convinced? You might want to take a leaf out of Sir Chris Hohn’s book: founder of the Children’s Investment Fund (TCI), one of the most successful hedge funds in the world, he has had repeated successes with privatisations where he has seen a good company being sold off cheaply and the management freed of political shackles. He has made fantastic profits with the privatisation of Australian railroad Aurizon and Spanish airport operator Aena. He did less well with Coal India and Royal Mail in the UK, but profited handsomely from the reduced role of the state at Airbus.
Conclusions
My conclusion is that IPOs are worth a small part of your time, because they offer an occasional opportunity for outsize reward, particularly if you can go both long and short. Such issues are less frequent these days. Increased pressure on private equity, as I have written about several times, might force more flotations going forward. And IPOs do still happen, especially in Emerging Markets, and might be worth exploring.
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