Navigating IPOs: Opportunities and Pitfalls – Insights from Nishit Lakhotia, Group Head of Research

Initial Public offerings (IPOs) provide an opportunity for smaller investors to participate in the growth of the broader economy and are an effective tool to diversify wealth for investors. Participating in IPOs can not only help build wealth over the long term, but also given the dividend centric approach by issuers, it can also help generate regular income. The recent IPO flurry within GCC markets has generated strong short-term returns with approximately eight out of 10 listings (since 2022) being positive and beating benchmark returns in the initial weeks post listing.

. A vibrant primary market is an important enabler for the issuing company to raise funds and/or selling shareholders to monetise at reasonable valuations. Furthermore, diversified capital markets attract international fund flows which can improve the dynamics of the listed companies and valuations. However, despite the positives and likelihood of making quick money in the short term, not all IPOs perform well after listing and accordingly, below are some important pitfalls to avoid before deciding to invest into an IPO.

1. Sustainability of Dividends – Investors in the GCC particularly love dividends and many IPOs are now using the dividend incentive effectively or even at times innovatively to raise funds at higher valuations. While there is nothing wrong with companies promising a certain payout or absolute dividends, the payout should be sustainable in the medium to long-term. Considering stocks tend to get priced in terms of the sustainability of dividend payouts over the long term, any offers on higher than sustainable dividends being promised initially should be assessed carefully. Such dividends tend to be paid at the expense of the majority shareholder (selling shareholder) compensating their share and may not be sustainable.
2. Oversubscription does not guarantee strong listing – During the book building period, numerous media articles on strong demand and over subscription multiples can influence investors who are evaluating whether to invest in the ongoing issuance as well as on the size of the bid. This can be misleading and there are multiple instances where companies with record over subscription levels have had poor listing and subsequent stock underperformance.
3. Inadequate consideration to one-offs, recent accounting policy tweaks or balance sheet changes – At times there is debt added and/or excess cash paid out as special dividends prior to listing. There are also instances where depreciation policy tweaks or provision reversals are done which can boost profits in recent financial years. In addition, factors such as corporate tax introduction (relevant for UAE companies in 2024) or costs from a new corporate structure for listed entity (general and administrative) should be considered. Accordingly, previous earnings performance may not be a good indicator of future earnings potential.
4. Ambitious Growth strategy, particularly for offer for sale - While the analysis of a company’s growth strategy is relevant in all IPOs (primary / offer for sale), it is particularly important in ‘offer for sale’ issuances where the company undertaking the IPO does not receive any new funds. Accordingly, if management expects growth to be significantly better than previous years, one needs to assess how pragmatic those assumptions are, what has changed and why the company did not opt to raise fresh capital to fund this growth. There is a natural temptation to overstate the growth prospects to justify premium valuations.
5. Insufficient analysis of shareholder profile –Background of shareholders plays a pivotal role in determining the credibility of the company and the valuations they are seeking from investors. Some independent research on the shareholder profile is essential in deciding the risk profile of the entity. A quick check on any corporate governance issues, past performance of other related entities of the shareholders can help investors in making informed decisions on the IPO and avoid companies where the shareholders track record is questionable. Companies with government ownership (direct/ indirect) is generally positive.

Some other aspects to consider would be relative valuation versus growth, receivables profile (ageing and provisions), related party transactions, regulatory and legal risks. I also recommend focussing on any major volatility of earnings in the past 2/3 years’ financials (if available), doing a quick analysis on IPO expenses as a % of the offering, evaluating how they are expected to be expensed and over what time period. From a listing perspective, the appointment of a stabilization manager for the stock post listing is a positive.

In an ideal world, IPOs are done at some discount to fair value such that participating investors are rewarded once the stock moves towards its fair value post listing. However, it is not an ideal world, so do be diligent.