Investing in private capital raises and initial public offers (IPOs) are high-risk, potentially high-growth strategies. Of the 113 IPOs to list on the ASX in 2017, the average return was 61.6%. This compares to an average return of 25.4% for IPOs in 2016.
Lately I've seen an increasing amount of early stage investment opportunities pass by my desk. This has coincided with noticeably more conversations with founders seeking capital. While some of these investments look like they've got potential, many quickly end up in the recycling.
If you plan to invest into a private capital raising or public float, what are the markers of a good investment? Here are seven considerations to keep in mind that may increase the probability of achieving a good outcome, and avoiding a painful one.
1. Who is selling?
Are the founders looking for a succession plan or money to fund the next stage in their company's journey? Or is it a private equity fund looking to cash in?
Private equity IPOs follow the same rules as the rest of the market – though they tend to be larger. In terms of performance, they are a mixed bag with more than a chance of gaining in value.
However, after the Dick Smith debacle, investors will be demanding private equity sellers to retain a larger equity stake (and to hold on for longer) than in the past to protect against a ‘take the money and run’ scenario. So, if the IPO is from private equity, find out how much of a stake they are retaining in the company.
2. Who will run the company?
Take a close look at the directors and managers and their track record. Do they have prior experience in the industry? How long have they been with the company? How much are they being paid? How well rounded is the board? Retaining skin in the game is a very good indication that management is motivated to do well.
Keep an eye out for the less obvious. For example, some small companies combine chief executive and executive chairman roles, which saves money but leaves a lot of power with one person. Conduct your own due diligence, including searching google. One negative event may be an innocent misunderstanding but several negative events is a red flag.
3. What are they going to use the money for?
Companies that seek to raise funds from investors should clearly state how those funds will be used.
Learn how the company will generate or expand revenues to increase the value of the shares you are buying. How will growth be achieved? Is it likely this growth be realised before they require further require a cash injection?
Also keep a lookout for anything that will benefit third parties, such as excessive fees being paid out to advisors, as occurs in some floats.
4. Do you understand the business?
The Oracle of Omaha, Warren Buffet, tells us never to invest in a business you can’t understand.
It is simple yet integral advice, and something to keep a close eye on when investing. Understanding the product may be particularly difficult when it comes to technology stocks and their love of acronyms.
The lesson here is that if you don’t understand it, remember, it’s not you, it’s them. Companies should be able to clearly articulate what their product or service is and why they have a competitive advantage.
5. How big is the market?
The size of the opportunity and the company’s ability to capture market share can make all the difference when it comes to growth and shareholder returns. Keep in mind that the size of the market is only an estimate based on many assumptions. These assumptions need to pass the reasonableness test.
For instance, say a company is selling products and is targeting high-income households. Assess how likely high-income households are likely to buy these products before accepting that the market size is equal to the number of high-income households. Are there substitutes? Is there a problem being solved? Do existing trends support the assumption that high-income households will want to buy the product or not?
6. Is the valuation reasonable?
The initial valuation of the company is one of the most significant predictors of financial gain for a capital raising. Often these valuations are based on unrealistic expectations of future market share or are not backed up by progress being made towards revenue generation.
This is sometimes difficult to determine, particularly with technology companies or mining companies who have limited history and no revenue, but huge potential. However depending on the idea, these companies can be the best performing investments.
7. How is the offer structured?
If the size of the market looks promising, the management are experienced and are solving a genuine problem, then it could be a great opportunity.
But if the offer is structured so that options, convertible notes or performance shares will automatically be issued to the seller at a future date, this may dilute your shareholding. Remember, each share you buy represents your piece of ownership of the company. The more shares there are on issue, the less value each one represents. So it’s something you should pay attention to.
Where you can manage inherent risks of this end of the risk/reward continuum by doing your own research, you will be much better placed to avoid the all too common disappointment from a failed investment.
To those who are looking to invest or have a business considering raising capital, don't hesitate to reach out for a conversation.
