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Phil Harris, manager of the UK Equity Growth Fund, looks at Aston Martin and Funding Circle as two recent examples that remind us of the potential pitfalls of investing in IPOs. Given the late stage of both the economic and IPO cycles, what should investors really be looking for in new issues?

Investing in late cycle IPOs

Phil Harris Phil Harris Fund Manager
Investing in late cycle IPOs
Opinion

Investing in late cycle IPOs

Phil Harris

Phil Harris
Fund Manager

Given the late stage of both of the economic and IPO cycles investors should expect a lowering of the overall quality of new issues as private equity and corporate sellers take advantage of strong markets to off load their weaker investments at premium prices.  While there are lessons to be learned, basic investment principles should help investors differentiate between quality entrants to the market and potentially wealth-destructive new issues.

The recent market plight of Aston Martin and Funding Circle are stark reminders of the potential pitfalls of investing in IPOs – with the stocks down 69% and 73% respectively since flotation in October 2018.

In the case of Aston Martin, while the company creates desirable cars, there were a number of alarm bells for investors. A blue chip roster of investment banks brought it to market at a value of £4.3bn – which was excessive considering it had previously gone bankrupt seven times and was lossmaking for six years until 2016. It was valued at multiple times what its shareholders paid a few years prior.

Automakers are also notoriously cyclical, and even small adverse moves in volumes can magnify into significant profitability changes. Only 10 months after the over optimism of its IPO Aston Martin’s stretched balance sheet will now need further equity funding to enable it to launch its new products. We expect shareholders to experience further pain.

If investors stick to the basics, there are many examples of highly successful IPOs in the UK market over recent years – such as drinks group Fevertree, software company Blue Prism and premium chocolate supplier Hotel Chocolat. 

Funding Circle came to market promising to transform traditional small and medium enterprise funding. Such was the initial enthusiasm for its industry-changing concept, the IPO price for the strongly-growing – but significantly loss making – company was at more than 8x enterprise value/sales.

Rapidly growing financial lending businesses rarely succeed, as systems – either paper-based or digital – cannot keep pace with surging lending volumes and struggle to cope with basic risk issues.

Funding Circle’s subsequent significant growth slowdown resulted from a tightening in underwriting criteria. Its slowing growth has also been blamed on heightened economic uncertainty, but this does not seem to have impacted other banks. Therefore, it speaks to wider issues in Funding Circle’s business model, a business yet to be tested in a downturn.

When investing in an IPO, we have identified a number of red flags – including the speed of the process, the lack of proper access to management and scarcity of independent research. Like any potential investment, the normal rules apply when considering IPO’s – they just have to be applied even more diligently. Investors should seek great businesses displaying strong growth potential, those exhibiting high and sustainable margins, as well as profits that convert into cash.

A margin of safety on valuation is also important. To maximise the chances of success, forward-looking forecasts for the company undertaking the IPO ideally should be conservative – as unrealistic estimates are only useful for boosting the proceeds for exiting private equity holders.

If investors stick to the basics, there are many examples of highly successful IPOs in the UK market over recent years – such as drinks group Fevertree, software company Blue Prism and premium chocolate supplier Hotel Chocolat. These are all companies that, at IPO stage exhibited these strong fundamentals and since then have gone on to achieve rapid and sustained growth, with early investors reaping the rewards over the long-term.