What does IPO stand for? ‘It’s probably overpriced’

Right now it seems that every other week another household name goes and lists its shares on the stock exchange.

This week it's the AA. But there'll be another along shortly, no doubt the London market is positively saturated with initial public offerings (IPOs) at the moment.

It's great news for City stockbrokers. The day-to-day business of trading shares doesn't make much money these days. But the chance to float a company on the stock exchange comes with the promise of fat fees in return.

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Based on what's been going on lately I reckon there'll be some big bonuses paid out come the end of the year. So they'll be cracking open the Bollinger.

But what about you? What about the private investor? Should you be buying into these IPOs?

Here's my simple rule of thumb when it comes to IPOs, and it's served me well: unless it's the government who's selling, steer well clear.

There will always be a few exceptions to this rule. But more often than not, the needs of private investors aren't first and foremost in the minds of the selling shareholder in an IPO. Most of the time, they are just trying to get the highest price they can for their company.

The smart guys are selling up

Now, these companies are supposedly stuffed to the gills with money masters. Armed with their MBAs and financial toolboxes, they are ruthless in their pursuit of financial alchemy.

Not that anything too clever goes on with many of the companies that they run. Yes, some private equity firms do make businesses more efficient. But a lot of financial engineering has gone on too. That's how private equity firms make money.

Too often, financial engineering in practice means that costs have been slashed, investment cut to the bone, and the business is being run to generate cash. It is then loaded up with lots of debt.

What the private equity firms are trying to do is to earn what is known as a high internal rate of return' (IRR) on the equity they invest. The maths behind this is actually rather simple. The return they get is based on the equity they invest at the start (the smaller, the better); the cash flows from the business during the time that they own it; and how much they can sell it for a few years down the line.

It's not unlike a buy-to-let property. You buy a house with as small a deposit as you can, earn enough rent from it to repay the mortgage costs with a bit on top hopefully, then sell it once the price has (again, hopefully) risen.

So what's all this got to do with IPO prices?

Well quite a lot actually. In days gone by, a good IPO always left something on the table for the buyer of the shares. This was done to ensure a good aftermarket' after the initial flotation had finished.

But by far the biggest bit of the private equity company's return (the IRR) comes from the selling bit at the end. This is why buying shares in an IPO from a private equity is often a bad thing to do. They are trying to get the best price they can. They are not really bothered about the aftermarket'. It's all about them getting the biggest return they can, which in turn means bigger fees and bigger bonuses.

On top of that you might well be paying a ridiculous price to buy the equivalent of a used car that's not been serviced for years with a load of outstanding finance on it. Companies like Premier Foods a few years ago spring to mind here.

The performance of recent IPOs

Now, perhaps Royal Mail was a little too generous, but if you look at some of the recent IPOs coming from private equity sellers, not much money has been made by the buyers yet.

Yes, it's very early days for some of them, but the fact that so few are above their offer prices lends weight to the view that the seller cashed out at a very good price.

So if you get a call or email from your broker telling you about the latest hot IPO, ask them who's selling. If it's a private equity company, I'd leave well alone it's probably overpriced.