The legend of investing in IPOs

Many investors know someone who has invested in an Initial Public Offering (IPO). This can become the stuff of IPO legend: "If only I'd bought shares in that company when they first went public. With just a $10,000 investment, I'd be a millionaire!"

To use a baseball analogy, the IPO legend tends to draw attention to the home runs but divert attention from the batting average. In this article, we'll discuss how IPOs have performed as investments, trends associated with stronger IPOs and strategies to invest in IPOs.

Three-year performance

Let’s look at various studies on the performance of IPOs three years after launch. A study of IPOs in the United States shows a wide range of performance¹: 

Longer-term analysis based on U.S. data from 1980 to 2022 paints a similar picture, with IPOs typically underperforming the market by 19.6% three years after launch.²

The Canadian IPO market shows similar three-year post-IPO results. Based on data from 1986 to 2012, an equal-weight investment in Canadian IPOs underperformed a small-cap benchmark by an average of 6.3% and a broad market benchmark by an average of 14.9%.³ Large issuers reporting profits were the only set of companies that provided reasonable returns, but they made up a small minority of Canadian IPOs.⁴

First-day performance

Three-year post-IPO performance is even lower than it seems, since it includes the effect of a first-day "pop". Based on IPO data in the U.S. from 1980 to 2023, the mean first-day return was 18.1%, while the median was 7.0%.⁵ These first-day returns assume that investors were able to get access to the IPO at the offer price, which is not always possible. And the pop can easily fizzle out. About one-third of IPOs fall on their first day of trading, compared to their offer price. About half of IPOs fall on their second day of trading, compared to their first-day closing price.⁶ 

The Canadian first-day IPO return was much smaller than in the U.S., ranging from a mean of 1.5% to 6.7%, based on three studies. First-day returns for Canadian IPOs were among the smallest of any country where a formal study has been conducted.⁷

While the average long-term performance of IPOs has not been impressive, the average covers a multitude of new companies. We now explore some of the trends associated with stronger IPOs. In this section, we focus on the IPO market in the U.S., since it is the largest in the world and has been extensively studied by researchers.

High revenue versus low revenue

In a study of IPOs from 1980 to 2022, Jay Ritter, a leading scholar of American IPOs, has found that revenues, more than profits, were strongly associated with post-IPO performance. Companies with revenues of less than $100 million underperformed the market by 33% three years post-IPO, while companies with revenues of more than $100 million underperformed by a much smaller margin of 2.3%.⁸ Profits matter over the long term but a large majority of companies are now unprofitable at the time of their IPO.⁹

Technology versus other sectors

There was a wide gap in performance between technology and non-technology IPOs. Based on Jay Ritter's data from 1980 to 2022 — excluding the internet bubble of 1999 to 2000 — tech firms outperformed the market by 26.7% three years post-IPO, while non-tech firms underperformed by 14%. These results are based on the offer price of the IPO.¹⁰ When results are based on the first-day closing price, both tech and non-tech firms underperformed the market, although tech firms underperformed by a much smaller margin — 4.4% versus 24.9%.¹¹

Underwriting versus SPACs

Companies are traditionally listed through an underwriting process, in which investment banks market the offering to institutional investors, whose level of interest sets the offer price for the listing. Over the last decade, an alternative listing method has emerged: the Special Purpose Acquisition Company (SPAC). One can think of SPACs as similar to reverse takeovers — a way of listing on public markets through the back door, rather than through the front door of the underwriting process. Based on data from 2012 to 2022, SPACs underperformed the market by 74.7% three years post-listing.¹² This indicates that the quality of the listing process may provide clues about the quality of the public company.

So far, we have discussed two strategies for investing in IPOs: investing at the time of IPO and holding for three years or more; and investing at the time of IPO for a short-term "pop". Another strategy is a "wait-and-see" approach, based on investing 6 to 12 months post-IPO. The rationale for waiting includes: 

• The IPO lock-up period — which restricts founders and other company insiders from selling their shares — typically expires six months post-IPO. Waiting until the end of the lock-up period can help investors assess the underlying demand for the company's shares, after insiders have sold.
• Waiting 6 to 12 months provides for several quarterly reports. This enables investors to see if the company's performance as a public company lives up to its IPO promise.
• Not all gains happen right away. When IPOs perform well three years after launch, a fair share of gains may come from years 2 to 3.

These strategies are some of the possible ways to think about investing in IPOs, including not investing in IPOs at all. Deciding whether or how to invest in IPOs depends on your investment objectives, time horizon and risk tolerance.

• IPO performance has typically lagged the market three years post-listing, both in the U.S. and Canada. First-day returns have been positive on average, and typically much larger in the U.S., although highly variable.
• IPO trends associated with stronger performance, based on U.S. market history, include whether the company had significant revenues at the time of listing; whether the company was in the technology sector; and whether the company was listed through a traditional underwriting process.
• IPO strategies include investing at the time of IPO and holding for three years or more; investing at the time of IPO for a short-term "pop"; and investing 6-12 months post-IPO with a "wait-and-see" approach.