Secrets Of An IPO Trader

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By Mercenary Trader :

With the much anticipated (and relatively successful) pricing of Groupon Inc. ( GRPN ) , attention is once again turning to the IPO market.

A number of investors have noted serious fundamental concerns with GRPN ( ourselves included ), and yet the stock opened sharply above the offering price - netting investors lucky enough to get in on the deal a handsome one-day profit. What gives??

Ironically, when it comes to the success of an IPO - especially a widely publicized IPO like Groupon - the initial success is much less about the fundamental quality of the stock, and much more about how the IPO transaction is managed . For the first few days of a stock's public life, the price is determined largely by how well underwriters drum up demand from institutional investors, and how much stock they actually offer on the deal.

Whenever a high-profile IPO like Groupon is priced and initially gaps higher, there is a general outcry that the shares were allocated to "preferred clients" while the majority of individual investors were unable to participate. To be quite honest, this is a relatively accurate assessment … As an individual investor, your chances of bagging shares of a hot IPO are slim.

But at the same time, institutional investors who receive allocations of hot IPOs aren't always as lucky as you may think. There are usually politics, restrictions, and significant risks that come along with IPO allocations - and in order to take those risks, managers must have a good shot at capturing profits when they agree to accept IPO shares.

In a former life, I managed a fund that focused exclusively on IPOs and secondary offerings . The IPO game is challenging. It requires a lot of research, attentiveness to both buy side and sell side psychology, and a Rolodex full of contacts - but if you can develop skill in this business, IPOs can add significant incremental value to your fund or advisory.

The Untold Risks of IPOs

Let's get one thing straight to begin with … IPOs are risky animals . During the first few months of a stock's existence, price trends are fickle, traders are hyper, and there are plenty of games being played behind the scenes. If you decide to manage a basket of IPOs as part of a hedge fund strategy, just know that you can't turn your back on these stocks for a moment.

But with volatility and risk comes profit … or maybe I should re-phrase that …

With volatility and risk comes the potential for profit … much better.

The IPO game is rigged to offer participating managers a profit. It must be that way! If I wasn't compensated for taking the risk of owning a brand new stock that had no trading history and significantly less liquidity, then I would never participate in an IPO transaction.

If managers decide that the potential returns in participating in the IPO market aren't worth the risk, they simply won't deal. IPOs won't get priced, and that means smaller companies won't get access to capital - leading to slower economic growth, less job creation, and a more difficult recovery. So we actually WANT IPO transactions to be profitable for managers - this keeps the wheels of finance turning and allows companies to access capital markets.

Ok, I'm stepping off my soap box now. Let's take a look at a couple of high-profile IPOs from the past decade.

Vonage Holdings Corp. ( VG ) issued their IPO on May 24, 2006. I remember the deal well as I received a boatload of stock on that deal ( more on allocations later ). There was a lot of hype surrounding this deal because Vonage was the leading firm offering Voice Over Internet Protocol - or VOIP. The expectation was that Vonage would take over the telecom world and everyone would be using their service instead of a local telephone line.

Of course, the flaw in this logic was that other companies could offer VOIP too - including cable companies that already had relationships (and installed lines) with a majority of customers. The IPO hype was soon hit by the cold-hard reality of competition.

In the first few minutes of trading, VG appeared to be ok. The stock briefly traded slightly above $17. But then the sellers emerged and VG was history. On the first day of trading, VG lost 15%. On the second day, it closed 24% below the offering price. And a year after the IPO, VG had lost more than 80% of its value.

Below is a 60 minute chart of the first few days of trading. As you can see, IPOs can offer sensational risks as well as sensational returns…

(Click to enlarge)

On the positive side of the ledger, Chipotle Mexican Grill ( CMG ) comes to mind as an exceptionally profitable IPO. The Chipotle transaction was particularly memorable for me because of my lack of participation.

I distinctly remember driving to a meeting the morning the stock debuted - yelling at "Dave" who only came up with a few dozen shares for our account. This after "playing the game" for months and directing plenty of business his way.

And that's the rub when it comes to IPO transactions. You never get enough of the good ones, and you tend to load the boat when a deal is busted . That's the nature of this market and the challenge for any manager taking allocations in these tricky securities.

CMG came out of the gate strong. The offer price was $22, and by the end of the day, the stock had doubled in value. Great news for the few blue-chip funds that received their full allocations - but disappointing for mid-tier funds that couldn't strong-arm their investment banker contacts.

(Click to enlarge)

Chipotle would eventually make a run to $150 - a move that my fund caught a big piece of. So the profits were still attractive, but the example goes to show how hard the IPO business can be - even when it's working the way it should …

Still interested in trading the IPO market? Well there are a few key principles you need to apply:

Getting A Shot At IPO Allocations

The first thing you need to know if you want to get involved with IPOs like Groupon or Chipotle is that you take every deal that comes down the pike .

That's right … You take the boring ones, the IPOs with hair all over, the ones you know will turn out to be duds - just so you can get your hands on the gems when they are available. We'll talk about how to hedge your bets and protect your capital in a minute. But just know that if you're not willing to take a hit with Vonage, you're never going to see a single share of the really good IPOs.

Here's the reason: Investment banks have a business to run. Their job is to bring companies public and collect fees for finding investors. If they have a reputation for "getting deals done," then they can continue to court new clients. However, if they fail to find homes for the mid-tier IPO companies, they're not likely to get a shot at participating themselves when Groupon decides to sell shares to the public.

So as a manager, you develop a reputation with the underwriter as a "team player." You tell him that you will scratch his back when he needs a home for some busted IPO dog - but that you want to participate when the deals are good too. Underwriters LOVE clients like you. It's still a hard business, but you're well on your way to getting some decent allocations.

Second key concept: Hold the IPO stock for at least 30 days . This may seem like a suicide mission, but it's important for your relationships. You see, Dave (your broker with Morgan Stanley or Credit Suisse) has to play his own political games to get stock for his clients. And the underwriting department needs to know that Dave is placing his allocations in "strong hands." They want to know that you will help them support this deal in the first few weeks of trading.

The worst thing in the world for you at this point is to be tagged a "flipper." A "flipper" is someone who takes a hot IPO and flips it out at a profit in the first few days of trading. Don't be one . You'll never see a good IPO again. In fact, you can really help your chances by calling Dave up after the deal has priced and buying MORE stock in the aftermarket. Now Dave gets to go to the underwriting department and brag on his client who is actively supporting the stock. Now you're a hero!

Third thing to keep in mind: Participate in Multiple Lines of Business . Remember, Dave has to present YOU to the underwriting department as a valuable client. If you're providing revenue to their company from multiple sources, you become more valuable.

Other lines of business can include margin loans, fixed income commissions, equity transaction commissions, structured products etc. Of course you are always protecting your capital, but if you can find a way to work in additional revenue lines, you'll be golden.

Tricks of the Trade - Managing Allocations

Up to this point we've talked exclusively about how to GET allocations to IPOs. But what happens when you have an account full of new stocks that may or may not be moving in the right direction?

One important factor is to have a GOOD prime broker where the majority of your funds positions are held. ( Mercenary Trader uses TradeStation Prime Services as our prime broker and they are a sponsor of our site.)

There are many important issues to consider when picking a prime broker including margin rates, commission rates, access to seed capital etc. In terms of an IPO strategy, we also need to have a prime broker with a strong short desk - making it possible to short IPOs within a few days of the offering.

Once you have a good prime broker, you need to start pressuring your broker to give you some stock in a DVP account (Delivery Versus Purchase). This basically means that instead of receiving your IPO allocation in a Morgan Stanley account, at least some of the shares are delivered to your prime broker.

Now you can sell part of your IPO immediately - without Dave knowing that you didn't hold it for an entire 30 or 60 days. Meanwhile, you're still holding half of your allocation in the account at Morgan Stanley - like a good little client. You're banking brownie points for the next IPO that you want to participate in.

If you're truly worried about an IPO - say Vonage is breaking down and you've got 30,000 shares left at Morgan Stanley you might have success shorting the stock at your prime broker. Imagine being short 50k shares at TradeStation Prime Services, while holding 30,000 shares long at Morgan Stanley.

You can call Dave up and yell at him because the deal is tanking. You can explain exactly why you are still holding the stock (out of respect for him and your "gentleman's agreement"). And you can remind him that the next time you ask for shares of a Chipotle or Groupon - he had better come through!

Meanwhile, you're booking a solid profit on the short side of your book and your investors are loving your returns.

A variation of this strategy is possible with secondary offerings (when a publicly traded stock raises more capital by offering new shares). Nearly all of these deals price "in the hole" - or below the previous close. And usually you have a day or two of warning between the announcement and the actual transaction.

You can typically short the stock ahead of the deal, and then get Dave to give you an allocation in the secondary offering. You can't "cover a short with deal stock," but if you close out both positions later at a similar price, you can usually book the difference between your short price and the deal stock you bought "in the hole."

Tracking the Calendar

There are periods where IPO and secondary offerings are scarce and deal flow is very slow. And then of course there are periods where up to a dozen deals (IPOs and secondary offerings) price each week.

During the high-volume periods, following the deal calendar can be a full time job. In fact, you might consider allocating a full-time analyst to this area with a mandate to track the deal flow, manage exposure and risk, and maintain a healthy relationship with multiple underwriting firms.

As the IPO calendar heats up, new opportunities are arising for professional and semi-professional traders, IPO transactions can yield healthy returns - while still managing the material risks of these type transactions. The key is developing relationships and playing by the rules of the game. Over time, you can build your reputation and increase your influence with the underwriters.

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This article appears in: Investing , Stocks

Referenced Stocks: CMG , GRPN , VG



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