A private equity-backed initial public offering (IPO) is the first sale of a firm's securities on the stock market. Private equity is money supplied by private investors in a company before it goes public. PE investors are eventually remunerated with profits from the sale of private stocks, referred to as IPOs or private securities. The value of an IPO is speculatively based on the anticipated future growth and income of a firm.
PE-backed stocks are highly speculative because their success hinges on harnessing willing buyers. Often, a company without enough cash will offer IPOs to raise revenue. Low liquidity is the undoing of many businesses that generate profits but lack sufficient cash reserves. Even firms with a wealth of tangible assets, such as land, buildings and machinery, may become bankrupt due to lack of cash due to the time required to liquidate their assets, which usually incur a loss of value.
Initial Public Offerings
IPOs are seen as an opportunity for the founders and early investors in a firm to make high profits by cashing in their stock holdings. IPOs are sold as "hot stocks" that are on their way up. Investors buy IPOs to take advantage of the initial jump in price that IPO shares can make. Information about IPOs that are about to be introduced on the stock market can be found at the Securities and Exchange Commission. Investors employ stockbrokers to locate pre-IPO stocks, which are generally priced at the last minute.
In the third quarter of 2011, 284 companies raised $28.5 billion by selling IPOs; down 57 percent from the second quarter, when companies raised $65.6 billion. PE-backed companies decreased dramatically -- with 21 firms raising only $2.9 billion, which represents an 80 percent drop from the second quarter of the same fiscal year. IPO market activity in the Americas fell by 82 percent, as of October 2011. The downturn caused 226 companies to withdraw or postpone their IPOs; which is similar to the record set over the same period during the recession of 2008 -- when 231 companies withdrew their IPOs.
IPO Pros and Cons
The perceived advantages of buying an IPO stock is to get in on the ground floor of a business that is expected to grow exponentially, based on its financial performance and reputation. IPOs, however, are considered nascent stocks sold by knowledgeable sellers to less knowledgeable buyers, according to Pat Dorsey, director of equity research at Morningstar. Dorsey argues that the price of IPOs is typically inflated and based on an exaggerated estimation of their worth. This, in turn, is designed to increase the profits of the founders and initial investors. Dorsey states that PE-backed IPOs often pose a high risk to stockholders because the investment is largely speculative.