IPOs (initial public offerings) are much in the news. Questions of valuation are rife. Access to IPOs for private investors is also a hot topic. Altogether, there have been about 50 such flotations so far this year on the Main Market of the London Stock Exchange and on Aim. By my reckoning fewer than 10 of these have had any retail offering as part of the IPO process.

As part of the IPO process, candidates for flotation are introduced to fund managers almost on a daily basis. What can we learn from these professional investors about how they assess these businesses?

Earlier this year the Quoted Companies Alliance and the accountants Baker Tilly released a report showing the results of a survey of small cap fund managers by YouGov. It carries some messages that I think will help any long-term investor.

Important lessons

Firstly, institutional fund managers who invest in small and mid-size companies typically favour secondary fundraisings over IPOs. There is a view that secondary fundraisings tend to offer better value for money for investors.

When a fund manager buys in the market he adopts a buy and hold policy, so he takes his time, meets the company several times to gauge the quality and depth of the management, watches as the company builds a track record as a public company and then gradually builds up a position without unduly affecting the share price. His or her time horizon is three to five years.

This doesn’t mean that fund managers will hold the shares for that time - prices can go up as well as down and sometimes short-term improvements in price may encourage investors to take a profit. But fund managers invest this way, particularly in the small-cap world, because shares are naturally and inevitably less liquid than the mainstream FTSE 100 stocks. Therefore the aim is to pick long-term winners, that will grow over time, pay regular and increasing dividends so that both the market capitalisation of the company and the liquidity of the shares improve commensurately.

Many of the investors raised significant concerns over the value for money during the IPO process. Fund managers often feel unable to get the best price or volume due to the amount of competition for the stock and they feel restricted by the window of time they have to make the investment decision. This must be a view that many private investors will relate to.

Some fund managers have told me they get just 45 minutes to meet the company and make up their mind. Competition for stock is inevitable for popular IPOs and the allocation process is opaque, to say the least. For the larger market-capitalised companies, there may be several investment banks working ‘to build the book’ to secure the best valuation for the company whilst also being mindful of their commission-paying investor clients; a potential conflict of interest that has to be carefully managed!

Most fund managers are very selective when it comes to IPOs. They say they invest in roughly one in 10 of the companies that are brought to them. This is largely because they like to have fully invested portfolios; their clients don’t want them to have idle cash, so any IPO has to add value to their portfolio, especially if there is no new net money flowing into a portfolio.

Trusted track record

I am drawn towards the proposition that investors of most hues should avoid most IPOs and take a long hard look at existing quoted companies that have built up a solid track record and demonstrated an ability to grow on a public market.

There is a huge difference in culture, regulation and behaviour between a private and a public company. It sometimes takes time for a company to adjust its ‘corporate eyesight’ when it enters into the glare of the public market. Fund managers seem to recognise this and other investors should consider this too.

Tim Ward is the chief executive officer of the Quoted Companies Alliance, the independent membership organisation that champions the interests of small to mid-size quoted companies.

IPO red flags

1. Valuation If investors feel that a company’s shares are overvalued, then investment is not going to happen.

2. Management The quality of management of the company is key and an established track record in a sector is very important.

3. Management stakes The fund managers we surveyed view management attempting to exit a business very suspiciously.

4. Related-party transactions Deals between two parties with a pre-existing relationship are viewed unfavourably.

5. Acquisition history Any recent acquisitions made by the company will need to be explained very carefully.

6. Investment Merely raising funds to plug extant underinvestment is frowned upon.

7. Competitive position A company needs to convince of the sustainability of its competitive position.