IPO Trading: Mastering Oversubscription and Undersubscription

understanding ipo trading
.14 Sep 2023
author avatar image Chad Smith

Table of Contents

Demystifying the realm of Initial Public Offerings (IPOs), their oversubscription, and undersubscription scenarios, and the significant impact they potentially have on individuals and organisations, is a crucial initiative for any dedicated professional in the spheres of finance and investment. The journey towards understanding these phenomena is indeed challenging – but vitally enriching. This discourse kicks off with an introduction and overview of IPOs, detailing the involved parties and the process’s impact on the market. Through careful analysis, we will delve into the implications and management strategies associated with over or undersubscription, providing insight into the landscape from both the investor’s and company’s perspective. Finally, tips and best practices for IPO trading will be shared, with critical focus placed on striking a balance to avoid over or underfunding scenarios. These concepts serve as key foundations for manoeuvring the highly volatile, yet profitable domain of IPOs – a terrain every professional investor must master.

Understanding IPO Trading

Understanding IPO Trading: The Basics

An Initial Public Offering (IPO) represents the first instance when a company issues public shares, marking its transition from a private to a public entity. The sale of these shares is facilitated through the stock market, allowing the general public to invest in the company for the first time. IPOs are crucial as they allow companies to raise funds for expansion and consolidation, offering the added benefit of increased media attention and prestige.

As a process, the IPO begins with a company engaging an underwriter, usually an investment bank, to assist in determining the offering price for the shares, the number of shares to be sold, and to attract potential investors. The underwriter helps with marketing, research, regulatory requirements, and negotiating deals with investors.

Oversubscription and Undersubscription in an IPO

In IPO trading, oversubscription and undersubscription are two critical concepts. Oversubscription occurs when the demand for shares is higher than their supply. It indicates strong investor interest, suggesting that investors perceive the stocks as valuable and the company as promising. Oversubscription can often lead to an increase in the stock’s price when trading starts, generating considerable first-day gains for investors.

Conversely, undersubscription is when the demand for the shares is less than their supply. Under such circumstances, the company may receive fewer funds than anticipated, impacting its capacity to undertake outlined projects or expansion plans.

How Oversubscription is Handled

The handling of oversubscription typically involves the use of an allocation method to decide how many shares each investor will get. The underwriters, together with the company, develop a fair system of allocation. This may include a proportionate system, where each investor receives a percentage of shares corresponding to their initial application, or a lottery system where allocation is randomised.

Alternatively, the company might opt for a ‘green shoe option’, which allows it to issue more shares – up to an agreed limit – in response to the excess demand.

How Undersubscription is Handled

Undersubscription requires alternative strategies, with the underwriters playing a significant role. At times, underwriters may agree to a ‘firm commitment’ contract where they buy the unclaimed shares themselves, later reselling them to the public. This arrangement ensures the company gets the required funds regardless of public response.

However, if the underwriters have not agreed to such terms, the undersubscription may lead to cancellation of the IPO or a decrease in the company’s public value.

In Conclusion

In the landscape of IPO trading, gaining a comprehensive understanding of phenomena such as oversubscription and undersubscription is highly critical for both corporations and investors. These circumstances play a vital role in the ability of the firm to generate capital, influences the function of underwriters, and can sway the potential profits for investors. Professionals expanding their knowledge in IPO trading intricacies can significantly refine their strategic capabilities in investment.

Image depicting a person analyzing IPO trading data and charts

The Phenomenon of Oversubscription

Delving into the Intricacies of Oversubscription and Undersubscription in IPOs

An Initial Public Offering, or IPO, serves as the conduit through which a privately-owned organisation metamorphoses into a publicly traded entity. Upon converting to public status, these corporations have the liberty to sell their shares to willing investors, effectively amassing capital that facilitates business growth and expansion. However, a situation termed as oversubscription arises when an overwhelming number of investors demand for shares shared during an IPO that surpass the number actually issued. Conversely, an undersubscription scenario surfaces when an equally perturbing lack of demand compared to the available number of shares emerges.

Why Oversubscription Occurs

Oversubscription typically arises when an IPO is expected to perform exceptionally well post listing, instigating high investor interest. Positive market conditions, strong financial performance, promising growth prospects, and a robust industry outlook are other potential factors contributing to oversubscription. This often implies that the issuing company has been undervalued, making its shares an attractive investment.

Implications of Oversubscription on Investors and Issuing Company

From an investor’s perspective, oversubscription can limit the number of shares received, as these may need to be proportionately allocated amongst investors due to high demand. However, oversubscription can also indicate a robust investor sentiment leading to potential price jumps post-IPO, ensuing profitable exit opportunities.

For the issuing company, oversubscription can affirm market confidence in their business model and growth prospects. It can also lead to a higher share price during the IPO, allowing the company to raise more capital than initially anticipated.

Managing Oversubscription

Depending on the jurisdiction, various measures have been institutionalised to handle oversubscriptions. Some may implement a proportional allocation or lottery system, while others might resort to a ‘greenshoe’ or ‘over-allotment’ option. This provision allows underwriters to issue up to 15% more shares than originally planned, meeting excess demand and stabilising the stock price post-IPO.

The Challenge of Undersubscription

Contrarily, undersubscription suggests a lack of investor confidence. This scenario could either lead to cancellation of the IPO or force the company to sell shares at a lower price, potentially raising less capital than initially anticipated.

The Role of Stock Exchanges and Financial Regulators

Regulators and exchanges play a crucial role in facilitating a fair allocation process during oversubscription and ensuring a smooth functioning of the post-IPO market. They set rules for handling oversubscriptions, protect investor rights, enforce transparency from the issuer, and monitor market behaviour to prevent manipulation and fraud.

Oversubscription in Reality

Facebook’s IPO in 2012 and Uber’s IPO in 2019 were both heavily oversubscribed, indicative of the high investor interest in these technology giants. Intriguingly, while Facebook’s shares struggled in the initial months post-IPO, they surged eventually. Conversely, Uber’s shares remained lacklustre, underscoring that oversubscription doesn’t unequivocally guarantee post-IPO success.

Dealing with oversubscription and undersubscription within IPO trading can be a complex task; it entails a deft blend of professional acumen, comprehensive understanding of market dynamics, and profound insights into the prospective company’s outlook. It’s crucial to focus on aspects such as the pricing of the IPO, the reputation of the financial institution underwriting the IPO, the regulatory landscape and macroeconomic components that shape the sentiment of investors.

Image illustrating the challenge of undersubscription in an IPO, showing two scales - one with few shares and the other with many shares, symbolizing lack of investor confidence and potential shortage of capital raised.

Dealing with Undersubscription

Comprehending Undersubscription in IPO Trading

Undersubscription transpires in situations when the demand for shares in Initial Public Offerings (IPOs) is less than the total number offered for public purchase. This issue emerges predominantly when investors, inclusive of institutional and retail types, exhibit insubstantial interest in the company’s shares. This lack of interest can originate from the potential risk linked to the company’s future profitability. It can be the result of unappealing share pricing, lacklustre market conditions, or other inherent aspects that lower the company’s attractiveness.

Impact of Undersubscription

The effects of undersubscription on companies can be detrimental. First, it means the company may not have raised the required capital necessary for expansions, acquisitions, or settling existing debts. Secondly, it can damage the reputation of the company and dent the confidence of existing and potential shareholders. An undersubscribed IPO often leaves a lingering negative impression, implying that market participants have reservations about the company’s prospects.

Strategies to Manage Undersubscription

There are several strategies that underwriters and companies can employ to manage undersubscriptions.

  1. Reducing Offering Price: One route to stimulate demand is by reducing the offering price. A discounted price might make the shares more attractive to investors and thus spur demand.
  2. Standby Underwriting: Contracting standby underwriters can also hedge against undersubscription. These underwriters commit to purchasing any remaining unsold shares, ensuring that the company receives the intended capital.
  3. Stabilising Manager: Appointing a stabilising manager can also be useful, especially in cases of volatile markets. The stabilising manager uses their own account to buy shares, supporting the price and creating an artificial demand.
  4. Subscription Assurance: Subscription assurance is a technique in which select investors promise to subscribe to a certain percentage of shares, regardless of market attitude towards the IPO.
  5. Green Shoe Option: Also known as an over-allotment option, it allows underwriters to issue up to an additional 15% of shares if the issue is oversubscribed. If undersubscribed, the underwriters can buy back the additional shares to prop up demand.

Historical Examination of Undersubscription

A study of past instances where undersubscription occurred can offer essential insight into the nature of this issue. A prime example is the 2011 IPO of Prada, which saw significant undersubscription. This was primarily due to an excessively high evaluation of the company and poor market conditions owing to the prevailing Eurozone crisis. However, through adopting strategies such as reducing prices and encouraging strategic investment from larger institutional investors, Prada successfully navigated these difficult circumstances.

Illustration of a graph showing the impact of undersubscription on IPOs.

Best Practices in IPO Trading

Delving Into IPO Oversubscription and Undersubscription

An Initial Public Offering (IPO), is the process whereby a private company makes available its shares to the public for the very first time. This provides an avenue for the company to generate funds while also offering investors an opportunity to garner potential profits. Nonetheless, striking a balance between the supply and demand for shares is usually instrumental in determining the success of an IPO.

Oversubscription of an IPO implies the existence of a demand for the shares that exceeds their availability. This surplus demand often leads to an increase in the price of shares, thereby creating a favourable return for investors. In contrast, undersubscription of an IPO signifies a lack of sufficient demand, leading to leftover shares post-offering. Such circumstances typically necessitate a reduction in share prices and could potentially diminish the company’s standing in the marketplace, as was the case with Prada in 2011.

Strategies for Investors

One way to manoeuvre an oversubscribed IPO is by subscribing for more shares than you intend to keep. In an oversubscription scenario, investors often receive fewer shares than they initially applied for. Therefore, subscribing for a higher number is a way to potentially secure the desired amount of shares.

Addressing an undersubscribed IPO necessitates caution. Pilfering from a pool of unwanted stocks could lead to making losses since share prices may drop even further once trading begins. It’s crucial to analyse the company’s fundamentals and business model meticulously before investing in an undersubscribed IPO.

When dealing with an IPO, regardless of it being oversubscribed or undersubscribed, one should abstain from speculating without proper evaluation. Researching the company’s financial history, understanding the potential of the industry it belongs to, and knowing the business strategies they plan to implement can help mitigate risks.

Tips for Companies

For corporations floating an IPO, a few strategies can be employed to avoid undersubscription and oversubscription. If the offering is oversubscribed, the company might consider increasing the number of shares offered or their price. A ‘green shoe’ clause is an option that allows underwriters to sell more shares than initially planned, if demand is too high.

In case of anticipated undersubscription, a company could consider decreasing the IPO size or lowering the price to create a buzz in the market. However, these measures may not always work, and a better option might be to postpone the IPO until market conditions are more favourable.

The pricing of IPO shares is often based on a valuation of the company. An accurate valuation and a realistic pricing of the shares will help balance the demand and supply, thereby achieving the right subscription level. This is where underwriters and financial advisors come in. With their experience and financial expertise, they ensure the pricing is correct and garners enough interest amongst potential investors.

Illustration showing a scale with boxes on one side representing oversubscribed IPO and boxes left on the other side representing undersubscribed IPO, with an arrow pointing to a balanced scale in the middle indicating the right subscription level.

Ultimately, understanding IPOs, the nuanced challenge of oversubscription and undersubscription, and developing effective trading strategies, imparts substantial leverage for any serious investor. It equips professionals with able strategies to handle a broad spectrum of possible contingencies and allows them to anticipate market movements, thereby benefiting from generated opportunities. Companies, too, gain potent insights into pricing IPOs adeptly to avoid unfortunate scenarios of over or undersubscription. By leveraging this knowledge, you are empowering yourself with the essential tools for meticulous investment decision-making, thus ensuring you are adeptly prepared to traverse the world of IPOs in a manner that mitigates risk and maximises return on investment. This insightful exploration concludes, pioneering a decisive path towards optimal IPO investments and fostering a healthier, more robust and resilient market.

author avatar image
Chad Smith

Chad Smith is the Director of Research & Analysis here at ForexBrokerListing.com. Chad previously served as an Editor for a number of websites related to finance and trading, where he authored a significant number of published articles about trading and the impact of technology in transforming investing as we know it. Overall, Chad is an active fintech and crypto industry researcher with more than 15 years of trading experience, and you can find him teaching his dog how to trade in his free time.