How to Invest in IPOs

As of March 4, 61 companies have filed for initial public offerings (IPOs) in 2014, leaving many investors wanting to know how to invest in IPOs.

What makes initial public offerings intriguing is how they can bring huge first-day gains to shareholders.

On Jan. 29, Dicerna Pharmaceuticals Inc. (Nasdaq: DRNA) went public and treated shareholders to a gain of almost 207% on the first day alone. Ultragenyx Pharmaceutical Inc. (Nasdaq: RARE) and Varonis Systems Inc. (Nasdaq: VRNS) brought in first-day gains of 101% and 100%, respectively.

Unfortunately, it's very difficult for the common investor to bring home those triple-digit gains.

"I often refer to the IPO market as the 'rich-man's market,'" Money Morning's Defense & Tech Specialist Michael Robinson told Money Morning's Executive Editor Bill Patalon. "And it's reprehensible that the gains are reserved for the rich."

In fact, unless you're a Wall Street insider or a very wealthy investor, investing in IPOs can be almost impossible…

The Difficulties of IPO Investing

When a company decides to go public, one of the first things it does is hire an investment bank to "underwrite" the financial filings required by the Securities and Exchange Commission (SEC).

From there, the IPO filing process is arduous.

The company and underwriter determine how much money will be raised, file registration documents, identify any legal issues, determine the IPO date, and decide on the share price. The process takes months to complete, leaving the company time to hype up the stock and excite potential investors.

As the IPO date approaches, the underwriter will begin selling the shares of the stock for the company.

That's where the common or "retail" investor comes into play, right? Not exactly.

The investment banks that perform the underwriting are typically large firms like JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs & Co. (NYSE: GS), or Merrill Lynch, to name a few. When it comes time to sell shares of the newly public company, these firms will typically sell shares to their favorite institutional clients.

Since so many companies will want a huge investment firm performing their underwriting, the banks can be choosy about which companies to underwrite. They'll pick the companies they think will have the most successful IPOs. In turn, they reward their favorite clients with shares of the hot new IPO they've just underwritten.

Additionally, firms will want to sell large chunks of their shares to very wealthy investors rather than selling smaller amounts of shares to thousands of retail investors. They want investors who can buy in bulk.

And the little guy is left watching…

"As I often tell people, because Wall Street tends to reserve the hottest issues for its 'best' customers – folks I often describe as the 'ultimate insiders' of the U.S. financial markets – IPO deals can be tough for retail investors to get into," Robinson said. "And even if you do manage to get a few shares, there are still difficult decisions to make – such as how long you should hold on, or under what circumstances you should sell."

In an attempt to capture some of those huge IPO profits, retail investors will often wait until a company goes public to buy shares… But that can an extremely risky strategy.