Money is cheap and a lot of it is sitting on the sidelines, making it an increasingly receptive market for initial public offerings (IPOs) (after all, how many bank preferred shares can one mutual fund buy?). A PricewaterhouseCoopers survey found that IPO activity in the U.S. increased quarter over quarter for Q2 2009 for the first time since Q4 2007. While too small of a sample size to predict medium to long term trends, the IPO market has nowhere to go but up. The Dollarama IPO could merely be a harbinger of a more robust IPO market.

But are IPO’s good investments? The answer is generally no.

A skeptic may point to the fact that studies show IPOs earn an average of 15% return on the 1st day of trading as proof that one, indeed, can make money from investing in IPOs. However, the profits are concentrated in the hands of the underwriters selling to the market, those lucky enough to be allotted shares and the day-traders buying and selling in the secondary market. As retail investors who tried and failed to buy the Tim Horton’s or Visa IPO know, the average investor often is left on the sidelines.

There is also an economic school of thought that IPOs are under-priced as insurance against future litigation costs.  IPO litigation risk typically arises from a lack of material disclosure and misrepresentations made in the prospectus. If a business under-prices an IPO, the quantum of damages to a class action lawsuit has been correspondingly reduced. Assuming the IPO is under-priced, the chances of a first day spike in share price increases since the market values the stock back to its “normal” valuation. This school of thought certainly has its critics but it does give pause as to whether first day returns are juiced (for once by the lawyers and not the sales department).

(as a side note, under-pricing as insurance as future litigation costs could partially explain why mature public companies issue new equities at more than nominal discount to the trading price although pre-March 2009 market conditions gives a more plausible explanation for recent underpricing)

Setting aside the first day spike, IPOs tend to make poor investments over the long term. The average return of an IPO from 1970-1990 on the NYSE, Amex and Nasdaq was 3% vs. 11.3% for the S &P 500. Jeremy Siegel found that 79% of companies that issued IPO’s between 1968 and 2001 underperformed a representative small stock index and almost 50% underperformed that index by more than 10%.

There are a myraid of explanations for poor performance but I will share one that a securities lawyer once told me. When a company goes public, it is like running two different businesses: whatever the company’s business line is and the business of being a public company. Many companies cannot handle the second properly since its DNA and corporate culture is firmly rooted in private company disciplines which sometimes do not reconcile well with public market expectations (see Conrad Black as an extreme example). Thus, the money raised tends to be spent like it was still a private company and at the expense of the shareholders. Over time, this will drive share price down.