2 Types of public security issuances IPO Issuances:IPO = Initial Public Offering. The first sale of stock by a company to the publicThis the most visible type of security issuance with respect to exposure in financial publicationsConsider the Google IPO of 2005, ICBC in 2006 and the news surrounding the issuance eventsIPO firms are being valued by the “market” for the first time, and establishing the initial valuation (based on firm private information) and finding public market investors willing to pay that valuation is the specialization of an investment bank
3 SEO Issuances:SEO = Seasoned equity offering. An already traded firm issues new shares.Market values are already established, so placing these securities is generally less difficult than an IPO since there is less asymmetric information.Types of SEO’sFollow-on offering: Is an SEO in which new shares are issued to the publicSecondary offering: Is an SEO in which existing shares held by current owners (like the founder of the firm – Bill Gates of Microsoft for instance) are sold to the market
4 Why go Public? Lack of other financing choices Private financing unavailableToo costlyFear of loss of controlToo much debt, so firm optimizes capital structureAllows current investors to cash outFounders demand liquidity, want to sell stake in firmFirm is valued by the market, shares sold get market price
5 Future source of capital Establish the firm in public capital markets for future capital raising (SEOs, bond issuances)Diversification / Risk sharingIncreases transparency of firm actionsEmployee compensationFirm can offer incentive contracts – stock options
6 Why not go Public?Going public is costly, time consuming and may not be appropriate for all firms, even when they are in need of additional financingOwnership is dilutedDecision making is delegated to an increased number of ownersFounder (entrepreneur) loses controlPublic monitoring increasesCompetitors benefit from transparencyRegulators have increased authority (legal restrictions to public firms)
7 Direct financial costs Filing costs of prospectus and subsequent filingsInvestment banks and new investors charge the firm via large transactions costsShares are underpriced (can be greater than 15%)Underwriters collect fees (7% of gross proceeds)Short-term performance pressuresChange in accounting practices
8 The IPO ProcessFirm selects an underwriter (investment bank) who also acts as the advisor, basing the decision on:The reputation and expertise of the underwriter (the advisor must be credible)Follow-on products like research coveragePrior relationships between the firm owners and investment banksDistribution channels available to underwriter (institutional clients)The investment banks willingness to take on the firm (high reputation underwriters may not risk their reputation on a firm with uncertain prospects)
9 Firm and underwriter agree on the offering method: Firm commitment: firm sells the entire issue to the underwriter who then attempts to sell it to the public (insured) – Although the underwriter fully commits to purchasing the issue, the price is not agreed (or committed to) until later in the issuance process.Best effort: underwriter makes no promise about the price, but makes a best effort to sell at the agreed price (uninsured)Rights offering: securities are first offered to existing shareholders (not common in the U.S.)
10 Valuing the offer: Underwriter provides a value of the firm. Firm opens its books to the underwriter so that they have full information for determining value – the underwriter is the agent that reduces asymmetric informationDiscounted cashflow analysis is one valuation method, but more commonly, underwriters identify a peer group of publicly traded firms and use multiples of different financial metrics to provide a range of values.Firm and underwriter agree and set an offer range, which may change once the underwriter has a better assessment of market interest in the offering.Six to 8 weeks have passed from the selection of the underwriter until the end of the due diligence.
11 Road show: Begins a few weeks prior to the IPO. The lead underwriter visits large investors (institutional) to solicit interest and build a demand schedule (book building)Book building occurs with “special” clients of the underwriter, including institutions (Fidelity, Janus etc.) and wealthy private investors.Book building is also spreading to smaller clients through electronic road shows, aided by the internet.Only once the waiting period is over, can the investment bank/underwriter solicit specific pricing and demand information from investors.The waiting period usually ends a few days prior to the IPO, allowing investment banks to reach what they think will be an equilibrium (final) offer price.
12 Offer: Underwriter sells the issue and an exchange begins trading the issue in a secondary market. Depending on demand for shares, the underwriter may have to ration shares to investors.Shares are sold to investors prior to trading in secondary marketsNew investors who didn’t get an allocation of the primary shares can now buy shares in the open marketInvestors who received an initial allocation of shares can begin selling them to new investorsInvestors who are allocated shares and immediately turn around and sell them in the market are not viewed favorably by investment bankers and may be cut off from future allocations.
13 Fees: Underwriters charge issuing firms for their services Fees are earned for reducing the asymmetric information between investors and the firmInvestment banks (underwriters) use their reputation in a repeated game setting (they do this over and over with different firms) to convince investors of the firm’s typeFor firm commitment offerings, fees come from the following sourcesGross spread: price sold to market – price bought from firm. Typically this is 7% of gross proceedsUnderpricing = closing price at end of first trading day – the offer price. Underwriters generally under price the offer by as much as 15%, and much more in certain cases.
15 Syndicate = A group of investment banks that work together to sell new security offerings to investors. The underwriting syndicate is led by the lead underwriter.The issuing firm may decide that several underwriters are needed to underwrite the equityThe size of the syndicate varies (5 underwriters for ICBC, 28 for Google)The primary underwriter is designated the “lead” underwriterThe lead underwriter allocates portions of the offering to syndicate membersSyndicate members may be lead underwriters on other offerings, so the relationships are frequently based on equal stature in terms of mutual respect
16 CompensationUnderwriting spread = difference between price to the public and theprice received by the issuerThe spread is determined by negotiationThe spread reflects the effort and the risk taken by the underwriter(firm commitment)Compensation includes mainly:Manager’s fee (20%)Syndicate allowance (20%)Selling concession (60%, buying stock at a discount and then reselling it to the public at a higher price)
17 Potential functions of underwriting syndicates Risk of underwriting large offersThere is a risk that the offering price is too high, and underwriters notbeing able to sell the sharesFor firm commitment contract: A single underwriter risks losing moneyif the price is difficult to determine.More underwriters means lower risk for each underwriterHowever, large size IB can bear risk, so why having syndicates?
18 Information production - Underwriters have to price a stock with no trading history- Syndicates help estimate the demand for the IPO thanks to different clientele or geographic origin (e.g. ICBC had 2 Chinese, 2 European and 1 US underwriters)Channels of information:Underwriters may inform directly the lead underwriter about market interest. This is however not in their best interest because they compete with the other underwriters.Underwriters prefer disclosing information directly to the issuer. This improves their reputation.
19 Certification and underwriter reputation The issuer’s quality may be unknown.Certifiability hypothesis: Reputable underwriters signal that the offeredprice is fair. This reduces uncertainty and the underpricing problem.Coverage by analystsSyndicate members can provide analyst coverage once trading starts.This is crucial to maintain investors’ interest in the issuing company.An underwriter with analyst coverage in the aftermarket mayincrease the demand for the stock.Krigman et al.(2001): analysts coverage is an importantdeterminant when selecting underwriters.
20 Empirical findings (Corwin and Schultz 2005) What is the added value of syndicates?Syndicate participation evidenceAn IB with top-ranked analyst in the issuer’s industry increases the likelihood of being included in the syndicateGeography matters: Being in the same state as the lead underwriter decreases the likelihood of being included in the syndicateStrong relationship with lead underwriter increases the probability of entering the syndicate. Suggests that ongoing relationships may mitigate the agency problems within the syndicate
21 Syndicate structure and offer price revision An efficient syndicate should uncover information on what the offerprice should be.In that case, the price revision from the expected offer price to actualoffer price should be substantial.Evidence shows that larger syndicates increase the likelihood of anoffer price revision.This suggests that syndicates produce valuable information.
22 Syndicate structure and certification effect The syndicate’s composition has no effect on the “fairness” of theoffer price.Hence, there is no evidence of the certification effect.Syndicates and analysts’ servicesThe number of analysts covering the firm depends on the number ofsyndicate members co-managing the equity issue.
23 Syndicates and effort (Pichler and Wilhelm 2001) Companies choose the lead underwriter. The lead underwriter chooses the syndicate members.Why do issuers want to have several underwriters?Moral hazard problem: Companies cannot measure perfectly how well IB work for their course, i.e. how much effort they put to attract the highest price investors.Syndicates may induce more effort.
24 How do syndicates induce effort? Stability of composition of syndicates, but changing lead underwriter.The lead underwriter receives by far the highest fee. Hence, there is competition between IB to become lead underwriter. This induces them to exert high effort.Moreover, the lead underwriter selects the syndicate members. He has an incentive to monitor them in order to be selected as lead underwriter for future deals.
25 How does a company choose a lead underwriter? (Hansen and Khanna 1994) General theories: the best way to choose a lead underwriter is to organize an auction. Indeed, letting underwriters compete may reduce the fees.In reality negotiation takes place with a single lead underwriter.Why? The bidding process gives lowest fee but not the highest price for the issue.
26 The lead manager has to exert effort: evaluate demand, contact investors etc. More effort increases the offer price.Effort is costly. Assuming that the profit of syndicates is constant, low fees are associated with low effort. Hence, issuers do not necessarily prefer lower fees.An IB approached has first to exert costly effort to determine the approximate offer price. In a bidding process, there is uncertainty on whether it will be selected as lead underwriter. This induces low effort. In negotiation, instead, the effort is unlikely to be useless. This induces higher effort.
28 What is underpricing?Underpricing: the first trading day closing price typically exceeds the price at which the shares were offered to the investors.Share priceOffer pricet=0
29 International evidence The first-day premium that investors experience is positive in virtually every country.Underpricing averages more than 15% in industrialized countriesUnderpricing is much higher in emerging economies.The difference between industrialized and emerging countries is due to (i) valuation uncertainty and (ii) regulation (e.g. Taiwan, Malaysia)
30 Underpricing was very high in 1999-2000 (around 50%) Consequence: Companies leave large amount of money on the table (sometimes more than $1bn)In the US, only 15 of the 160 quarters between 1960 and 1999 saw the average company trade below its offer priceUnderpricing was very high in (around 50%)Predictability of underpricing:Underpricing varies over timeUnderpricing is highly positively autocorrelated overtime
32 Principal-agent theory Underwriters are faced with a trade-off. On the one hand, underpricing lowers both the risk of failing to place equity, and their effort in marketing the issue. On the other hand, the fee is proportional to the price.If the success of an IPO is important enough, the IB choosesunderpricingIssuers, because they delegate the pricing decision to the underwriter, cannot prevent opportunistic behavior
33 Information revelation theories Some investors are better informed about the issuing firm’s value. They also know better their demand of shares and the price they are willing to pay.The key function of underwriters is to elicit information from better informed investors about the firm’s value, especially when the information is positive.Problem: Investors are unwilling to reveal positive information, becausedoing so would result in a higher offer price and a lower profit.Solution: Underpricing + allocation of more shares to the most aggressivebidders.This induces investors to reveal their information truthfully andbid aggressively.
34 The winner’s curse problem Illustrative example:Your firm is considering making a takeover offer for a start-up. The true value (V) of the shares are known with certainty only to the start-up management.You know that the shares are worth somewhere between £0 and £1000 and each possible value has equal probability.Synergy: shares would be worth 50% more than their current value to your firm if you successfully acquire the start-up.The start-up sells to you if you bid more than V, and will turn you down if you bid less than V.How much do you bid per share? On average the firm is worth 500.However, if you bid 500, you will only win if V < 500. But, if the firm is worth at most 500, it is worth on average only 250, so you overpaid! Even with the synergies, 250x1.5 = 375 is less than your bid. This is the winner's curse!
35 Same problem in IPOs for uninformed investors: If an investor overvalues the issue (bids H), he will end up will many shares and makes a loss.If an investor undervalues the issue (bids L), he will face strong competition and end up with only a few shares.Underpricing implies that investors no longer make losses on average.bids distributionLVH
36 Institutional explanations Legal liabilityInvestors can sue underwriters on the ground that material facts were mis-stated or omitted in the IPO prospectus.Intentional underpricing may act as insurance against such litigation.Evidence that underpricing reduces (i) the probability of a lawsuit, (ii) the probability of an adverse ruling conditional on a lawsuit, and (iii) the amount of damages awarded in the event of an adverse ruling.
37 Price supportUnderwriters can be required to stabilize trading prices at the offer price, thus minimizing the occurrence of overpricing. This leads to the censoring of the initial return distribution.Evidence:Underwriters are aggressive buyers in the aftermarketInitial returns are censored: they are non-normal and peak at zero. There is almost no negative tail.Over time, underwriters remove price support. The effects of price support are temporary, leading prices to fall as support is withdrawn.
38 Ownership and controlUnderpricing help to retain control of the issuing company.Underpricing ensures that the offer is over-subscribed and that investors will be rationed.Rationing allows the manager to discriminate between applicants of different sizes and so to reduce the block size of new shareholdings.Greater ownership dispersion implies that the manager benefits from a reduced threat of being ousted in a hostile takeover.Evidence: Very large applicants are discriminated against in favorof smaller ones.
39 Stock flippingWhen an IPO is underpriced, some investors who do not value thecompany high are allocated shares, while some valuing thecompany higher do not receive any shares.This demand of the latter causes the price to rise and the formersell their shares, hence trading activity will be high.The trading activity generates income for market makingunderwriters.
40 shares. When trading starts, only few shares are traded. If an issue is overpriced (price=PH), only the high bidders are allocatedshares. When trading starts, only few shares are traded.Low trading activityIf an issue is underpriced (price=PL), all bidders are allocated shares.When trading starts, those who value the issue high will buy shares fromthose valuing the issue low.High trading activityUnderpricing More trading More income for the market makingunderwriters.PLVPH
41 Long-run performance of IPOs Puzzle: The long-run performance of IPOs is negative!Share pricet=0
42 ExplanationsOnly the most optimistic investors buy the IPOs, and they pay too much for the sharesIt seems that many firms go public near the peak of industry-specific fads. Issuers are then able to sell at high price“Window dressing”: Firms manipulate their accounts before going publicLack of clear theoretical understanding or empiricalevidence
43 Evidence from Bath MSc students Li-Wen Chen (2006):211 IPOs in Taiwan from 2001 to 2005Underpricing: 6%1-year performance: -9%Finds that firms that have a lending relationship with their underwriters suffer from more underpricing.Consistent with conflicts of interest.
44 Huajing Wang (2007)296 IPOs on the Shanghai Stock Exchange from 1992 to 2007Underpricing of 127%Controls for almost 20 explanatory variablesEvidence of the winner's curseUnderpricing higher for young, weakly profitable, and small companies. Consistent with information asymmetry.Kwanpongsa Dacharux (2006)122 IPOs in Thailand from 2001 to 2005Underpricing of 20%, decreasingMore underpricing for risky, small, young firms, with a high D/E ratio
46 What are the costs of IPOs for IB? Risk of firm commitment underwriting: not selling all shares at a designated price and suffering a loss.Costs of analyzing and administrating the issue.Analyst coverage: often included in the underwriting contract.
47 4. High effort to maintain reputation. Compensation paid to syndicate members.Price support: Aftermarket support of the stock to ensure a minimum of liquidity and to prevent a price slump due to some investors selling their shares.
48 Underwriting spread and costs Chen and Ritter (2000) Facts:Spreads in the US are much larger than in the rest of the worldAt first sight, the fee structure does not reflect the existence of fixed costsInvestment bankers concede that there is no price competition
49 In 90% of cases, the spread of IPOs raising $20m-$80m is 7% (despite fixed costs). Spread is higher for IPOs below $20m (existence of fixed costs). (Japan: average spread of 3-3.5%Australia: average spread of 3.4%Suggests that spreads are competitive for deals below $20m-$30m, but increasingly profitable on larger dealsThis does not necessarily imply that fees are too high. There are indeed other dimensions in competition(effort, analysts coverage, price support etc).
50 Competition and the spread Hansen (2001) Potential explanations for the 7% underwriting spread:Explicit collusion hypothesis: Joint agreement to fix the spread at 7%.Implicit collusion hypothesis: Long-term competition between IB. Price cut may trigger price war and induce lower profits in the long-run.Competition in other dimensions: underpricing, reputation, placement efforts, analysts coverage etc.Hansen argues that the 7% spread is consistent with efficientcontracting. By fixing one dimension of the contract, thecompetition is in the other dimensions. This also saves time.
51 Evidence on the state of competition Concentration in the IB industry: The same as before the 7% era. Argues against collusionEntry: New banks enter the market. Moreover there is volatility in IPO market shares. Argues against collusionEffect of Department of Justice probe: No effect on spread. Argues against collusionProfit: No evidence of abnormal profit when the spread is 7%. Argues against collusion
52 Evidence of efficient contracts: 7% spread IPOs are more frequent for firms with highearnings volatility, high debt, i.e. firms that are risky anddifficulty to value.The risk factors associated with the IPO placementdifficulty could explain the 7% contract use.
53 Ljungqvist and Wilhelm (1999) The 7% spread in the US is competitive, otherwise USfirms would flock to non-US investment banks.Many issuing firms are willing to pay a premium to have a US bank in the syndicateThe presence of a US bank in a syndicate may decrease by 17% the IPO underpricing
55 What determines market shares? Several hypothesis:First-day return- Underpricing imposes costs on the issuers by leaving money on the table.- Overpricing is also not beneficial for the IB. Their role is tocertify the value of the shares for investors. If there is overpricing, investors will be reluctant to buy shares underwritten by this investment bank.Underwriting spread- Issuers may choose lower fee underwriters.- On the other hand, reputable banks may charge higher fees.Reputation is volatile and high fees signal that the bank does not fearlosing its reputation.
56 Long-run performance: Investors will be reluctant to buy shares from IB offering shares of companies with no positive prospects.Analyst reputation:- High level analyst coverage is central for the success of an IPO.- The presence of a top analysts certifies the IPO value to investors.Industry specialization- Experience is central for evaluating companies, and specializationcan increase the precision of pricing due to information spillovers from other equity issuances.- For well established IB, however, specialization reduces the amount of business that can be acquired.
57 Lager banksSmall banksSpecializationBusiness size limitedAttract first customersNo specializationMore potential clients, less riskDifficult to attract first customers
58 Good long-run performance has a positive effect on market shares Findings:First-day returnInitial overpricing has a negative effect on market sharesVery positive first-day returns also have a negative effect on market sharesA reasonable level of underpricing seems optimalGood long-run performance has a positive effect on market sharesLower fees increase market sharesIndustry specialization has a negative impact on market shares for established banks. It has a positive impact on market shares for smaller banksFor reputable banks, improvements to the reputation of the bank’s analysts have a positive effect on market shares changes
59 A note on privatizations Privatizations constitute a particular class of IPOs, where thevendor is not an entrepreneur but the government.Particularity of privatizations: Governments have been veryinnovative in their approach to IPO, and most of the largest IPOsever are privatizations.Government were among the first to:Include foreign IB in IPO syndicatesUse book-building techniques for pricing and allocationIntroduce multi-tranche IPOs with block of shares reserved for particular groups of investorsLimit the downside risk faced by investorsNegotiate down the fees paid to the IB