Initial Public Offerings (IPOs

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• • • • • • • • Financing new ideas Venture capital Initial Public Offering Why issue equity publicly IPO process Underpricing puzzle Long-run performance of IPOs Other IPO/Divestiture methods
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Financing New Ideas
• • • • • Personal savings Bank, but not likely to work Government but a very limited resources Large industrial companies Venture Capital Funds
– – – – Mostly organized as private partnerships Need to prepare a business plan for funding They invest in stages to control risk They require board representation and get shares
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• • http://www.nvca.org/

How Successful is Venture Funds http://www.ventureeconomics.com/

Venture Economi Investment Fund Type 1 Yr Early/Seed VC -2.00 Balanced VC 11.90 Later Stage VC 18.70
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Number of IPOs 100 200 300 400 500 600 700 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Years IPO Activity • If idea is successful then more money can be raised through an IPO • IPO also allows venture capital to exit the investment Historical IPO Activity 4 Source: Ritter.com/abstract=296393 . Pricing and Allocations" (February 2002). Ivo. 02-01. "A Review of IPO Activity. Jay Rial and Welch. Yale ICF Working Paper No. http://ssrn.

internet firms during 95-98 • Supply-side explanation suggests that during some time periods investors and institutions that invest in IPOs have excess funds to invest 5 .Why IPO Activity is Cyclical • Demand-side explanation suggests that start-up firms with good projects cannot get private funding and they use IPO for raising capital .

Why IPO Activity is Cyclical • A time period with a lot of IPOs is called “hot issue period” • If a hot issue period is driven by supply-side then it may be advantageous for a new firm to go public • If a hot issue period is driven by demand for funds then a new firm may be better off delaying to go public .competition for funds 6 .

Advantages Access to capital markets Improved liquidity for share Allowing original owners to Monitoring by external capi Information provided by cap 7 .Why Issue Equity Publicly 1. 2. 5. 4. 3.

IPO Process • • • • • Underwriter Selection Registration Marketing and Book Building Pricing After Market Activities 8 .

price differential is called the “gross spread” 9 .individual or institutional Prior banking relationships • The most common underwriting arrangement is the “firm commitment” • In this case the underwriter purchases all issued securities and then resells them to the public .Underwriter Selection • Factors to consider: – – – – Investment banker’s general reputation and expertise Quality of its research coverage Investment bank’s distribution expertise .

60% of the gross spread • The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread 10 . and assembling a group of underwriters to sell shares to the public • The syndicate members are paid a portion of the gross spread for their participation . pricing.Lead Underwriter • The lead manager plays the major role in the IPO .scheduling. distribution of new issue.

Underwriter • Letter of intent – The letter of intent protects the underwriter against expenses if the offer is withdrawn – The letter of intent obligates the company to reimburse the underwriter – It also specify the gross spread – In most cases. the gross spread is 7% of the proceeds – It also includes clauses on: • • • • Underwriter’s firm commitment Cooperation by the company Releasing of all available relevant information Commitment by the private firm to grant 15% overallotment option to the underwriter – Letter of intent is in effect until Underwriting Agreement is signed at pricing of the issue 11 .

Registration • The Securities Act of 1933 (Section 5) requires a registration statement to be filed with the SEC • The registration statement consists of two parts – The prospectus to be given to every purchaser of the securities – “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC • The registration statement allows public to obtain information about the issue • The underwriter has a “due diligence” requirement to verify the information • The Securities Act also makes it illegal to offer or sell securities to the public without registration • The SEC has no authority to block a public offering based on the quality of the securities involved. It can require the issuer to provide all material facts • The registration statement has to be signed by directors and principal officers of the issuer. accountants. the underwriters. appraisers and other experts • Investors who maintain losses as a result of misstatements or omissions in the 12 registration statement may sue these signatories .

Marketing • Once it is filed the registration statement is transformed into the preliminary prospectus or “Red Herring” • The preliminary prospectus is used to market the issue • The SEC has 20 days to declare the issue effective • At that point the red herring becomes a prospectus • The company and the underwriter promote the IPO through the “road show” • Road shows provide important monitoring for the underwriter on investor demand 13 .

Marketing • During the road shows the underwriter receives orders from individual and institutional investors .book building – Retail investors typically submit a “market order” in which only the quantity desired is stated – Institutions typically submit limit orders where the quantity demanded is subject to a maximum price – Retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders – Institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled 14 .

Pricing • Once the registration statement is approved by the SEC then two most important items have to be determined: – offer price – the number of shares to be sold • Book building at this stage is very important to gauge the investor demand • Some suggest that an IPO may be successful if it is three times oversubscribed 15 .

Pricing • Ritter (1991) on IPO pricing suggests that IPOs are “under-priced” – meaning that you can make money buy buying stocks from an underwriter and selling them in the market once public trading starts • Flipping – dumping of shares as soon as trading starts – is discouraged by the underwriters. but it is not easy to control 16 .

IPO Underpricing Percentage average first-day returns 120 100 80 60 40 20 0 -20 -40 Year 1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 17 .

00% 40.00% 0.00% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Years IPO Underpricing IPO Underpricing 18 Source: Ritter.00% 20. Ivo.00% 30.00% 50.com/abstract=296393 . 02-01. Yale ICF Working Paper No.Underpricing % 10.00% 70. "A Review of IPO Activity.00% 80. Jay Rial and Welch. Pricing and Allocations" (February 2002).00% 60. http://ssrn.

000 $20.000 $30. Jay Rial and Welch.000 $40.000 $5. millions IPO Underpricing 19 Source: Ritter.000 $15.000 $35. "A Review of IPO Activity.Millions $10. Yale ICF Working Paper No.com/abstract=296393 . http://ssrn.000 $25. 02-01. Ivo.000 $0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Years Aggregate Money Left on the Table. Pricing and Allocations" (February 2002).

Why IPOs are Underpriced • If an issue is too low then the issuing firm’s owners will not like bearing the additional cost of going public • If an issue is priced too high then the underwriter is stuck with shares plus a bad reputation • The underwriter is to balance between the tow extreme – Underpricing allows the underwriter to sell shares of the firm easily 20 – It reduces the possibility of lawsuits .

bad for the underwriter 21 .Underpricing and Average Investor • Assume that average investor is not informed well on the quality of an issue • The uninformed investor faces a “winner’s curse” that is if you bid in an auction and you end up with the item you most likely over bid • Underwriters know that most average investors cannot distinguish between good and bad issues and to keep uninformed investors interested they underprice • Otherwise uninformed investors would not play the game for long reducing the demand for the issue .

After Market • Stabilization activities by the underwriter: – These involve trading by the underwriter to support the stock by buying shares if order imbalances arise – This price support can be done only at or below the offering price – The standard prohibitions against price manipulation do not apply to the underwriter during this period • The final stage of the IPO begins 25 calendar days after the IPO when the so called “quiet period” ends • During the “quiet period” investors rely on prospectus • After the “quiet period” underwriters can comment on the valuation and provide earnings estimates on the new company 22 .

http://ssrn.20% 20 12. 02-01.70% Source: Ritter.70% 36 15. Pricing and Allocations" (February 2002). Yale ICF Working Paper No.50% 44 32. Ivo. Jay Rial and Welch.40% 1999-2000 -51.30% -53 27.80% 1990-1994 -36. "A Review of IPO Activity.Long-Run IPO Performance Year 1980 1981 1982 1983 1984 Average 3-year BuyMarket IPOs Adjusted I Periods 35.com/abstract=296393 23 .20% 1995-1998 -38.50% 88.20% 1980-1989 -26.

Yale ICF Working Paper No. Pricing and Allocations" (February 2002).com/abstract=296393 Correlation 24 .LR IPO Performance and Hot Issue Periods IP Source: Ritter. 02-01. Ivo. Jay Rial and Welch. "A Review of IPO Activity. http://ssrn.

34% to parent firms over days (0.Other Divestiture Methods • Spin-off: a company gives the shares of a subsidiary to its own shareholders • Shareholders can then sell their shares in the market • Shareholders are not subject to taxes if 80% of the subsidiary stock is distributed • Miles and Rosenfeld (1983) find an abnormal return of +3. +1) around the announcement 25 .

Why Spin-off? • Eliminate negative synergies • Increases focus • Improves managerial compensation contract design • Reduces the possibility of unprofitable business lines being supported by profitable ones 26 .

Other Divestiture Methods • Sell-off: a parent firm sells the assets of a subsidiary to another firm • Signaling effect is different depending on why assets are sold – If firm is refocusing its investments then it may be good news – If assets are sold to raise cash to pay down debt then it may be bad news • Capital gains tax would be paid • Rosenfeld (1984) finds an abnormal return of +2.21% over days (0.+1) 27 .

but if the parent indicates special dividend payment or debt reduction with the proceeds then abnormal return is +6.63% • In other cases the abnormal returns is close to zero 28 .+1).Other Divestiture Methods • Carve-out: shares of a subsidiary are sold to general public through an IPO • The parent usually maintains the control – Funds that are made available for the subsidiary can be invested for positive NPV projects – Reduced asymmetric information improves the value of subsidiary – Improved managerial compensation • Allen and McConnel (1998) find an abnormal return of +1.9% over days (-1.

Jeffrey W.org/sici?sici =0022-1082%28199802%2953%3A1%3C163%3AECAMD%3E2. McConnell.CO%3B2-Z JSTOR-Equity Carve-Outs and Managerial Discretion.org/sici?sici =0022-1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.. John J.jstor. Vol. 1. 125-135. 53. Yale ICF Working Paper No.jstor. Pricing and Allocations" (February 2002).Additional Articles • Muscarella and Vetsuypens. Ivo. Jay Rial and Welch. The Journal of Finance. Vol. "A Review of IPO Activity. http://ssrn. 1998). Journal of Financial Economics 24. 02-01. 53. Marco Pagano. pp.com/abstract=296393 JSTOR-Why Do Companies Go Public? An Empirical Analysis.. (Feb. URL: http://links. 1989. Luigi Zingales. Allen. 163-186. No. 1. No. 1998).0. The Journal of Finance.CO%3B2-W • • • • • 29 . SSRN-Ritter. pp. A simple test of Baron’s Model of IPO Underpricing.0. Fabio Panetta. URL: http://links. 27-64. (Feb.

No. Rosenfeld. 1.org/sici?sici =0022-1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2. Jay R.0.jstor. 5. 1984). 1983).org/sici?sici =0022-1082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2. URL: http://links.CO%3B2-0 JSTOR-The Long-Run Performance of Initial Public Offerings. 3-27. pp.. Ritter. Vol. 1597-1606.0. Vol. No. (Dec. (Dec. 1437-1448. URL: http://links. James A.jstor. (Mar. 46..0. 39. URL: http://links. Miles. James D.. James D. 5. pp. 1991). Rosenfeld. No.org/sici?sici =0022-1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.Additional Articles • • JSTOR-Additional Evidence on the Relation Between Divestiture Announcements and Shareholder Wealth. pp.CO%3B2-1 JSTOR-The Effect of Voluntary Spin-off Announcements on Shareholder Wealth. 38.CO%3B2-9 30 • • • • . The Journal of Finance. Vol. The Journal of Finance.The Journal of Finance.jstor.

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