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Corporate Finance

New Issue

Yanzhi Wang

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Basic Procedures of IPOs Pre-underwriting conference Preliminary prospectus (red-herring) Roadshow / bookbuilding Pricing Public offering Overallotment option (Green shoe

option) Stabilization

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Pre-Underwriting Primary pre-issue role: provide

advice and help plan offer Firm needing capital selects one or

more lead underwriters. (book-runner)

Top firm the lead manager, others are co-managers

Underwriting syndicate organized early in process

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Preliminary Prospectus & Roadshow

Preliminary Prospectus Red Herring after title page disclaimer (in red

ink) Statements are submitted to SEC. Firm makes

changes and resubmits. Becomes effective with SEC’s final approval.

After preliminary filing, issuing firm and investment banker begin a road show. Investment banker does book building during

road show providing key pricing info

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Pricing & Public Offering

Prior to offerings Initial offer price set as a range; final

price set the day before offer. Details lock-up agreement Bulge bracket underwriter’s spread

(commission) usually 7.0% for IPOs Public offerings

Lead underwriter sets each syndicate member’s percentage of participation

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Issuing for Cash

Firm commitment The investment bank buys the securities for

less than the offering price and accepts the risk of not being able to sell them.

Investment bank underwrites the securities in a firm commitment.

Best efforts The investment bank sells all the securities at

the agree-upon offering price. The underwriter does not bear the risk.

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Overallotment Option & Stabilization

Overallotment option Also called Green Shoe option. A call option granted to underwriter(s) to be

able to sell up to 15% additional shares than scheduled

After-market service Lead underwriter is responsible for price

stabilization after offering After offering, lead underwriter serves as

principal market maker Research coverage

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Features (Anomalies) of IPOs Underpricing

Initial returns are huge and consistent across world

Offering price is lower than the after-market price Leave huge money on the table

Hot issue market High-volume months are followed by high-volume

months Hot issue markets (periods of high initial return)

are followed by hot issue markets High-volume months follow hot issue markets

Long-run underperformance IPOs underperform in 3-5 years after the issuing

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Initial return and long-run return, 1980-2011

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Ritter and Welch (2002)

This paper surveys three main questions in the IPO literature: Reason for going public Why leaving money on the table to

investors Why IPO underperforms in the long run

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Why Firms Go Public

Life cycle theories A firm going public is much easier to be a

potential takeover target. From a pre-IPO “angel”, there are costs of going

public that small firms cannot bear. So, early in its life cycle, a firm will be private until the optimal size for going public.

Timing An information asymmetry interpretation An irrational but information symmetry

explanation

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Why Leave Money on the Table? Information asymmetry / Signaling

Between investors: Winner’s curse (adverse selection)

Between issuer and investors: Leave a good taste

Between underwriter and investors: Underwriter reputation

Information acquisition Price partial adjustment

Lawsuit avoidance Cascades Prospect theory

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Hot Issue Market and Long Run Underperformance

Hot Issue market Time the market. Firms go public when bull

market since the cost of equity is low Long run underperformance

Market timing Pseudo market timing IPO lock-up Low risk of beta Model specification error

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Long Run Underperformance Debate

Why IPO firms underperform in the long run?

Small/growth firms size/BM control

Overlapping problem in BHARs Equal weight in stock returns or in

calendar time FF three-factor model

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Explanation by FF Model

Equal weight on calendar time Solve the overlapping and pseudo

market timing problem Value weight monthly portfolio return-

least powerful testing in market efficiency

Sensitive to time period Underperformance is dominated by 90s Internet bubble period

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Chambers and Dimson (2009)

This paper presents new and comprehensive evidence covering British IPOs since World War I.

During the period from 1917 to 1945, public offers were underpriced by an average of only 3.80%, as compared to 9.15% in the period from 1946 to 1986, and even more after the U.K. stock market was deregulated in 1986.

The post-WWII rise in underpricing cannot be attributed to changes in firm composition, and occurred in spite of improvements in regulation, disclosure, and the prestige of IPO underwriters.

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British IPOs

Around 1900 London was the preeminent international financial center: The British stock market was larger relative to GDP than in the United States, and was the second largest exchange in the world (Rajan and Zingales (2003)).

British IPOs lies in the dominance of the fixed offer price regime for much of the last century. In contrast, the U.S. market had moved to book-building IPOs much earlier.

In examining how underpricing changed over time, this paper considers whether improvements in investor protection and underwriting have resulted in lower underpricing over the course of the last century.

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Fixed offer price of LSE market

The IPO market on the LSE operated under a fixed offer price regime from at least WWI until the Big Bang in 1986.

The Big Bang induced competition in the securities business generally, and in IPO underwriting specifically, by allowing any bank including U.S. investment banks to own an LSE member firm. Thereafter, book-building became a more important IPO method in London (see Ljungqvist (2003), p. 24 and endnote 25).

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IPO underpricing

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IPO underpricing

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IPO underpricing determinants

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IPO underpricing determinants

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Liu and Ritter (2011) The paper develops a theory of initial public offering

(IPO) underpricing based on differentiated underwriting services and localized competition.

Even though a large number of investment banks compete for IPOs, if issuers care about non-price dimensions of underwriting, then the industry structure is best characterized as a series of local oligopolies.

They posit that venture capitalists (VCs) are especially focused on all-star analyst coverage, and develop the analyst lust theory of the underpricing of VC-backed IPOs. Consistent with this theory, it is found that VC-backed IPOs are much more underpriced when they have coverage from an all-star analyst.

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Non-price dimensions of IPO underwriting

This paper posits that issuers care not only about IPO proceeds, but also about non-price dimensions of IPO underwriting such as underwriter quality, industry expertise, and analyst coverage from influential analysts. quality, industry expertise, and analyst coverage from influential analysts.

A limited number of underwriters can provide these services for a given company, the IPO underwriting market is thus best characterized as a series of local oligopolies.

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Role of VC The model also generates a new theory of the

under- pricing of venture capital-backed IPOs: the analyst lust theory. Venture capitalists (VCs) are rationally focused on the market price on the day when shares in the company are distributed to limited partners, which is typically six months to 1 year after the IPO.

The market price is boosted by coverage from influential analysts, which we measure by using the ‘‘all-star’’ designation in the October issue of Institutional Investor magazine.

Because of their concern with this price, VCs have a greater lust for all-star analyst coverage that is bundled with IPO underwriting, resulting in greater under- pricing for VC-backed IPOs with all-star analyst coverage .

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Model- assumption

This paper focuses on differentiated IPO underwriting services and localized competition in the IPO underwriting market, it is assumed that only a subset of underwriters has some market power in each industry, and that only a subset of issuers is willing to pay for the differentiated product offered by these underwriters.

It is assumed that underwriters want to underprice IPOs more than is needed. Underwriters can benefit from underpricing IPOs in several ways.

First, underwriters can allocate underpriced shares to investors in exchange for soft dollar commission business.

Second, underwriters can allocate underpriced IPOs to executives to sway their decision in choosing which investment banking firm to hire, a practice known as spinning.

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Model- assumption

Although an underwriter would like to underprice IPOs, if issuers want to avoid excessive underpricing, an underwriter will win fewer IPO mandates if it underprices too much.

When choosing an IPO underwriter, issuers care about many dimensions of the underwriting service, which can be categorized into price and non-price dimensions.

The model starts with a single period, where a period denotes the length of time between IPOs in that industry.

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Model- assumption

Issuer’s objective function can be expressed as

Which are sum of the Net IPO proceeds and the Xi’s are the issuer’s perceived value of the n1 non-price dimensions. Sum of αi is 1.

One special case is Loughran and Ritter (2004)

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Model- assumption

Suppose that there are N underwriters in the market and a unit mass of issuers. Issuers differ in their preference parameter θ, which is distributed uniformly on the [0,1] interval, and represents the relative importance of having all-star analyst coverage.

Of the N underwriters, three of them have an all-star analyst. The perceived effect on the market value of retained shares from being covered by an all-star analyst is given by A.

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Issuer’s net surplus An issuer’s net surplus from going public at under-

pricing level U is

M is the market value of the shares being sold net of the gross spread and U is the cost of going public in terms of the under- pricing level in dollars (the money left on the table).

The first part of the net surplus, M-U, is the net proceeds from selling a fixed number of shares at the IPO. The second part of the net surplus, θ A, is the effect of all-star analyst coverage on value, A, multiplied by the issuer’s preference for an all-star analyst, θ.

Eq.(3)is a special case of Eqs.(1) and (2).

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Underwriter profit

The profit to underwriter k is

where Ū is the dollar amount of under pricing needed to compensate investors for the ex-ante uncertainty of issue valuation, which for simplicity is assumed to be the same across all issues

C is the cost of providing all-star analyst coverage (C=0 when no all-star coverage is provided).

Dk is the demand for underwriter k’s service. It is assumed that a fraction γ of the incremental

money left on the table U - Ū flows back to the underwriters through indirect channels.

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Underwriter profit under noncooperation

If N is large ,then the N-3 underwriters without an all- star analyst will not be able to charge U -Ū because they behave in a perfectly competitive market with a large number of underwriters and homogeneous services. Therefore, they will set U= Ū

Now we consider the level of underpricing that the three underwriters with an all-star analyst will charge. If the three underwriters do not cooperate, then under Bertrand competition, from Eq (4), each of the three underwriters charges

and obtains zero profit .

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Underwriter profit under collusion

If the three underwriters collude and charge the same level of underpricing (where the dot notation indicates collusion values), then the aggregate demand for their service from a unit mass of issuers can be calculated by finding an issuer that is indifferent between choosing an underwriter with or without an all-star analyst, which occurs when

Thus, the aggregate demand is

U

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Underwriter profit under collusion

The under pricing level that maximizes

, which is the aggregate profit of the colluding underwriters, occurs when

From Eq (6) we obtain and

, then substitute them into Eq (7), we get:

U

AUUD

1 AUD /1/

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Underwriter profit under collusion

Substituting Eq. (8) into (6), the aggregate demand from the unit mass of issuers for underwriters offering all-star coverage is then

Only issuers with will choose an underwriter with an all-star analyst.

The aggregate profit of the three underwriters is

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Underwriter profit profit under collusion

Generally, in an infinitely repeated game, each underwriter decides whether to cooperate by evaluating the following equation:

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Implications

Underpricing implication: Issuers that choose an under- writer with an all-star analyst are more underpriced than issuers that choose an underwriter without an all-star analyst.

Differential analyst influence implication: The underpricing charged for having an all-star analyst is higher for issuers with a higher perceived effect of all-star analyst coverage, A, and is higher in periods when all-star analyst coverage is more important.

Coverage cost implication: As the cost of all-star analyst coverage increases, the underpricing charged for having an all-star analyst increases.

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Implications

Analyst turnover and deal frequency implication: Excess underpricing is lower when a) all-star analyst turnover is high, or b) the frequency of deals in the industry is low, providing there is persistence of turnover and deal frequency

Underwriter concentration implication: The average underpricing and the Herfindahl-Hirschman Index (HHI) measuring underwriter concentration for an industry both increase as the effect of all-star analyst coverage, A, increases. Thus, HHI and underpricing should be positively correlated cross-sectionally.

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Underpricing regression

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IPO underpricing regressions with proxies for the cost of all-star analyst coverage.

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IPO underpricing regressions with industry volume and all-star analyst variables

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IPO underpricing regressions with issuer-specific HHI

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IPO underpricing regressions sorted by VC category

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Purnanandam and Swaminathan (2004)

This paper studies the valuation of initial public offerings (IPO) using comparable firm multiples.

This paper finds that the median IPO is overvalued at the offer by about 50% relative to its industry peers.

This overvalued IPOs provide high first-day returns but low long-run risk adjusted returns.

These results suggest IPO investors are deceived by optimistic growth forecasts and pay insufficient attention to profitability in valuing IPOs.

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IPO under/over pricing

It is found in the literature that IPOs earn large first-day returns (between 10% and 15%) after going public. This phenomenon is widely referred to as IPO underpricing.

But if there is underpricing, what is the underpricing with respect to? The underpricing is with respect to fair value. Or, issuers underprice IPOs with respect to the

maximum price they could have charged given the observed demand in the pre-market but not necessarily with respect to the long-run fair value.

This examines whether IPOs are underpriced with respect to fair value.

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Benchmarking and IPO overpricing

We value IPOs using price multiples, such as price-to-EBITDA, price-to-sales, and price-toearnings of industry peers and then compare this fair value to the offer price.

Our analysis reveals the surprising result that IPOs are systematically overvalued at the offer with respect to fundamentals. We find that, in a sample of more than 2,000 relatively largecapitalization IPOs from 1980 to 1997, the median IPO firm is overvalued by about 50% relative to its industry peers.

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Benchmarking and IPO overpricing P/V ratios

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IPO initial return is higher for overvalued IPOs, whereas the long-run risk-adjusted return is lower for those IPOs.

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Lowry, Officer and Schwert (2010)

This article proposes a new metric for evaluating the pricing of IPOs in traditional firm-commitment offerings: the volatility of initial returns to IPO stocks.

The monthly volatility of IPO initial returns is substantial, fluctuates dramatically over time, and is considerably larger during “hot” IPO markets.

Consistent with IPO theory, the volatility of initial returns is higher for firms that are more difficult to value because of higher information asymmetry.

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Volatility of initial returns to IPO stocks and information asymmetry

Beatty and Ritter’s (1986) extension of Rock (1986) predicts that companies characterized by higher information asymmetry will tend to be more underpriced on average.

It should be more difficult to estimate precisely the value of a firm that is characterized by high information asymmetry: Firms with higher uncertainty should have a higher volatility of initial returns.

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IPO data

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Frequency distribution of first-month IPO returns,

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Descriptive Statistics

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Variable definitions

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Relation between the Mean and Variance of Initial Returns and Information Asymmetry