Advanced Corporate Finance Initial Public Offerings Vol II: Market Players and Evidence

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1 Advanced Corporate Finance Initial Public Offerings Vol II: Market Players and Evidence Thomas J. Chemmanur Carroll School of Management Boston College

2 THE NEW ISSUES PUZZLE: UNDERPRICING *The large abnormal return observed in most countries and markets from the initial offer price to the closing price on the first day of trading in the secondary market. *Varying days (first-week return is an alternative) of measurement-but essentially same results. *Also called initial return : This is probably better terminology, since the word underpricing implies that the large initial return is due to deliberately setting a lower price than necessary.

3 Underpricing examples $80 $70 $69 $60 $50 $40 $30 $20 $13 $33 $16 $22 $33 Offer price First day closing price $10 $0 Yahoo (Apr 12, 1996) Priceline.com (Mar 30, 1999) Chipotle Mexican Grill (Jan 26, 2006)

4 IPOs are underpriced in every country In the U.S. from , the average initial return (underpricing) is 18% The evidence in the following two charts also covers this period

5 Average first-day returns 140% Average first-day returns on non-european IPOs 120% 100% 80% 60% 40% 20% 0%

6 Average first-day returns 60% Average first-day returns on (mostly) European IPOs 50% 40% 30% 20% 10% 0% -10%

7 IPO volume has been very low in the U.S. since In , an average of 310 firms went public every year In , an average of 103 firms went public every year Number of Offerings (bars) and Average First-day Returns (yellow) on US IPOs,

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9 Underpricing over the years

10 INTERNATIONAL EVIDENCE ON IPO UNDERPRICING The article on the course website, Initial Public Offerings: International Insights by Loughran, Ritter, and Rydqvist gives a good summary of the international evidence on IPOs. I will present several tables and figures from that article here

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13 IMPORTANT EMPIRICAL REGULARITIES: (See Ritter article in Chew book for a quick review) *Underpricing over the years *Underpricing versus size of the firm Other important results: (i) Older the firm, less underpricing. (ii) Larger the issue (or larger the issuing firm), less the underpricing. (iii) More costly it is to learn about firm, more underpricing.

14 Note that, while IPO stocks are underpriced on average, about a third have negative initial returns.

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17 Correlation between where the IPO offer price is set (relative to the initial filing) and underpricing There is a correlation between how the IPO offer price was set relative to filing range and underpricing (or initial return). Setting above the initial filing range indicates high demand for the IPO shares, while setting below the range indicates a low demand during the bookbuilding process This translates into higher or lower initial return (underpricing) What does this say about what causes underpricing?

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19 BEST EFFORTS VS. FIRM- COMMITMENT OFFERINGS, AND THE COSTS OF GOING PUBLIC *BEST EFFORTS CONTRACT: The issuer and underwriter negotiate an offering price; underwriter only needs to make the best effort possible. If there is no demand, the offering is withdrawn.

20 *FIRM-COMMITMENT OFFERING: Underwriter agrees to guarantee that a certain amount of capital will be raised. Thus, underwriter buys all the stock offered, in effect.

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25 COSTS OF IPOS VERSUS OTHER SOURCES OF PUBLIC CAPITAL How does the cost of an IPO compare with that of SEOs, Straight bonds, and Convertible debt offerings? The total direct costs of IPOs is much larger as a fraction of gross proceeds

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28 Does IPO Underpricing Hurt Pre-issue Shareholders (Insiders)? The Effect of Underpricing on the Wealth and Ownership of Pre-issue Shareholders : A Numerical Example Assumptions: Pre-issue shares outstanding: 15.6 million shares Gross proceeds of IPO: $78 million Post-issue market cap: $280.8 million # of shares sold by pre-issue shareholders: zero Strategy 1 Strategy 2 Offer price and number of shares offered: 7.8 m at $ m at $13.00 Post-issue shares outstanding: 23.4 million 21.6 million Market price per share: $12.00 $13.00 Money left on the table: $15.6 million zero Post-issue wealth of pre-issue shareholders: $187.2 million $202.8 million Post-issue % of firm owned by pre-issue shareholders: 66.7% 72.2%

29 THEORIES OF IPO UNDERPRICING 1. Winner s curse theory (Rock, 1986). 2. Information production theory (Chemmanur, 1993). 3. Signaling theory (Allen and Faulhaber, 1989; Welch, 1989). 4. Issuer-exploitation theories. 5. I won t ask you to describe any of the above theories in the exam; all the above mentioned articles (including Chemmanur, 1993) are advanced readings, not required for the exam

30 CHOOSING AN IPO UNDERWRITER Selection of the investment bank to underwrite the IPO. Issues: Reputation and commitment to provide analyst coverage. This is important as analyst coverage leads to visibility and higher valuations. Prior IPOs underwritten by the investment bank and their valuations. Surprisingly, competition is less on underwriting fee: The 7% underwriter spread puzzle. Smaller bank (specialized) vs. larger, bulge bracket bank. E.g., Hambrecht and Quist vs. Goldman. Multiple investment banks may be co-managers, but one or two act as lead managers.

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32 CHOOSING AN IPO UNDERWRITER Role of the underwriter: Due-diligence (any skeletons in the closet?), pricing, marketing, legal support, postmarket liquidity, and analyst coverage. Analyst coverage has been considered especially important in creating a market for the IPO stock; (sell side) analysts are employed by investment banks

33 OTHER ISSUES RELATED TO CHOOSING AN IPO UNDERWRITER 1. Underwriter reputation; experience 2. Underwriting syndicates and distribution capability. - Relationship with large institutional investors. 3. Underwriter compensation Underwriter warrants The green shoe option..

34 OTHER ISSUES RELATED TO CHOOSING AN IPO UNDERWRITER 4. Aftermarket support underwriters can act as market-makers; underwriters may provide price stabilization if the price goes down below a certain range 5. IPO initial return (underpricing): Greater the underwriter reputation, smaller the underpricing (prior to the 1990s); greater the underwriter reputation, greater the underpricing (if we study data).

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37 THE ROLE OF ANALYSTS IN IPOS Analysts provide coverage and produce information about stocks. Keeps investors interested in a stock by providing information to investors. Promotes liquidity of the stock. Recent allegations suggest that analysts provide overly positive opinion of stocks that their employer (investment banks) underwrite. CFO Magazine, Oct 1, 2002: There may be a few investors left who don't know that analysts may issue overly optimistic recommendations about companies that do investment-banking business with their firms.

38 THE ROLE OF ANALYSTS IN IPOS Flip side: Analyst coverage is an important part of the IPO process. The demise of many boutique banks which provided analyst coverage to small firms has partly been blamed for the dearth of small firm IPOs. However, more recently, most IPOs have been able to obtain analyst coverage

39 Evidence on post-ipo analyst coverage There is near universal analyst coverage on IPOs in 1994 to 2009 The percentage of small (grey) and large (red) firm IPOs with analyst coverage from at least one lead underwriter within one year of the IPO % 95% 90% 85% 80% Source: Table 5, column 3 of Gao, Ritter, Zhu (2013 JFQA)

40 The Role of Venture Capitalists For VCs, exit is usually the main liquidity event. Typical VC funds are designed to last for 10 years (on average). To pay off investors, it becomes important for venture capitalists to exit their investments through various options. Two prominent ones are IPO of the portfolio firm. This is the golden standard. Sale of the portfolio firm to another company (Acquisition).

41 The Role of Venture Capitalists VC firms are intermediaries, i.e., they are agents of the venture fund s limited partners. To finance the next fund, VCs have to prove they ve made money on the current fund by selling portfolio firms or taking them public, i.e., reach a liquidity event. This creates incentives to sell or take a company public too early Fund have an incentive to grandstand. Particularly for young and small VC firms.

42 The Role of Venture Capitalists Evidence of Grandstanding (Gompers (1996)). On average, first-fund VC firms take firms public after 2.7 years versus 4.5 years for later-fund VC firms. First-fund VCs set up next fund 1 year after first IPO in first fund; later-fund VC firms set up next fund in 2.4 years. The fraction of IPOs of first-fund VC firms are greater than IPOs of later-fund VC firms (18.5% versus 7.8%). Age of VC firm matters!

43 The Role of Venture Capitalists On the other hand, the IPOs of firms backed by higher reputation venture capitalists are associated with higher reputation underwriters, greater analyst coverage, and larger fraction of equity held by institutional investors

44 Recently IPO Exits for VC-backed Firms Have Been Reduced 44 Source: NVCA 2013 Yearbook Tables 9 and 10

45 Value multiples for first-round Venture investments: IPOs versus acquisitions

46 The Timing of IPOs: 1. TIMING VIS-À-VIS THE MARKET - HOT ISSUE MARKETS 2. TIMING VIS-À-VIS THE COMPANY. IT IS EASIER TO TIME THE IPO RELATIVE TO THE EARNINGS CYCLE OF YOUR FIRM THAN TO THE MARKET (i.e., GO PUBLIC WHEN THE P/E FOR YOUR INDUSTRY IS HIGH).

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50 Where should a firm list its shares? *Typical exchange choices in the U.S.: NYSE; Nasdaq National Market; Nasdaq OTC *More reputable the exchange, higher the listing standards, higher the listing fees (initial and recurring annual fees) *Usually firms choose to list on the most reputable exchange that will allow them to list, though not always (Why?) *Microsoft is listed on the Nasdaq National Market, though they can easily get listed on the NYSE if they choose to

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