Lecture on Initial Public Offerings

Some Thoughts on Initial Public Offering 1 Why do firms go public? • Raise capital • Achieve liquidity – Investors can be more diversified – Stock can be used for M&A activity • Entrepreneurs regain control from venture capitalists when shares are distributed • Signals stability and dependability to customers and suppliers 2 Costs of going public • IPO creates substantial fees – Legal, accounting, investment banking fees are often 10% of funds raised in the offering • Greater degree of disclosure and scrutiny • First day under-pricing • Market cycles in IPOs valuations 3 Direct and Indirect Costs of IPOs Proceeds (in millions of dollars) Gross Spreads (in %) Other Expenses (in %) Total Direct Costs (in %) Average Initial Return (in %) Average Direct & Indirect Costs (in %) Number of IPOs Interquartile Range of Spread (in %) 2-9.99 9.05 7.91 16.96 16.36 25.16 337 8.00-10.00 10-19.99 7.24 4.39 11.63 9.65 18.15 389 7.00-7.14 20-39.99 7.01 2.69 9.70 12.48 18.18 533 7.00-7.00 40-59.99 6.96 1.76 8.72 13.65 17.95 215 7.00-7.00 60-79.99 6.74 1.46 8.20 11.31 16.35 79 6.55-7.00 80-99.99 6.47 1.44 7.91 8.91 14.14 51 6.21-6.85 100-199.99 6.03 1.03 7.06 7.16 12.78 106 5.72-6.47 200-499.99 5.67 0.86 6.53 5.70 11.10 47 5.29-5.86 500-up 5.21 0.51 5.72 7.53 10.36 10 5.00-5.37 7.31 3.69 11.00 12.05 18.69 1767 7.00-7.05 Totals: Direct and Indirect Costs (in %) of Equity IPOs from 1990 to 1994 Based on: Lee, Lochhead, Ritter, and Zhao (1996) 4 Step 1: Selecting an underwriter • Criteria: – Reputation of the analyst covering the firm – Performance of past IPOs – Not a criteria: fees! (7% of capital raised) • Hi-Tech IPOs are often underwritten by a consortium – Technology specialist plus large underwriter, “bulge bracket” 5 Step 2: Tasks of the underwriter • • • • Due Diligence Determine the offering size Prepare the marketing material Prepare regulatory filings (S-1) together with the legal representation of the firm 6 Step 3: Marketing the offering • “Red Herring”: Circulate a preliminary prospectus to potential investors • Road-Show • Book-building: Collect information about the demand from potential investors to set the price and size of the offering – “Firm commitment offerings”: Investment bank commits to sell the shares at the set price 7 Step 4: The offering • The underwriter buys the shares from the company at a fixed price and immediately sells it to investors at the IPO price • “Green Shoe” option: • Clause in the underwriter agreement specifying that in case of exceptional public demand the issuer will authorize additional shares for distribution by the underwriter at the offering price (usual is overallotment option of 15%) 8 Step5: Aftermarket activities • Short covering: • Underwriter shorts the stock prior to the IPO. If the share price rises after the IPO, underwriter uses over-allotment option to cover the short, if the price falls it buys stocks in the market • “Pure” stabilization bids • Underwriter posts bid in the open market not exceeding the offer price • Penalty bids • Revoke selling concession if shares are “flipped” 9 Empirical Regularities • First-day under-pricing • Long-run under-performance • IPO markets are very cyclical – “Hot issue markets” 10 First day under-pricing • On average the stock price jumps on the first day of trading – From 1990 to 1998 companies left over $27 billion on the table – The median firm has modest first day return, but a few firms have several hundred percent • This pattern is found in most developed capital markets 11 Average first-day returns on IPOs 1980s Return (in %) 1980s N 1990s Return (in %) 1990s N Segmented by issue size - Small - Large 8.7 6.7 944 1425 12.9 27.5 1761 2280 Segmented by underwriter prestige - Low prestige - High prestige 8.7 5.0 1889 663 14.5 26.8 2056 2189 Segmented by venture capital backing - Not VC-backed - VC-backed 6.7 7.8 1664 515 15.7 29.0 2293 1637 All All (excluding OP < $5.00) 7.8 6.8 2552 2358 20.9 20.9 4245 4129 Data Source: Lee, Locheed, Ritter and Zhao (1996) 12 ~1 00 >1 00 50 ~5 0 40 ~4 0 30 ~3 0 20 ~2 0 10 0~ 10 0 0> 0 x> -1 0 35% 30% 25% 20% 15% 10% 5% 0% <1 % of IPOs First day returns of IPOs (1990-98) % first day return Data Source: SDC 13 Average first-day returns Average Price Increase on First Trading Day (Closing Price vs. Offer Price ) -9 Ja 6 n97 Ap r-9 7 Ju l-9 7 O ct -9 7 Ja n98 Ap r-9 8 Ju l-9 8 O ct -9 8 Ja n99 O ct 6 l-9 Ju r-9 6 Ap Ja n9 6 100% 80% 60% 40% 20% 0% January 1996 to March 1999 Data Source: SDC 14 Money left on the table Company $16 Ivillage Inc Morgan Stanley Dean Witter Goldman Sachs Pricing Valuation (mil.) $160 $24 $88 $95.88 $350 $262 Pacific Internet Lehman Brothers $17 $51 $88 $264 $213 MarketWatch.com BT Alex Brown $17 $47 $90 $248 $201 United Pan-Europe Communications Covad Communications Group Delphi Automotive Systems Corporations ZDNet Group Goldman Sachs $32.78 $577 $43 $757 $180 Bear Stearns $18 $140 $40.50 $316 $176 Morgan Stanley Dean Witter Goldman Sachs $17 $1,700 $18.75 $1,875 $175 $19 $190 $35.75 $358 $168 OneMain.com BT Alex Brown $22 $187 $38 $323 $136 Autobytel.com BT Alex Brown $23 $104 $52.75 $238 $134 Priceline.com Lead Underwriter Offer Price First Trade Price $81 First Trade Valuation (mil.) $810 Money on the Table (mil.) $650 Data Source: "Why Don't Issuers Get Upset About Leaving Money on the Table in IPOs?," Tim Loughran and Jay R. Ritter, Review of Financial Studies, Vol. 15, No. 2 (2002), pp. 413-443. 15 Possible reasons for under-pricing • Herding effects – Demand by institutional investors induces less informed investors to “rush in” • Winner’s Curse – Uniformed investors fear that they will only be allotted shares in bad IPOs • “Leave a good after taste” • Market power: – Underwriter has control over the order book 16 Flipping and spinning • Flipping: Investors that are allocated shares in the IPO sell these at the first day of trading at a significant profit – A way for investment banks to reward their institutional clients? • Spinning: Underwriters offer shares in hot IPOs to executives in companies, whose business the bank is looking to attract 17 Flipping of IPO shares Institution Shares allocated in the IPO Shares bought on the first day Shares sold on the first day % of Allocation bought/sold Fidelity Management 150,000 0 150,000 100% AIM Capital Management 60,000 0 60,000 100% Alliance Capital Management 60,000 0 60,000 100% American Express 60,000 0 60,000 100% Morgan Stanley Asset Mgt. 60,000 0 60,000 100% Delaware Inv. Advisers 60,000 470,000 0 783% Weiss Peck & Greer 30,000 180,000 0 600% Columbia Management 25,000 25,000 0 100% 18 Why don’t issuers get upset about leaving money on the table? • Issuers believe the reasons their investment bankers present to them • Issuers are very risk averse and want to make sure that IPO succeeds • Since the issuers get rich themselves in the IPO, they do not mind the under-pricing • Some of them do! – WR Hambrecht’s OpenIPO, E-Offering 19 IPOs with downward revisions have less under-pricing >1 00 40 ~5 0 50 ~1 00 30 ~4 0 20 ~3 0 0~ 10 10 ~2 0 0> x> -1 0 0 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% <10 % of IPOs Downward Revisions % first day return Data Source: "Why Don't Issuers Get Upset About Leaving Money on the Table in IPOs?," Tim Loughran and Jay R. Ritter, Review of Financial Studies, Vol. 15, No. 2 (2002), pp. 413-443. 20 IPOs with upward revisions have more under-pricing 0~ 10 10 ~2 0 20 ~3 0 30 ~4 0 40 ~5 0 50 ~1 00 >1 00 0 30% 25% 20% 15% 10% 5% 0% <1 0> 0 x> -1 0 % of IPOs Upward Revisions % first day return Data Source: "Why Don't Issuers Get Upset About Leaving Money on the Table in IPOs?," Tim Loughran and Jay R. Ritter, Review of Financial Studies, Vol. 15, No. 2 (2002), pp. 413-443. 21 Quiet Period • During the first 25 days after the IPO the firm and its underwriters have to remain silent about the firm’s financial prospects – Prevent insiders from “hyping up” the price • After 25 days underwriters release their (usually favorable) reports about the firm • On average stock price rises at the end of the quiet period 22 Lock-up Period • Underwriters require that initial pre-IPO shareholders do not sell their stock for a pre-determined period (usually 180 days) – Keep incentives aligned – Prevent pressure on stock prices, if demand curves are downward sloping • Stock price drops significantly after the expiration of the lock-up period 23 Long-run under-performance • IPOs under-perform the market in the 5 years after the IPO • Reasons: – “Clientele effects”: Only optimistic investors buy into an IPO, but believes converge when more information is released about the firm – “Window of opportunity”: Valuations of IPOs is subject to fads so issues try to go public in “hot markets” 24 Long-run under-performance First six months Second six months First year Second year Third year Fourth year Fifth year Geometric Mean years 1-5 IPO firms 6.2% 2.6% 9.2% 8.5% 10.4% 13.7% 12.1% 10.7% Sizematched 4.5% 5.9% 10.8% 14.1% 14.2% 17.2% 14.0% 14.1% Difference 1.7% -3.3% -1.6% -5.6% -3.8% -3.5% -1.9% -3.4% Number 6226 6215 6226 6113 5327 4400 3704 6621 IPO firms 6.8% 2.9% 10.1% 11.5% 11.4% 12.6% 9.7% 11.0% Stylematched 2.2% 4.4% 6.7% 12.4% 11.2% 13.1% 10.8% 10.8% Difference 4.6% -1.5% 3.4% -0.9% 0.2% -0.5% -1.1% 0.2% Number 5967 5957 5967 5676 4911 4010 3348 6081 Percentage Returns on IPOs During the First Five Years After Issuing (1970-1998) Data Source: Lee, Locheed, Ritter and Zhao (1996) 25 Long-run performance of VCbacked IPOs • VC-backed IPOs show much less underperformance than non-VC-backed IPOs • Relative to their industry benchmarks VCbacked IPOs have no under-performance – VCs are better able to time industry cycles? • Most of the under-performance in the aggregate is driven by the smaller offerings 26 VC-backed IPOs Benchmarks Five-Year Equal-Weighted Buy-and-Hold Returns IPO Return Benchmark Return S&P 500 Index 44.6 65.3 NASDAQ Composite 44.6 NYSE/AMEX Value-Weighted Wealth Relative IPO Return Benchmark Return 0.88 22.5 71.8 0.71 53.7 0.94 22.5 52.4 0.80 44.6 61.4 0.90 22.5 66.4 0.75 NYSE/AMEX Equal-Weighted 44.6 60.8 0.90 22.5 55.7 0.79 Size and Book-to-Market (5x5) 46.4 29.9 1.13 21.7 20.8 1.01 Fama-French Industry Portfolio 46.8 51.2 0.97 26.2 60.0 0.79 Venture-Backed IPOs Benchmarks Five-Year Value-Weighted Buy-and-Hold Returns IPO Return Benchmark Return S&P 500 Index 43.4 64.5 NASDAQ Composite 43.4 NYSE/AMEX Value-Weighted Wealth Relative Nonventure-Backed IPO Wealth Relative IPO Return Benchmark Return 0.87 39.3 62.4 0.86 50.4 0.95 39.3 51.1 0.92 43.4 60.0 0.90 39.3 57.6 0.88 NYSE/AMEX Equal-Weighted 43.4 56.4 0.92 39.3 47.7 0.94 Size and Book-to-Market (5x5) 41.9 37.6 1.03 33.0 38.7 0.96 Fama-French Industry Portfolio 46.0 45.0 1.01 45.2 53.2 0.95 Venture-Backed IPOs Wealth Relative Nonventure-Backed IPO Data Source: Brav and Gompers, Journal of Finance (2001) 27 “Hot Issue” Markets • High average initial IPO returns lead to higher volume in the IPO market • Reasons: – Cycles in the quality and risk composition of firms that go public – Correlation in the fund inflow of large money managers, but this cannot explain under-pricing – “Animal spirits” 28 Number of IPOs from 1996-1999 Ja n96 Ap r-9 Ju 6 l-9 O 6 ct -9 Ja 6 n97 Ap r-9 7 Ju l-9 O 7 ct -9 Ja 7 n98 Ap r-9 Ju 8 l-9 O 8 ct -9 Ja 8 n99 120 100 80 60 40 20 0 January 1996 to March 1999 Data Source: SDC 29 IPO volume from 1996 to 1999 $12.00 $8.00 $6.00 $4.00 $2.00 $0.00 Ja n96 Ap r-9 6 Ju l-9 6 O ct -9 6 Ja n97 Ap r-9 7 Ju l-9 7 O ct -9 7 Ja n98 Ap r-9 8 Ju l-9 8 O ct -9 Ja 8 n99 $ billions $10.00 January 1996 to March 1999 Data Source: SDC 30