Initial Public Offerings Flashcards
IPO
A company’s first offering of shares to the general public
- previously private firm
- not a private placement
Seasoned Equity Offering (SEO)
Equity issue by a firm that is already public. As in an IPO the shares issued can be primary or secondary shares.
Primary Offer
Shares offered are new shares being issued by the company. The money raised by selling these shares is invested in the firm.
Secondary Offer
The shares are sold by current investors (e.g. founder, VC’s,…). The money raised by selling these shares goes to their previous owners.
Benefits of IPOs
- New funds
- Lower funding costs (increased liquidity)
- Transparency (disclosure requirements, higher visibility)
- Offer an exit for financiers (but lock-up period)
- Merger and Aquisitions
- Lower debt ratios
Costs of IPOs
- Costly process (direct costs approx. 7%)
- Ownership dispersion and loss of control
- Compliance
- Increased disclosure and scrutiny
- Perceptiondependency
- Stock is susceptible to all kinds of market errors and imperfections
Key “window-dressing” activity
Earnings management
Standard IPO process
1) Choose an investment bank
2) Assess value and set offer details
3) Gauge investor demand
4) Regulatory filings and prospectus
5) Allocate shares
6) Manage IPO and post-issue phase
1) Choose an investment bank
IPO process
- Should have industry experience (story line - CIM)
- Client base and reputation are key
- Agree on IB contract: firm commitment vs. best effort
- Lead IB/Underwriter then forms a banking syndicate
2) Assess value and set offer details
IPO process
- Lead IB is valuing the private business
- Price “per share” is set
- If IB guarantees the price, often 10-15% price reduction as buffer against errors (discount from lead bank)
3) Gauage investor demand
IPO process
- Building the books: sound the offering price with investors
- IB gets the anchor investor
- Road shows
- Price is adapted accordingly if demand is very strong/weak
4) Regulatory filings & prospectus
IPO process
- Prepare firm for regulatory compliance
- Prepare and publish prospectus for potential investors
5) Allocate shares
IPO process
- Investors start to request shares
- IB allocates available shares across syndicate/investors
- Deman > Supply: Rationing of shares, opportunity to “make friends”
- Deman < Supply: if IB guaranteed the deal, IB buys the remaining shares at the offering price
6) Manage IPO and post-issue phase
IPO process
- On offering date, shares open for trading
- Post-issue management = potential support for stock in case of high volatility (stabilization activities)
Red herring
Preliminary draft of the prospectus (lower information regulation, missing some key information on issue)
Firm Commitment
IB contract
- Underwriter guarantees the deal
- Underwriter bears the uncertainty of the issue (10-15% price buffer)
- Compensation via underwriting comission
Most common method
Best Effort
IB contract
- Underwriter does not guarantee that the stock will be sold
- Issuing company bears the uncertainty/risk of the issue
- Compensation of IB via flat fee
Overallotment Option
IB has the right to sell 15% more shares than initially guaranteed
Also called “Green Shoe Option” (1963)
IPO pricing methods
- Fixed-price Offer
- Book-building
- Auctions
Fixed-price Offer
IPO pricing methods
- Determined price at which securities will be sold
- No investor involvement in pricing (no market sounding)
- Price determination via financial modelling and industry multiples
Book-building
IPO pricing methods
IB determines the price range (DCF & multiples) and gets indications (non-binding) of interest from investors
Auctions
IPO pricing methods
A market clearing price is set after bids are submitted
Special Purpose Acquisition Companies
SPACs
- “Blank check” companies are directly-listed cash shells
- Created for the purpose of merging/acquiring a pricate/non-listed company
Regulations on SPACs
1) Restricted purpose (acquiring a business)
2) Time constraint (18 months)
3) Use of proceeds (escrow account)
4) Shareholder approval required
5) Opting out provisions
Characteristics of IPOs
3 puzzling characteristics
1) Short-run Underpricing
2) Cycles in the number of IPOs
3) Long-run Underperformance
Short-run Underperformance
3 puzzling characteristics of IPOs
Offering price too low: firm left money on the table
- Maximize firm value = maximizing aftermarket/long-term price
- Maximizing proceeds to selling shareholders = maximize offer price
- Minimize costs associated with the ongoing public process = minimize spread between price offered by IB and market offering price
Reasons for Underpricing
Short-run Underpricing (IPO characteristic)
- Winner’s Curse
- Signalling Hypothesis
- Corruption
- Informational Cascades
- Lawsuit Avoidance
- Dispersed Ownership Hypothesis
- There is no underpricing (behavioural)
Cycles in the number of IPOs
3 puzzling characteristics of IPOs
Hot markets - many IPOs
- firms need funds –> IPO
- firms have higher share price –> SEO
Cold markets - fewer IPOs
Irrational market story:
- Markets run hot and cold based on investor sentiment
- Against the concept of efficient markets
Efficient market story:
- The quality of investment opportunities varies over time (clustering of these can lead to a hot market)
- Firms tend to issue stock to the public when there are great investment opportunities (IPO timing)
Long-run Underperformance
3 puzzling characteristics of IPOs
- The divergence of opiniuon hypothesis
- The impresario hypothesis
- Window of opportunity hypothesis
