Part 8 : Going public - IPO

Question 1

Immediate effects of the IPO include changes in

Answer 1

• Ownership structure: the IPO brings in new shareholders, implying a reduction in ownership concentration
• Capital structure: if new shares are issued, the IPO brings in new
  equity capital resulting in lower leverage
• Governance structure: the board of directors is typically restructured to meet the requirements of a public company, and to reflect the new
  ownership structure
• Management: often (partially) replaced, particularly if the IPO is used as an exit for the entrepreneur and/or existing private investors

Question 1

Motives for going public

Answer 1

• The IPO may serve as an exit for the entrepreneur and/or for private investors (such as PE or VC companies)
• It allows for diversification for entrepreneur/private investors
• Raising fresh equity enables the firm to pay off debt to reduce risk and reduce (indirect) bankruptcy costs
• The dispersed ownership and pooling of risk made possible through issuing equity publicly make it one of the most efficient ways to raise large amounts of capital; public equity also facilitates raising additional
  equity further on for investment, acquisitions, expansion, etc.
• Having publicly traded equity is likely to substantially reduce the firm’s cost of equity via a reduction in liquidity premia and the possibility for investors to diversify firm-specific risk, resulting in increased profitabil-
  ity of investment projects; publicly traded equity also provides an objective measure of value (useful for many purposes, including incentive
  pay of management)
• The higher level of disclosure, and analyst and media coverage of public firms reduce information asymmetries vis-`a-vis outside investors, again
  facilitating raising additional financing
• Governance effects:
  – monitoring opportunities increase with a reduction in information asymmetries, and the spotlight of analyst and media coverage sharpens indirect incentives to perform
  – going public increases the exposure to the market for corporate control (takeover threats), again disciplining management
  – on the flip side, the free-riding and coordination problems of dispersed ownership may reduce investors’ incentives to monitor

Question 2

Types of offering

Answer 2

In a primary offering, new shares are issued and offered to the public (it’s a primary-market issue that raises new capital to the firm; the firm’s balance sheet is expanded)

In a secondary offering, existing shares are sold off by current owners (brings no fresh capital to the firm, only implies a secondary-market sale of existing shares from one owner to another)

A traditional IPO is usually (but not always) a combination of both a primary and a secondary offering

Question 3

What is a direct listing?

Answer 3

There are ways to go public without a traditional IPO. In a direct listing (e.g. Spotify in 2018, Coinbase in 2021), there is no underwritten offering, and no pre-set offer price; the company goes public by allowing existing shareholders to trade their stock on an exchange. Consequently, this way of going public also does not raise fresh capital to the firm. Indirect ways of going
public include reverse mergers (a private firm acquires control of a public firm and assumes its public status), and getting acquired by a previously IPO-
ed blank cheque company (Special Purpose Acquisition Company, or SPAC).

Question 4

Types of sale

Answer 4

• Firm commitment: the underwriting investment bank guarantees the sale by purchasing the shares at a spread below the offer price and
  commits to reselling them to investors (often with an overallotment “greenshoe” option, which gives the underwriter the right to increase
  the size of the offering in case of high investor demand). In a firm
  commitment sale, the underwriter acts as a dealer and bears the price risk
• Best-efforts method : the underwriter commits only to selling as much as possible of the offering, but without any guarantee (often with an
  “all-or-nothing” clause permitting withdrawal of the offer if it is under-subscribed by investors). In this case, the underwriter acts as broker,
  and the issuing firm bears the risk
• Pure (Dutch) auction: the underwriter accepts bids from investors, and the offer price will simply be the highest price at which all shares are
  sold; this sales method has historically been unusual (the most well-known example is Google, which went public in 2004, and whose IPO

Check example

Question 5

In general (except in auctions), a fundamental part of the underwriter’s job in an IPO is to determine the offer price. In so doing, the underwriter faces
an obvious tradeoff. If the price is too low…

Answer 5

• the existing owners of the firm effectively sell too cheaply, and the value of any shares they retain is diluted
• the firm raises less capital than it could have at equal cost
• the underwriter’s percentage commission on the sale will be lower than it could have been (commissions are substantial, often 4–7 percent of the proceeds of the sale)

Question 6

In general (except in auctions), a fundamental part of the underwriter’s job in an IPO is to determine the offer price. In so doing, the underwriter faces
an obvious tradeoff. If the price is too high

Answer 6

• not all shares offered will be sold
• the underwriter may incur a loss if the IPO is guaranteed
• the underwriter may suffer reputational costs and lose future business from issuers and/or investors
• the IPO may fail altogether and be called off
• the aftermarket may suffer (lower liquidity, reduced ability to do follow-up issues)

Question 7

What is bookbuilding?

Answer 7

Price discovery in IPOs is typically achieved via bookbuilding (although fixed-
price offers were the norm internationally – including in well-developed markets like the UK – until mid-1990s). Bookbuilding essentially entails “polling” of institutional investors by the underwriting bank to gauge investor demand
for the issue. The process helps to determine the size, the price and the allocation of the offering.

Question 8

How does the IPO process start?

Answer 8

Any IPO process starts with putting together a preliminary prospectus of the issue and submitting it to the relevant financial supervisory authority.
Once the FSA has given its approval, the prospectus is circulated, and the issuer and underwriter take the proposed offering on a “road show”, where it is presented to potential institutional investors. Based on an initial price range set by the underwriter, investors give feedback on the proposed issue and make non-binding bids, which are recorded in a “book”.

Question 9

The bookbuilding
process thus involves two types of information flow

Answer 9

• From the issuer to potential investors (information about the issue, the company, etc.)
• From potential investors to the underwriter (about the appropriateness of the initial price range, and demand among investors for the issue)

Question 10

Out of the two two types of information flow for the bookbuilding process, which is more important and why?

Answer 10

Of these two flows, the latter is arguably more important. First because issuer firms are unable/unwilling to divulge information not in the prospectus to a select group of investors only (due to the legal risk entailed in giving some investors an informational advantage). The road show may therefore be considered to be more about marketing than about providing some investors
with information which is not already publicly known. Second, potential investors have better knowledge than the underwriter if not about what the offer price should be, then at least about their own demand for the issue at the initially proposed price range.

Question 11

How does the IPO process continue?

Answer 11

Based on the bookbuilding and on investors’ indications of interest in the issue, both the price and the size of the issue may be revised. A final price
range for the offering is then established, and a final offer price decided very shortly before the IPO date, possibly with some additional migration from
the price range established through the bookbuilding process.

Question 12

A main potential problem with bookbuilding

Answer 12

A main potential problem with bookbuilding is that approached investors have an incentive to understate their interest in the issue, as this is likely
to reduce the price at which they get to invest in the issue. To handle this problem, underwriters use discriminatory allocations to favor investors
who make strong indications of interest during bookbuilding. This reduces investors’ incentives to understate their interest (since that would reduce the likelihood that they are allocated shares) and encourages truthful indications
of interest, thereby reducing the downward bias in issue price and increasing the expected proceeds from the issue.

Question 13

Why are institutional investors are favored in IPO allocations?

Answer 13

This also gives a rationale for why institutional investors are favored in IPO allocations: retail investors don’t contribute to price discovery in IPOs,
institutional investors do, and are therefore rewarded with higher allocations. Whether pricing via bookbuilding primarily contributes to more efficiently priced IPOs, or is primarily a problem by inviting collusion between underwriters and their favored institutional clients through the possibility of
discriminatory allocations, is debated.

Question 14

What is IPO underpricing?

Answer 14

the difference between the offer price and the closing price on the day of the IPO, in percent.

A large increase in the price on the first day suggests that the offer price was “too low”, and that the issuer is “leaving money on the table”.

Question 15

Main beneficiaries of underpricing? Who loses?

Answer 15

Investors who are allocated
shares at the offer price.

The underwriter may also gain if the offer is guaranteed, as it gives the opportunity to resell retained shares at a profit.

This gain comes at the expense of the initial shareholders. Underpricing is effectively a cost paid by the initial shareholders
to investors participating in the IPO.

The underwriters also bear some cost of underpricing as they get a slice of a smaller pie

Question 16

Winner’s curse (adverse selection)

Answer 16

• The model assumes information asymmetry between informed and uninformed investors
• It starts with the observation that abnormal first-day returns (i.e. underpricing) holds on average but not in each IPO
• It is assumed that informed investors are able to distinguish between profitable (underpriced) and unprofitable IPOs, and will bid only for
  the profitable ones, whereas uninformed investors bid indiscriminately
• Because all investors bid for underpriced IPOs, there will be excess demand for these issues, so underpriced offers will be rationed; this will not be the case for unprofitable IPOs
• Uninformed investors will therefore face the “winner’s curse” and will get rationed allocations in underpriced IPOs that generate gains, but
  full allocations in overpriced IPOs that generate losses
• In the limit, uniformed investors may get allocated almost only unprofitable IPOs, making their expected, rationing-adjusted returns negative, therefore making it rational for uninformed investors never to bid in any IPO
• If informed investors’ demand is insufficient, IPOs must be underpriced in expectation to make rationing-adjusted returns positive and uninformed investors willing to participate

Example page 12!!

Question 17

The winner’s curse story also has an interesting free-rider implication

Answer 17

Collectively, issuing firms benefit from underpricing, because without it, the IPO market would dry up due to adverse selection (uninformed investors exit the
market due to ending up with a disproportionate share of loss-making in vestments).

Individually, however, each issuer has an incentive to free-ride by trying to minimize underpricing for their own particular issue (i.e. they
would like to avoid paying for the “collective good”). But underwriters (unlike issuers) are involved in a repeated game, which gives them an incentive
to try to coerce issuers into accepting underpricing, for fear of losing future business

Question 18

Information-revelation theory

Answer 18

The information-revelation theory of underpricing is directly related to the price-discovery process in IPOs. It assumes information asymmetry between
better-informed investors and the underwriter of the IPO. As noted above, during the bookbuilding process, the well-informed potential investors in the IPO have an incentive to withhold information with a positive price impact and understate their demand for the issue to maximize their returns.

This gives the underwriter an incentive to design an allocation mechanism that encourages the informed investors to truthfully reveal their demand and
any information that may make pricing of the issue more efficient. This is achieved by excluding conservative bids and rewarding “aggressive” bids with
larger allocations during the bookbuilding process, which critically relies on discretion for the underwriter to decide on allocations

The main point is that for this mechanism to work, the IPO has to be underpriced, otherwise investors don’t care about being excluded. The more positive the information, the greater is the investor’s incentive to withhold it, and the greater the underpricing has to be to induce information revelation.
The main prediction of the theory is therefore that there should be a positive association between upward price revisions during the bookbuilding stage,
the allocation to “informed” investors, and underpricing.

This prediction is largely consistent with the empirical evidence, which suggests that institutional investors are favored over retail investors, and the more so the more the offer price exceeds the initial price range. Underpricing
also tends to be greater the larger the share allocated to institutional investors, and the larger the upward price revision. There is also some detailed (book-level) evidence that more informative bids receive larger allocations, and that allocations increase in bid aggressiveness (which doesn’t directly explain underpricing, but does confirm that underwriters use allocations to discourage downward-biased bids from investors during bookbuilding).

Question 19

3.3 Agency conflics

Answer 19

Text

Question 20

There are a number of ways in which issuers can attempt to reduce agency problems

Answer 20

• By monitoring the underwriter
• By increasing the share of the underwriter’s compensation that depends on the offer price (it’s possible that this partially explains why percentage commissions are so high)
• By threatening to call off the issue if proceeds are too low; having alternative financing in place makes this threat more credible (and some evidence suggests that underpricing is lower for issuers with recourse to alternative sources of financing)
• Granting the underwriters a greenshoe option may also reduce their self-dealing incentives (increases the size of the issue and thereby commissions; also increases the underwriter’s opportunities to make gains from own sales)

Question 21

Signaling

Answer 21

• Information asymmetry between issuers and uninformed investors
• Investors can’t distinguish between “good” and “bad” firms
• Good firms have an incentive to signal their quality to raise equity on more favorable terms, and are prepared to incur the cost of underpricing to provide such a signal (cf. the debt contracting model in Part 6 – the
  mechanism is exactly the same)
• The cost of the signal is recouped in a follow-up SEO (which is when the benefit of being able to raise equity on more favorable terms is
  realized)
• Bad firms can’t mimic this signal because post-IPO they will be revealed as low-quality and won’t be able to recoup the cost

Question 22

Underpricing just reflects the uncertainty

Answer 22

A particularly simple idea is that underpricing just reflects the uncertainty of the issuer firm’s true value, and that offer prices are set conservatively in response to price risk. Invoking standard asset pricing theory, the counterargument would be that this type of risk should be more or less totally unsystematic and therefore perfectly diversifiable. Consequently, underpricing
should be zero on average. It is also not clear why the uncertainty should disappear immediately after the IPO (by definition, underpricing implies that the price adjusts to the market value on the first day).

Question 23

Other explanations of underpricing include

Answer 23

• Institutional (procedural issues, trading rules and conventions, regulatory constraints, taxes and other legal issues, etc.)
• Control theories (strategic underpricing to optimize post-IPO owner ship structure for retained control by insiders)
• Behavioral (biases of investors and/or issuers move offer prices away from their true value)

Question 24

IPO pricing: The example of Facebook

Answer 24

TEXT

Question 25

Cyclicality in IPOs

Answer 25

Besides IPO underpricing, another stylized empirical fact is the cyclicality of IPOs, as exemplified in Figures 4–7 for the US, the UK, Singapore and Sweden (somewhat randomly chosen). To some extent, cyclicality in IPOs is to be expected. In real business-cycle upturns, more investment and growth opportunities are created, implying that firms have a greater need for capital.
Consequently, IPO volumes should increase (the IPO market is just one of many potential sources of capital for firms, and other financial markets are highly cyclical as well). However, general business cycle fluctuations alone fail to explain the magnitude of the swings in IPO markets. In addition, offering volumes are, in general, positively correlated with the extent of underpricing. The most likely explanation for this phenomenon is that firms go public when equity valuations (or at least when stock prices) are high, i.e. in “hot markets”. Issuers must always trade off the proceeds of the issue against the probability of the IPO succeeding. Setting the issue price too high increases the probability that the IPO fails. When the valuation of comparable firms is high, the opportunity cost of a failed IPO is high, which makes issuers less insistent on a high price. Conversely, when the valuation of comparable firms is low, the issuer has little to lose from pushing for a high price – i.e. the tradeoff swings in favor of trying to maximize the proceeds. As a result, both IPO volumes and underpricing are high in hot markets (and vice versa).

Question 26

Is going public becoming less attractive?

Answer 26

A more long-term and recent trend, which was first visible in the US but
also applies to other developed stock markets (from about a decade later) is
the decline in the number of listed firms. In the US, the number of listed
firms peaked in 1997 at about 7,500, and has since fallen by half, putting
the current number (less than 3,800) 20 percent below the number of listed
firms in the mid-1970s (see Figure 8). Before 1997, by contrast, the number of listed firms showed a steady trendwise increase roughly at the rate of real growth in the economy (which might be a reasonable first guess). A similar trend of negative net listings can be seen in Europe, and the OECD as a
whole, since the global financial crisis in 2008 (see Figure 9).

During the post-war period, a substantial decline in the number of US public firms has only happened once before: during the buyout wave of the 1980s. During that period, the drop was much smaller in both absolute and relative terms, although it appeared dramatic at the time. Over the course
of the 1980s,
- the number of buyouts of public firms increased five-fold

• the average value of the buyouts of public firms increased eight-fold
• the total value of buyouts from public equity markets (including divisional buyouts) increased by a factor of 50

Question 27

Jensen (1989)

Answer 27

In a well-known article, Jensen (1989) made the analysis that this massive increase in buyouts of corporate assets from public markets occurred as a response to the failure of internal and external governance mechanisms – specifically, boards of directors and product markets – to countervail severe agency problems in mature, profitable, and widely held firms. In line with the agency-costs-of-free-cashflow hypothesis, Jensen viewed these firms as inefficient, value-wasting, and expropriating shareholder wealth to the benefit of managerial self-interest (this was before rise in payouts seen since the mid-
1990s)

The buyout wave was an exponent of the market for corporate control (in the guise of specialized LBO firms) stepping in as a “governance mecha-
nism of last resort”, and the development was made possible by the financial deregulation and innovation that started in the late 1970s and early 1980s. Particularly the emergence of the market for below-investment-grade corpo-
rate bonds (the junk bond market), which provided much of the financing for the buyouts, and the growth of derivatives markets, which made it possi-
ble for the highly leveraged buyout firms to manage interest rate risk, were important in this regard. Jensen argued in favor of debt as disciplinary mechanism, and argued that this, in combination with incentive alignment and monitoring by the LBO firms, had the potential to unleash large values from
the bought-out firms.

Importantly, the drop in the number of listed firms during the 1980s was almost completely driven by buyouts, and there was no trendwise change in the number of IPOs during this period. The more current trend not only constitutes a much bigger drop in the number of listed firms. It is also completely different. The drop results at least as much (arguably more) from a lower number of IPOs as from a high number of delistings

• The average number of US IPOs annually since 2000 is about one third of the average number during 1980-2000; the average number of small-firm IPOs is 80% lower
• The dominant reason for delistings is mergers (not buyouts, which account for only about 10%, see Ljungqvist et al., 2016
• The agency explanation is inconsistent with the rise in payouts seen during the same period (cf. Lecture Notes, pt. 5)

Question 28

The characteristics of listed firms have also changed drastically over the last
decades, including

Answer 28

• They are older (average age since the IPO has increased from 11–12 years on average over the 1970s–90s to 18 years )
• They are bigger (average real market capitalization has increased 9-fold; the fraction of small firms has dropped from 60 to 22%)
• They have less fixed and more intangible assets (5-fold increase in R&D expenditure over assets, CAPEX halved, average fixed-assets share has dropped by more than 40%)
• They have much less debt (market leverage almost halved, the share of firms without any debt tripled, cash doubled, net leverage has dropped from 17 to 1.3%)
• They are less profitable on average: equal-weighted average ROA from 4 to −8% (but stable and high for the largest firms); the fraction of loss-making firms has more than doubled from 14 to 37%)
• Ownership structure has changed (institutional ownership from 18 to 50%, the fraction of firms with blockholders has increased from 12 to
  32%)
• The concentration of earnings and assets among the very largest firms has increased (see Figure 10)

Question 29

Possible explanations:
Could the trend be the effects of a healthy, efficiency-increasing wave of
consolidation? Probably not:

Answer 29

• The number of public firms drops, not the total number of firms in the economy; if it were driven by consolidation, both the number of public and private firms should decrease
• The number of public firms drops also in growing industries
• Firms’ propensity to go public drops across industries and size classes
• The gains from mergers appear to come from market power (monopoly rents), not from increases in efficiency

Question 30

Could it be driven by the increased regulatory burden of being a public firm
following reforms like the Sarbanes-Oxley Act, the Dodd-Frank Act, etc.?
Probably not:

Answer 30

• The drop in the number of public firms started before these reforms were implemented

ˆ Firms that delist don’t voluntarily go private (because of an excessive regulatory burden), they are acquired

Question 31

Other (more likely) explanations:

Answer 31

• The increased importance of R&D makes the indirect (competitiveness) costs of the information disclosure requirements for public firms
  higher; higher intangibility also increases information asymmetries vis-`a-vis outside investors, making widely held public equity a less suitable
  financing form
• The increased dominance of institutional investors makes public markets less attractive for small firms, because large institutions cannot easily invest in small firms; it also makes exchanges cater more to institutions and to large firms, reducing the value of being public for small firms
• Public markets are receiving increased competition from alternative sources of funding which are in many cases possibly more suitable for
  small, R&D-intensive firms (VC and PE firms, P2P financing, etc.)
• Economies of scope, and network and platform externalities have increased in importance, making it more important to grow big fast; at
  least half of the top-10 listed US firms (by market cap) are tech firms competing in typical “winner-take-all” markets
  – In this environment, small firms may be better off selling to a large firm rather than going public and trying to grow organically
  – The increased concentration of earnings among large firms also
  makes it harder for small firms to make it on their own and compete with increasingly dominant market leaders
• Finally, technological developments and increased possibilities for outsourcing production makes it easier for firms to bring a product to market without hard assets and large employee forces; as a consequence, firms may not need to go public and raise large amounts of equity to invest in production