Week 9 - Initial Public Offerings

Question 1

Free-rider problem in shareholder monitoring // VC monitoring

Answer 1

A -ve externality that arises for shareholders of large public companies, who are often small & have no skill/incentive to monitor the company
- Monitoring is costly, requires time & effort
- So if benefit of an activity is shared by everyone & the cost is borne by only one person, it is not worthwhile.
-> No one monitors

On the other hand, VCs are big shareholders of a company, so they enjoy a big part of the benefits from monitoring

Question 2

Fund structure of a VC

Answer 2

1. VC funds belong to the Private Equity (PE) industry, as opposed to publicly-traded equity.
2. VC funds are usually structured as LIMITED PARTNERSHIPS consisting of 2 types of partners:
   - Limited partners, provide capital for the partnership & don’t directly make investment decisions
   - General partners, responsible for choosing & monitoring the fund’s investments. Contribute mainly skill & less capital

Question 3

2 ways VCs can exit the portfolio firms

Answer 3

1. M&A
2. IPO - a company’s equity is available to the public for the first time

Related terminology: seasoned equity offering (SEO) - sale of new securities by a firm that is already publicly traded
^not to be confused with Secondary offering

Question 4

3 main benefits of IPOs

Answer 4

1. Funds for investment
2. Diversify the initial investors
   - Founders can cash out & use money for other ventures
   - Current equity holders usually sell a fraction of their shares but not a large fraction! Why not?
   > Outside investors would take it as a NEGATIVE SIGNAL that the INSIDERS of the firm have -ve information.
3. Exit strategy for VCs and other investors
   - Founders want VCs and banks out. Would rather have dispersed shareholders
   - VCs and other early investors want out. Typically have a 5-10 year timeframe, want to realise returns and move on.

Question 5

3 main costs of IPOs

Answer 5

1. Monetary costs
   - Administrative costs -> big economies of scale in IPOs; expensive to comply w/ regulatory filing requirements after becoming publicly traded
   - Underwriting costs (7-11%): the fee that Its charge for their services
   - UNDERPRICING: IPO price < < day 1 closing price
   -> Loss for existing shareholders, gain for new shareholders
2. Disclosure requirements
3. Loss of control and freedom
   - Dilution of ownership stake & greater regulatory oversight

Question 6

What does it mean by “FAIR IPO issue price” given the 7% direct issuance cost?

Answer 6

Pre-issuance price = post-IPO price

Question 7

IPO Direct costs vs Underpricing

Answer 7

Underpricing costs are way HIGHER than the direct costs.

Question 8

Seasoned equity offerings (SEOs):
“X for Y” Rights issue + Value of right formula

*SEOs also include:
- General cash offer (sale of securities open to all investors)
- Private placement (sale of securities to a limited no. of investors w/o a public offering)

Answer 8

For every Y shares you own, you have the option to buy X more shares from the company. (Allocating call options to existing shareholders)

As long as the rights are exercised / sold by existing shareholders for a FAIR PRICE, they are not made worse off!!!

Value of right = (P_current - P_issue) x N/(N+1) dilution factor
and N = Y/X = no. of shares per right

Question 9

Money left on the table

Answer 9

Underpricing cost, ie. how much money that a firm could’ve raised but didn’t b/c issued underpriced equity

Question 10

4 reasons why IPOs are underpriced (on average)

Answer 10

1. Underwriter price supports
   - Investment banks might purposely set IPO price low to MITIGATE their own RISK
2. Benefit the underwriter
   - Favours for the clients of the underwriters so that they might return to the investment bank for future services (essentially bribing)
3. Risk averse owners
   - Once-in-a-lifetime very positive NPV project
4. Information asymmetry (“Winner’s curse”)
   - (A very small group of) INFORMED INVESTORS stay away from BAD DEALS as they know for sure if IPO is underpriced
   - UNINFORMED investors who subscribe to all IPOs receive a disproportionate allocation of shares in bad deals (since smart investors stay away. Hence they get EXPECTED -ve RETURNS on average)
   - When the IPO is a good deal, informed investors also subscribe hence uninformed investors receive a small (or no) allocation.
   - Bidding strategy: To get uninformed investors to be willing to PARTICIPATE in IPOs, uninformed investors need a DISCOUNT on the fair price in order to break even. If not, IPO cannot go ahead.

Question 11

3 costs & 3 benefits of going public

Answer 11

Significant benefits
1. Capital
2. Diversification
3. Exit strategy for early investors

Significant costs
1. Direct upfront costs (incl. underpricing)
2. Subsequent disclosure costs
3. Loss of control and freedom