1 initial public offerings (ipos) financing new ideas venture capital initial public offering why...

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1 Initial Public Offerings (IPOs) • Financing new ideas • Venture capital • Initial Public Offering • Why issue equity publicly • IPO process • Underpricing puzzle • Long-run performance of IPOs • Other IPO/Divestiture methods

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Initial Public Offerings (IPOs)• Financing new ideas

• Venture capital

• Initial Public Offering

• Why issue equity publicly

• IPO process

• Underpricing puzzle

• Long-run performance of IPOs

• Other IPO/Divestiture methods

2

Financing New Ideas• Personal savings• Bank, but not likely to work• Government but a very limited resources• Large industrial companies• Venture Capital Funds

– Mostly organized as private partnerships– Need to prepare a business plan for funding– They invest in stages to control risk– They require board representation and get shares

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How Successful is Venture Funds

• http://www.ventureeconomics.com/

• http://www.nvca.org/

Fund Type 1 Yr 3 Y 5 Yr 10 Yr 20 YrEarly/Seed VC -2.00 -18.30 25.70 39.80 19.10Balanced VC 11.90 -8.00 13.20 21.40 13.60Later Stage VC 18.70 -7.00 4.60 16.80 13.80All Venture 7.40 -12.20 14.40 26.70 15.60Small Buyouts 14.70 -1.20 1.00 8.70 27.20Med Buyouts 14.20 -0.60 4.10 10.20 17.80Large Buyouts 19.30 4.20 4.10 10.50 14.20Mega Buyouts 26.30 2.40 2.90 7.30 9.10All Buyouts 23.70 2.20 3.10 8.50 12.70Mezzanine 13.70 1.40 5.20 7.40 9.50All Private Equity 18.80 -2.00 5.70 12.90 13.70NASDAQ 26.20 -1.90 -5.30 11.20 13.20S & P 500 17.10 -2.30 -3.60 9.90 13.50

Investment Horizon Performance through 06/30/2004Venture Economics' US Private Equity Performance Index (PEPI)

Source: Thomson Venture Economics/National Venture Capital Association

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IPO Activity• If idea is successful then more money can be raised

through an IPO

• IPO also allows venture capital to exit the investmentHistorical IPO Activity

0

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700

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of I

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Why IPO Activity is Cyclical

• Demand-side explanation suggests that start-up firms with good projects cannot get private funding and they use IPO for raising capital - internet firms during 95-98

• Supply-side explanation suggests that during some time periods investors and institutions that invest in IPOs have excess funds to invest

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Why IPO Activity is Cyclical• A time period with a lot of IPOs is called “hot

issue period”

• If a hot issue period is driven by supply-side then it may be advantageous for a new firm to go public

• If a hot issue period is driven by demand for funds then a new firm may be better off delaying to go public - competition for funds

7

Why Issue Equity PubliclyAdvantages Disadvantages

1. Access to capital markets 1. Expensive2. Improved liquidity for shareholders 2. Costs of dealing with shareholders3. Allowing original owners to diversify 3. Allowing competitiors gain information4. Monitoring by external capital markets 4. Public pressure5. Information provided by capital markets6. Enhanced credibility with stakeholders

8

IPO Process

• Underwriter Selection

• Registration

• Marketing and Book Building

• Pricing

• After Market Activities

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Underwriter Selection• Factors to consider:

– Investment banker’s general reputation and expertise

– Quality of its research coverage

– Investment bank’s distribution expertise - individual or institutional

– Prior banking relationships

• The most common underwriting arrangement is the “firm commitment”

• In this case the underwriter purchases all issued securities and then resells them to the public - price differential is called the “gross spread”

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Lead Underwriter• The lead manager plays the major role in the

IPO - scheduling, pricing, distribution of new issue, and assembling a group of underwriters to sell shares to the public

• The syndicate members are paid a portion of the gross spread for their participation - 60% of the gross spread

• The lead underwriter receives a fee for its efforts that is typically 20% of the gross spread

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Underwriter• Letter of intent

– The letter of intent protects the underwriter against expenses if the offer is withdrawn

– The letter of intent obligates the company to reimburse the underwriter

– It also specify the gross spread

– In most cases, the gross spread is 7% of the proceeds

– It also includes clauses on:• Underwriter’s firm commitment

• Cooperation by the company

• Releasing of all available relevant information

• Commitment by the private firm to grant 15% overallotment option to the underwriter

– Letter of intent is in effect until Underwriting Agreement is signed at pricing of the issue

12

Registration• The Securities Act of 1933 (Section 5) requires a registration statement to be filed

with the SEC

• The registration statement consists of two parts– The prospectus to be given to every purchaser of the securities

– “Part II” which contains information that need not be furnished to the public but is made available for public inspection by the SEC

• The registration statement allows public to obtain information about the issue

• The underwriter has a “due diligence” requirement to verify the information

• The Securities Act also makes it illegal to offer or sell securities to the public without registration

• The SEC has no authority to block a public offering based on the quality of the securities involved. It can require the issuer to provide all material facts

• The registration statement has to be signed by directors and principal officers of the issuer, the underwriters, accountants, appraisers and other experts

• Investors who maintain losses as a result of misstatements or omissions in the registration statement may sue these signatories

13

Marketing• Once it is filed the registration statement is

transformed into the preliminary prospectus or “Red Herring”

• The preliminary prospectus is used to market the issue• The SEC has 20 days to declare the issue effective• At that point the red herring becomes a prospectus• The company and the underwriter promote the IPO

through the “road show”• Road shows provide important monitoring for the

underwriter on investor demand

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Marketing• During the road shows the underwriter receives orders

from individual and institutional investors - book building– Retail investors typically submit a “market order” in which

only the quantity desired is stated

– Institutions typically submit limit orders where the quantity demanded is subject to a maximum price

– Retail orders are received earlier than institutional orders since institutions prefer to wait to a later stage of the process before submitting their orders

– Institutions submit an order with a commitment to purchase more shares in the open market if their order is fulfilled

15

Pricing• Once the registration statement is approved by the

SEC then two most important items have to be determined:– offer price– the number of shares to be sold

• Book building at this stage is very important to gauge the investor demand

• Some suggest that an IPO may be successful if it is three times oversubscribed

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Pricing• Ritter (1991) on IPO pricing suggests that IPOs

are “under-priced” – meaning that you can make money buy buying stocks from an underwriter and selling them in the market once public trading starts

• Flipping – dumping of shares as soon as trading starts – is discouraged by the underwriters, but it is not easy to control

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IPO UnderpricingPercentage averagefirst-day returns

1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000

120

100

80

60

40

20

0

-20

-40 Year

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IPO UnderpricingIPO Underpricing

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%19

80

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Years

Und

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IPO UnderpricingAggregate Money Left on the Table, millions

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Years

Mill

ion

s

Sou

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Why IPOs are Underpriced• If an issue is too low then the issuing firm’s

owners will not like bearing the additional cost of going public

• If an issue is priced too high then the underwriter is stuck with shares plus a bad reputation

• The underwriter is to balance between the tow extreme– Underpricing allows the underwriter to sell shares of

the firm easily– It reduces the possibility of lawsuits

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Underpricing and Average Investor• Assume that average investor is not informed well on the

quality of an issue• The uninformed investor faces a “winner’s curse” that is if

you bid in an auction and you end up with the item you most likely over bid

• Underwriters know that most average investors cannot distinguish between good and bad issues and to keep uninformed investors interested they underprice

• Otherwise uninformed investors would not play the game for long reducing the demand for the issue - bad for the underwriter

22

After Market• Stabilization activities by the underwriter:

– These involve trading by the underwriter to support the stock by buying shares if order imbalances arise

– This price support can be done only at or below the offering price

– The standard prohibitions against price manipulation do not apply to the underwriter during this period

• The final stage of the IPO begins 25 calendar days after the IPO when the so called “quiet period” ends

• During the “quiet period” investors rely on prospectus

• After the “quiet period” underwriters can comment on the valuation and provide earnings estimates on the new company

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Long-Run IPO Performance

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02-01. http://ssrn.com/abstract=296393

Year IPOsMarket

AdjustedSize and Book-to-Market Adjusted

1980 88.20% 35.50% 17.10%1981 12.80% -26.20% -7.40%1982 32.20% -36.50% -48.70%1983 15.40% -38.70% 2.50%1984 27.70% -51.30% 3.00%1985 7.60% -39.50% 7.30%1986 18.60% -20.40% 14.30%1987 -1.80% -18.90% 4.50%1988 55.70% 8.30% 51.30%1989 51.10% 16.80% 32.50%1990 12.20% -34.10% -32.40%1991 31.50% -1.70% 5.80%1992 34.80% -2.30% -19.40%1993 44.90% -7.80% -23.90%1994 74.10% -8.30% 1.00%1995 24.80% -62.30% -14.10%1996 25.60% -57.00% 8.60%1997 67.70% 6.80% 41.00%1998 27.10% 9.10% 12.20%1999 -46.20% -32.90% -74.20%2000 -64.70% -36.40% -42.60%

Average 3-year Buy-and-Hold Return

Periods IPOsMarket

AdjustedSize and Book-to-Market Adjusted

1980-1989 20.80% -24.70% 6.90%1990-1994 44.70% -7.20% -12.70%1995-1998 36.00% -32.30% 11.60%1999-2000 -53.80% -34.30% -61.20%

Average 3-year Buy-and-Hold Return

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LR IPO Performance and Hot Issue Periods

IPOsMarket

AdjustedSize and Book-to-Market Adjusted

Correlation with # of

IPOS-0.21 -0.34 -0.18

Correlation with First Day

Return-0.67 -0.18 -0.64

Average 3-year Buy-and-Hold Return

Source: Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02-01. http://ssrn.com/abstract=296393

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Other Divestiture Methods• Spin-off: a company gives the shares of a

subsidiary to its own shareholders

• Shareholders can then sell their shares in the market

• Shareholders are not subject to taxes if 80% of the subsidiary stock is distributed

• Miles and Rosenfeld (1983) find an abnormal return of +3.34% to parent firms over days (0, +1) around the announcement

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Why Spin-off?• Eliminate negative synergies

• Increases focus

• Improves managerial compensation contract design

• Reduces the possibility of unprofitable business lines being supported by profitable ones

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Other Divestiture Methods• Sell-off: a parent firm sells the assets of a subsidiary to

another firm• Signaling effect is different depending on why assets

are sold– If firm is refocusing its investments then it may be good

news

– If assets are sold to raise cash to pay down debt then it may be bad news

• Capital gains tax would be paid• Rosenfeld (1984) finds an abnormal return of +2.21%

over days (0,+1)

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Other Divestiture Methods• Carve-out: shares of a subsidiary are sold to general public

through an IPO

• The parent usually maintains the control– Funds that are made available for the subsidiary can be invested for

positive NPV projects

– Reduced asymmetric information improves the value of subsidiary

– Improved managerial compensation

• Allen and McConnel (1998) find an abnormal return of +1.9% over days (-1,+1), but if the parent indicates special dividend payment or debt reduction with the proceeds then abnormal return is +6.63%

• In other cases the abnormal returns is close to zero

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Additional Articles• Muscarella and Vetsuypens, 1989, A simple test of Baron’s Model of IPO Underpricing,

Journal of Financial Economics 24, 125-135.

• SSRN-Ritter, Jay Rial and Welch, Ivo, "A Review of IPO Activity, Pricing and Allocations" (February 2002). Yale ICF Working Paper No. 02-01. http://ssrn.com/abstract=296393

• JSTOR-Why Do Companies Go Public? An Empirical Analysis, Marco Pagano; Fabio Panetta; Luigi Zingales, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 27-64.

• URL: http://links.jstor.org/sici?sici=0022-1082%28199802%2953%3A1%3C27%3AWDCGPA%3E2.0.CO%3B2-Z

• JSTOR-Equity Carve-Outs and Managerial Discretion, Jeffrey W. Allen; John J. McConnell, The Journal of Finance, Vol. 53, No. 1. (Feb., 1998), pp. 163-186.

• URL: http://links.jstor.org/sici?sici=0022-1082%28199802%2953%3A1%3C163%3AECAMD%3E2.0.CO%3B2-W

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Additional Articles• JSTOR-Additional Evidence on the Relation Between Divestiture Announcements and

Shareholder Wealth, James D. Rosenfeld,The Journal of Finance, Vol. 39, No. 5. (Dec., 1984), pp. 1437-1448.

• URL: http://links.jstor.org/sici?sici=0022-1082%28198412%2939%3A5%3C1437%3AAEOTRB%3E2.0.CO%3B2-1

• JSTOR-The Effect of Voluntary Spin-off Announcements on Shareholder Wealth, James A. Miles; James D. Rosenfeld, The Journal of Finance, Vol. 38, No. 5. (Dec., 1983), pp. 1597-1606.

• URL: http://links.jstor.org/sici?sici=0022-1082%28198312%2938%3A5%3C1597%3ATEOVSA%3E2.0.CO%3B2-0

• JSTOR-The Long-Run Performance of Initial Public Offerings, Jay R. Ritter, The Journal of Finance, Vol. 46, No. 1. (Mar., 1991), pp. 3-27.

• URL: http://links.jstor.org/sici?sici=0022-1082%28199103%2946%3A1%3C3%3ATLPOIP%3E2.0.CO%3B2-9