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Public equity issuance

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Types of public security issuances

• IPO Issuances:

– IPO = Initial Public Offering. The first sale of stock by a company to the public

– This the most visible type of security issuance with respect to exposure in financial publications

– Consider the Google IPO of 2005, ICBC in 2006 and the news surrounding the issuance events

– IPO firms are being valued by the “market” for the first time, and establishing the initial valuation (based on firm private information) and finding public market investors willing to pay that valuation is the specialization of an investment bank

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• SEO Issuances:

1. SEO = Seasoned equity offering. An already traded firm issues new shares.

2. Market values are already established, so placing these securities is generally less difficult than an IPO since there is less asymmetric information.

3. Types of SEO’s• Follow-on offering: Is an SEO in which new shares

are issued to the public• Secondary offering: Is an SEO in which existing

shares held by current owners (like the founder of the firm – Bill Gates of Microsoft for instance) are sold to the market

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Why go Public?

• Lack of other financing choices

– Private financing unavailable• Too costly• Fear of loss of control

– Too much debt, so firm optimizes capital structure

• Allows current investors to cash out

– Founders demand liquidity, want to sell stake in firm– Firm is valued by the market, shares sold get market

price

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• Future source of capital

– Establish the firm in public capital markets for future capital raising (SEOs, bond issuances)

– Diversification / Risk sharing– Increases transparency of firm actions

• Employee compensation

– Firm can offer incentive contracts – stock options

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Why not go Public?

• Going public is costly, time consuming and may not be appropriate for all firms, even when they are in need of additional financing

• Ownership is diluted– Decision making is delegated to an increased number of

owners– Founder (entrepreneur) loses control

• Public monitoring increases– Competitors benefit from transparency– Regulators have increased authority (legal restrictions to

public firms)

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• Direct financial costs

– Filing costs of prospectus and subsequent filings – Investment banks and new investors charge the

firm via large transactions costs• Shares are underpriced (can be greater than

15%)• Underwriters collect fees (7% of gross

proceeds)

• Short-term performance pressures

• Change in accounting practices

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The IPO Process

• Firm selects an underwriter (investment bank) who also acts as the advisor, basing the decision on:

– The reputation and expertise of the underwriter (the advisor must be credible)

– Follow-on products like research coverage– Prior relationships between the firm owners and

investment banks– Distribution channels available to underwriter

(institutional clients)– The investment banks willingness to take on the firm (high

reputation underwriters may not risk their reputation on a firm with uncertain prospects)

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• Firm and underwriter agree on the offering method:

– Firm commitment: firm sells the entire issue to the underwriter who then attempts to sell it to the public (insured) – Although the underwriter fully commits to purchasing the issue, the price is not agreed (or committed to) until later in the issuance process.

– Best effort: underwriter makes no promise about the price, but makes a best effort to sell at the agreed price (uninsured)

– Rights offering: securities are first offered to existing shareholders (not common in the U.S.)

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• Valuing the offer: Underwriter provides a value of the firm.

– Firm opens its books to the underwriter so that they have full information for determining value – the underwriter is the agent that reduces asymmetric information

– Discounted cashflow analysis is one valuation method, but more commonly, underwriters identify a peer group of publicly traded firms and use multiples of different financial metrics to provide a range of values.

– Firm and underwriter agree and set an offer range, which may change once the underwriter has a better assessment of market interest in the offering.

– Six to 8 weeks have passed from the selection of the underwriter until the end of the due diligence.

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• Road show: Begins a few weeks prior to the IPO.

– The lead underwriter visits large investors (institutional) to solicit interest and build a demand schedule (book building)

– Book building occurs with “special” clients of the underwriter, including institutions (Fidelity, Janus etc.) and wealthy private investors.

– Book building is also spreading to smaller clients through electronic road shows, aided by the internet.

– Only once the waiting period is over, can the investment bank/underwriter solicit specific pricing and demand information from investors.

– The waiting period usually ends a few days prior to the IPO, allowing investment banks to reach what they think will be an equilibrium (final) offer price.

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• Offer: Underwriter sells the issue and an exchange begins trading the issue in a secondary market.

– Depending on demand for shares, the underwriter may have to ration shares to investors.

– Shares are sold to investors prior to trading in secondary markets

– New investors who didn’t get an allocation of the primary shares can now buy shares in the open market

– Investors who received an initial allocation of shares can begin selling them to new investors

– Investors who are allocated shares and immediately turn around and sell them in the market are not viewed favorably by investment bankers and may be cut off from future allocations.

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• Fees: Underwriters charge issuing firms for their services

– Fees are earned for reducing the asymmetric information between investors and the firm

– Investment banks (underwriters) use their reputation in a repeated game setting (they do this over and over with different firms) to convince investors of the firm’s type

– For firm commitment offerings, fees come from the following sources• Gross spread: price sold to market – price bought

from firm. Typically this is 7% of gross proceeds• Underpricing = closing price at end of first trading

day – the offer price. Underwriters generally under price the offer by as much as 15%, and much more in certain cases.

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Syndicates in IPOs

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Syndicate = A group of investment banks that work together to sell new security offerings to investors. The underwriting syndicate is led by the lead underwriter.

– The issuing firm may decide that several underwriters are needed to underwrite the equity

– The size of the syndicate varies (5 underwriters for ICBC, 28 for Google)

– The primary underwriter is designated the “lead” underwriter

– The lead underwriter allocates portions of the offering to syndicate members

– Syndicate members may be lead underwriters on other offerings, so the relationships are frequently based on equal stature in terms of mutual respect

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Compensation

Underwriting spread = difference between price to the public and the

price received by the issuer

The spread is determined by negotiation

The spread reflects the effort and the risk taken by the underwriter

(firm commitment)

Compensation includes mainly:1. Manager’s fee (20%)2. Syndicate allowance (20%)3. Selling concession (60%, buying stock at a discount

and then reselling it to the public at a higher price)

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Risk of underwriting large offers

There is a risk that the offering price is too high, and underwriters not

being able to sell the shares

For firm commitment contract: A single underwriter risks losing money

if the price is difficult to determine.

More underwriters means lower risk for each underwriter

However, large size IB can bear risk, so why having syndicates?

Potential functions of underwriting syndicates

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Information production

- Underwriters have to price a stock with no trading history

- Syndicates help estimate the demand for the IPO thanks to different clientele or geographic origin (e.g. ICBC had 2 Chinese, 2 European and 1 US underwriters)

Channels of information:

- Underwriters may inform directly the lead underwriter about market interest. This is however not in their best interest because they compete with the other underwriters.

- Underwriters prefer disclosing information directly to the issuer. This improves their reputation.

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Certification and underwriter reputation

The issuer’s quality may be unknown.

Certifiability hypothesis: Reputable underwriters signal that the offered

price is fair. This reduces uncertainty and the underpricing problem.

Coverage by analysts

Syndicate members can provide analyst coverage once trading starts.This is crucial to maintain investors’ interest in the issuing company.

An underwriter with analyst coverage in the aftermarket may increase the demand for the stock.

Krigman et al.(2001): analysts coverage is an important determinant when selecting underwriters.

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What is the added value of syndicates?

Syndicate participation evidence

- An IB with top-ranked analyst in the issuer’s industry increases the likelihood of being included in the syndicate

- Geography matters: Being in the same state as the lead underwriter decreases the likelihood of being included in the syndicate

- Strong relationship with lead underwriter increases the probability of entering the syndicate. Suggests that ongoing relationships may mitigate the agency problems within the syndicate

Empirical findings (Corwin and Schultz 2005)

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Syndicate structure and offer price revision

An efficient syndicate should uncover information on what the offer

price should be.

In that case, the price revision from the expected offer price to actual

offer price should be substantial.

Evidence shows that larger syndicates increase the likelihood of an

offer price revision.

This suggests that syndicates produce valuable information.

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Syndicate structure and certification effect

The syndicate’s composition has no effect on the “fairness” of the

offer price.

Hence, there is no evidence of the certification effect.

Syndicates and analysts’ services

The number of analysts covering the firm depends on the number of

syndicate members co-managing the equity issue.

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Syndicates and effort(Pichler and Wilhelm 2001)

• Companies choose the lead underwriter. The lead underwriter chooses the syndicate members.

• Why do issuers want to have several underwriters?

Moral hazard problem: Companies cannot measure perfectly how well IB work for their course, i.e. how much effort they put to attract the highest price investors.

• Syndicates may induce more effort.

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How do syndicates induce effort?

- Stability of composition of syndicates, but changing lead underwriter.

- The lead underwriter receives by far the highest fee. Hence, there is competition between IB to become lead underwriter. This induces them to exert high effort.

- Moreover, the lead underwriter selects the syndicate members. He has an incentive to monitor them in order to be selected as lead underwriter for future deals.

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How does a company choose a lead underwriter?

(Hansen and Khanna 1994)

• General theories: the best way to choose a lead underwriter is to organize an auction. Indeed, letting underwriters compete may reduce the fees.

• In reality negotiation takes place with a single lead underwriter.

• Why? The bidding process gives lowest fee but not the highest price for the issue.

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• The lead manager has to exert effort: evaluate demand, contact investors etc. More effort increases the offer price.

• Effort is costly. Assuming that the profit of syndicates is constant, low fees are associated with low effort. Hence, issuers do not necessarily prefer lower fees.

• An IB approached has first to exert costly effort to determine the approximate offer price. In a bidding process, there is uncertainty on whether it will be selected as lead underwriter. This induces low effort. In negotiation, instead, the effort is unlikely to be useless. This induces higher effort.

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Underpricing of IPOs

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• Underpricing: the first trading day closing price typically exceeds the price at which the shares were offered to the investors.

What is underpricing?

t=0

Share price

Offer price

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• The first-day premium that investors experience is positive in virtually every country.

• Underpricing averages more than 15% in industrialized countries

• Underpricing is much higher in emerging economies.

• The difference between industrialized and emerging countries is due to (i) valuation uncertainty and (ii) regulation (e.g. Taiwan, Malaysia)

International evidence

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• Consequence: Companies leave large amount of money on the table (sometimes more than $1bn)

• In the US, only 15 of the 160 quarters between 1960 and 1999 saw the average company trade below its offer price

• Underpricing was very high in 1999-2000 (around 50%)

• Predictability of underpricing:– Underpricing varies over time– Underpricing is highly positively autocorrelated overtime

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What explains underpricing?

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• Underwriters are faced with a trade-off. On the one hand, underpricing lowers both the risk of failing to place equity, and their effort in marketing the issue. On the other hand, the fee is proportional to the price.

• If the success of an IPO is important enough, the IB chooses underpricing

• Issuers, because they delegate the pricing decision to the underwriter, cannot prevent opportunistic behavior

Principal-agent theory

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• Some investors are better informed about the issuing firm’s value. They also know better their demand of shares and the price they are willing to pay.

• The key function of underwriters is to elicit information from better informed investors about the firm’s value, especially when the information is positive.

Problem: Investors are unwilling to reveal positive information, because

doing so would result in a higher offer price and a lower profit.

Solution: Underpricing + allocation of more shares to the most aggressive

bidders. This induces investors to reveal their information

truthfully and bid aggressively.

Information revelation theories

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Illustrative example:• Your firm is considering making a takeover offer for a start-

up. The true value (V) of the shares are known with certainty only to the start-up management.

• You know that the shares are worth somewhere between £0 and £1000 and each possible value has equal probability.

• Synergy: shares would be worth 50% more than their current value to your firm if you successfully acquire the start-up.

• The start-up sells to you if you bid more than V, and will turn you down if you bid less than V.

• How much do you bid per share? On average the firm is worth 500.

• However, if you bid 500, you will only win if V < 500. But, if the firm is worth at most 500, it is worth on average only 250, so you overpaid! Even with the synergies, 250x1.5 = 375 is less than your bid. This is the winner's curse!

The winner’s curse problem

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• Same problem in IPOs for uninformed investors: If an investor overvalues the issue (bids H), he will end up will many shares and makes a loss. If an investor undervalues the issue (bids L), he will face strong competition and end up with only a few shares.

• Underpricing implies that investors no longer make losses on average.

V

bids distribution

L H

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Legal liability

• Investors can sue underwriters on the ground that material facts were mis-stated or omitted in the IPO prospectus.

• Intentional underpricing may act as insurance against such litigation.

• Evidence that underpricing reduces (i) the probability of a lawsuit, (ii) the probability of an adverse ruling conditional on a lawsuit, and (iii) the amount of damages awarded in the event of an adverse ruling.

Institutional explanations

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Price support

• Underwriters can be required to stabilize trading prices at the offer price, thus minimizing the occurrence of overpricing. This leads to the censoring of the initial return distribution.

Evidence:

• Underwriters are aggressive buyers in the aftermarket

• Initial returns are censored: they are non-normal and peak at zero. There is almost no negative tail.

• Over time, underwriters remove price support. The effects of price support are temporary, leading prices to fall as support is withdrawn.

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Underpricing help to retain control of the issuing company.

• Underpricing ensures that the offer is over-subscribed and that investors will be rationed.

• Rationing allows the manager to discriminate between applicants of different sizes and so to reduce the block size of new shareholdings.

• Greater ownership dispersion implies that the manager benefits from a reduced threat of being ousted in a hostile takeover.

Evidence: Very large applicants are discriminated against in favor of smaller ones.

Ownership and control

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When an IPO is underpriced, some investors who do not value the

company high are allocated shares, while some valuing the

company higher do not receive any shares.

This demand of the latter causes the price to rise and the former

sell their shares, hence trading activity will be high.

The trading activity generates income for market making underwriters.

Stock flipping

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If an issue is overpriced (price=PH), only the high bidders are allocated shares. When trading starts, only few shares are traded.

Low trading activity

If an issue is underpriced (price=PL), all bidders are allocated shares. When trading starts, those who value the issue high will buy shares from those valuing the issue low.

High trading activity

Underpricing More trading More income for the market making underwriters.

VPL PH

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Long-run performance of IPOs

t=0

Share price

Puzzle: The long-run performance of IPOs is negative!

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Explanations• Only the most optimistic investors buy the IPOs,

and they pay too much for the shares• It seems that many firms go public near the peak

of industry-specific fads. Issuers are then able to sell at high price

• “Window dressing”: Firms manipulate their accounts before going public

Lack of clear theoretical understanding or empirical evidence

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Evidence from Bath MSc students

• Li-Wen Chen (2006):

– 211 IPOs in Taiwan from 2001 to 2005

– Underpricing: 6%

– 1-year performance: -9%

– Finds that firms that have a lending relationship with their underwriters suffer from more underpricing.

– Consistent with conflicts of interest.

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• Huajing Wang (2007)

– 296 IPOs on the Shanghai Stock Exchange from 1992 to 2007– Underpricing of 127%– Controls for almost 20 explanatory variables– Evidence of the winner's curse– Underpricing higher for young, weakly profitable, and small companies.

Consistent with information asymmetry.

• Kwanpongsa Dacharux (2006)

– 122 IPOs in Thailand from 2001 to 2005

– Underpricing of 20%, decreasing

– More underpricing for risky, small, young firms, with a high D/E ratio

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The Underwriting Spread in IPOs

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1. Risk of firm commitment underwriting: not selling all shares at a designated price and suffering a loss.

2. Costs of analyzing and administrating the issue.

3. Analyst coverage: often included in the underwriting contract.

What are the costs of IPOs for IB?

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4. High effort to maintain reputation.

5. Compensation paid to syndicate members.

6. Price support: Aftermarket support of the stock to ensure a minimum of liquidity and to prevent a price slump due to some investors selling their shares.

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Facts:

1. Spreads in the US are much larger than in the rest of the world

2. At first sight, the fee structure does not reflect the existence of fixed costs

3. Investment bankers concede that there is no price competition

Underwriting spread and costsChen and Ritter (2000)

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• In 90% of cases, the spread of IPOs raising $20m-$80m is 7% (despite fixed costs). Spread is higher for IPOs below $20m (existence of fixed costs). (http://bear.cba.ufl.edu/ritter/sprd99.pdf)

• Japan: average spread of 3-3.5% Australia: average spread of 3.4%

Suggests that spreads are competitive for deals below $20m-$30m, but increasingly profitable on larger deals

This does not necessarily imply that fees are too high. There are indeed other dimensions in competition

(effort, analysts coverage, price support etc).

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Potential explanations for the 7% underwriting spread:• Explicit collusion hypothesis: Joint agreement to fix the

spread at 7%.• Implicit collusion hypothesis: Long-term competition

between IB. Price cut may trigger price war and induce lower profits in the long-run.

• Competition in other dimensions: underpricing, reputation, placement efforts, analysts coverage etc.

Hansen argues that the 7% spread is consistent with efficient

contracting. By fixing one dimension of the contract, thecompetition is in the other dimensions. This also saves time.

Competition and the spreadHansen (2001)

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Evidence on the state of competition

• Concentration in the IB industry: The same as before the 7% era. Argues against collusion

• Entry: New banks enter the market. Moreover there is volatility in IPO market shares. Argues against collusion

• Effect of Department of Justice probe: No effect on spread. Argues against collusion

• Profit: No evidence of abnormal profit when the spread is 7%. Argues against collusion

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Evidence of efficient contracts:

7% spread IPOs are more frequent for firms with high

earnings volatility, high debt, i.e. firms that are risky and

difficulty to value.

The risk factors associated with the IPO placement difficulty could explain the 7% contract use.

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Ljungqvist and Wilhelm (1999)

The 7% spread in the US is competitive, otherwise US

firms would flock to non-US investment banks.

• Many issuing firms are willing to pay a premium to have a US bank in the syndicate

• The presence of a US bank in a syndicate may decrease by 17% the IPO underpricing

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Market shares in IPOs

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Several hypothesis:

• First-day return- Underpricing imposes costs on the issuers by leaving money on the table.- Overpricing is also not beneficial for the IB. Their role is to

certify the value of the shares for investors. If there is overpricing, investors will be reluctant to buy shares underwritten by this investment bank.

• Underwriting spread- Issuers may choose lower fee underwriters.- On the other hand, reputable banks may charge higher fees. Reputation is volatile and high fees signal that the bank does not fear

losing its reputation.

What determines market shares?

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Long-run performance:

Investors will be reluctant to buy shares from IB offering shares of companies with no positive prospects.

Analyst reputation:

- High level analyst coverage is central for the success of an IPO.- The presence of a top analysts certifies the IPO value to investors.

Industry specialization

- Experience is central for evaluating companies, and specialization

can increase the precision of pricing due to information spillovers from other equity issuances.- For well established IB, however, specialization reduces the amount of business that can be acquired.

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Lager banks Small banks

Specialization Business size limited

Attract first customers

No specialization More potential clients, less risk

Difficult to attract first customers

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Findings:

• First-day return- Initial overpricing has a negative effect on market shares - Very positive first-day returns also have a negative effect on market

shares- A reasonable level of underpricing seems optimal

• Good long-run performance has a positive effect on market shares

• Lower fees increase market shares

• Industry specialization has a negative impact on market shares for established banks. It has a positive impact on market shares for smaller banks

• For reputable banks, improvements to the reputation of the bank’s analysts have a positive effect on market shares changes

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Privatizations constitute a particular class of IPOs, where the vendor is not an entrepreneur but the government.

Particularity of privatizations: Governments have been very innovative in their approach to IPO, and most of the largest

IPOs ever are privatizations.

Government were among the first to:• Include foreign IB in IPO syndicates• Use book-building techniques for pricing and allocation• Introduce multi-tranche IPOs with block of shares reserved

for particular groups of investors• Limit the downside risk faced by investors• Negotiate down the fees paid to the IB

A note on privatizations