by Kunal Rathi (Written on: 5th December 2008)
Introduction
Initial Public Offering (IPO), are one of the common methods used by companies to raise huge amount of capital for their future projects and expansion. Management and owners sell a part of firm in form of shares to public in order to get more money in return. IPOs are more popular than bank loans because of the fact that bank loans are needed to be repaid before specific deadline, where as in IPO (shared) can be repurchased in later dates i.e. if or whenever a company wishes to do so. In this assignment I would be summarising the main argument of Roger, Jody, & Jay (n.d.) article “Initial Public Offering” printed Donald H. Chew, Jr. (eds) ‘The New Corporate Finance: Where Theory Meets Practice’ 3rd Edition. I would be discussing the topic, what Initial Public Offerings and Underwriters are? Also discussing about the process of issuing of IPO and how their prices are set in the market. In the last I would be adding some practical and experimental findings of different writers supporting this article {Roger, et. Al., n.d.} from different case studies and articles as well as brief current market condition of IPOs after world financial crisis.
Initial Public Offerings
IPOs are also referred as ‘Public Offering’. IPO takes place when a company issues shares or common stock to public for the first time. It’s often done by smaller and young companies looking for capital for new projects and to expand. Large privately-owned companies can also issue IPO to becoming publicly traded. (Gregoriou, 2006)
IPOs are almost all the time risky. Risks are faced and involved by each of the three major parties: investment banker (underwriters), issuer and investor. The pricing of IPOs is a difficult job. The reason being is that there is no observable market price prior to the offering and also because many of the issuing firms have little or no operating history. If the prices are set too low, the issuer does not get the full advantage of its ability to raise capital. On the other hand if the prices are set too high, then the investor would get an inferior return and can also result in rejection of the offering. “Numerous empirical studies have shown that unseasoned new issues are significantly underpriced, on average” (Roger, et al, n.d.: 309)
Underwriters
Underwriter is a company which manages the public issuance and allocation of securities for a business firm or some other issuing body. It works with the issuing body closely to determine the offering price of the security, then they buy them from the issuing firm and sell to different investors through a network known ad underwriter’s distribution network. If an underwriter is not able to sell the securities at the specified prise offered, they are forced to sell the security at lower price than they paid for them to issuer or they can just retain the security. Hence, it’s very important to get a good underwriter for the firm as they are responsible for pricing, marketing and positioning firm’s IPO and therefore is critical to its ultimate success. (Berg, 1996)
The Process
Interpretation for issuing of IPOs by the company can be stated as by going public the firm is provided by more capital at the same time original owners of the firm can diversify their holdings. The setting up of the prices and the response of the people outside the firm to the price give a picture to the management and shareholders with the outside information about the firm value. In IPO, the issuer is selling a part of his firm to public in form of shares, and will be willing to get as much as possible and maximum funds for the expansion and new projects. The price of the share or IPO at which the company trade ownership for cash depends upon the company position in market, policies of the investment bankers and specifics of the firm. IPO can be made by two different ways; “firm commitment” or “best efforts”. (Jay, 1987; Jay, et al, 1977 cited in Roger, et al, n.d.: 310)
Setting The Price
A successful offering is all based upon setting the price of IPO as the firm is going public for the first time and has no price history and is totally unaware of the market reaction on the price of security. (Roger, et al, n.d.: 310-1) In the past IPOs were being underpriced globally. Reasoning behind is that the underpriced IPOs can be defined and supported by the term that it generates additional interest in stock for the investors when the company first time becomes publicly traded. However, under pricing can result in “money left on table” i.e. loss of capital, which could be yield with high price stock. For IPO issuing companies, overpricing of the stock is also an important consideration. It could result in the price of the stock higher then market expectation and as a result underwriters will be able to collect less capital for the company, as less investor will take interest in investing their money. According to research and historical statistic whenever a company issue it’s IPO under overprice condition, there are chances in fall of stock prices in the first day of trading, and company can also lose its marketability and can result in less investor in future and hence more of its value falls. (Loughran & Ritter, 2004; Roger, et al, n.d.: 310) So we can say that both under and over pricing of IPO could have a bad effect for the future of the company. But to attract investors to invest in IPO the company has to under price its IPO but not with a high percentage. It should reflect the investor positive side of the company for future investment.
Boron & Holmstrom (1980) have shared their views on the theory that underwriters are significantly informed better then the issuer itself. The main reasoning of the statement can be that underwriters are mainly more informed about the market-clearing price because of their marked survey and experience on new issues. It doesn’t matter if the issuer knows more about their firm’s specifics; it’s the underwriter who knows more about what market thinks about the firm then issuer. (Boron, et al., 1980 cited in Roger, et al, n.d.: 314)
Practical And Experimental Findings
Many writers and scholars have given their views and assumptions on IPO in the history. Now I would be discussing some these cases which will clear th understand of why underpricing has changed over time?; how UK firms chose to list contracts; Effects of investors uncertainty on underpricing; Asymmetric Information model; and on how underpricing can become signal of firm quality.
Why has underpricing changed over time?
“Underpricing is estimated as the percentage difference between the price at which the IPO shares were sold to investors (the offer price) and the price at which the shares subsequently trade in the market.” (Ljungqvist, 2006: 6)
During the period of 1980s, the first-day returns on IPOs were average to 7%, which almost doubled during 1990-1998 to 15%. But during bubble year of 1999-2000 the return were at its unexpected heights of 65% and then reverting to 12% during 2001-2003. (Loughran & Ritter, 2004: 5) These figures clearly shows the underpricing of IPOs have changed over time. Now the question arise that “Why has underpricing changed over time?” Loughran & Ritter (2004) suggests that three non-mutually and limited reasons i.e. a realignment of incentives, a changing issuer objective function, and changing risk composition. Their research was based on assumption of hypothesis. They saw the during 1980s and 1990s the physical riskiness of firms going public didn’t changed greatly, but high percentage of very young firms were going public during bubble period, and high percentage of older firms in post-bubble period. Through realignment of incentives hypothesis they argued that managerial incentives to reduce underpricing have decreased with time for the reason that it reduced CEO ownership and a higher percentage of IPOs were with no secondary shares. Loughran & Ritter (2004) found two reasons that why issuers become smugger about underpricing in the 1990s and internet bubble period through changing issuer objective function hypothesis. They stated two reasons as; firstly, market analyst coverage became a more significant factor for issuers choosing a direct underwriter, reasoning being more assessment then in the 1980s. Lastly, the executives and venture capitalists of the firms issuing IPOs were appoint through the allotment of hot IPOs to their private brokerage accounts. (Loughran & Ritter, 2004)
The Strategy of Going Public: How UK Firms Choose Their Listing Contracts
Goergen, Khurshed & Mudambi (2006) state that the firms in UK have a choice when they are going public between placing and public offers. As this choice can have significant inference on the fact that who bears the risk of the issue failing and of its costs. Their study proposed that the constrict choices are essentially subjective by three types of factors: ex ante uncertainty, certification, and the exposure or visibility of the issue. Higher will be the ex ante uncertainty at the time of IPOs, greater will be the odds that the firm chooses a placing contract. Thus, it’s the facts that sponsor and creditor screening signals the quality of the IPO firm. Goergen, Khurshed & Mudambi (2006) propose that MNCs and large corporations should show a resemblance towards a public offers and also suggested that the firm making small issues will find it much more cost efficient to use placing contracts. High IPO activity periods are characterised by higher regularity of placing contracts. It has been seen that UK industries don’t show any similarity to any kind of IPO contracts in compare to US industries (exception in this result were vehicle, metal goods and engineering industries). “The evidence suggests that in general the decision to choose a placing rather than an offer or vice versa is taken by the firm within the framework of rational behavior.” (Goergen, Khurshed & Mudambi, 2006) Firms in United Kingdom were aware of the characteristics of their company and were taking it into account when deciding on listing contracts.
The Effects of Investors’ Uncertainty on Underpricing
The average initial returns for 2439 IPOs during 1975-1984 were 20.7% that were listed in going public. During the period IPO firms were categorized according to annual sales they use to make, with the thinking that sales might serve as an alternative for the investors’ uncertainty about the firm. From the data it can be seen that the firms with the less annual sales are underpricing their IPOs so that it can attract investors to invest in their company as on the first day (initial return) it would give them return for more than 30% which is almost 50% more than the average initial return, compare to firms with large amount of annual sales giving less than 10% of initial return which is less than 50% of the average initial return. (Roger, et al, n.d.: 313-4) Seeing this figures one can say that underpricing of the security is one of the major technique for the small and new companies to go public and with a successful attraction for the investors, but a huge percentage of underpricing for good firms (good sales record, old and known firm) is a bad idea, as they can lose the huge amount of money which they could have generated by rise in price of IPO and reducing the margin of underpricing of IPOs.
Roger (n.d.) has found that the effect of uncertainty of investor’s on IPOs underpricing is the recent experience of “reverse LBOs”. A study by Chris and Michael (1988) suggested that during 1976-1987 the average initial return to IPOs’ investors was only 2.1%. (Chris and Michael, 1988; cited in Roger, n.d.: 314)
Roger (n.d.) found and suggested that IPO arc on an average are normally underpriced; more established an issuer results in very less uncertainty to the investors about the firm giving real image of firm to market, results in lower underpricing amount; hot and cold performance are predictable and come in wave; cold issue market can have a negative average initial returns; there can be waves of number of new offerings in form of highly correlated heavy and light activities; and underpricing of IPO are normally followed by new offerings issued within an year. (Roger, n.d.: 314)
Asymmetric Information Model: The Winner’s Curse
In an IPO the bank, issuing firm and the investors are the three main parties. Asymmetric information model of underpricing assumes that the information is not evenly distributed to three of the parties, and one knows more than other. Till the date Rock’s (1986) winner’s curse is the best-known model in asymmetric information, which is an application of Akerlof’s (1970) lemons problem. (Chris & Michael, 1988:11)
Rock (1986) presumed that few of the investors are better informed about the true value of the offered shares then other investors, its underwriting back, or the issuing firm as it is more costly and difficult for them to be informed. This results in that the uninformed investors bid at random, but informed investors only bid for IPOs with attractive price. This oblige a ‘winner’s curse’ on uninformed investors resulting in unattractive offerings and receive all the shares they have bid for. While on the other hand attractive offerings are partly crowded out by informed investors. In such case the uninformed investor can partly or completely receive 100 percent allocations in overpriced IPOs in place of underpriced IPOs, resulting in negative average return on the investment.
Underpricing as a Signal of Firm Quality
Rock’s assumption of informational asymmetry is reversed by this model. It believed that if businesses have better knowledge regarding present value or their future cash flow risk than underpricing of IPO can be used to signal companies’ true high value. This process is costly, but if successful, can result in issuer’s return in market to sell equities at later date on better terms and conditions. Ibbotson (1975) and Welch (n.d.) believes that issuer only under price is order to ‘leave good taste in investors’ mouth’. (Ljungqvist, 2006: 36) Researches have shown that one out of three companies that issues IPOs in late 1970s and 1980s issues additional equities to the public at least once more. (Welch, n.d. cited in Roger, n.d.)
Current Condition of IPOs and Examples
In this example I would be showing a brief view of the current market condition of IPOs after the world financial crisis. In current time, we should not be surprised that the investors have little interest in IPOs. Even though market has enjoyed meek recovery in past, but they are still struggling. Due to investors’ unwillingness to buy IPOs their price in NASDAQ has fallen by about 7.1% where as in S&P 500 by 5.3%. (Ellis, 2008) Large size IPOs is having no sign of recovery, such as Ventures India and Abani Power. These companies were planning to rise there capital about 8 billion pounds which is likely to be delayed due to current market condition. Failures of high profiled offers have forced issuers to take a back-foot approach i.e. cautious view of primary market.
Conclusion
The experiential IPO’s short story has now fairly matures. We know that IPOs are globally underpriced and numerous companies are now going public or/and will be going public shortly. There are theories explaining IPO’s underpricing and most of them are subjected to accurate testing. The only thing which companies can learn who is going public is that underwriters should not under price their securities (IPO) too much (too little) as it can lose business from issuers (investors). To make a final note, underpricing can be reduced if information asymmetry between uninformed and informed investors is reduced or eliminated. To do so an issuer can disclose as much information as possible about the company at the time of going public.
References & Bibliography.
1. Akerlof, G. (1970) ‘The Market of “Lemons”: Quality Uncertainty and the Market Mechanism’, Quarterly Journal of Economics, (23): 303-323.
2. Berg, C. (1996) ‘how to choose a qualified IPO underwriter’, Business Courier. Updated 14th June 1996. (Accessed on: 5th December 2008) Available at: http://www.bizjournals.com/cincinnati/stories/1996/06/17/smallb6.html
3. Boron, D.P. & Holmstrom, B. (1980) ‘The investment Banking Contract for New Issuers Under Asymmetric Information: Delegation and the Incentive Problem’, Journal of Finance, (35): 1115-1138.
4. Chris, J. M. & Michael R. V. (1988) “The Underpricing of ‘Secondary’ Initial Public Offerings”, Unpublished Southern Methodist University working paper.
5. Ellis, D. (2008) ‘IPO market is stuck in neutral’ CNNMoney.com. Last Updated: 23rd May 2008. (Accessed on: 5th December 2008) Available at: http://money.cnn.com/2008/05/23/markets/ipo/ipos/index.htm?postversion=2008052311
6. Gurav, V. (2008) ‘Fate of big IPOs hanging in balance’ Economics Times. Last updated: 26th November 2008. Accessed on: 5th December 2008. Available at: http://economictimes.indiatimes.com/Markets/IPOs/Fate_of_big_IPOs_hangs_in_balance/articleshow/3757197.cms
7. Goergen, M., Khurshed, A. & Mudambi, R. (2006) “The Strategy of Going Public: How UK Firms Choose Their Listing Contracts”, Journal of Business Finance & Accounting, 33(1 & 2):79-101
8. Gregoriou, G. (2006), Initial Public Offerings (IPOs), Butterworth-Heinemann, an imprint of Elsevier.
9. Ibbotson, R.G., (1975) ‘Price Performance of Common Stock New Issues’, Journal of Financial Economics, (2): 235-272.
10. Jay R. R., “The Cost of Going Public”, Journal of Financial Economics (December 1987) 19: 269-281.
11. Jay R. R., Mandelker, G. & Raviv, A., “Investment Banking: An Economic Analysis of Optimal Underwriting Contracts”, Journal of Finance (June 1977) 32: 683-694.
12. Ljungqvist, A. (2006) “IPO Underpricing” in Eckbo, B. E., (eds.) ‘Handbook of Corporate Finance: Empirical Corporate Finance, Volume A’, Handbooks in Finance Series, Holland.
13. Loughran, T. & Ritter, J.R. (2004) “Why Has IPO Underpricing Changed Over Time?”, Financial Management, 33(3): 5-37
14. Rock, K. (1986) ‘Why New Issues Are Underpriced’, journal of Financial Economics, (15): 187-212.
15. Roger, G. I., Jody, L. S. & Jay R. R. (n.d.) “Initial Public Offering” in Donald H. Chew, Jr. (eds) ‘The New Corporate Finance: Where Theory Meets Practice’ 3rd Edition, McGraw-Hill, London.
16. Welch, I. (n.d.) ‘Seasoned Offerings Imitation costs, and the underpricing of Initial Public Offerings’, Unpublished University of Chicago working paper.
Source: Kunal Rathi’s University’s Assignment (2009)
