Transcript Titre - Solvay Brussels School

Corporate Valuation and Financing
IPOs
Prof H. Pirotte
Introduction
Prof H. Pirotte
Equity Financing
 Initial Capital
» Very early stage “Family, Friends and Fools”, notion of Angel Investors
» Venture capital firms=> specialized in raising capital for young firms
» => often diversification benefits
» =>possibility to benefit from expertise
» => substantial costs in terms of control
» Private Equity Firms
 Invest in firms already existing
» Institutional Investors (pension funds, insurance companies etc…)
» Corporate Investors
» Outside Investors
 One general point of attention: the exit strategy
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Introduction
Going public
Prof H. Pirotte
Introduction
 The natural evolution of firm’s capital
» Association of founders
» Incorporation (shares owned by founders, key-employees and some early
investors)
» Bank and private loans
» Going public, mainly through an IPO  a strategic decision
 Steps
» Awareness and preparation

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
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Cleansing
Manage as a public firm
Change marketing strategy
Develop key contacts
» The offer
» The new corporate life
 Primary vs. secondary issues
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Introduction
Going public
Prof H. Pirotte
Ex-ante
 Examination
» Realities, limits, willingness and HR requirements
 Don’t neglect other alternatives (is it a good timing for us?)
 Is it a good timing for the market?
» Estimation of the new cost structure
» Advantages:
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Diversifying founders’ wealth
Establishing a market value of the firm
Easier future operations
Better visibility
Better liquidity (?)
Ready (+ -) to raise additional funds
» Disadvantages
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
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Direct costs (spread) and indirect costs (confidentiality)
Loss of control
Consequences of the information being revealed and public
Suppression of implicit advantages for founders-entrepreneurs
Liquidity  depends on the market mechanisms and the type of the exchange
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Introduction
Going public
Prof H. Pirotte
Ex-post
 Evidence
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»
»
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Any decision will be judged by the market
Rumours, internal and external events will have an impact
Never neglect your shareholders
You must keep the contact with the market
The management activity must be more structured, ready to justify any decision
Keep enough breath to guarantee the continuity of the strengths of the firm
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Introduction
Prof H. Pirotte
IPO process
The Market
 It is highly dependent on the state of the economy and it generally concerns
»
»
»
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Firms of “new economies” and birth of “new markets”
Firms deciding to go public
Privatisations
Spin-offs
 In Switzerland
Le marché des IPO en Suisse
IPO en Suisse
30
CSFB
25
19%
20
24%
5%
UBS Warburg
Bank Vontobel
15
ZKB
10
Bank Julius Bär
6%
9%
5
0
1997
1998
1999
2000
2001
2002
2003
13%
24%
ABN Amro
Autres
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Introduction
IPO process
Prof H. Pirotte
The Market
 In Europe
Source:
ECMI Paper,
n°2, August 2006
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Introduction
IPO process
Prof H. Pirotte
Process
 Preliminary phase
» After approval of the Board of Directors, the managers ask for an “underwriter”.
Role:
Advisory / Pricing / Sale of shares / Syndication
» Selection of the investment banker: “competitive bid” or “negotiated offer”
» Appraisal of fundamental data of the firm
 Long-term planning and future opportunities
» The firm uses the services of lawyers and expert accountants (via the investment
banker) to write the preliminary prospectus (“red herring”).
 Due diligence
» Follow-up of market conditions
» Pre-marketing: analysis of attractiveness, price sensitivity, feedback
 Final phase
» Roadshow: presentation of the “equity story”
» Once the corrections made following the comments of the regulatory commission,
the final prospectus is issued.
 “Tombstones” are used before and after the issuance (marketing the IPO)
» Bookbuilding and the book
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Introduction
IPO process
Prof H. Pirotte
Types of placements

Usually, need of an underwriter

Nature
»
»

Cash offer
Rights offer
Market
»
»
Public placement
Private placement

Distinction between primary offering (new shares) and secondary offering (existing shares)

Modalities
»
»
»
Best efforts (commissioned, often with all or nothing clauses)
Firm commitment (bought deal)
Auction IPO (Open IPO) => bidders bid, offer is made at the price of the lowest bid allowing the sale of
the number of shares planned

Sherman (2005) => sealed bid IPO almost gone, mostly book building… because of risk reduction
offered by the second method (number of investors evaluating the offering)

The process lasts several months and is concluded on the day of the issuance
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Introduction
IPO process
Prof H. Pirotte 10
Price and costs
 3 main actors
» the issuing firm, the investment banker and the (potential) investors
 How do the firm and banker price the issue?
 What are the direct costs incurred by the firm?
» Preparing: audit and accounting fees, legal fees, salaries, director’s fees, …
» Offering: underwriter’s fees, audit and accounting fees, legal fees, road show,
printing costs, …
» After!
 Indirect costs
» Underpricing
 offering prices determined by the investment banking firm are systematically set below
the fair market value of a security
» Announcement effect
» Diversion of management
Introduction
IPO process
Types of mechanisms
Source:
ECMI Paper,
n°2, August 2006
Prof H. Pirotte 11
Introduction
IPO underpricing
Prof H. Pirotte 12
Short-term performance (underpricing)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
Introduction
IPO underpricing
Prof H. Pirotte 13
Short-term performance (underpricing)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
Introduction
IPO underpricing
Short-term performance (underpricing)
Ritter & Welch (2002), A REVIEW OF IPO ACTIVITY, PRICING AND ALLOCATIONS, Yale Working Paper
Prof H. Pirotte 14
Introduction
IPO underpricing
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
Prof H. Pirotte 15
Introduction
IPO underpricing
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
Prof H. Pirotte 16
Introduction
IPO underpricing
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
Prof H. Pirotte 17
Prof H. Pirotte 18
Introduction
IPO underpricing
Short-term performance (underpricing)
 Various studies
Paper
Period
Abnormal Return (1st month)
Ibbotson [1975]
60-69
11.4 %
Ibbotson & Jaffe [1974]
60-70
16.8 %
Ritter [1984]
77-82
Firm commitment 14.8 %
Best efforts 42.8 %
Paper
Conclusion
Loughran & Ritter [1995]
5y 30% underperformance against benchmark
Brav and Gompers [1997]
Even with benchmark
Fama [1998]
IPOs are typically small high-growth stocks and they all have low returns in
the post-1963 period.
Prof H. Pirotte 19
Introduction
IPO underpricing
But in the long-run…
 While all studies show a positive average of 19% abnormal return at the end
of the first trading day based on unadjusted returns, they show a negative
abnormal performance in the long-run, underperforming the market by 23%
over the next 3 years, or underperforming a benchmark portfolio of similar
size and book-to-market ratio by 5%.
(Copeland, Weston and Shastri 2005)
Paper
Conclusion
Loughran & Ritter [1995]
5y 30% underperformance against benchmark
Brav and Gompers [1997]
Even with benchmark
Fama [1998]
IPOs are typically small high-growth stocks and they all have low returns in
the post-1963 period.
 Puzzle?
Prof H. Pirotte 20
Introduction
IPO underpricing
Evidence…
Paper
Hickman [1953],
Taggart [1977]
Conclusion
Marsh
[1982],
Fluctuations of outside finance raised via equity.
Firms issue equity after their own stock has risen relative to the
market
Choe, Masulis & Nanda [1989]
Negative reaction to announcement of an equity issue is smaller
when volume of all equity issues is high.
Krigam, Shaw and Womack [1999]
First day winners continue to be winners over the first year.
First day dogs continue to be relative dogs.
Exception for extra-hot IPOs that provide the worst future perf.
Large “informed” traders “flip” IPOs that perform the worst in the
future. IPOs with low flipping perform well during the first 6 months.
Flipping is predictable and underwriters pricing errors are
intentional.
1988-1995: 1’232 large-capitalization IPOs
12%: +30% or more on the first trading day
25%: closed at or below the offer price
Introduction
IPO underpricing
Prof H. Pirotte 21
Evidence… (2)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
Introduction
IPO underpricing
Prof H. Pirotte 22
Why?

Offer and demand (banker’s explanation)

Truncated distribution (because of flipping…)

Regulation
»
Maximum issuing price must be filed with the SEC 2 weeks in advance of the actual offering  creates a
situation of “heads I lose, tails you win” for the underwriter

Information asymmetry and the winner’s curse (Rock [1986], Beatty & Ritter [1986], Carter &
Manaster [1990])

Underpricing provides both protection and compensation for the se o the underwriter’s
reputational capital (Booth and Smith [1986])

Insurance to protect underwriters against potential due diligence legal liabilities (Tinic [1988])

Signal by a more informed issuer to indicate firm value and variance of E(R) to less informed
investors (Greenblatt & Hwang [1989])

Other impacts tested through empirical evidence
»
Trading mechanism
 But the debate persists among researchers whether the systematic short-term underpricing of
IPOs is rational or not.
Introduction
IPO underpricing
Prof H. Pirotte 23
The winner’s curse
 The Medium guy and the Smart guy…
» Since prices tend to rise during the first hour of trading, Medium invests an
equivalent amount in all IPOs. Can Medium obtain an abnormal return?
» Example
 Smart can take 1’000 shares
Medium can take 1’000 shares, and invests 100 shares by IPO
 A is an undervalued firm: Smart asks for 1’000 shares, Medium asks for 100 shares
But only 110 shares are issued: 100 for Smart and 10 for Medium.
 B is an overvalued firm: Medium asks for 100, Smart for 0.
» To avoid this phenomenon, issuing prices are understated by 30-40% to ensure a
minimum riskfree rate to Medium.
Introduction
IPO underpricing
Prof H. Pirotte 24
Rock (1986)
 Assumptions
»
»
»
»
»
Prices and volumes are fixed
If demand > offer  rationing
The firm wants to issue N shares
Each share has a value v (random variable, know probability density function f )
2 types of investors
 Uninformed: U investors owning 1€ each, don’t know v.
 Informed: total wealth of I, they know v.
»
»
»
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The firm doesn’t know v, but chooses p, the issuing price.
I < N  E(v)  the firm must attract uninformed investors
The demand of the uninformed investors depends on p, not on v.
Demand of informed investors
 I if v > p
 0 if v  p
Prof H. Pirotte 25
Introduction
IPO underpricing
Rock (1986) - 2
 Model
» The profit of uninformed investors, if they invest is given by
E (U ) 

v p
(v - p) f (v)dv 
U
I U
 (v - p) f (v)dv
v p
» Uninformed investors receive more shares when v < p  winner’s curse
» To attract uninformed investors, the company must choose a price lower than
E(v) such that E(U) = 0
pmax such that E( U )  0  E (V )  p  
where   I
IU
 (v  p) f (v)dv  0
v p
Prof H. Pirotte 26
Introduction
IPO underpricing
Rock (1986) - 3
 Example
1
1
» Hypothesis: f (v) is uniform on the following interval  v  , v   

2
2 
» The condition can be written
 
1

vp
 v    p  0

2 
2
2
» Typical cases
 =0
dp
0
d

 dp  0
d