Transcript Lesson 4
Lesson 4
Investment Banks, Equities and Initial Public Offerings
A. Common and Preferred Stock Characteristics
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Provide for payments to shareholders after other corporate obligations are fulfilled, making them residual securities. Might also provide for voting rights.
Common Equity
• • • • • • Common stock is a limited liability security (shareholders cannot lose more than their investment) with residual rights. Publicly traded shares are issued either through: – a public offering, – a rights offering or – through deferred equity securities such as warrants and convertibles. The corporation will be authorized by its charter to issue a specified number of shares, some of which may remain unissued. Issued shares will either be held by shareholders (outstanding shares) or held in the corporate treasury (treasury stock). Treasury stock was previously outstanding and subsequently repurchased. Shares may be classified according to shareholder rights to vote and to receive dividend income.
Preferred Equity
• • • • • • • • • • Given priority over common stock in a firm liquidation and in the payment of dividends "Plain vanilla" preferred stock can often be valued as a perpetuity with its dividend as the periodic cash flow. Use of preferred stock was initiated in the United Kingdom and United States in the early part of the nineteenth century to finance canal and railroad construction, such as the mid-1830s expansions of the Baltimore & Ohio Railroad and C&O Canal. Why issue preferred stock rather than common stock or bonds?
– Common equity issues were often restricted by financial distress .
– Common stock issues were restricted by shareholders who did not want their control diluted or restricted – Borrowing was restricted by government limitations on debt levels. – Similar to debt and easy to value.
Because preferred stock dividends are not tax deductible to the issuing corporation and usually have no growth potential, it is not usually an attractive source of funds to most firms. Historically, preferred stock was typically issued by companies before corporate taxes became an important issue. Much of the recently offered preferred stock has been issued by utility companies which are often able to pass on higher costs of financing to consumers. A number of commercial banks have issued preferred stock due to the Fed's classification of preferred stock as primary capital for bank regulatory purposes, making it easier for banks to meet their capital requirements. Other recently offered preferred shares have been issued by new, growing companies. In many instances, these firms had no earnings against which to deduct interest payments on debt. Furthermore, in some cases, purchasers of these preferred shares were other corporations that receive a 70%-80% exclusion of preferred dividends from taxable income. More recently in the United States, individual owners of preferred stock have enjoyed 15% top marginal income tax rates on their preferred share holdings. These shares are often convertible into common stock. In some instances, firms issued voting preferred equity to help defend against unfriendly takeover activity.
B. Benefits and Costs of Going Public
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Privately held firms sell stock to the general public for a number of reasons:
– To raise capital – To enable the entrepreneur to “cash out” – To reduce debt – To enter the market for mergers and acquisitions – To affect the distribution of control of the firm – To enhance the visibility of the firm.
Costs of Going Public
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However, these benefits are obtained at a substantial cost:
– IPOs generate substantial fees – Tax and legal entity restructuring costs in anticipation of the IPO – Public firms subject themselves to increased disclosure, scrutiny and regulation by the media, competitors, the general public, the S.E.C. and other regulators – Increased auditing, legal and other fees incurred on an ongoing basis after the IPO.
– IPO underpricing
Direct and Indirect Costs of IPOs
Proceeds (in millions of dollars) 2-9.99 10-19.99 20-39.99 40-59.99 60-79.99 Gross Spreads (in %) Other Expenses (in %) Total Direct Costs (in %) 9.05 7.24 7.01 6.96 6.74 7.91 4.39 2.69 1.76 1.46 16.96 11.63 9.70 8.72 8.20 80-99.99 100 199.99 200 499.99 500-up Totals: 6.47 6.03 5.67 5.21 7.31 1.44 1.03 0.86 0.51 3.69 7.91 7.06 6.53 5.72 11.00 Average Initial Return (in %) 16.36 9.65 12.48 13.65 11.31 Average Direct & Indirect Costs (in %) 25.16 Number of IPOs 337 Interquartile Range of Spread (in %) 8.00-10.00 18.15 18.18 17.95 16.35 389 533 215 79 7.00-7.14 7.00-7.00 7.00-7.00 6.55-7.00 8.91 7.16 5.70 7.53 12.05 14.14 12.78 11.10 10.36 18.69 51 106 47 10 1767 6.21-6.85 5.72-6.47 5.29-5.86 5.00-5.37 7.00-7.05
Offering costs incurred, based on gross proceeds of offerings
(Numbers in millions, except External Legal Printing Registration/ Miscellaneous Underwriter discount number of IPOs) auditor filing Avg. % Gross Number proceeds of IPOs
$0-50 51-100 115
of gross Avg. Range Avg. Range Avg. Range Avg. Range Avg. Range Avg. Range Avg. proceeds total
41 $0.0-$2.5 $0.6 $0.1-$4.2 $1.0 $0.0-$0.7 $0.2 $0.0-$0.3 $0.1 $0.0-$0.9 $0.2 $0.2-$3.9 $2.0 6.9% $4.1 0.- 4.4 1.0 0.3-7.3 1.5 0.1-0.9 0.3 0.0-0.5 0.2 0.0-2.8 0.4 1.2-6.7 5.1 6.8% 8.5 101-200 201-300 301+ 115 45 73 0.1-5.6 1.0 0.2-4.9 1.6 0.1-1.2 0.3 0.0-1.9 0.2 0.0-4.0 0.5 2.5-12.2 9.4 6.6% 13.0 0.1-4.2 0.0-5.0 0.9 0.6-4.8 2.1 0.0-1.0 0.4 0.1-0.5 0.3 0.0-6.7 0.7 8.0-16.4 15.2 6.3% 19.6 1.2 0.0-17.0 2.3 0.1-9.8 0.5 0.1-2.4 0.3 0.0-4.5 0.5 7.9-237.9 23.3 5.5% 28.1
Uses for IPO Proceeds
• • • • IPO issuers are required to detail their uses of IPO proceeds on their SEC Form S-1 registration filing, and most other countries require similar filings. Kim and Weisbach [2005] examine how issuing firms use the proceeds of IPOs. – They argue that raising capital is an important motive for going public.
– For every dollar raised in an IPO, cash holdings rise by 68.8 cents during one subsequent year. – R&D and capital expenditures increase by 17.1 cents and 8.3 cents.
– Inventory levels rise by 2.3 cents – long-term debt is reduced by 4.2 cents.
All of these changes occur in the year subsequent to the IPO. By four years after the IPO – each dollar raised in the IPO is associated with a 50 cent increase in cash relative to the pre IPO-level. – Thus, the firm does not instantly spend its IPO proceeds. – This 19.9 percent reduction from the first-year increase in cash is a companied by 88.2 cent and 38.7 cent increases in R&D and capital expenditures four years subsequent to the IPO. – inventory levels rise by 5.3 cents – long-term debt is reduced by 10.4 cents.
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C. Investment Banking and the Underwriting Process
Corporations raise money by selling securities to investors. An investment bank is an institution whose traditional role is to assist corporations in the issue and sale of securities to the general public. This issue of new securities can be referred to as a primary offering or primary distribution. The secondary market where previously issued securities are sold. The secondary market provides liquidity for the primary market If new corporate stock is being sold to the public for the first time, it is said that the corporation is making an initial public offering of its stock. The firm can also issue securities via: – private placement – selling share in 144A markets
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Firm Commitment and Best Efforts Offerings
The investment bank assists the corporation in making the primary offering by first providing advice and counsel and then acting as a "middleman" in the sale of the new securities. This "middleman" function is served by the investment banker acting either as a broker selling the securities on a "best efforts" basis or by underwriting the new issue. If the investment banker acts as an underwriter in a firm commitment, it purchases the new securities from the issuing corporation and attempts to resell them at a profit, in a sense, acting as a wholesaler or dealer. The investment bank can also act as a broker, selling the new securities for the corporation or other investment banks on a commission or best efforts basis. underwriting syndicate: Reduces managing underwriter (capital commitment and risk selling group: Further enhances selling ability.
A study of 1028 IPOs from 1977-1982 found: – approximately 35% were brought to market on a best efforts basis. – Almost half of these best efforts IPOs failed – average returns for best efforts offerings were 48%, compared to 15% for underwritten .
Selecting the underwriter – Issuing firms often select an underwriter based on its experience taking similar firms public. – Having a well-known analyst in the same industry is usually a strong selling point – willingness to make a market for the new issue – – Many industrial corporations maintain an ongoing relationship with an investment bank In some instances, there will be a sharing of directors of the investment bank and its client. – publicly regulated utilities and municipalities are required to submit their primary offerings for competitive bidding.
Preparing for the IPO
• • • Preparation: – The issuing firm prepares a business plan – – The plan will detail how the firm plans to use IPO proceeds. The firm will begin auditing, legal, restructuring, governance, risk management, public relations and other operations.
Underwriter Selection: – Issuing firms consider the practices and reputations of prospective underwriters – bulge bracket underwriters normally being preferred. Advice and Counsel: – issuing firm and prospective investment bank discuss the issuing firm's need for funds, the amounts and various means of raising funds. – The investment bank will conduct a due diligence investigation of the issuer.
Administering the IPO
• • • • Registration: – A registration statement (Normally Form S-1) containing a prospectus. – – The SEC at least 20 days to analyze this statement for omissions. The underwritermay print a preliminary prospectus (red herring).
Syndicate Formation: – There may be an overallotment provision (sometimes called green shoe).
Price Setting
Road Shows: The investment bank will present the new issue to prospective purchasers in "dog and pony shows" or “road shows” in its efforts to create interest in the issue.
– not binding – Oversubscribed vs. Undersubscribed
C. After-market Matters
• • • • • • Fee Distribution: The price of the securities is often determined just before the IPO’s effective date. The IPO is said to be effective and the shares are then offered for sale to the public Consider a typical offering whose offer price might be set at $15 per share.
– The issuing firm receives $13.95 per share. The 7% difference is taken by the underwriting syndicate. – – The lead underwriter might take a manager's fee of $.20 for each share. Each share that the managing underwriter sells itself produces the full fee of $1.05. – Each underwriting syndicate member might receive $.85 ($1.05 minus the $.20 managing underwriter’s fee) – Selling group syndicates that might receive $.50 for each share that it sells. – This $.50 concession would be paid from the relevant underwriting syndicate member’s $.85.
Price Stabilization
– Managing underwriter places a buy order in secondary markets at a specified price to support the new issue should its market price drop. – Lasts for approximately two to four days and the underwriting syndicate shares its costs. – – The prospectus must state that there will be a price-pegging operation if one is planned. The price stabilization program may also contribute to the IPO underpricing phenomena discussed below. – Price supports and stabilization also seem to enhance underwriters' reputations.
Greenshoe Option: Overallotment option whereby the underwriter retains an option from the issuing firm to purchase additional shares, up to 15% of the original issue. – Typically supports the price stabilization process. – The underwriter then oversells the issue by up to 15% (shortselling). – – If interest in the issue appears to weaken, the underwriter supports its price by purchasing oversold shares. If sales are strong, the underwriter covers its short position by exercising its greenshoe option.
Quiet and Lock-up Periods: A 25-day quiet period (40 days for lead underwriters) – The IPO price typically rises at the end of this period due to renewed marketing efforts. – Many IPOs will have a “lock-up” period where existing IPO shareholders are discouraged or prohibited from selling their shares. These lock-up periods typically extend for 180 days.
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D. Alternatives to Traditional Underwriting
IPO Auctions – Google: 2004 offering, structured a Dutch auction process intending to sell 25.8 million shares of its stock, suggesting bids in the range of $108 to $135. – – Sold 19.6 million shares at the IPO price of $85, thereby raising $1.67 billion. The first trade price was $100.01, rising to over $300 within a year and over $1,000 by 2013. – – Lead underwriters, Morgan Stanley and CS First Boston collected a 3% commission on the offering rather than the standard 7% fee. It is not clear just how successful the IPO was. The IPO price was not as high as anticipated or nearly as high as subsequent trading prices. – A follow-on offering was priced at $295 per share, raising $4.18 billion. – The IPO created substantial favorable publicity for the firm and raised fortunes for its owners.
Web-based IPOs – The 1996 offering of the Manhattan microbrewery Spring Street Brewing Company. – – – The company raised $2mm of its $5mm goal. Spring Street used web-based documents, prospectuses and solicitations to offer its IPO. Annie's Homegrown and Logos Research Systems, solicited their customer base to draw in investors. (DPO) Smaller IPOs can qualify for more simple filing alternatives, including the SB-1 (up to $10mm) and the SB-2 (up to $25mm), though these limits can be as high as $50mm due to the 2012 Jobs Act. WitCapital was formed by Spring Street founder Andrew Klein for the purpose of providing web-based IPOs. – W.R. Hambrecht & Co. is a smaller investment bank founded in 1998 (later affiliated with J.P. Morgan Chase) that markets primarily to individual investors. – Hambrecht uses a web-based auction process called OpenIPO to offer securities for its clients. – – Hambrecht brought the 2002 CSFB offering of Instinet and July 2001 offering of Ravenswood Winery to the market. Some observers believe that these nontraditional approaches to offering IPOs will improve prices received by issuing firms and allow smaller retail investors to participate in IPO markets that they are generally shut out of. Nevertheless, it appears that even Hambrecht’s and similar offerings experienced IPO price run-ups.
The Reverse Takeover: The reverse takeover is the acquisition of a public company by a private company in an effort to take itself public. – New York Stock Exchange and the Archipelago Group, – This technique had been used in 1989 by Long Distance Discounting Services, taken over by Advantage Companies, which was listed on NASDAQ. This firm ultimately became WorldCom, which melted down a decade later.
– Self-Underwritten IPOs Self-written IPOs : typically motivated by the costs associated with traditional underwritten IPOs. – Self-underwritten IPOs lack some of the benefits associated with traditional underwritings, including the certification . – Self-underwritten IPOs include a number of investment banks that take their own issues (e.g., Goldman Sachs) to the market.
E. The IPO Underpricing Anomaly
• • • IPO anomalies refer to three unusual pricing patterns associated with Initial Public offerings of equities: – 1.
Short-term IPO returns are abnormally high.
– 2.
IPOs seem to under-perform the market in the long run.
– 3.
IPO under-performance seems to be cyclical.
Additional evidence suggests that "favored" clients of the underwriting firm frequently are the beneficiaries of this apparent underpricing. Perhaps favored customers benefit financially at the expense of issuers. – IPO returns are due to the provision of useful price-setting information by IPO market participants – May be due to supports in the IPO aftermarket.
Visa
Table 4: Money Left on the Table
First Money Company Lead Underwriter
JP Morgan Goldman Sachs
Offer Price
44.00
Pricing Valuation ($mm.)
$17,864
First Trade Price
56.50
Trade Valuation ($mm.)
22,939
on the Table ($mm.)
$5,075 United Parcel Service Morgan Stanley 50.00 $4,376 68.25 5,973 $1,597 Goldman Sachs 53.00 $2,926 70.375 3,885 $959 Goldman Sachs Priceline.com $16 $160 $81 $810 $650 Ivillage Inc Pacific Internet MarketWatch.com Morgan Stanley Dean Witter Goldman Sachs Lehman Brothers BT Alex Brown $24 $17 $17 $88 $51 $47 $95.88 $88 $90 $350 $264 $248 $262 $213 $201 Goldman Sachs $32.78 $577 $43 $757 $180 United Pan-Europe Communications Covad Communications Group Delphi Automotive Systems Corporations ZDNet Group OneMain.com Autobytel.com Bear Stearns Morgan Stanley Dean Witter Goldman Sachs BT Alex Brown BT Alex Brown $18 $17 $19 $22 $23 $140 $1,700 $190 $187 $104 $40.50 $18.75 $35.75 $38 $52.75 $316 $1,875 $358 $323 $238 $176 $175 $168 $136 $134
F. Explaining the Short-run IPO Anomalies
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Different sets of information regarding to the value of the issue. Underpricing might be a form of compensation for risk Adverse selection Underpricing might be compensation for providing information to other participants.
Information-based Explanations
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The information-based theories maintain that IPO underpricing is the result of information asymmetries, which can take three forms:
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Issuing firms hold superior information (Myers & Majluf)
– Underwriters hold superior information: underwriters use information to either exploit their clientele or to “certify” issues on behalf of issuing firms. – Institutional investors: Rock [1986] and Benveniste and Spindt [1989] argue that certain investors have superior information concerning IPO firm marketability and issuing firm competitors.
Investment Bank Exploitation
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