Transcript Slide 1

Public equity issuance
1
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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Potential functions of underwriting syndicates
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?
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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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Empirical findings (Corwin and Schultz 2005)
What is the added value of syndicates?
Syndicate participation evidence
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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
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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?
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Stability of composition of syndicates, but changing lead
underwriter.
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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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What is underpricing?
•
Underpricing: the first trading day closing price typically exceeds
the price at which the shares were offered to the investors.
Share price
Offer price
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t=0
International evidence
•
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)
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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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Principal-agent theory
•
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
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Information revelation theories
•
•
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.
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The winner’s curse problem
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!
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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.
bids distribution
L
V
H
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Institutional explanations
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.
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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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Ownership and control
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.
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Stock flipping
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.
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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
PL
Underpricing
underwriters.
More trading
V
PH
More income for the market making
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Long-run performance of IPOs
Puzzle: The long-run performance of IPOs is negative!
Share price
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t=0
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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What are the costs of IPOs for IB?
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.
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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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Underwriting spread and costs
Chen and Ritter (2000)
Facts:
1.
2.
3.
Spreads in the US are much larger than in the rest of the
world
At first sight, the fee structure does not reflect the
existence of fixed costs
Investment bankers concede that there is no price
competition
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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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Competition and the spread
Hansen (2001)
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, the
competition is in the other dimensions. This also saves time.
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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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What determines market shares?
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.
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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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A note on privatizations
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
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