Initial Public Offerings

(IPOs)

Definition
1st offer of equity to the public
On a public market
Usually existing company going
public for the first time

Largest US IPOs

Source: http://www.renaissancecapital.com/ipohome/rankings/biggestus.aspx

Recent South Africa IPOs

Name

Date

Accelerate Property Fund

12/12/2013

3 110

Advanced Health*

25/4/2014

80

Alexander Forbes Group

24/7/2014

9 768

Ascendis Health

22/11/2013

453

Pharmaceutical

Attacq

14/10/2013

800

Property fund

Equites Property Fund

18/6/2014

650

Property fund

Freedom Property Fund

12/6/2014

1,005

Property fund

PSG Konsult

18/6/2014

10 171

Financial services

Safari Investments

7/4/2014

1 445

Property fund

Tharisa

10/4/2014

600

Mining

Visual International Holdings*

23/5/2014

27

Property development

* AltX listings

Size (R nn) Industry

Property fund
Hospitals
Financial services

Why go public?
Capital for growth

Greater liquidity (for shares of current shareholders or

founders of the business)

Exit strategy
Access to future funding through public markets

Image of company as stable, serious player

Shares can be used to motivate management /
employees
Overall value of company (can) increase
5

Bill Gates
Microsoft
IPO: 1986
Personal stake: US$350,000,000

Mark Zuckerberg
Facebook
IPO: 2012
Personal stake: US$19,100,000,000

Jack Ma
AliBaba
IPO: 2014
Personal stake: US$28,000,000,00
6

The IPO process: role players

1. (Lead) Underwriter

Typically investment banker

2. Underwriting syndicate

Shares fees, work and (most importantly) risk

Roles:
procedural and financial advice to company.
buys issue from company at issue price.
then sells it to public at offer price.
7

Underwriting agreements
Firm commitment:
Underwriters buy all the shares and assume full risk
if not all shares are sold on listing.

Best Efforts Agreement:

Underwriter acts as intermediary but does not
purchase shares.
Does not carry any risk of shares not being sold.
8

The IPO process: steps

1.

File registration docs with JSE (SEC in the US)

2.

Appoint underwriter(s)

3.

Set initial price range

4.

5.

Valuation by underwriter

For preliminary / red herring prospectus

Go on roadshow

To do book building

Visit to potential investors by top management, investment

banker and lawyer(s)

Final price set for IPO

Valuation by prospective investors

Valuation approaches
1. Absolute valuations
2. Relative valuations
Which one?
Depends on information available and
confidence in inputs
Absolute valuation requires predictions of
future, relative may not to same extent
May use more than one to get value range
10

Absolute valuations
Components
1. Project discounted cash flows
2. Discount rate
3. Terminal value

11

Relative valuations
Multiples options
Price : earnings (P/E)
Price : book (NAV) (P/B)
Price : sales (P/S)
Enterprise Value /EBITDA (EV/EBITDA)

Find relative multiples for similar companies

in the market
Average across a number of companies?
12

Relative valuations
Apply to historical metrics
e.g. IPO company earnings
which are available from the prospectus

Can use latest metric

Or average of metrics, especially if cyclical
company
Perhaps weigh in favour of more recent
numbers if they are more representative
of the future
13

Relative valuations
But what determines if a company is similar?
1.
2.
3.
4.
5.

Industry / operations
Growth prospects
Risk profile
Size
Geographical footprint (etc.)

Adjustments to valuation multiple may be

required to adjust for especially 2 and 3
above
14

Relative multiples: issues to consider

Sensitive to market conditions
Short-run value

Cross-sectional distribution of multiple

Consistency of metrics
Forward looking vs. historical

Impact of accounting consistency

Consistency of numerator/denominator
E.g. EV/EBITDA

Risk of manipulation / subjectivity

15

Final price and share allocation

Price based on indications by potential investors
Conflict of interest: institutions being asked to
indicate what price they are willing to pay
Should institutions pretend not to be interested in
an issue so that the price is driven down?
No, because:
IPO shares are partially awarded based on enthusiasm
of investors
(i.e., order from institution with highest indicated price is filled
first)
16

The actual IPO

17

IPO costs
Explicit costs
Underwriter fees.
Underwriter spread
In the US approximately 5- 7% of gross IPO
proceeds

Costs of roadshow, documentation, registration

etc.

Implicit costs:
Under-pricing (money left on the table)

18

Over and Under-subscription

Over Subscription
More demand than IPO shares available.
E.g., 7x oversubscribed means 1 share available
for every 7 demanded / applied for.

Under Subscription
If there was a firm commitment the
underwriter ends up with unwanted shares
that has to be sold on the secondary market
(normally over a period of time)
19

Greenshoe Provisions
Clause which permits an underwriter to
increase the number of shares being sold
to investors should demand be higher
than expected
Extra shares come from current owners

Current owners end up selling a larger %

of the company than they originally
intended.
20

Costs of going public (1)

Direct costs of IPOs / equity listings
Public market compliance costs (legal,
accounting, systems etc.)

Transparency and disclosure obligations

(e.g., executive compensation)

Loss of control
21

Costs of going public (2)

Greater scrutiny by various stakeholders
Limitations to operational / strategic
flexibility satisfying all stakeholders (e.g.
analysts)

Shareholder relations costs and

management of expectations
Insider trading limitations
22

Listing & Business Value

Theories on link between listing and business value:
1. Diversified public market investors willing to pay
more for share in business (becomes part of diversified
portfolios of large number of shareholders, therefore reduces
overall investment risk)

2. Listing leads to greater confidence in company,

resulting in investor willingness to pay more

23

IPO Timing Issues

1. When is it best to list a company?
When market ratings are high
2. What does a relatively small number of
IPOs in a given period tell us?

That the market may be cheap (or

undervalued)
24

CFO views on IPO timing factors

Sample of 336 US CFOs as follows:

Successful IPOS 2000 2002: 87
Filed IPO prospectus but withdrew: 37
Could have IPOd, but did not: 202
Source: Brau & Fawcett, JACF (2006) ,18, 107-17

25

Hot and Cold IPO years

*

* US market

http://aswathdamodaran.blogspot.com/2012/02/facebook-playing-ipo-pop-game.html

26

IPOs Signals sent to the market

Positive signal: increase markets confidence / valuation

Negative signal: decreases markets confidence / valuation
Source: Brau & Fawcett, JACF (2006) ,18, 107-17

27

IPOs and share prices

market evidence

First day
Underpricing

Longer term:
Often negative returns for along time
28

Leaving money on the table

http://aswathdamodaran.blogspot.com/2012/02/facebook-playing-ipo-pop-game.html

29

30

IPO Underpricing
Leaving money on the table
In US IPO discount averaged about 20% between
1960 and 2007, but fluctuated greatly over the
period

Highest in Internet boom (late 90s).

In 1999/2000, US issuers left $62 billion on the
table (underpricings of 71% and 57%)
Such markets are called hot markets
31

Evidence of Underpricing
Typically measured as % change in share price
between opening and closing on the first day
or

money left on table (#shares x [trading price offer price])

32

Example: extreme underpricing

December 1999.
VA Linux.
Shares issued at $30 (IPO).
End of first day of trading: $239.25.
Return of 698% in a day!

The losers:
existing shareholders in the issuing company could
have sold share in the business for 7x more sold
their asset (a share in the business) for far less than
the market was willing to pay.
33

Why would there be IPO

underpricing or at least the
appearance of underpricing?

34

(Some) Theories

Winners Curse
Information revelation
Principal agent conflict
Signal of quality
Litigation avoidance
Investor sentiment
35

Theory 1: Winners Curse (1) (Rock, 1986)

Some investors are better informed about value of new
shares than bank, general investors and issuing firm
Informed investors only bid on attractively priced IPOs,
reducing success rate of uninformed investors on these
Uninformed investors get all shares they bid for on
unattractively priced IPOs (winners curse)
Which means uninformed investors will have negative
return over time and therefore lose interest in IPOs
But there are not enough informed investors to take up all
share offers, so market needs uninformed investors to
remain interested.
36

Theory 1: Winners Curse (2)

Therefore, on average IPOs have to be priced such that
even uninformed investors have positive returns over time
But, why would individual companies care about the
market as a whole when pricing their IPO?
They dont they would underprice by less if they could
But investment banks are dependent on the markets
continuing to function and attract uninformed investors
Investment banks therefore coerce firms into underpricing
(but not too much, as would lose market share if they
overdid this)
37

Theory 2: Information Revelation (1)

Implications of Winners Curse:
Institutions will get a greater share of attractively priced
IPOs (therefore have greater returns on IPOs on average
than private investors)
Bookbuilding exercise needs to focus on extracting informed
investors private information so as to reduce need for
underpricing.
But the incentive for the informed investor is to underplay
positives and even misrepresent perceived prospects of
company

How can underwriter incentivise informed investors (e.g.

institutions) to reveal true judgements on firms value?
38

Theory 2: Information Revelation (2)

Solution:
Selective share allocation by underwriter: aggressive bidder
gets more shares than conservative bidder (even though
issue price the same for all)
More aggressive bidding allows issue price to be raised,
hence reduces underpricing
Still have to be some underpricing, otherwise no incentive
to be aggressive in order to get more shares

Ability to selectively allocate may be limited by legislation

requiring minimum % to retail investors
39

Theory 2: Information Revelation (3)

Second incentive to tell truth:
Investors active in IPO market has incentive to reduce lying
for fear of being excluded from future IPOs

Implication 1:
underwriters who have greater IPO deal flow will find it
easier to get true valuations from investors

Implication 2:
in the interests of future business, underwriters should treat
regular investors favourably even if they are not the most
aggressive bidders on a particular IPO
40

Theory 2: Information Revelation (4)

Third mechanisms to elicit true valuations:
If credible threat of withdrawal of IPO offer if valuations are
too low exists (tested and found to be valid for firms with large
line of credit lower underpricing)

Tests
Many experimental tests have been conducted.
Complex and varied methods
Mixed results

41

Theory 3: PrincipalAgent Conflict (1)

Underpricing effectively transfers wealth from issuing
companys owners to investors.
But investment banks strongly influence (in most cases
determine) both price and allocations

Is there a conflict of interest here? Can investors

influence banks to underprice and misallocate in their
favour?
How would they be able to do this?
42

Theory 3: PrincipalAgent Conflict (2)

Practice 1 (example):
In 2002 Credit Suisse First Boston was fined $100 million
for accepting millions of dollars in inflated commissions
from customers in exchange for allocating them shares in
IPOs
Practice 2: Spinning
Allocating underpriced IPO shares to company executives
with hope of getting future corporate finance business
from them
43

Theory 3: PrincipalAgent Conflict (3)

In both cases, underwriters have incentive to under-price
clients' shares on IPO.
What is the counter-incentive (i.e., not to under-price)?
Answer:

Banks underwriting fees (typically a % of IPO proceeds)

44

Theory 3: PrincipalAgent Conflict (4)

Assumption: Issuer leaves determination of IPO pricing to bank,
resulting in bank largely determining the nature of the contract
between it and the issuer.
Bank selects option that maximises its profits based on
expectation of demand for IPO shares as follows:

Likely Demand

Spread

IPO Price

High

Low

High

Low

High

Low
45

Theory 3: PrincipalAgent Conflict (5)

Implication:
Greater value uncertainty = greater information asymmetry =
greater reliance on bank in IPO = potentially greater underpricing

How to avoid?
1. Monitor investment banks selling effort, bargain hard
over price
2. Use contract design to realign banks incentives by
making its compensation more dependent on offer
price
46

Theory 4: Signal of Quality (1)

Companies have better information on their future
prospects than investors.
Then, using underpricing to signal companys true high
value
But costly, so why do this?
Answer:
So that can return to markets in future on better terms in
other words, underpricing to keep investors happy.
47

Theory 4: Signal of Quality (2)

Scenario:
High quality company (A) and low quality company (B),
and: investors cannot tell the difference
High quality firms leave money on the table at IPO so
that investors are keen to come back for subsequent
funding rounds (money then recouped through better
prices)
Low quality firms do not underprice by as much as may
not be able to recoup cost in subsequent funding
rounds (may be caught out before)
48

Theory 4: Signal of Quality (3)

But would companies not rather use less costly and
more obvious ways of signalling their quality? Such
as...
Use reputable underwriters
Use respected auditors
High quality board of directors (especially non-execs)

Etc.
49

Theory 5: Litigation Avoidance (1)

Legal insurance or lawsuit avoidance hypothesis

High levels of litigation in US for IPOs typically

claiming that material facts were omitted or
misrepresented in prospectus
Higher IPO prices increase risk of poor subsequent
performance and hence of litigation
Therefore, firms underprice their IPO shares to reduce
likelihood of disappointed shareholders suing because
of poor post-IPO share performance
50

Theory 5: Litigation Avoidance (2)

Also to minimise risk of adverse ruling in any litigation
and the amount of damages if found guilty
However, a trade off: minimising risk of litigation (and
associated costs) vs. maximising IPO proceeds
Problem with theory
Underpricing is global, while IPO litigation is largely
restricted to the US
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Theory 6: Investor Sentiment

Essentially that investors tend to be overoptimistic,
resulting in prices going up on IPO even if
realistically valued at start
Knowing this, issuers may even slightly overprice
IPO relative to true value
In the long-term, share price reverse to real value
Therefore, expect negative IPO returns on average
in the long-term (consistent with findings)
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