1

Advanced Corporate Finance

(Econm 2032)

Initial Public Offerings

Piotr Korczak
P.Korczak@bristol.ac.uk

2
Outline of the lecture
• The benefits and costs of going public
• IPO cycles
• The process of going public
• Stylised facts about IPO stock returns
• Underpricing
– Theoretical explanations
• Long-run underperformance
– Measurement problems
– Some explanations

3
Advantages of going public

• Better access to capital markets

• Shareholders gain liquidity
– Including managers compensated with shares, target
shareholders paid in stock (M&A)
• Original owners can diversify
• Monitoring and information provided by external
capital markets (‘information spillovers’)
• Enhances the firm’s credibility
• Facilitates acquisition of the company for a higher
value

•1
4
Disadvantages of going public

• Direct IPO expenses

• Costs of dealing with shareholders
• Information revealed to competitors
• Public pressure
• Underpricing – indirect cost (?)

5
Pagano, Panetta and Zigales (1998)

• An analysis of determinants of initial public

offerings (Probit analysis) – ex ante
• An analysis of the effects of an IPO on the financial
situation of the firm (profitability, investment, debt
financing etc.) – ex post
• Independent IPOs and carve-outs

6
Pagano et al. (1998) – Table III

•2
7
Pagano et al. (1998) – parts of Table IV (1)

8
Pagano et al. (1998) – parts of Table IV (2)

9
IPO cycles (US data)

Source: Jay Ritter, University of Florida, available from his website

•3
10
IPO cycles - explanations
• Demand- side explanations
– Demand from firms for capital
– For example, internet start-ups in mid-1990s
• Supply-side explanations
– Supply of funds from investors
• Which driver of the hot issue period would an
entrepreneur prefer?
• Support for supply-side explanations – the link
between the number of firms going public and
post-issue performance

11
IPO cycles and post-issue performance
800 60%

700 40%
3-year market adjusted BHR

600
20%
Number of IPOs

500
0%
400
-20%
300

-40%
200

100 -60%

0 -80%
1980 1985 1990 1995 2000 2005 2010

No of IPOs Return

Source: Jay Ritter, University of Florida, available from his website

12
The process of going public

• Appointment of the underwriter

• The registration statement
• Marketing the issue
• Pricing the issue and allocation
– Book building vs. fixed-price method
– Oversubscription (?)

•4
13
IPO underpricing

• Shares sold in IPOs tend to be underpriced

– The share price jumps substantially on the first day of
trading
– Also called ‘first-day return’
• Cost to the firm’s owners
• Money ‘left on the table’

14
IPO market and undepricing over time (US)

800 80

700 70

600 60
Average First-day Returns
Number of IPOs

500 50

400 40

300 30

200 20

100 10

0 0

Source: Jay Ritter, University of Florida, available from his website

15
IPO undepricing – international evidence (1)
250.0%

200.0%

150.0%

100.0%

50.0%

0.0%
Jordan

Japan
Taiwan

Morocco

Switzerland
Sweden

Germany
Iran
Pakistan

Ireland
Saudi Arabia

China
India
Korea
Malaysia
Greece

Bulgaria
Thailand
Sri Lanka

Brazil

Singapore
Indonesia

Australia
Tunisia

Cyprus
New Zealand

Source: various studies surveyed by Jay Ritter, available from his website

•5
16
IPO undepricing – international evidence (2)
20.0%

15.0%

10.0%

5.0%

0.0%
Poland

Turkey

Denmark
Philippines

Finland
United States
United Kingdom
Hong Kong
Italy

Belgium

Portugal
Mexico
France

Spain

Norway

Russia
South Africa

Mauritius
Israel

Nigeria

Egypt

Netherlands

Chile

Canada
Austria
Source: various studies surveyed by Jay Ritter, available from his website Argentina

17
Money left on the table, top 5 IPOs (US)
• Wealth transfer from the ‘old’ to ‘new’ shareholders
• (closing P on the 1st day – offer P) × no. of shares sold

Dollar amount Company IPO Offer First closing Number of

left on the table date price market price shares sold
$5,075,000,000 Visa 080319 $44.00 $56.50 406,000,000

$1,597,240,000 United Parcel Service 991110 $50.00 $68.25 87,520,000

$1,539,512,500 Corvis 000728 $36.00 $84.71875 31,600,000

$1,323,000,000 Twitter 131107 $26.00 $44.90 70,000,000
$1,312,437,500 Palm 000302 $38.00 $95.0625 23,000,000

Source: Jay Ritter, University of Florida, available from his website

18
Uderpricing – Asymmetric info (1)
• The issuer more informed than investors
– A lemons problem – an attempt to signal quality
– Good-quality firms deliberately underprice
• Demonstrate quality by throwing money away
• Recoup their sacrifice later: future issuing activity,
favourable market responses to future dividend
announcements, analyst coverage
• ‘a good taste in investors’ mouths’
– Mixed empirical evidence

•6
19
Uderpricing – Asymmetric info (2)
• Investors are more informed than the issuer
– Simplest assumption: all investors equally informed, hence
buy only good IPOs
• Observed IPOs are underpriced

20
Uderpricing – Asymmetric info (3)
• Investors are more informed than the issuer
– Investors differentially informed: winner’s curse
• Full allocation of overpriced IPOs and partial allocation
of underpriced IPOs
• Average return negative
• Underpricing needed to break even – to attract broad
investor base
• Empirical evidence from fixed-price allocation
(Singapore, Finland)

21
Uderpricing – Asymmetric info (4)
• Investors are more informed than the issuer
– Investors differentially informed: negative cascade
• Investors judge the interest of other investors
• Request share only if the IPO is ‘hot’
• Pricing slightly too high may trigger the cascade and
lead to a failure
• Empirical support: IPOs either undersubscribed or
hugely oversubscribed, few moderately oversubscribed

•7
22 Uderpricing – Asymmetric info (5)
• Investors are more informed than the issuer
– Investors differentially informed: how to induce informed
investors to reveal their intentions truthfully?
• Offer to allocate more and underprice
• Empirical evidence
– Informed investors receive more allocations
– Evidence on underpricing

23
Uderpricing – Asymmetric info (6)
• The underwriter is more informed than the issuer
– Agency-based explanation
– The issuer cannot monitor the underwriter without cost
– Underpricing makes selling easier and less risky (for the
underwriter)
– Not supported by the empirical evidence
• If the underwriters (investment banks) go public
themselves, they are underpriced too

24
Uderpricing – Symmetric info
• Underpricing to reduce the risk of legal liability
– Investor lawsuits if subsequent poor performance
– Not supported by the empirical evidence
• Other arguments
– Higher trading in the aftermath if more underpriced –
additional revenues for the underwriter (e.g. from market
making)
– In the internet bubble period analyst coverage more
important than proceeds from the issue (Loughran and
Ritter, 2004)
– ‘The corruption hypothesis’ – hot IPOs allocated to
personal brokerage accounts of executives of potential
issuers (Loughran and Ritter, 2004)

•8
25
Long-run performance – Measurement
• Benchmark?
• Overlapping events – statistical inference?
• Event time vs. calendar time

26
Long-run performance – US evidence (1)

• Style: small/growth

27
Long-run performance – US evidence (2)

•9
28
Long-run performance – Explanations
• Optimistic investors buy IPOs; over time the
marginal investor’s valuation converges towards
the mean valuation
• More IPOs follow successful IPOs; the last (and
large) group would underperform
• ‘Optimistic’ accounting before/during IPO
• Price reversal after underpricing? (confirmed for
penny stocks)

29
Allocation of shares – Some issues
• To extract information from investors – see above
• Allocation to favoured buy-side clients
• Allocation to institutional vs. individual investors
– Controlling role of large shareholders
– Liquidity
– Flippers – quick profit

•10