INTOSAI Privatisation Working Group (PWG)

1. INTOSAI Privatisation Working Group (PWG) Technical case example Series 1 – Privatisation 4. Conducting an IPO

2. Table of Contents • List of acronyms 3 • Introduction 4 • 1. Overview of the IPO privatisation process 5 • 2. Choice of stock market 7 • 3. Structural issues 8 • 4. Valuation and pricing 9 • 5. Marketing the issue 10 • 6. Underwriting 11 • 7. Allocation 15 • 8. Aftermarket 16 • 9. The Audit : VFM issues 17 • Appendix 1 : Lead adviser check list 19

3. List of Acronyms GAB General Auditing Bureau GCO Global co-ordinator INTOSAI International Organisation of Supreme Audit Institutions IPO Initial Public Offering OECD Organisation for Economic Co-operation and Development SAI Supreme Audit Institution UK United Kingdom UN United Nations

4. 1. Introduction • The role of the IPO in privatisation • In recent years, the largest international privatisations have tended to be carried out by way of an Initial Public Offering. Although the process involved can be long and complicated, it is a method of privatisation that has a high level of transparency and, provided the policy objectives are clearly defined, can be the most effective way of obtaining value for money. • A two stage process • The starting point for any privatisation is the work required to put the business concerned into a corporate form that is capable of an independent existence. This requires not only work to ensure that the business is appropriately corporatised but also that the relationship with government in the future will be arm’s length and sustainable. • The second stage is the work needed to take the company from being a government owned entity to being a listed independent company with its shares traded on one or more stock exchanges. This requires further work specifically aimed at putting the company in a form suitable for listing and culminates in the actual listing of its shares on the stock exchange. • This paper focuses on the marketing of the IPO • Once the preparatory work has been completed, it is necessary to market the company to potential shareholders and then launch the IPO. This paper covers the work needed to market the issue and the procedures and relationships that apply in an international issue. There are many variations and market-specific regulations that will influence this process when applied to a particular stock exchange. As a result, the process described here is presented in a general form, without regard to regional variations.

5. 2. Overview of the IPO process • What is an IPO? • An Initial Public Offering is the process by which a company has its shares listed on a stock exchange. This means that they can be freely traded on the exchange and are subject to its regulation. • All the shares in the company will become listed. They may either be existing shares sold by the owners for their own benefit, existing shares retained by the owners, or new shares issued by the company when the proceeds are used for financing its business. • In the context of privatisation, the owners are the government and there are often special features of the company which have to be addressed before the company can be listed. • The term IPO strictly applies to the first time a company’s shares are listed (a primary offering) but similar techniques can be used for a sale of shares in an already listed company (a secondary offering). • Is the company fit for listing? • In order for a company to be listed, it must meet the criteria of the relevant exchange for suitability for listing. These include the independence and viability of the business, the presence of experienced and competent management, an appropriate trading history and, where relevant, a clear regulatory environment (particularly important for a former government run business). • The IPO process • Preliminary work focuses on getting the business into a corporate form that will be be viable and capable of independent growth and development. This will include the legal and accounting work needed to put this in place, as well as due diligence associated with the marketing documentation used in the IPO. • The appointment of advisers is critical to address the various issues that form the core of the IPO process. • Once the preliminary work has been completed, the IPO process can get under way. The overall position is shown in the diagram on the next page.

6. IPO decisions and preparation Marketing Appoint lead adviser • GCO / bookrunner / sponsor Appoint syndicate • Co-leads / co-managers Choice of market • Domestic / international Analysts reports • Company coverage Capital structure • Debt / equity / new money / dividends Road shows • Institutional presentations Offer structure • Institutions / general public / employees PR campaign • Analysts / Press / institutions Timing • Accounts / historical record / events Bookbuilding • Sales campaign / book built Valuation • Business value / investor demand Pricing finalised • Issue covered by book at price 2. Overview of the IPO process (cont.) Final agreements and launch Issue launched Trading and aftermarket Underwriting Allocation Aftermarket • final undertakings • fee splits / performance • Target shareholder list • Aftermarket trading • Price stabilisation • Continuing obligations

7. 3. Choice of stock market • Choice of market will determine the character of the IPO • Listing shares on a particular exchange will mean that the company’s conduct will be governed by the requirements of that exchange. It will also influence the composition of the shareholder list and the liquidity of the shares that are traded. • Option 1 : listing solely on the local stock exchange, possibly designed to attract foreign institutional investors. • Option 2 : dual listing on a domestic and an international exchange launched at the same time. • Option 3 : an international listing. • What are the choices? • The suitability for listing on domestic or international exchanges will depend upon the characteristics of the company and whether it is more likely to appeal to foreign investors if it is listed internationally. • The choice will also depend upon the domestic stock market and how it is viewed by both domestic and foreign investors. • If international investors are being sought, a local listing is appropriate if the reputation of the exchange is such that it will command respect amongst such investors. If not, the price obtained and the liquidity in the aftermarket will suffer. • There are a number of exchanges world-wide that list foreign companies. However, the three principal ones are New York, London and Hong Kong. Each have different requirements for listing but all have a high reputation for regulation and this is important for providing investor confidence. • What are the implications? • International exchanges may have more onerous regulations for corporate governance and accounting requirements than the domestic exchange. • An international issue will be more expensive to arrange at the IPO stage and may be more expensive to maintain with higher on-going fees for listing and accounting charges. • Against these higher costs, if the company is of a suitable size and business type, the additional liquidity of the international markets and wider range of potential investors could lead to a larger and more successful issue at a higher price.

8. 4. Structural issues • Determining the capital structure • The capital structure will need to be tailored to the future requirements of the business. Target levels of debt and dividends must be capable of being serviced by the projected earnings of the business. This will have an influence on both the credit rating of the company and the pricing of the issue. • The other major factor will be the amount of new money raised as against shares sold by the government, together with the amount retained by the government and what restrictions are placed on future sales. • New money may be raised at the time if appropriate for the company’s future requirements, but any overhang of shares held by the government must be presented carefully so that the market price is not depressed by fear of future sales. • Determining the offer structure • A privatisation IPO may have other considerations beyond maximising the sale value for government. If wider share ownership or the participation of the general public or employees in the issue are major objectives, it may be necessary to give incentives to these particular investors. This can be through preferential share entitlements or even discounts to the issue price. • Marketing to a wider range of individual investors requires a more extensive marketing campaign of a different style to an institutional investor programme. Specifically identified groups such as employees or customers can be marketed through direct contact mailings. A marketing campaign to attract members of the general public requires a more high profile approach and will usually involve an expensive series of TV and newspaper advertising, together with an extensive support apparatus to process applications and handle enquiries. • The terms of the offer will be highly influenced by the type of investor base that is eventually required. The possibility of specific discounts has been mentioned, but the actual pricing of the overall offer will also be an influence as any underpricing will lead to a premium in the aftermarket and the opportunity for investors to make a quick profit. • Careful selection of the investor base at the time of an IPO is critical to the share price performance of the company in future. A solid core of institutional investors is needed to support the company while a balance of less stable shareholdings, together with some unsatisfied demand amongst institutions, can provide liquidity and interest in the shares.

9. 5. Valuation and pricing • Business valuation central to the IPO process • Forming a view on the value of the business as a quoted company is the starting point of IPO pricing and is the crucial first stage in the negotiation process leading to the pricing of the issue. The valuation will be undertaken on the basis of current information on the company, the value of analogous companies in the market (if available), and using techniques such as discounted cash flow valuations. Although the lead adviser may drive the process, the vendor needs to have his own views, and sometimes seeks independent advice, if good value is to be obtained. • Once the likely market value is established, a view then needs to be taken on the price or range of prices at which the shares should be offered to the market. • Valuation and pricing will not necessarily be the same • The pricing of the issue will be based on an estimate of what the company should be valued at immediately post flotation. However, the market may view the business, since it is a former government entity, as being untried and therefore demand a discount. • The government may also want to ensure that the issue is a success and therefore be prepared to issue the shares at a discount to the theoretical as-floated value. • In practice, a range will be selected as embracing the high and low points of the valuation possibilities and it is this range that will be tested on the market. • Establishing the price in the market • Traditionally, in some markets, an issue would be priced in private and then launched on the market having been underwritten at that price. Its success would be “guaranteed” by the fact it was underwritten. However, an issue left with the underwriters was deemed a failure and there would have been a consequent pressure on the price in the aftermarket. • The current method of issue involves building a book of interested shareholders who are prepared to buy a certain number of shares at a certain price (“bookbuilding”). The starting point for pricing will be the price at which the whole issue is covered, subject to a reasonable spread of investors. • The mechanism of bookbuilding and the determination of the final price, through the target allocation, are considered below.

10. 6. Marketing the issue • The balance between marketing and regulation • Marketing an IPO is governed by complex regulations relating to both the requirements of the stock exchange through which the issue is being conducted and the legal requirements for selling shares in that country and in any other where the shares will be sold. In most countries, the marketing regulations are very restrictive, with the USA being particularly demanding. • The selling document is usually a prospectus which contains all the information that a prospective investor would need in order to form a view on whether to invest in the company. The content of the prospectus is governed by market practice and the regulations of the exchange on which the shares are to be listed. Throughout all the marketing activities conducted in connection with the issue, it is essential that no new information is given out which is not included in the prospectus. • Reaching the investors • As already mentioned, the approach to marketing an issue to the general public and to institutional investors are quite different. This paper does not address the subject of marketing to the individual investor but focuses on the institutional market. If it is decided to access the retail market simultaneously (to create added pricing tension or to fulfil overall policy objectives), a parallel public offer may be conducted. • The marketing of an issue will concentrate on both opinion formers (research analysts and journalists) and potential investors. The aim is to prepare the market and shareholder interest in the period running up to the date of the issue. • Although the organisation of the marketing will be often led by the investment banks, a specialist financial PR firm may be employed and the management of the company to be floated will also play a crucial role. • The marketing will normally commence with a presentation to research analysts although there may sometimes be prior contact with potential large investors to gauge market sentiment. The material made available at presentations and meetings needs to be carefully controlled. Equal provision of information must be given to all interested parties and the market. • The most crucial part of the marketing will be a series of roadshows, these are face-to-face meetings with investors or groups of investors. This is a demanding process, perhaps lasting 2-3 weeks, involving senior management of the company visiting international financial centres to explain the company and answer questions.

11. 7. Underwriting • Soft and hard underwriting • Underwriting is the process by which an investment bank or a syndicate of banks guarantee to buy the shares at a pre-determined price. The underwriters then on-sell the shares to market purchasers. Underwriting is described as either “hard” or “soft” depending at what stage in the selling process a commitment is entered into. • The traditional method of hard underwriting is now only done for the smallest issues. In this, the underwriters will agree beforehand a price at which they will cover the issue. If the issue fails they will buy the shares. In practice, most issues are now soft underwritten which means that demand is established in detail by a bookbuilding exercise before there is any commitment towards the issue. • Although bookbuilding has taken away much of the risk associated with the underwriting exercise, some banks will make up-front commitments in order to secure a position on the syndicate. • The bookbuilding exercise • At the commencement of the bookbuilding exercise, a “red herring” or preliminary prospectus is published giving full details about the company and setting the price range within which the shares are expected to be sold. Sales teams of the syndicate members will approach institutions with a view to determining their interest in buying shares at a particular price within the price range. This is called building the book (i.e. a “book” of orders). For instance: • Institution A Institution B • Price (p) No. of shares No. of shares • 240 100,000 - • 230 300,000 50,000 • 220 500,000 300,000 • 210 700,000 500,000 • A crucial part of bookbuilding is to categorise the quality and behaviour of likely investors. This is covered below under Allocation.

12. 7. Underwriting (cont.) • The underwriting syndicate structure is fundamental to the Offer • The underwriting syndicate will be led by the Global Co-ordinator (GCO) who will almost invariably also be the Bookrunner (and the Sponsor of the Offer if required by local regulations). One or more banks may be appointed to this role although more than two may give rise to problems of communication and co-ordination. Generally, the GCO will have been the lead adviser on the IPO but the roles and appointment process are often delineated and separate. The role of GCO is prestigious and highly fought over by competing banks. • Below the GCO in terms of status and importance are the Co-lead managers and below them the Co-managers. The GCO runs the IPO process, the Bookrunner controls the allocation of shares, the Co-lead managers provide research and incremental demand, and the Co-managers research and some sales support. All syndicate members are expected to “soft” underwrite part of the offering. The syndicate needs to be tightly-controlled and disciplined if it is to work effectively and there may be rules set by the GCO as to who can approach which institutions. • Fees for the syndicate will be pre-agreed although there may be performance criteria also applied including a discretionary element following a post-IPO assessment of syndicate performance. Depending upon the size and location of the issue, gross fees may be in the range of 1.5% - 3.0%. • Gross fees will be split between management fees as compensation for arranging the issue (20%), underwriting fees as compensation for underwriting the risk (20%), and selling concessions earned through actual sales achieved (60%). The management fee is normally divided between the managers in proportion to their underwriting commitments but with a “praecipium” retained for the lead managers. A specific additional fee may also be paid to the GCO. • Selling commissions are paid according to the number of shares sold by each manager although, to incentivise the lower members of the syndicate, the amount that can be earned by the lead managers will often be capped with the balance being known as the “overage”. • It is important when designing the fee structure to encourage competition between the syndicate members although such competition needs to be regulated and monitored if a “free-for-all” is not to develop. The general principle should be to reward those banks who obtain the highest quality orders at the best possible price. • Banks compete fiercely for syndicate positions and such competition can be used to drive down fees to the lowest possible levels.

13. Number Fee split 1 - 3 70% - 80% 15% - 20% 3 - 5 3 - 5 5% - 10% 7. Underwriting (cont.) • The underwriting syndicate structure and fee split arrangements are illustrated in the following diagram Global co-ordinator and Bookrunner Co-Lead Manager Co-Lead Manager Co-Lead Manager Co-Manager Co-Manager Co-Manager

14. 7. Underwriting (cont.) • Selecting the optimum syndicate members will greatly increase the chance of a successful issue • A formal beauty parade should be held to select the GCO and each of the other syndicate members. • In deciding who to approach, the following aspects should be considered: Relevant transaction experience Knowledge of sector and company Research capabilities Approach to valuation Trading record in comparable companies Resources, commitment and enthusiasm Fees and Value for Money • The structure of the syndicate and its fee arrangements should encourage competition between members without interfering with the smooth running of the whole process. In general, performance in the bookbuilding and other tasks should be rewarded with increased final allocations of stock and fee split. • As the lead adviser role of GCO or bookrunner is crucial to the whole process, Appendix 1 sets out what issues would normally be covered in specifying the appointment of a lead adviser in an IPO.

15. 8. Allocation • Fixing the price • The bookbuilding exercise will take into account the size of the order, the potential price at which it will be purchased, and the quality of the tendering institution. The object will then be to decide on the allocations so that the target shareholder list (in terms of balance between the different Tiers of investor) is achieved at the highest price. This is inevitably a balancing act and compromise as the allocation which gives the highest price that covers the issue is unlikely to provide the best shareholder distribution. • When categorising investors, the following would be a typical hierarchy: Tier 1 Top Quality, Long Term Tier 2 Good Quality, Smaller Size Tier 3 Medium Quality, Lower Priority Tier 4 Low Quality, Private Clients, Retail Tier 5 Brokers, Short Term Investors • The higher the tier, the better the quality of the investor in terms of likely behaviour in the aftermarket. • During the bookbuilding, Daily Demand Summaries are normally produced showing the total demand from the various tiers and the indicatives prices that have been offered. The vendor should be kept in close touch with progress. • At the end of the process, a price will be struck at which the shares will be sold. In order to ensure a satisfactory aftermarket in the shares, the book of demand would normally only be deemed satisfactory if there are sufficient orders from Tier 1 and Tier 2 investors to cover the volume of shares that are being sold. This should help ensure a satisfactory aftermarket. • The vendor should insist on full transparency during the bookbuilding process and should see details of investors, order size, and price. • Once the price has been determined, shares will be allocated to investors who have tendered at or above the strike price. In order to ensure an unbiased process, the basis of the allocation should be agreed with and monitored by the vendor.

16. 9. Aftermarket • Trading commences • As soon as the offer process has been completed, and the shares allotted to successful applicants, trading in the shares can commence on the stock exchange. • If demand has been identified during the marketing phase which was not satisfied in the allocation, it is likely that there will be some immediate demand for the shares and upward price pressure in initial trading. On the other hand, a barely subscribed issue will be more likely to have selling pressure on the price. • Immediately post IPO market stabilisation • Depending upon the stock exchange, mechanisms may be available to stabilise the price of an issue immediately after it has been launched (aftermarket price). This is usually an exception to otherwise stringent rules on not manipulating or creating a false market in shares. • A classic mechanism is an over-allotment option, otherwise known as a “Greenshoe option”. The offer structure to bookrunners comprises a minimum amount of stock plus an option to purchase additional stock (up to 15% of offer including option). • Bookrunners may overallocate stock to investors due to high aftermarket demand. If the aftermarket price is volatile or low, the bookrunner can exercise the option and purchase additional shares at the offer price from the vendor to satisfy the over-allotment. This has the effect of supporting the price in the aftermarket. • The offer structure for the sale of British Energy was a minimum of 610 million shares plus an over-allocation option of 90 million (12.9% of offer including option). The price fell from the initial partly-paid price of 104 pence to an aftermarket price of 94 pence. However, the bookrunners only partially satisfied the option, purchasing 9 million shares leaving the UK Government with 81 million unsold shares. • Because there is no certainty that the Greenshoe shares will be sold for the shareholder, fees payable on this part of the IPO are usually less than for the rest of the issue. • Continuing obligations • Once the company has set out on its new life as a listed company, it will have a new set of masters and new obligations to both them and the market in general. This will include keeping the market informed on events in the company and publishing accounts and other documents in a timely fashion. • As part of this, corporate governance rules of the particular exchange must be observed and the appropriate composition and independence of the Board of Directors maintained.

17. 10. The audit : VFM issues • VFM considerations will depend upon the objectives of the privatisation and will need to address both the financial and the non-financial aspects • Non-financial issues • The business itself may be in need of improvement and reinvestment, possibly something that can be achieved more easily under private ownership and without recourse to government expenditure. New management can be introduced and both management and employees can be incentivised through share schemes and share ownership. • Other policy objectives may include promoting wider share ownership and providing a participation in the business for customers. • All these features may impact on the net financial gains. • Financial issues will be more easily measured • The direct benefit to the government will be the net proceeds of the sale and the value of any residual holding, both in capital and dividend terms. There will be a balance between ensuring the success of the business, and hence future value, and immediate returns. It will not be sensible in political or financial terms to launch the new company with too much debt or not enough financial resources; this may impact the value and any future difficulties will be blamed on the government. • The appropriateness of the price obtained can be measured against comparable companies but, more directly, it can be measured against any increase in value in the immediate aftermarket. All issues are designed to create some stock shortages or unsatisfied demand so that the share price will move up after listing. However, if the increase relative to the market is dramatic, say more than 15%, it is possible that the issue was under priced. • The other main VFM aspect is the costs of the IPO. These can be expressed in percentage terms (money raised and value of the company at the issue price) and this overall expense ratio compared against other IPOs in that market. Commission structures and costs of other advisers, such as accountants and lawyers, can also be tested against comparable transactions. However, in doing so it is necessary to analyse the nature of the commitments provided, in particular with respect to underwriting, to determine the value that was obtained from the arrangements.

18. 10. The audit : VFM issues (cont.) • Viable alternatives should also be considered • There may be alternatives to the IPO and these should all be considered when assessing the VFM aspects of the privatisation. At the most basic, the business could have continued in public ownership. • However, if a sale or partial sale is to be achieved, then there are alternatives to an IPO. For instance, a trade sale or leveraged buy-out might have been feasible and potentially raised more money. This would have to be matched against the achievement of any other policy objectives of the privatisation.

19. Appendix 1 : Lead adviser check list • The role of the lead adviser (whether the GCO or Bookrunner) is critical to the success of the issue. An important point is to understand the various aspects of this role and the elements that go into the terms of the appointment. A check list is given in this Appendix. • Engagement/Offer structure • listing location • target investors and markets • target amount of capital to be raised • source of greenshoe shares • legal liability (joint/several) • Lead adviser responsibilities • scope of advice (including separation of roles if relevant) • valuation methodology • timing of valuation updates • prompt communication of changes in valuation views • scope of IPO preparation work • marketing, bookbuilding and pricing • stabilisation manager • Syndicate issues • syndicate selection and rules of engagement • syndicate member briefings • access to bookrunner personnel • prompt communication of relevant information • salesforce briefing materials • draft managers agreement • pre-agreed fee structure • Proactive market education • investor education on equity story before IPO announcement • target investor rankings and investor fact sheets • due notice and permitted attendees at investor education meetings • format for post-meeting feedback

20. Appendix 1 : Lead adviser check list (cont.) • Pre-marketing process • involvement of all syndicate members in pre-marketing process • written report on target investors, pre-agreed timetable • full disclosure of investor feedback and summaries prior to agreeing pricing range • Roadshows • written reports on target invesrtors • agreed timetable • distribution of one-on-one meetings, including to other syndicate members • Bookbuilding pricing • agreement of roles of joint bookrunners • length of bookbuilding period • agreement of price range • regular provision of updates on bookbuilding process / real time access to book of demand • agreement of final pricing • Allocation process • allocations to be made only with consent of vendor • treatment of demand from large fund management groups • specific allocation criteria to be observed • Fees • base fee definition of shares on which fees payable (ie including / excluding any employee and/or customer offers) • size off incentive fee, criteria and timing of payment • fee split between management, underwriting and selling commission, including praecipium (if any) and basis of distribution • treatment of syndicate costs • treatment of designations by investors, cap on selling fees payable to bookrunners, and split of “overage” amongst remaining syndicate • fees payable on greenshoe • timing and method of payment of base and incentive fees

21. Appendix 1 : Lead adviser check list (cont.) • Greenshoe • size of greenshoe • outline of stock lending agreement • Expenses • treatment of company costs (legal, accounting, printing, document distribution, listing, PR, roadshow costs) • treatment of syndicate costs (out-of-pocket) • cost reimbursement if IPO pulled • payment of accountants’ indemnity insurance, if any • General • agreed employees to be dedicated to the IPO • Underwriting Agreement / Legal opinions • underwriting agreement to be entered into • scope of company reps and warranties and indemnities • scope of underwriter reps and warranties on compliance with securities laws • limitation for claims • scope of material adverse change clauses • company and management lockup • delivery of accountants’ and lawyers’ comfort letters / opinions • Responsibilities and duties after the IPO • dialogue with investors post IPO • preparation of post-transaction audit • provision of daily trading data • Termination • term of letter and exclusion of follow-on offerings from terms of letter • termination procedures

22. Appendix 1 : Lead adviser check list (cont.) • Information and announcements • preparation and observance of publicity guidelines • provision and co-ordination of all information required to form a true and fair view of the company • no announcement by the bookrunners without prior approval • Confidentiality • application to adviser, employees and agents • agreement to observe strict confidentiality for a specified period • Conflicts of interest • agreement not to accept any new assignments that would impact committed resources • agreement not to accept conflicting equity capital markets assignments or M&A assignments • agreement not to advise potential purchasers of the company for a specified period • Miscellaneous • procedure for modifications to the engagement letter • governing law and jurisdiction