Corporate Finance New Issue

1. Corporate FinanceNew Issue Yanzhi Wang

2. Basic Procedures of IPOs • Pre-underwriting conference • Preliminary prospectus (red-herring) • Roadshow / bookbuilding • Pricing • Public offering • Overallotment option (Green shoe option) • Stabilization

3. Pre-Underwriting • Primary pre-issue role: provide advice and help plan offer • Firm needing capital selects one or more lead underwriters. (book-runner) • Top firm the lead manager, others are co-managers • Underwriting syndicate organized early in process

4. Preliminary Prospectus & Roadshow • Preliminary Prospectus • Red Herring after title page disclaimer (in red ink) • Statements are submitted to SEC. Firm makes changes and resubmits. • Becomes effective with SEC’s final approval. • After preliminary filing, issuing firm and investment banker begin a road show. • Investment banker does book building during road show providing key pricing info

5. Pricing & Public Offering • Prior to offerings • Initial offer price set as a range; final price set the day before offer. • Details lock-up agreement • Bulge bracket underwriter’s spread (commission) usually 7.0% for IPOs • Public offerings • Lead underwriter sets each syndicate member’s percentage of participation

6. Issuing for Cash • Firm commitment • The investment bank buys the securities for less than the offering price and accepts the risk of not being able to sell them. • Investment bank underwrites the securities in a firm commitment. • Best efforts • The investment bank sells all the securities at the agree-upon offering price. • The underwriter does not bear the risk.

7. Overallotment Option & Stabilization • Overallotment option • Also called Green Shoe option. • A call option granted to underwriter(s) to be able to sell up to 15% additional shares than scheduled • After-market service • Lead underwriter is responsible for price stabilization after offering • After offering, lead underwriter serves as principal market maker • Research coverage

8. Features (Anomalies) of IPOs • Underpricing • Initial returns are huge and consistent across world • Offering price is lower than the after-market price • Leave huge money on the table • Hot issue market • High-volume months are followed by high-volume months • Hot issue markets (periods of high initial return) are followed by hot issue markets • High-volume months follow hot issue markets • Long-run underperformance • IPOs underperform in 3-5 years after the issuing

9. Initial return and long-run return, • 1980-2011

10. Ritter and Welch (2002) • This paper surveys three main questions in the IPO literature: • Reason for going public • Why leaving money on the table to investors • Why IPO underperforms in the long run

11. Why Firms Go Public • Life cycle theories • A firm going public is much easier to be a potential takeover target. • From a pre-IPO “angel”, there are costs of going public that small firms cannot bear. So, early in its life cycle, a firm will be private until the optimal size for going public. • Timing • An information asymmetry interpretation • An irrational but information symmetry explanation

12. Why Leave Money on the Table? • Information asymmetry / Signaling • Between investors: Winner’s curse (adverse selection) • Between issuer and investors: Leave a good taste • Between underwriter and investors: Underwriter reputation • Information acquisition • Price partial adjustment • Lawsuit avoidance • Cascades • Prospect theory

15. Hot Issue Market and Long Run Underperformance • Hot Issue market • Time the market. Firms go public when bull market since the cost of equity is low • Long run underperformance • Market timing • Pseudo market timing • IPO lock-up • Low risk of beta • Model specification error

16. Long Run Underperformance Debate • Why IPO firms underperform in the long run? • Small/growth firms • size/BM control • Overlapping problem in BHARs • Equal weight in stock returns or in calendar time • FF three-factor model

17. Explanation by FF Model • Equal weight on calendar time • Solve the overlapping and pseudo market timing problem • Value weight monthly portfolio return- least powerful testing in market efficiency • Sensitive to time period • Underperformance is dominated by 90s • Internet bubble period

19. Chambers and Dimson (2009) • This paper presents new and comprehensive evidence covering British IPOs since World War I. • During the period from 1917 to 1945, public offers were underpriced by an average of only 3.80%, as compared to 9.15% in the period from 1946 to 1986, and even more after the U.K. stock market was deregulated in 1986. • The post-WWII rise in underpricing cannot be attributed to changes in firm composition, and occurred in spite of improvements in regulation, disclosure, and the prestige of IPO underwriters.

20. British IPOs • Around 1900 London was the preeminent international financial center: The British stock market was larger relative to GDP than in the United States, and was the second largest exchange in the world (Rajan and Zingales (2003)). • British IPOs lies in the dominance of the fixed offer price regime for much of the last century. In contrast, the U.S. market had moved to book-building IPOs much earlier. • In examining how underpricing changed over time, this paper considers whether improvements in investor protection and underwriting have resulted in lower underpricing over the course of the last century.

21. Fixed offer price of LSE market • The IPO market on the LSE operated under a fixed offer price regime from at least WWI until the Big Bang in 1986. • The Big Bang induced competition in the securities business generally, and in IPO underwriting specifically, by allowing any bank including U.S. investment banks to own an LSE member firm. Thereafter, book-building became a more important IPO method in London (see Ljungqvist (2003), p. 24 and endnote 25).

22. IPO underpricing

23. IPO underpricing

24. IPO underpricing determinants

25. IPO underpricing determinants

26. Liu and Ritter (2011) • The paper develops a theory of initial public offering (IPO) underpricing based on differentiated underwriting services and localized competition. • Even though a large number of investment banks compete for IPOs, if issuers care about non-price dimensions of underwriting, then the industry structure is best characterized as a series of local oligopolies. • They posit that venture capitalists (VCs) are especially focused on all-star analyst coverage, and develop the analyst lust theory of the underpricing of VC-backed IPOs. Consistent with this theory, it is found that VC-backed IPOs are much more underpriced when they have coverage from an all-star analyst.

27. Non-price dimensions of IPO underwriting • This paper posits that issuers care not only about IPO proceeds, but also about non-price dimensions of IPO underwriting such as underwriter quality, industry expertise, and analyst coverage from influential analysts. quality, industry expertise, and analyst coverage from influential analysts. • A limited number of underwriters can provide these services for a given company, the IPO underwriting market is thus best characterized as a series of local oligopolies.

28. Role of VC • The model also generates a new theory of the under- pricing of venture capital-backed IPOs: the analyst lust theory. Venture capitalists (VCs) are rationally focused on the market price on the day when shares in the company are distributed to limited partners, which is typically six months to 1 year after the IPO. • The market price is boosted by coverage from influential analysts, which we measure by using the ‘‘all-star’’ designation in the October issue of Institutional Investor magazine. • Because of their concern with this price, VCs have a greater lust for all-star analyst coverage that is bundled with IPO underwriting, resulting in greater under- pricing for VC-backed IPOs with all-star analyst coverage .

29. Model- assumption • This paper focuses on differentiated IPO underwriting services and localized competition in the IPO underwriting market, it is assumed that only a subset of underwriters has some market power in each industry, and that only a subset of issuers is willing to pay for the differentiated product offered by these underwriters. • It is assumed that underwriters want to underprice IPOs more than is needed. Underwriters can benefit from underpricing IPOs in several ways. • First, underwriters can allocate underpriced shares to investors in exchange for soft dollar commission business. • Second, underwriters can allocate underpriced IPOs to executives to sway their decision in choosing which investment banking firm to hire, a practice known as spinning.

30. Model- assumption • Although an underwriter would like to underprice IPOs, if issuers want to avoid excessive underpricing, an underwriter will win fewer IPO mandates if it underprices too much. • When choosing an IPO underwriter, issuers care about many dimensions of the underwriting service, which can be categorized into price and non-price dimensions. • The model starts with a single period, where a period denotes the length of time between IPOs in that industry.

31. Model- assumption • Issuer’s objective function can be expressed as • Which are sum of the Net IPO proceeds and the Xi’s are the issuer’s perceived value of the n1 non-price dimensions. Sum of αi is 1. • One special case is Loughran and Ritter (2004)

32. Model- assumption • Suppose that there are N underwriters in the market and a unit mass of issuers. Issuers differ in their preference parameter θ, which is distributed uniformly on the [0.1] interval, and represents the relative importance of having all-star analyst coverage. • Of the N underwriters, three of them have an all-star analyst. The perceived effect on the market value of retained shares from being covered by an all-star analyst is given by A.

33. Issuer’s net surplus • An issuer’s net surplus from going public at under- pricing level U is • M is the market value of the shares being sold net of the gross spread and U is the cost of going public in terms of the under- pricing level in dollars (the money left on the table). • The first part of the net surplus, M-U, is the net proceeds from selling a fixed number of shares at the IPO. The second part of the net surplus, θ A, is the effect of all-star analyst coverage on value, A, multiplied by the issuer’s preference for an all-star analyst, θ. • Eq.(3)is a special case of Eqs.(1) and (2).

34. Underwriter profit • The profit to underwriter k is • where Ūis the dollar amount of under pricing needed to compensate investors for the ex-ante uncertainty of issue valuation, which for simplicity is assumed to be the same across all issues • C is the cost of providing all-star analyst coverage (C=0 when no all-star coverage is provided). • Dkis the demand for underwriter k’s service. • It is assumed that a fraction γof the incremental money left on the tableŪ -Uflows back to the under- writers through indirect channels.

35. Underwriter profit under noncooperation • If N is large ,then the N-3 underwriters without an all- star analyst will not be able to charge Ū -Ubecause they behave in a perfectly competitive market with a large number of underwriters and homogeneous services. Therefore, they will set U=Ū • Now we consider the level of underpricing that the three underwriters with an all-star analyst will charge. If the three underwriters do not cooperate, then under Bertrand competition, from Eq (4), each of the three underwriters charges and obtains zero profit.

36. Underwriter profit under collusion • If the three underwriters collude and charge the same level of underpricing (where the dot notation indicates collusion values), then the aggregate demand for their service from a unit mass of issuers can be calculated by finding an issuer that is indifferent between choosing an underwriter with or without an all-star analyst, which occurs when • Thus, the aggregate demand is

37. Underwriter profit under collusion • The under pricing level that maximizes , which is the aggregate profit of the colluding underwriters, occurs when • From Eq (6) we obtain and , then substitute them into Eq (7), we get:

38. Underwriter profit under collusion • Substituting Eq. (8) into (6), the aggregate demand from the unit mass of issuers for underwriters offering all-star coverage is then • Only issuers with will choose an underwriter with an all-star analyst. • The aggregate profit of the three underwriters is

39. Underwriter profit profit under collusion • Generally, in an infinitely repeated game, each underwriter decides whether to cooperate by evaluating the following equation:

40. Implications • Underpricing implication: Issuers that choose an under- writer with an all-star analyst are more underpriced than issuers that choose an underwriter without an all-star analyst. • Differential analyst influence implication: The underpri- cing charged for having an all-star analyst is higher for issuers with a higher perceived effect of all-star analyst coverage, A, and is higher in periods when all-star analyst coverage is more important. • Coverage cost implication: As the cost of all-star analyst coverage increases, the underpricing charged for having an all-star analyst increases.

41. Implications • Analyst turnover and deal frequency implication: Excess underpricing is lower when a) all-star analyst turnover is high, or b) the frequency of deals in the industry is low, providing there is persistence of turnover and deal frequency • Underwriter concentration implication: The average underpricing and the Herfindahl-Hirschman Index (HHI) measuring underwriter concentration for an industry both increase as the effect of all-star analyst coverage, A, increases. Thus, HHI and underpricing should be positively correlated cross-sectionally.

42. Underpricing regression

43. IPO underpricing regressions with proxies for the cost of all-star analyst coverage.

44. IPO underpricing regressions with industry volume and all-star analyst variables

45. IPO underpricing regressions with issuer-specific HHI

46. IPO underpricing regressions sorted by VC category

47. Lowry, Officer and Schwert (2010) • This article proposes a new metric for evaluating the pricing of IPOs in traditional firm-commitment offerings: the volatility of initial returns to IPO stocks. • The monthly volatility of IPO initial returns is substantial, fluctuates dramatically over time, and is considerably larger during “hot” IPO markets. • Consistent with IPO theory, the volatility of initial returns is higher for firms that are more difficult to value because of higher information asymmetry.

48. Volatility of initial returns to IPO stocks and information asymmetry • Beatty and Ritter’s (1986) extension of Rock (1986) predicts that companies characterized by higher information asymmetry will tend to be more underpriced on average. • It should be more difficult to estimate precisely the value of a firm that is characterized by high information asymmetry: Firms with higher uncertainty should have a higher volatility of initial returns.

49. IPO data

50. Frequency distribution of first-month IPO returns,