Initial Public Offering (IPO) and theories of underpricing

1. Introduction

Related to the issuance of shares there are different kinds of “puzzles” which motivate to take a closer look at: Short-run ‘underpricing’, hot and cold issue markets, spread clustering and long-run underperformance. Even though these phenomena are frequently discussed in several scientific papers and journals, there is no conclusively completed theory. This work will concentrate on the various approaches developed to explain ‘underpricing’. As an introduction into the topic it will also provide a summary of the process of an Initial Public Offering (IPO).

2. The Process of an IPO

An IPO is a financing instrument and emerges if a formerly privately owned company is selling stocks to the public for the first time¹. A previously core number of financiers (e.g. a family or parent company) will be opened to new lenders of capital by going public. Instead of these primary offerings, secondary offerings are also possible (e.g. when venture capitalists and founders sell a part of existing shares). Also combinations of these two types are conceivable. The issue is conducted in a public offering or a private placement to a specific group of investors.

Companies can have different motivations and reasons for going public, e.g. to minimise capital costs, exit of venture capitalists and previous owners, facilitate fusions and acquisitions, diversify owner structure or arouse corporate image benefits. A good indicator out of practice could be the survey of 336 CFOs were Brau and Fawcett (2006) amongst others find out that the primarily reason for going public is to simplify mergers and acquisitions and generate cash for growth. Ritter and Welch (2002) discuss several explored life cycle- and market-timing theories which try to explain IPO activity. They mention that researchers found evidence for some explanations within different cases and datasets, but not a general rule. Probably it is not only one reason to issue securities but a full basket of influencing factors which interact and result in a complex decision making process.

After the decision to issue shares companies have to face the process of going public. There are different practices to use. This paper will concentrate on the most common one which is called ‘bookbuilding’. Ljungqvist, Jenkinson and Wilhelm (2003), show that the proportion of bookbuilding in Europe increased from 29.6 % in 1994 to 88.7 % in 1999.

¹ cp. Bodie Z., Kane A., Markus A. (2005). Investments p. 66-71

In the past ‘fixed price’-methods were more common and they are still popular in specific countries. In recent years ‘auction’-methods became an increasing influence as well.

The normal case to go to the stock market is with an investment bank as an underwriter. As a first step companies’ selection of a consortium bank (book runner) is called “beauty contest” because investment banks have to be on their best behaviour with their going public concepts. Important criteria for their choice are the banks’ placement and consultancy concepts, their standing and expertise, as well as the intensity of both business connexions. It is possible without an investment banker (e.g. Spring Street Brewing Company, 1995)¹ but typically there is more than one bank in a syndicate to facilitate the process. Mainly the lead bank is coordinating the whole process and is managing direct contacts to the company. To reduce its exposure the lead underwriter bears the risk together with the other attending investment banks.

Investment banks give advice how to handle the terms of selling shares. They also prepare the registration statement for the Securities and Exchange Commission (SEC ) with a description of the issue and prospects of the company. Banks can play an intermediary role if they arrange a ‘best-efforts agreement’. In this case they help to resell the shares to investors but have no risk to keep a long position if there is not enough demand. A more risky role appears if they arrange a ‘firm commitment’. In that case the investment bank receives the complete issue and resells it with a spread to the public for own account. Even if Marchand and Roufagalas (1996) use some simplifying assumptions, they build a model to understand basic thoughts of the involved actors around the decision-making processes.

In opposition to ‘fixed price’-methods investors are more integrated into the process of pricing during ‘bookbuilding’, it also bears a likeness to an auction. After the subscription period expires and all underwritings are received, the final price and the issuing volume will be determined. The ‘book building’ process can be illustrated in four phases: Pre-marketing phase, marketing-phase, order-taking, price fixing and allocation of shares.

The pre-marketing phase is like a market pre-test. The investment bank and the issuing company have already created an ‘equity story’, using available intern information and in-house research reports. During press conferences and presentations to mainly institutional investors they try to convince them to invest. They give them arguments why a stake in this company is valuable and

describe the main ‘equity story’. Trough this first contacts to potential investors they get indications of interest and feedback. At the end they can figure out a preliminary fixing of a price range which normally represents a 10 to 20 percent price spectrum.

Subsequently marketing activities start during the next phase. Road shows are organised in major centres for finance. Together, the investment bank and the board of directors initiate presentations for potential investors like financial consultants or analysts. To get a better picture of the company’s operations, strategy and figures it is common to arrange one-to-one interviews between weightily investors and management.

Parallel to the marketing phase the underwriter is starting the ‘order-taking’, i.e. a collection of all subscriptions in an order book. The order book is one of the most important components in this method because investors’ proposals regarding price and quantity are contained. It is managed by the lead manager (book runner) and can consist of non-binding, limited or unlimited orders. The bank can take notes of identity and type of investors if they are institutional. This is important for the issuer to judge the quality of future shareholders. They obviously prefer shareholders with a long investment horizon.

During the subscription period of normally up to two weeks all orders are collected. Based on that and in coordination with the issuing company the bank takes the price fixing and allocation of shares. In general the bank determines the price below market equilibrium to make sure that the issue will be successful. This suits with Marchand and Roufagalas (1996) who stated that an “investment bank has an incentive to charge a price low enough to eliminate the probability of under-subscription”.

Two types of placement and allocation of shares are possible. A ‘direct allotment’ is operated manually or via placement rules and predominantly used to institutional investors. In a ‘free retention’ shares are allocated in a free way by the consortium bank and it is mostly used to private investors.

The IPO is completed if stocks are traded the first time at a stock exchange. After the opening price is fixed a phase of price stabilisation can occur during the next weeks. As a general rule the bank has different options. It can purchase additional 10 to 15 percent of the issuing volume from

the company during 30 days. Especially if the issue is oversubscribed the bank can react to heavy soaring prices with this possibility called ‘green shoe’². In fact it holds a short position (sells more shares than it has) but can cover this position through exercising the ‘green shoe’ option. If the share price falls during the first days of quotation the bank can buy shares on secondary market to peg the price. Because of the additional demand, prices will increase and the effect is a stabilisation into the other direction. The investment bank takes normally a big part in after trading; typically it has a market maker function.

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¹ cp. Bodie Z., Kane A., Markus A. (2005). Investments p. 66-71