Lesson 4
Investment Banks, Equities
and Initial Public Offerings
A. Common and Preferred Stock
Characteristics
• Provide for payments to shareholders after
other corporate obligations are fulfilled,
making them residual securities.
• Might also provide for voting rights.
Common Equity
• Common stock is a limited liability security (shareholders cannot
lose more than their investment) with residual rights.
• Publicly traded shares are issued either through:
– a public offering,
– a rights offering or
– through deferred equity securities such as warrants and convertibles.
• The corporation will be authorized by its charter to issue a specified
number of shares, some of which may remain unissued.
• Issued shares will either be held by shareholders (outstanding
shares) or held in the corporate treasury (treasury stock).
• Treasury stock was previously outstanding and subsequently
repurchased.
• Shares may be classified according to shareholder rights to vote and
to receive dividend income.
Preferred Equity
•
•
•
•
Given priority over common stock in a firm liquidation and in the payment of dividends
"Plain vanilla" preferred stock can often be valued as a perpetuity with its dividend as the periodic cash flow.
Use of preferred stock was initiated in the United Kingdom and United States in the early part of the nineteenth
century to finance canal and railroad construction, such as the mid-1830s expansions of the Baltimore & Ohio
Railroad and C&O Canal.
Why issue preferred stock rather than common stock or bonds?
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•
•
•
•
•
Common equity issues were often restricted by financial distress .
Common stock issues were restricted by shareholders who did not want their control diluted or restricted
Borrowing was restricted by government limitations on debt levels.
Similar to debt and easy to value.
Because preferred stock dividends are not tax deductible to the issuing corporation and usually have no growth
potential, it is not usually an attractive source of funds to most firms.
Historically, preferred stock was typically issued by companies before corporate taxes became an important issue.
Much of the recently offered preferred stock has been issued by utility companies which are often able to pass on
higher costs of financing to consumers.
A number of commercial banks have issued preferred stock due to the Fed's classification of preferred stock as
primary capital for bank regulatory purposes, making it easier for banks to meet their capital requirements.
Other recently offered preferred shares have been issued by new, growing companies. In many instances, these
firms had no earnings against which to deduct interest payments on debt. Furthermore, in some cases, purchasers
of these preferred shares were other corporations that receive a 70%-80% exclusion of preferred dividends from
taxable income.
More recently in the United States, individual owners of preferred stock have enjoyed 15% top marginal income
tax rates on their preferred share holdings. These shares are often convertible into common stock. In some
instances, firms issued voting preferred equity to help defend against unfriendly takeover activity.
B. Benefits and Costs of Going Public
• Privately held firms sell stock to the general
public for a number of reasons:
– To raise capital
– To enable the entrepreneur to “cash out”
– To reduce debt
– To enter the market for mergers and acquisitions
– To affect the distribution of control of the firm
– To enhance the visibility of the firm.
Costs of Going Public
• However, these benefits are obtained at a
substantial cost:
– IPOs generate substantial fees
– Tax and legal entity restructuring costs in anticipation
of the IPO
– Public firms subject themselves to increased
disclosure, scrutiny and regulation by the media,
competitors, the general public, the S.E.C. and other
regulators
– Increased auditing, legal and other fees incurred on an
ongoing basis after the IPO.
– IPO underpricing
Direct and Indirect Costs of IPOs
Proceeds
(in
millions
of
dollars)
Average
Initial
Return (in
%)
Average
Direct &
Indirect
Costs (in
%)
Number of
IPOs
16.96
16.36
25.16
337
8.00-10.00
4.39
11.63
9.65
18.15
389
7.00-7.14
7.01
2.69
9.70
12.48
18.18
533
7.00-7.00
40-59.99
6.96
1.76
8.72
13.65
17.95
215
7.00-7.00
60-79.99
6.74
1.46
8.20
11.31
16.35
79
6.55-7.00
80-99.99
6.47
1.44
7.91
8.91
14.14
51
6.21-6.85
6.03
1.03
7.06
7.16
12.78
106
5.72-6.47
5.67
0.86
6.53
5.70
11.10
47
5.29-5.86
5.21
0.51
5.72
7.53
10.36
10
5.00-5.37
7.31
3.69
11.00
12.05
18.69
1767
7.00-7.05
Gross
Spreads
(in %)
Other
Expenses
(in %)
2-9.99
9.05
7.91
10-19.99
7.24
20-39.99
100199.99
200499.99
500-up
Totals:
Total
Direct
Costs
(in %)
Interquartile Range of
Spread (in %)
Offering costs incurred, based on
gross proceeds of offerings
(Numbers in
millions, except
number of IPOs)
Gross
proceeds
$0-50
51-100
101-200
201-300
301+
External
auditor
Legal
Printing
Registration/ Miscellaneous
filing
Number
of IPOs
Range Avg. Range Avg. Range Avg. Range
41
$0.0-$2.5 $0.6 $0.1-$4.2 $1.0 $0.0-$0.7 $0.2 $0.0-$0.3
115
0.- 4.4
1.0 0.3-7.3 1.5 0.1-0.9
0.3 0.0-0.5
115
0.1-5.6
1.0 0.2-4.9 1.6 0.1-1.2
0.3 0.0-1.9
45
0.1-4.2
0.9 0.6-4.8 2.1 0.0-1.0
0.4 0.1-0.5
73
0.0-5.0
1.2 0.0-17.0 2.3 0.1-9.8
0.5 0.1-2.4
Avg. Range Avg. Range Avg.
$0.1 $0.0-$0.9 $0.2 $0.2-$3.9 $2.0
0.2 0.0-2.8
0.4 1.2-6.7
5.1
0.2 0.0-4.0
0.5 2.5-12.2 9.4
0.3 0.0-6.7
0.7 8.0-16.4 15.2
0.3 0.0-4.5
0.5 7.9-237.9 23.3
Underwriter discount
Avg. %
of gross
proceeds
6.9%
6.8%
6.6%
6.3%
5.5%
Avg.
total
$4.1
8.5
13.0
19.6
28.1
Uses for IPO Proceeds
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•
IPO issuers are required to detail their uses of IPO proceeds on their SEC Form S-1
registration filing, and most other countries require similar filings.
Kim and Weisbach [2005] examine how issuing firms use the proceeds of IPOs.
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They argue that raising capital is an important motive for going public.
For every dollar raised in an IPO, cash holdings rise by 68.8 cents during one subsequent year.
R&D and capital expenditures increase by 17.1 cents and 8.3 cents.
Inventory levels rise by 2.3 cents
long-term debt is reduced by 4.2 cents.
All of these changes occur in the year subsequent to the IPO.
By four years after the IPO
– each dollar raised in the IPO is associated with a 50 cent increase in cash relative to the preIPO-level.
– Thus, the firm does not instantly spend its IPO proceeds.
– This 19.9 percent reduction from the first-year increase in cash is a companied by 88.2 cent
and 38.7 cent increases in R&D and capital expenditures four years subsequent to the IPO.
– inventory levels rise by 5.3 cents
– long-term debt is reduced by 10.4 cents.
C. Investment Banking and the
Underwriting Process
• Corporations raise money by selling securities to investors.
• An investment bank is an institution whose traditional role is to
assist corporations in the issue and sale of securities to the general
public.
• This issue of new securities can be referred to as a primary offering
or primary distribution.
• The secondary market where previously issued securities are sold.
• The secondary market provides liquidity for the primary market
• If new corporate stock is being sold to the public for the first time, it
is said that the corporation is making an initial public offering of its
stock.
• The firm can also issue securities via:
– private placement
– selling share in 144A markets
Firm Commitment and Best Efforts
Offerings
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The investment bank assists the corporation in making the primary offering by first providing advice and counsel
and then acting as a "middleman" in the sale of the new securities.
This "middleman" function is served by the investment banker acting either as a broker selling the securities on a
"best efforts" basis or by underwriting the new issue.
If the investment banker acts as an underwriter in a firm commitment, it purchases the new securities from the
issuing corporation and attempts to resell them at a profit, in a sense, acting as a wholesaler or dealer.
The investment bank can also act as a broker, selling the new securities for the corporation or other investment
banks on a commission or best efforts basis.
underwriting syndicate: Reduces managing underwriter (capital commitment and risk
selling group: Further enhances selling ability.
A study of 1028 IPOs from 1977-1982 found:
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approximately 35% were brought to market on a best efforts basis.
Almost half of these best efforts IPOs failed
average returns for best efforts offerings were 48%, compared to 15% for underwritten .
Selecting the underwriter
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Issuing firms often select an underwriter based on its experience taking similar firms public.
Having a well-known analyst in the same industry is usually a strong selling point
willingness to make a market for the new issue
Many industrial corporations maintain an ongoing relationship with an investment bank
In some instances, there will be a sharing of directors of the investment bank and its client.
publicly regulated utilities and municipalities are required to submit their primary offerings for competitive bidding.
Preparing for the IPO
• Preparation:
– The issuing firm prepares a business plan
– The plan will detail how the firm plans to use IPO proceeds.
– The firm will begin auditing, legal, restructuring, governance, risk
management, public relations and other operations.
• Underwriter Selection:
– Issuing firms consider the practices and reputations of prospective
underwriters
– bulge bracket underwriters normally being preferred.
• Advice and Counsel:
– issuing firm and prospective investment bank discuss the issuing firm's
need for funds, the amounts and various means of raising funds.
– The investment bank will conduct a due diligence investigation of the
issuer.
Administering the IPO
• Registration:
– A registration statement (Normally Form S-1) containing a prospectus.
– The SEC at least 20 days to analyze this statement for omissions.
– The underwritermay print a preliminary prospectus (red herring).
• Syndicate Formation:
– There may be an overallotment provision (sometimes called green
shoe).
• Price Setting
• Road Shows: The investment bank will present the new issue to
prospective purchasers in "dog and pony shows" or “road shows” in
its efforts to create interest in the issue.
– not binding
– Oversubscribed vs. Undersubscribed
C. After-market Matters
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•
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Fee Distribution: The price of the securities is often determined just before the IPO’s effective date.
The IPO is said to be effective and the shares are then offered for sale to the public
Consider a typical offering whose offer price might be set at $15 per share.
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Price Stabilization
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Managing underwriter places a buy order in secondary markets at a specified price to support the new issue should its market
price drop.
Lasts for approximately two to four days and the underwriting syndicate shares its costs.
The prospectus must state that there will be a price-pegging operation if one is planned.
The price stabilization program may also contribute to the IPO underpricing phenomena discussed below.
Price supports and stabilization also seem to enhance underwriters' reputations.
Greenshoe Option: Overallotment option whereby the underwriter retains an option from the issuing firm to
purchase additional shares, up to 15% of the original issue.
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The issuing firm receives $13.95 per share. The 7% difference is taken by the underwriting syndicate.
The lead underwriter might take a manager's fee of $.20 for each share.
Each share that the managing underwriter sells itself produces the full fee of $1.05.
Each underwriting syndicate member might receive $.85 ($1.05 minus the $.20 managing underwriter’s fee)
Selling group syndicates that might receive $.50 for each share that it sells.
This $.50 concession would be paid from the relevant underwriting syndicate member’s $.85.
Typically supports the price stabilization process.
The underwriter then oversells the issue by up to 15% (shortselling).
If interest in the issue appears to weaken, the underwriter supports its price by purchasing oversold shares.
If sales are strong, the underwriter covers its short position by exercising its greenshoe option.
Quiet and Lock-up Periods: A 25-day quiet period (40 days for lead underwriters)
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The IPO price typically rises at the end of this period due to renewed marketing efforts.
Many IPOs will have a “lock-up” period where existing IPO shareholders are discouraged or prohibited from selling their shares.
These lock-up periods typically extend for 180 days.
D. Alternatives to Traditional Underwriting
•
IPO Auctions
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Web-based IPOs
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W.R. Hambrecht & Co. is a smaller investment bank founded in 1998 (later affiliated with J.P. Morgan Chase) that markets primarily to
individual investors.
Hambrecht uses a web-based auction process called OpenIPO to offer securities for its clients.
Hambrecht brought the 2002 CSFB offering of Instinet and July 2001 offering of Ravenswood Winery to the market.
Some observers believe that these nontraditional approaches to offering IPOs will improve prices received by issuing firms and allow
smaller retail investors to participate in IPO markets that they are generally shut out of. Nevertheless, it appears that even
Hambrecht’s and similar offerings experienced IPO price run-ups.
The Reverse Takeover: The reverse takeover is the acquisition of a public company by a private company in an effort to
take itself public.
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The 1996 offering of the Manhattan microbrewery Spring Street Brewing Company.
The company raised $2mm of its $5mm goal. Spring Street used web-based documents, prospectuses and solicitations to offer its IPO.
Annie's Homegrown and Logos Research Systems, solicited their customer base to draw in investors. (DPO)
Smaller IPOs can qualify for more simple filing alternatives, including the SB-1 (up to $10mm) and the SB-2 (up to $25mm), though
these limits can be as high as $50mm due to the 2012 Jobs Act.
WitCapital was formed by Spring Street founder Andrew Klein for the purpose of providing web-based IPOs.
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•
Google: 2004 offering, structured a Dutch auction process intending to sell 25.8 million shares of its stock, suggesting bids in the range
of $108 to $135.
Sold 19.6 million shares at the IPO price of $85, thereby raising $1.67 billion.
The first trade price was $100.01, rising to over $300 within a year and over $1,000 by 2013.
Lead underwriters, Morgan Stanley and CS First Boston collected a 3% commission on the offering rather than the standard 7% fee.
It is not clear just how successful the IPO was. The IPO price was not as high as anticipated or nearly as high as subsequent trading
prices.
A follow-on offering was priced at $295 per share, raising $4.18 billion.
The IPO created substantial favorable publicity for the firm and raised fortunes for its owners.
New York Stock Exchange and the Archipelago Group,
This technique had been used in 1989 by Long Distance Discounting Services, taken over by Advantage Companies, which was listed
on NASDAQ. This firm ultimately became WorldCom, which melted down a decade later.
Self-Underwritten IPOs
Self-written IPOs : typically motivated by the costs associated with traditional underwritten IPOs.
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Self-underwritten IPOs lack some of the benefits associated with traditional underwritings, including the certification .
Self-underwritten IPOs include a number of investment banks that take their own issues (e.g., Goldman Sachs) to the market.
E. The IPO Underpricing Anomaly
• IPO anomalies refer to three unusual pricing patterns associated
with Initial Public offerings of equities:
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1.
2.
3.
Short-term IPO returns are abnormally high.
IPOs seem to under-perform the market in the long run.
IPO under-performance seems to be cyclical.
• Additional evidence suggests that "favored" clients of the
underwriting firm frequently are the beneficiaries of this apparent
underpricing.
• Perhaps favored customers benefit financially at the expense of
issuers.
– IPO returns are due to the provision of useful price-setting information
by IPO market participants
– May be due to supports in the IPO aftermarket.
Table 4: Money Left on the Table
44.00
Pricing
Valuation
($mm.)
$17,864
First
Trade
Price
56.50
First
Trade
Valuation
($mm.)
22,939
Money
on the
Table
($mm.)
$5,075
50.00
$4,376
68.25
5,973
$1,597
53.00
$2,926
70.375
3,885
$959
Morgan Stanley
Dean Witter
Goldman Sachs
Lehman
Brothers
BT Alex Brown
$16
$160
$81
$810
$650
$24
$17
$88
$51
$95.88
$88
$350
$264
$262
$213
$17
$47
$90
$248
$201
United Pan-Europe
Communications
Covad
Communications
Group
Delphi Automotive
Systems
Corporations
ZDNet Group
Goldman Sachs
$32.78
$577
$43
$757
$180
$18
$140
$40.50
$316
$176
$17
$1,700
$18.75
$1,875
$175
Goldman Sachs
$19
$190
$35.75
$358
$168
OneMain.com
Autobytel.com
BT Alex Brown
BT Alex Brown
$22
$23
$187
$104
$38
$52.75
$323
$238
$136
$134
Company
Visa
United Parcel
Service
Goldman Sachs
Priceline.com
Ivillage Inc
Pacific Internet
MarketWatch.com
Lead
Underwriter
JP Morgan
Goldman Sachs
Morgan Stanley
Goldman Sachs
Bear Stearns
Morgan Stanley
Dean Witter
Offer
Price
F. Explaining the Short-run IPO
Anomalies
• Different sets of information regarding to the
value of the issue.
• Underpricing might be a form of
compensation for risk
• Adverse selection
• Underpricing might be compensation for
providing information to other participants.
Information-based Explanations
• The information-based theories maintain that IPO
underpricing is the result of information
asymmetries, which can take three forms:
– Issuing firms hold superior information (Myers &
Majluf)
– Underwriters hold superior information: underwriters
use information to either exploit their clientele or to
“certify” issues on behalf of issuing firms.
– Institutional investors: Rock [1986] and Benveniste
and Spindt [1989] argue that certain investors have
superior information concerning IPO firm
marketability and issuing firm competitors.
Investment Bank Exploitation
• Baron [1982] argues that underwriters exploit
superior market knowledge and underprice new
issues to facilitate their IPO marketing efforts,
and to curry favor with buy-side institutional
clients.
• Muscarella and Vetsuypens [1989] cast doubt on
this conclusion based on their finding that issuers
act as their own underwriters experience as
much IPO underpricing as issuers employing
underwriters.