This lecture notes is about Initial Public Offerings. The notes includes advantages and disadvantages of IPO, why would company choose to do IPO, and the process of IPOs. It also discuss the Anomalies in IPO, for example short-run underprice, Long-run Underperformance and Hot Issue Market Phenomeno...
Advantages vs Disadvantages
Advantages
1. Cash to make investment
2. Strength Equity Base —- Reduce leverage
3. More liquidity than selling to one institution
4. More information, understanding to the company (reports…)
5. Better reputation
6. Act as exit strategy for VCs
7. Diversifying risk of original owners (tolerate higher profit variability)
Disadvantages
1. Financial costs
- Expensive
- Underpricing stocks
- Increase legal requirements (reports, financial statements, etc)
2. Stock-price emphasis
- Short-term orientated for management, not friendly to long-term investment
projects
- Separate ownership and control (lost of control for founder)
- Hostile take-over risk (Eg. Hermes)
3. Being watched
- More attention and pressure from public towards management
- More disclosure to product market competitors (unfriendly to tech company)
Reasons for IPOs
For all countries, main reasons is financing —
Main differences between US and Europe: Europe care more about reputation and American
care more about costs in IPOs
Process of IPOs
1. Underwrite
- Two kinds of underwriters: Lead underwriter (one underwrite) and Syndicate
(a group of underwriter)
- Two kinds of offering
i) Best-efforts: investment bank try the best to sell to public and buy
the rest of stock unsold
, ii) Firm-commitment: underwrite the issue. Investment banks buy
everything sponsor price and resell to the public in offer price
But underwriters receives compensation spread:
Spread = offer price - sponsor offer
2. Valuation of the company
3. Road show: senior management and its underwriters travel around to promote the
company and explain the rationale for the offer price
4. Alternative underwriting practices:
i) Book building: Through communication with investors, underwriters tries to
measure demand curves and decide the offer price based on it
ii) Fixed-price offering (Offer for sale): underwrites set price for final offer in
advance, and offer share by inviting subscriptions from retail and institutional
investors
iii) Placing: target institutional investors, it’s not normal underwritten
iv) Auction 拍卖
Anomalies in IPO
a) Short-Run Underprice
● Post IPOs, ‘short run’ is taken as the first day/week/month of trading
Offer price for stock ‘i’ is Pi0
● Price at the first trading day Pi1
Ri1 = (P1-P0)/ P0 greater than 0 (increase in stock price)
● Market adjusted measure are used to quantify the abnormal return at the end
of trading day (Market adjusted abnormal return = MAARi1)
Actual return = Ri1 = (P1-P0)/P0
Abnormal return = Expected return - Actual return
( 1+ Ri 1)
MAARiq = 100 x [ −1 ]
(1+ Rm 1)
● Shares are offered at a price much lower than trading price on the first
day of listing
● Eg. VA Linux Systems 1999: offer price $ 30, by the end of the day $ 239
Theories for why is it underpriced
1) Risk- averse underwriter (Hypothesis)
- Underwriters underprice to reduce risk of unsuccessful
IPO (most IPOs are firm-commitment offers)
- So firm-commitment IPOs are more underpriced than
Best-effort ones
2) The Winner’s Curse (Hypothesis)
- Fixed amount of share issued, so ration starts when
there’s excessive demand
- 2 kinds of investors: perfectly formed and completely
informed
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