The Phenomenon of IPO Underpricing in the European and U.S. Stock Markets
©2014
Textbook
103 Pages
Summary
The Initial Public Offering (IPO) marks one of the most important events of a company. Basically, the aim is to generate maximum proceeds by selling the company’s shares to investors. However, the shares that are sold seem to be underpriced as the price significantly soars on the first trading day. Since the very first detection of this phenomenon in the United States in 1969, several subsequent studies have documented the existence of worldwide IPO underpricing.<br><br>This study focuses on IPO Underpricing in the European and United States Stock Markets by outlining and discussing the following essential issues:<br>What is underpricing in the context of the IPO?<br>Which motivations are there and how do they impact?<br>Is there IPO underpricing in the markets of Europe and the United States of America?
Excerpt
Table Of Contents
VIII
List of Abbreviations
A
AFM
Authority for the Financial Markets
AG
Aktiengesellschaft
AIM
Alternative Investment Market
B
BaFin
Bundesanstalt für Finanzdienstleistungsaufsicht
C
CFO
Chief
Financial
Officer
D
DCF
Discounted
Cash
Flow
E
ECMH
Efficient Capital Markets Hypothesis
EU
European
Union
F
Fed
Federal Reserve System
FESE
Federation of European Securities Exchanges
FSA
Financial
Services
Authority
G
GAAP
Generally Accepted Accounting Principles
I
IAS
International
Accounting
Standard
IASB
International Accounting Standard Board
IFRS
International Financial Reporting Standards
IPO
Initial Public Offering
Inc
Incorporated
IX
M
M&A
Mergers & Acquisitions
N
NASDAQ
National Association of Securities Dealers Automated Quotation
NYSE
New York Stock Exchange
P
PE
Private
Equity
S
SE
Stock
Exchange
SEC
Securities and Exchange Commission
SME
Small and Medium-Sized Enterprise
SOX
Sarbanes-Oxley
Act
SPAC
Special-Purpose Acquisition Company
V
VC
Venture
Capitalist
U
UK
United
Kingdom
UKLA
United Kingdom Listing Authority
U.S.
United
States
USD
United States Dollar
UP
Underpricing
W
WFE
World Federation of Exchanges
X
List of Tables
Table 2-1: Distribution of IPOs by industry and the incidence of SME-conducted IPOs
in European markets from 1995 to 2008 ... 16
Table 2-2: Key differences between the Main Market and AIM ... 33
Table 2-3: Key differences between the Eurolist, Alternext and Free Market ... 34
Table 2-4: Key differences between the Regulated Market and the Open Market ... 36
Table 2-5: Key differences between the NYSE and the NYSE Arca ... 38
Table 2-6: Key differences between the NASDAQ's GM, GSM and CM ... 40
Table 4-1: Mean First-day Returns in Germany from 1997 to 2012 ... 62
Table 4-2: Other results from former studies on IPO Underpricing in Germany ... 63
Table 4-3: Mean First-day Returns in the U.S. from 1997 to 2012 ... 68
Table 4-4: Other results from former studies on IPO Underpricing in the U.S. ... 68
XI
List of Figures
Figure 2-1: CFOs who agree or strongly agree in % ... 18
Figure 2-2: Global IPO Activity - Annual (1996 - 2012) ... 20
Figure 2-3: IPO timeline ... 22
Figure 2-4: Capitalizations of 5 largest stock exchanges in Europe and the U.S. ... 31
Figure 3-1: IPO Underpricing versus Overpricing ... 43
Figure 3-2: Asymmetric information between the key parties ... 47
Figure 3-3: Post-IPO lockup expire analysis on Facebook and Visa ... 58
Figure 4-1: Average first-day returns on European IPOs ... 60
Figure 4-2: Number of IPOs and UP-Average First-day Return (1997 2012) ... 63
Figure 4-3: Average first-day returns on almost non-European IPOs ... 66
Figure 4-4: Number of IPOs and Average First-day Return from (1997 - 2012) ... 69
XII
List of Appendices
Appendix 1: Global distribution of IPOs in 2011 and 2012 ... LXXV
Appendix 2: Notable Upcoming Global IPO ... LXXVI
Appendix 3: All Time Largest Global IPOs - Top 25 ... LXXVII
Appendix 4: Largest stock market capitalizations in Europe and the U.S. ... LXXVIII
Appendix 5: The 2005 Competitiveness of the Financial Centers ... LXXVIII
Appendix 6: Country of origin and websites of the analyzed markets ... LXXIX
Appendix 7: U.S. monthly IPO volume: January 1960 - December 2012 ... LXXIX
Appendix 8: Post-IPO price development of Facebook and Visa for 6 months .. LXXX
Appendix 9: Post-IPO lockup expires of Facebook and Visa ... LXXX
Appendix 10: Average UP on the first trading day in European countries ... LXXXI
Appendix 11: Average UP on the first trading day on almost non
European countries ... LXXXII
Appendix 12: Top managing underwriters of 2012 ... LXXXIII
Appendix 13: Top managing underwriters of 2010 ... LXXXIII
13
1 Introduction
The Initial Public Offering (IPO) which marks one the most important events of a
company basically aims to generate maximum proceeds by selling company's shares to
investors.
1
Nevertheless, the shares they sell often seem to be underpriced, insofar that
the price significantly soars on the first trading day.
2
Consequently, the company
generates fewer proceeds and, hence "leaves money on the table."
3
Since the very first detection of this phenomenon in the United States in 1969, several
subsequent studies documented the existence of worldwide IPO underpricing nowa-
days.
4
Considering that underpricing is costly for the company, a question arises why,
therefore, despite the fact that the companies "leave money on the table", they do not try
to avoid this by setting the issuing price on the very high?
5
One of the most striking features of this question is that it had inspired many researchers
who tried to explain in various models why IPOs are generally underpriced.
6
Besides, a
lot of theoretical explanations concerning this phenomenon have been given by now;
however, no common sense has been so far developed.
7
1.1 Problem Statement
Taking into consideration the problems mentioned before the primary focus of this
Master's Thesis is IPO Underpricing in the European and United States Stock Markets
by outlining and discussing three essential issues:
The first issue:
What is underpricing in the context of the IPO?
The second issue: Which motivations are there and how do they impact?
The third issue:
Is there IPO underpricing in the markets of Europe and
the United States of America?
1
Cf. Ljungqvist, A. (2004), p. 1; Hopp and Dreher (2007), p.2.
2
Cf. Arugaslan, O. et al. (2004), p. 2403; Booth and Booth (2010), p. 2.
3
Cf. Loughran and Ritter (2004), pp. 5-6; Booth, L. (2006), pp. 1-2; Ljungqvist, A. (2006), p. 62.
4
Cf. Sahoo and Rajib (2007), pp. 39-40; Loughran, T. et al. (2013), pp. 165-167.
5
Cf. Ljungqvist, A. (2004), p. 1; Sahoo and Rajib (2007), p. 40; Loughran, T. et al. (2013), p. 164.
6
Cf. Ljungqvist, A. (2004), p. 2; Boulton, T. et al. (2011), p. 484.
7
Cf. Elston and Yang (2010), p. 518; Brealey, R. et al. (2011), pp. 372-373.
14
1.2 Methodological Approach
In order to gain the objectives the Master's Thesis was structured as follows: Chapter 2
presents a compact overview of the Initial Public Offering (IPO), which includes the
main aspects of an IPO, its procedure as well as major listing requirements on selected
stock exchanges in Europe and the United States of America. These principals of the
IPO are crucial for the understanding of the chapters which follow in this thesis. Hence,
chapter 3 discusses the IPO Underpricing and provides main theories of this phenome-
non according to asymmetric information, institutional motivations, control considera-
tions and behavioral approaches. In addition, two former IPOs of VISA Inc. and FACE-
BOOK Inc. have been conducted in order to review some theoretical aspects of
underpricing by the own investigation. Chapter 4, however, provides evidence of IPO
underpricing in Europe and the United States, combined with empirical results by
researchers and the own analysis starting from 1959 till the end of 2012. The own
analysis with database over the last 15 years thereby focuses on the markets of Germany
and the United States. Finally, Chapter 5 outlines the results and provides an overall
conclusion.
15
2 Initial Public Offerings
It is generally agreed today that an Initial Public Offering is one of the most exciting
events in the life of a company which fascinates almost all involved parties around. It
allows companies to go public and raise capital by issuing equity for the first time.
8
Mostly this occurs, when the business environment seems appropriate and global
markets are stabilized.
9
But one of the most controversial features of this issue is why it
is so and what motivates companies and their participants to conduct an Initial Public
Offering (IPO)?
This chapter will define an IPO and examine the main issues regarding the motivation,
the legal differences and the entire process in both Europe and the United States (U.S.).
2.1 The IPO
It is necessary to mention that there are a lot of definitions of an IPO in the literature;
nevertheless, it can be generally defined "as the first public offer of shares of a privately
held firm on the primary market and the introduction of these shares to a security
market".
10
Furthermore, it is the first sale of stock by a private company to the public
which can be also described as to "go public" or "public flotation".
11
Once the going public process has started, often through small and medium-sized
enterprises (SMEs), the company transforms from privately held into publicly held
firm.
12
Before the primary issue, a company can choose from three offering methodolo-
gies which are either considered through the issues of new shares, in order to raise
additional cash for the enterprise ("primary placement"), or through the issue of existing
shares, owned by the pre-IPO shareholders in order to change the ownership structure
("secondary placement"), or even through a mix of the two strategies.
13
However, it is
also necessary to mention, in the context of an IPO, that already listed companies can
also raise money by issuing new shares which are called secondary issues.
14
Unlike to go public through mergers and acquisitions (M&A), in which the company
sells itself to an existing listed company and therefore loses corporate control over all
8
Cf. Paleari, S. et al. (2012), p. 5; Deloitte (2012), p. 2; PwC (2010), pp. 5-6.
9
Cf. Ragupathy, M. (2011), p. 41; PwC (2012), p. 3.
10
Cf. Carls, A. (2007), p. 415; Drobetz, W. (2008), p. 21.
11
Cf. Dimovski, B. (2006), pp. 25-26; Downes and Goodman (2010), p. 349.
12
Cf. Paleari, S. et al. (2009), p. 9; PwC (2010), p. 8.
13
Cf. Draho, J. (2004), p. 2-3; Paleari, S. et al. (2009), p. 99.
14
Cf. Muscareiia and Vetsuypens (1989), p.1.
16
further investment issues due to the new owner, an IPO diversifies this exposure by
selling shares to retail investors.
15
2.1.1 Typology and Motivation
The first thing that needs to be said is that the main motivation which drives IPO
decisions is often set by smaller, younger companies which seek to expand the capital,
however, it can be also conducted by large privately-owned companies which aspire to
become publicly traded.
16
This can be clearly seen in the Table 2-1 in which we
distinguish the former IPO decisions across the industries.
Table 2-1: Distribution of IPOs by industry and the incidence of SME-conducted IPOs in European
markets from 1995 to 2008
17
In the technology sector, for instance
18
, we usually have young and dynamic companies
with high growth during the first years of their life-business cycles, which are able to
require substantial capital, but often cannot acquire cash from banks due to their
uncertainty and therefore high-risk business models.
19
Considering the data in Table
2-1, it is no wonder that maximum proportion of IPOs during the last two decades
reached almost 65% in the technology sector.
20
The great majority of the venture
capitalists (VCs) usually preferred to invest in such "start-up" companies in order to
participate in their potential future growth, though there was an uncertain exposure on
the future development.
21
However assumed, that the business model works, a number
15
Cf. Ragupathy, M. (2011), p. 41; Paleari, S. et al. (2012), p. 5; Hsieh, J. et al. (2011), p. 1367.
16
Cf. Dimovski, B. (2006), pp. 25-26; Paleari, S. et al. (2009), p. 7.
17
I llustration following Paleari, S. et al. (2009), p. 12.
18
This sector contains businesses revolving around the manufacturing of electronics, creation of
software, computers or products and services relating to information technology, such as Internet-
based and Bio-Tech-based companies. Cf. Investopedia (http://www.investopedia.com, 2012).
19
Cf. Xiong and Bharadwaj (2011), p. 88; Harmon, S. (2001), pp. 2-3.
20
Based on the data in Table 2-1, IPO initial reached astronomical levels during 1999-2000.
21
Cf. Gompers, P. (2006), p. 2; Rossetto, S. (2006), pp. 30-31.
ICB
Classification
IPOs in this industry over the
whole sample of IPOs
Fraction of SME-conducted IPOs
in the same industry
0
Oil & Gas
4.1%
38.6%
1
Basic Materials
6.2%
29.6%
2
Industrial
19.7%
49.9%
3
Consumer Goods
8.1%
47.0%
4
Health Care
6.9%
62.9%
5
Consumer Service
17.8%
53.5%
6
Telecommunication
2.3%
51.2%
7
Utilities
1.5%
26.3%
8
Financials
13.2%
26.4%
9
Technology
20.1%
64.8%
17
of key issues arise for both parties regarding the expanding and "exit" strategies at a
certain time. While on the one hand it can be said that it is necessary for the company to
raise capital for expansions of operations, it is on the other hand important for the
venture capitalist to make money on their investments.
22
Typically, as was discussed
above, the best solution for the company and the most profitable exit opportunity for the
VC is an IPO.
23
In the energy, chemical, automotive or even in the financial sector, however, dynamic
and high growth rates are less prevalent in comparison to the technology sector.
24
Most
companies are established and mostly large are privately held. That is why private
equity (PE) funds are engaged to such kind of companies and diversify their portfolios
through all the sectors mentioned above.
25
Unlike young and dynamic firms which seek
to expand the capital, these companies are looking forward to become publicly traded
while PE funds, in the meantime, are interested to gain high returns for their investors
through so called "harvest" event.
26
In both cases, this results in an IPO.
Furthermore, another beneficial reason of going public is the fact that the company's
stock can be used as currency through the channel of takeovers to enable cheaper access
to the capital and higher liquidity, or just increase prestige, visibility and enhance name
recognition.
27
On the other hand, an IPO can also reduce the dependency on money
lenders through financing debt reduction, what implies lower financing costs.
28
Figure 2-1 shows a survey of 336 chief financial officers (CFOs) from the United States
which are motivated to go public.
29
As we can recognize from this empirical study, the
main reason to go public underlies in the context of transactions and reputation, which
can be verified by several other empirical studies as well.
30
22
Cf. Draho, J. (2004), p. 1; Gompers, P. (2006), p. 24; Rossetto, S. (2006), p. 31.
23
Cf. Gompers, P. (2006), p. 34; Rossetto, S. (2006), p. 31-32.
24
Academic studies have scientifically proven that the dotcom bubble at the global markets in 2000 and
2001 where caused by IPOs of technology-related firms. A dotcom bubble however is defined as a
"rapid inflation in the valuation of public and private technology companies that exceeds their funda-
mental value by a large margin." Cf. Cendrowski, H. et al. (2008), pp. 86-90; The Economist
(http://www.economist.com, 2011).
25
Cf. Bundesverband Deutscher Kapitalbeteiligungsgesellschaften (http://www.bvkap.de/, 2009).
26
A "harvest" is an event whereby the investor and the management of a company sell at least a portion
of their shares to the public or corporate buyers. Cf. Cendrowski, H. et al. (2008), p. 83.
27
Cf. Paleari, S. et al. (2012), p. 6; Drobetz, W. (2008), p. 21; Rossetto, S. (2006), pp. 38-39; Hsieh, J. et
al. (2011), p. 1368.
28
Cf. NYSE Euronext (http://usequities.nyx.com, 2012); Birkenbeul, C. (2012), p. 4.
29
Cf. Brau and Fawcett (2006), pp. 399-404; Brealey, R. et al. (2011), p. 367.
30
Cf. Ragupathy, M. (2011), p. 42; Birkenbeul, C. (2012), p. 5.
18
Figure 2-1: CFOs who agree or strongly agree in %
2.1.2
Disadvantages
Despite all benefits mentioned in the former section of an IPO, the other side of the coin
is, however, that companies also have to take risk exposures into account before, during
and after the process of going public.
31
First of all, these are the costs in the forefront of
the IPO which can be split into direct and indirect costs.
32
Direct costs which are fairly
predictable include stock exchange and registration fees, pre-marketing activities,
investor relation activities, and legal fees, underwriting fees, consulting and auditing
fees.
33
Basically, these direct costs are, for example, between 5-10% in Germany, while
in the U.S. a general price of 7% of the gross volume for issues up to $80 million.
34
Indirect costs contain subsequently costs of publicity and management time, where
regulations and restrictions are imposed in the IPO market.
35
Another significant but
also most complex issue in the context of indirect costs is the underpricing of an IPO
which will be described in the third chapter and evidenced in the fourth chapter.
36
Moreover, reasons against to go public can be local social and corporate culture aspects
which may discourage before the process, besides, it is a time-consuming process, and,
finally, there is a probability that one of the requirements is dividends which must be
paid after the process.
37
So before deciding whether to go public or not, companies must
31
This also includes the potential failure of an entire IPO process. Failures occur for instance through:
inappropriate valuation (e.g. Evonik Industries AG in 2012), system errors at the stock exchange (e.g.
Bats Global Markets Inc. in 2012) or inappropriate market conditions (e.g. DB Mobility Logistics in
2008). Cf. Demers and Joss (2007), pp. 333-337; Ritter and Welch (2002), p. 6; Bloomberg
(http://www.bloomberg.com, 2012); Reuters (2012), p. 3; Chemical Week (2012), p. 6.
32
Cf. Drobetz, W. (2008), p. 28; PwC (2010), pp. 9-11.
33
Cf. Draho, J. (2004), pp. 5-8; Drobetz, W. (2008), pp. 28-29.
34
Cf. Paleari, S. et al. (2009), pp. 46-67; Birkenbeul, C. (2012), p. 5.
35
Cf. Drobetz, W. (2008), p. 29; PwC (2010), p. 10.
36
Cf. Ghosh, C. et al. (2012), p. 2; Ritter, J. (http://bear.warrington.ufl.edu, 2013).
37
Cf. Sullivan, B. (1965), pp. 49-50; Draho, J. (2004), p. 182.
19
take into consideration several risk factors, weigh up and consider what the advantages
and disadvantages of the process are.
38
2.2 Going Public
When a company decides to go public, further issues regarding the thoroughly prepara-
tion arise in order to call successfully attention to the potential investors. Normally, this
is a long, intensive and complex process which includes both financial and time
expenses.
39
That is why most companies engage advisors who coordinate the entire
equity transaction process from preparing for life as a public company, selecting the
right capital market and establishing the right team of advisers, advising on regulatory
and all other issues.
40
However, it is not only the question about the right strategy of the entire process but
also the "optimal IPO timing" relative to market conditions and other IPOs.
41
Certain
unfavorable market conditions can be triggered through the unexpected (e.g. the
September 11 attacks in 2001) or financial turmoil (e.g. Asia crisis in 1997; Dot-com
Bubble in 1999/00; Subprime crisis in 2007/08; European sovereign debt crisis since
2010), which had a dramatic impact on the companies and had to wait for more favora-
ble market conditions before going public.
42
Nevertheless, unlike in the previous years
the markets nowadays distress from an uninterrupted sovereign crisis since 2010,
especially in Europe. Hence, most companies which want to go public must face with
the uncertainty for an "optimal IPO-timing" due to volatile markets and therefore they
need to work out and pursue a well thought-out and flexible strategy in a shorter time
frame of the entire process ("prepare early, move fast").
43
Figure 2-2 describes the historical development of global IPO activity. Basically, there
is to recognize a positive correlation between the market conditions and the IPO
38
Cf. Demers and Joss (2007), pp. 333-337; Birkenbeul, C. (2012), p. 5.
39
Cf. Ritter and Welch (2002), pp. 6-8; Cao, J. (2011), p. 1001.
40
Cf. PwC Hong Kong (http://www.pwchk.com, 2012); Cendrowski, H. et al. (2008), p. 373.
41
Appendix 7 illustrates a database of monthly frequency of IPO volumes in the U.S. since 1960. There
is to recognize that most of IPOs generally proceed from spring to summer in a year. Cf. Draho, J.
(2004), p. 10; Cao, J. (2011), p. 1002; Ritter, J. (http://bear.warrington.ufl.edu, 2013).
42
Figure 2-2 visualizes all downturns mentioned in the context of optimal IPO-timing. Cf. Elschen and
Lieven (2009), p. 18; Ljungqvist and Wilhelm (2003), pp. 724-725; Bernd, F. (2012), p. 2; Payne, B.
(2011), pp. 150-151; Barrell and Dury (1998), p. 57.
43
Cf. Bernd, F. (2012), p. 2; PwC (2012), p. 5; Paleari, S. et al. (2012), p. 65; E&Y (2012), p. 2.
20
activities which can be verified through several empirical analyses as well as aspects of
the optimal IPO-timing already mentioned before.
44
Figure 2-2: Global IPO Activity - Annual (1996 - 2012)
45
We can see that the IPO market remained cyclical for a long time; however, general
downturn trend of global IPO activities had been strongly affected since 2010 by the
unstable economic and political conditions in the Eurozone.
46
Despite that, some IPO
markets such as Asian, U.S. and even in the EU performed well under these circum-
stances.
47
Appendix 1 illustrates that the North American market, mainly the U.S.,
raised regardless of a low number of IPOs in 2012 with 152 (2011: 108) in comparison
to all other markets the highest capital with USD 41,5 billion (2011: USD 36,0 billion).
This primarily can be explained through the "Facebook" IPO in May, 2012 with a deal
size of USD 16,0 billion and at the same time the largest technology IPO on record.
48
Measured on the number of deals, Europe is leading with 263 IPOs in 2012 (2011: 430
IPOs), followed by the Greater China with 228 IPOs in 2012 (2011: 388 IPOs).
Based on Ernst & Young and PwC studies in 2012, the outlook for IPOs in 2013 is
more optimistic, especially within the Eurozone since the market volatility has remained
stable and stock market indices continued to recover in the second half of 2012.
49
In the
following sections, the general milestones of going public will be described which
44
Cf. PwC (2012), pp. 2-4; Draho, J. (2004), pp. 10-13; Cendrowski, H. et al. (2008), pp. 96-99.
45
Illustration based on data of Bloomberg (http://www.bloomberg.com, 2013); WFE (http://www.world-
exchanges.org, 2013); Renaissance Capital (http://research.rencap.com, 2012).
46
Cf. E&Y (2012), pp. 2-3; PwC (2012), pp. 2-4.
47
Appendix 4 shows a deeper analysis of global distribution data of IPOs in 2011 and 2012.
48
Appendix 3 illustrate a compact view of "All time largest global IPOs, Top 25", based on the
Renaissancecapital data as of Dec. 31, 2012 and Bloomberg (http://www.bloomberg.com, 2012).
49
Appendix 2 illustrates upcoming global IPOs in 2013, where the German market expects two large
fund raisings. Cf. E&Y (2012), pp. 3-12; PwC (2012), pp. 2-5.
$132
$145
$116
$177
$210
$99
$70
$58
$131
$180
$267
$295
$96
$113
$285
$170
$119
1,837
1,748
1,042
1,372
1,883
876
847
812
1,520 1,552
1,796
2,014
769
577
1,393
1,225
768
0
500
1,000
1,500
2,000
2,500
$0
$50
$100
$150
$200
$250
$300
$350
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Ca
p
it
a
l r
a
is
ed
(
U
S
D
b
ill
io
n
)
Capital raised (USD billion)
Number of Global IPOs
21
include the entire phases of preparation, legal and regulatory, valuation, marketing,
pricing, underwriting and listing.
2.2.1
The IPO Process
,,Some rules of thumb for a firm considering an IPO are that the company is growing,
that it has a definite need for much larger funding, that it has a "good story", and that it
is a good time in the market for this type of company."
50
GHOSH pointed out, there-
fore, that the company needs also to meet market requirements in addition to regulatory
requirements and an optimal timing in order to fulfill the IPO with a "good equity
story".
51
That is why the process of an IPO starts long before the first day of trading.
52
From the
decision to go public until the initial listing, issuers must undergo a number of proce-
dures which are time-consuming and typically take from 12 up to 16 weeks from the
start till the end of the process.
53
Overall, the IPO can generally be completed within 15
till 20 weeks.
54
However, the exact time depends on actual market conditions, com-
plexity of the transaction and several other factors.
55
Hence, considering the entire process, the issuer must hire appropriate partners (under-
writer, auditor, legal counsel), and make a careful assessment whether the requirements
for going public are met regarding diligence, elaborating the issuing concept and the
equity story as well as setting up an efficient corporate organization.
56
Figure 2-3 presents a detailed timeline of events which are generated through a combi-
nation of different IPO guidelines but can be generally applied to overall IPO processes.
50
Cf. Ghosh, A. (2006), p. 21.
51
Market requirements can be classified into quantitative criteria and qualitative criteria which include:
a proven product range or service range in a strong market; satisfactory record of profits growth;
reasonable prospects for future profits and growth; sound management; that the timing of the flotation
is appropriate. Cf. Draho, J. (2004), pp. 182-183; Petersen, M. (2001), pp. 57-58; Cendrowski, H. et
al. (2008), p. 88; Downes and Goodman (2010), pp. 576-577.
52
Cf. Draho, J. (2004), p. 212; Deutsche Börse Group (2010), p. 2.
53
Cf. Draho, J. (2004), p. 182; Deutsche Börse Group (2010), pp. 2-3.
54
Cf. London SE (2010), p. 26; NYSE Euronext (2010), pp. 35-36.
55
Cf. NYSE Euronext (2010), p. 36; Cendrowski, H. et al. (2008), pp. 87-88.
56
Cf. Draho, J. (2004), p. 212; Deutsche Börse Group (2010), p. 2.
22
Figure 2-3: IPO timeline
57
57
Own illustration following Draho, J. (2004), p. 183; London SE (2010); pp. 23-25; Deutsche Börse
Group (2010), pp. 1-5; NYSE Euronext (2010), pp. 34-43; SEC (http://www.sec.gov, 2012).
23
2.2.1.1 Phase I: Preparation of the IPO
At the very beginning, assuming the private company itself successfully accomplished
all issues regarding the readiness to go public, it is the first step to select an appropriate
underwriter.
58
This is normally a syndicate of investment banks in which one bank takes
the leadership and is in charge of the entire process.
59
The lead underwriter plays an
essential intermediary role in the offering process.
60
While he coordinates all involved
parties in the process, amongst other things between the advisors, the issuer, the stock
exchange, selling stockholders and potential investors, he also involves own internal
bank divisions such as the Equity Capital Markets, Research and Sales and Trading in
order to guarantee offering success.
61
As already mentioned, however, other profession-
al advisors (e.g. auditors, lawyers and consultants) selected by the issuer due to legal
and regulatory requirements, play also an important role in the pre-IPO planning
process.
62
After all, the company then refines its strategy for the IPO in conjunction with its
advisors and syndicate bank to develop an adequate "prospectus" (also known as
"equity story"), a legal document that basically serves as a brochure for the company.
63
2.2.1.2 Phase II: Structuring & Valuation
The second phase evaluates and prepares the company for the upcoming flotation
process by conducting a due diligence and a company's prospectus.
64
Besides, consider-
ations on the admission for listing will be discussed.
65
"The purpose of due diligence is to ensure the accuracy, completeness and truthfulness
of the company's registration statement," in order to provide the interested party the
58
Cf. Cendrowski, H. et al. (2008), p. 87; Drobetz, W. (2008), p. 25; Corwin and Schultz (2005), p. 445;
NYSE Euronext (2010), p. 36; Deutsche Börse Group (2010), p. 3.
59
"In most cases, lead underwriters are "bookrunners." Lead underwriters/bookrunners take on most of
the responsibilities of the managing underwriters, which might include due diligence, marketing of the
issue, pricing, price stabilization, market making, and analyst research coverage of the stock." Cf. Hu
and Ritter (2007), p.3; Corwin and Schultz (2005), p. 446; Schenone, C. (2004), p. 2903; Downes and
Goodman (2010), p. 795; Cendrowski, H. et al. (2008), p. 88.
60
Figure 3-2 illustrates the intermediary role of the underwriter in the IPO process. Cf. Ragupathy, M.
(2011), p. 43; Draho, J. (2004), p. 212.
61
Cf. Corwin and Schultz (2005), p. 447; Gygax and Stephanie (2011), pp. 124-125.
62
Cf. Cendrowski, H. et al. (2008), p. 87; Draho, J. (2004), p. 212; NYSE Euronext (2010), p. 34.
63
Several strategic issues on the determination of the transaction structure and the motivation behind the
IPO in order to fulfill a "good equity story." Cf. Ghosh, A. (2006), p. 22; Deutsche Börse Group
(2010), p. 3; Downes and Goodman (2010), p. 565.
64
Cf. Downes and Goodman (2010), p. 204; NYSE Euronext (2010), p. 36.
65
Section 2.3 describes detailed the listing requirements. Cf. Deutsche Börse Group (2010), p. 4.
24
concrete evidence.
66
While the due diligence is an important internal approach for all
advisors, especially for the lead underwriter (also known as the "sponsor"), to fully
understand the company and to confirm readiness for the IPO, the prospectus which is
derived from the due diligence report is an extended but official version and must be
filed with the nations securities and exchange commission's (e.g. in the U.S.: SEC, UK:
UKLA, Germany: BaFin).
67
Nevertheless, it is ultimately the responsibility of the lead
underwriter (and the lawyers) to ensure that all material facts are analyzed, reviewed
and disclosed in the prospectus through the due diligence.
68
One of the major challenging steps throughout this phase marks the first valuation of the
company which is the basis for the final offer price and needed to be set in the fourth
phase.
69
A firm conducting a flotation process needs to have its stock valued before the
IPO, in order to determine an appropriate price range which will be finalized with the
best possible price after the roadshow.
70
However, since there will be no public market
value for the business to inform them "right price", their challenge is to establish what
public market value should be."
71
This is a crucial part of the valuation due to various
factors such as market conditions, characteristics of the firm, stock exchange or even
valuation method aspects, which impact the valuation of a company and eventual
pricing in the stock.
72
Basically, there are numerous methods for stock valuation in which we focus on the
major valuation methods, widely used valuation approaches in the IPO process.
73
That
is, on the one hand, the discounted free cash flow (DCF) method and, on the other hand,
66
Cf. NYSE Euronext (2010), p. 36; Dunlap, N. (2011), p. 46; London SE (2010), p. 27.
67
The prospectus must contain all financial information and a description of a company's business
history, officers, operations, pending legation (if any), and plans (including the use of the proceeds of
the issue), risks, necessary for investors to determine if they will subscribe to the listing. Moreover, it
satisfies the requirements of the related rules for listing, disclosure and prospectus directive. In other
words, it is a formal written offer for the sale of company's shares approved by the nations Securities
and Exchange Commission's and published with the roadshow. Cf. Downes and Goodman (2010), p.
565; NYSE Euronext (2010), p. 36; London SE (2010), p. 27; "Facebook" Prospectus published by
the SEC (http://www.sec.gov, 2012); Deutsche Börse Group (2010), p. 4; Cendrowski, H. et al.
(2008), p. 91; Deloitte (2012), p. 42; PwC (2010), pp. 20-21.
68
Cf. PwC (2010), p. 50; Dunlap, N. (2011), p. 46; Deloitte (2012), p. 32.
69
Section 2.2.1.4 describes how the final offer price results. Cf. Neill, J. et al. (1995), p. 68; Draho, J.
(2004), p. 158; Cendrowski, H. et al. (2008), p. 88; Deloitte (2012), pp. 35-36.
70
Cf. Deloof, M. et al. (2009), p. 130; Neill, J. et al. (1995), pp. 68-69; NYSE Euronext (2010), p. 63.
71
Cf. London SE (2010), p. 63; Deloitte (2012), p. 36; Lerner, J. et al. (2008), p. 400.
72
Since the New Economy, most of academic studies as well as in the market itself pointed especially
for technology/internet firms out that "traditional" valuation do not work e.g. due to short track record
or a fast growth business for which no benchmark exist. Cf. Seppelfricke, P. (2012), p. 144; PwC
(2010), p. 8; Draho, J. (2004), p. 158; Deloitte (2012), p. 72; Aggarwal, R. et al. (2009), pp. 253-254;
Guo, R. J. et al. (2005), p. 424; Ragupathy, M. (2011), p. 44; Bartov, E. et al. (2002), p. 324.
73
Cf. Seppelfricke, P. (2012), p. 144; Deloitte (2012), p. 36; London SE (2010), p. 63.
25
valuation approaches that rely on multiples of already listed comparable companies or
comparable companies involved in similar transactions.
74
While the DCF method is
static, complex and time-consuming approach, the multiple method is able to deal with
IPO firm characteristics, aggregate stock market return and stock market volatility and,
hence, it is very helpful.
75
That is why most of lead underwriters nowadays use the
multiple method approach as the major valuation method instead of DCF in the IPO
process.
76
The most frequently used multiple in the comparable approach is the price-earning (P/E)
ratio, which consists in value measure, the share price P, an accounting measure, the
earnings per share E.
77
Either through the comparable company method or through the
historical comparable transactions method with premium discount, both based on peers,
the aggregated multiple of single numbers by using the arithmetic mean can be applied
to an approximate earnings per share of the target company in order to compute a price
per share.
78
The estimated price per share, however, is only approximate and does not reflect the
market expectation.
79
It is the first visible value which will be discussed and further
negotiated and in most cases significantly downgraded until the first day offer.
80
2.2.1.3 Phase III: Marketing & Roadshow
After the company's value has been estimated, the marketing process comes next and
consists in number of distinct stages which take place in the following order:
81
- Preparing the media
- Research analysts briefing
- Pre-Marketing to key investors
- Marketing to investors through roadshows
74
Cf. Deloof, M. et al. (2009), p. 130; Draho, J. (2004), pp. 159-160.
75
Cf. Deloof, M. et al. (2009), pp. 130-131; Schreiner, A. (2007), p. 48.
76
Cf. Bartov, E., et al. (2002), pp. 323-324; Deloof, M. et al. (2009), p. 131; Seppelfricke, P. (2012), p.
144; Aggarwal, R. et al. (2009), p. 253; Draho, J. (2004), p. 160; Sahoo and Rajib (2007), p. 60.
77
Cf. Schreiner, A. (2007), p. 49; Draho, J. (2004), p. 161; Deloof, M. et al. (2009), p. 131.
78
The "peers", also known as the "peer group", represents a basket of firms or corporate transactions,
whose profile of expected future free cash flow and other characteristics are comparable to the target
firm's profile. Cf. Schreiner, A. (2007), pp. 50-51; Draho, J. (2004), p. 161.
79
Note: ,,Traditional valuations" do not work, when there exist no benchmark, e.g. Facebook IPO. Cf.
Koller, T. et al. (2005), p. 371; Cusumano, M. A. (2012), p. 20; Bartov, E. et al. (2002), p. 322.
80
Cf. Draho, J. (2004), p. 161, Schreiner, A. (2007), p. 51; Ragupathy, M. (2011), p. 45.
81
Cf. London SE (2010), p. 61; Deloitte (2012), p. 54; NYSE Euronext (2010), p. 37.
26
Preparing the media
Typically, some months before the IPO is expected to go public, articles about the
company, its business and its management are published in the media.
82
Studies found
out that the media influences the market performance of firms vice versa the manage-
ment increases performance for a good publicity of the company to be used in the
marketing efforts.
83
Research analysts briefing
Outside the IPO process and approximately 2-3 weeks prior to the pre-marketing, the
investment banks arrange meetings at which the company presents detailed financial
and strategic information to syndicate research analysts and enable them to prepare
detailed research.
84
This is an important procedure in the line of the IPO process,
because hereby the analysts reflect fairly the company's prospects which will be
additionally informing investor's opinion.
85
However, the research must be independent
which implies the provision of unbiased reports of the company to be completed by the
time the company issues its "Announcement of Intention to Float".
86
Pre-Marketing to key investors
The announcement of intention to float is the official beginning of the public market-
ing.
87
It is usually a number of meetings to be held with the media and visiting for a
number of key investors to "warm them up" and get their feedback which is also known
as the "Investor Education" phase.
88
This is essential for the success of the roadshow
presentation because it is used to refine company's thinking on critical aspects and
about the valuation, to be used to set a price range for the shares which will be offered
in the IPO.
89
82
Cf. Deloitte (2012), p. 8; London SE (2010), p. 61.
83
Cf. Ojala, M. (2012), pp. 52-53; Pollock, T. et al. (2008), pp. 337-338.
84
Detailed analysis on operations, financial data and on the company's outlook and strategy. Cf. London
SE (2010), p. 61; Deloitte (2012), p. 54; NYSE Euronext (2010), p. 37.
85
Cf. London SE (2010), p. 61; Jaisfeld, M. (2012); pp. 1-8; Deloitte (2012), p. 55.
86
Cf. SEC of Sri Lanka (2012), p. 4; London SE (2010), p. 62.
87
Cf. London SE (2010), p. 62; Deloitte (2012), pp. 55-56.
88
Cf. PwC (2010), p. 23; NYSE Euronext (2010), pp. 37-38; London SE (2010), p. 62.
89
Cf. London SE (2010), p. 62; Deloitte (2012), pp. 55-56; PwC (2010), p. 23.
27
Marketing to investors through roadshows
The last step in the marketing process is the roadshow, generally 2 weeks prior to the
IPO.
90
Though the investment bank ("lead underwriter") will spearhead the process, it is
the time where the company's management will present professionally itself to institu-
tional investors, typically they do attend each location for a half hour, and answer
questions.
91
All meetings are fundamental for the entire process as the management is
selling the IPO story to investors.
92
The company conducts a series of one-on-one and
group meetings or telephone conference calls with investors that will potentially
purchase the shares being offered.
93
Due to the demand and price offering of investors
to company shares, this last step in the chain of marketing is amongst other things,
highly relevant for the last phase of the IPO process, the final pricing and trading.
2.2.1.4 Phase IV: Pricing & Trading
In the last phase of the IPO process, the company in conjunction with the syndicate,
especially the lead underwriter, combines all information they received in order to set
up an appropriate offering price.
94
But how they do and whether valuation and the
company's future operation excellence have an impact on pricing or is it just a market-
ing decision, remain the most frequent issues in the literature.
95
On the one hand, there are three pricing options which are bookbuilding, tender (also
known as auction) and fixed price to set an offering price.
96
On the other hand, it is the
"grey market" which reflects the opinion of retail investors and takes place simultane-
ously to the bookbuilding.
97
The three IPO mechanisms in conjunction with the "grey
market" opinion allow the lead underwriter to review the estimated price per share with
90
The definition of the ,,Roadshow" is regarding to Downes and Goodman, a presentation by an issuer
of securities to potential buyers about the merits of the issue. Management of the company issuing
stocks or bonds doing a road show travels around the country presenting financial information and an
outlook for the company and answering the questions of analysts, fund managers, and other potential
investors which is also known as a "dog and pony show". Cf. Downes and Goodman (2010), p. 620;
London SE (2010), pp. 63-64; Deloitte (2012), p. 56.
91
It is also the time where all reports on and of the company will be published those are the final
prospectus and the analyst reports. Cf. Deloitte (2012), p. 56; London SE (2010), p. 63; Lerner, J. et
al. (2008), p. 385; NYSE Euronext (2010), pp. 44-46; Draho, J. (2004), pp. 188-190.
92
Cf. London SE (2010), p. 64; NYSE Euronext (2010), p. 44.
93
Cf. NYSE Euronext (2010), p. 44; PwC (2010), p. 56; Lerner, J., et al. (2008), pp. 385-386.
94
Cf. Deutsche Börse Group (2010), p. 6; Deloof, M. et al. (2009), p. 132.
95
Cf. Ragupathy, M. (2011), p. 44; Corwin and Schultz (2005), p. 444.
96
Cf. Draho, J. (2004), p. 215; Lerner, J. et al. (2008), p. 387.
97
Cf. Schnigge Wertpapierhandelsbank AG (https://www.schnigge.de, 2012).
28
capital market before the IPO.
98
At the end, using information between the issuer and
the investors, the underwriter sets an appropriate offering price.
99
However, this is
particular the moment where this advantage knowledge might be used for own interest
of the underwriter.
100
Despite the fact, the operation mechanisms principles of all
mentioned factors shall be shortly described in the following.
Bookbuilding
The Bookbuilding is the exercise by which institutional demand for an issue is estimat-
ed in advance of fixing the price for an issue which usually takes place alongside the
roadshow.
101
This bookbuilding process helps to review the estimated price per share by
a daily communication and submission of new orders as well as confirmation to
financial advisors from stockbrokers of cumulative orders and pricing.
102
The final offer
price, however, will be then set with the number of shares to be issued in correspond-
ence with the "bookrunner" ("lead underwriter"), the company and certain existing
shareholders, one day before the IPO starts.
103
This is why the bookbuilding mechanism
is mostly used in the practice due to its fairness and control for all parties.
104
Fixed Price
The fixed price method is where the estimated company value and through this the firm
price is written into the prospectus and therefore determined. So there is neither an
opportunity for both the issuer and the underwriter to review the estimated price, nor the
chance for the investors to negotiate
.
105
This, in comparison to all other methods, is the
most risky due to the fix issuing price which can be either too high or too low and is,
hence, out of control
.
106
98
Cf. Biais, B. et al. (2002), p.118; Draho, J. (2004), p. 216; Cornelli, F. et al. (2004), p. 1; Schnigge
Wertpapierhandelsbank AG (https://www.schnigge.de, 2012).
99
Cf. Cendrowski, H. et al. (2008), p. 89; Ragupathy, M. (2011), p. 44.
100
This phenomenon will be detailed examined in section 3.2.1 ("Asymmetric information"). Cf.
Ragupathy, M. (2011), p. 44; Chemmanur and Krishnan (2012), p. 770; Drobetz, W. (2008), p. 29.
101
Cf. Draho, J. (2004), p. 216; PwC (2010), p. 57; Deutsche Börse Group (2010), p. 6.
102
However, the interests are not obligated so that they can be rescinded without a penalty. Cf. Draho, J.
(2004), p. 216; London SE (2010), p. 64; NYSE Euronext (2010), p. 44.
103
Hu and Ritter pointed in a study on multiple bookrunners out that so long there exist only one book
runner in the process, so more the likelihood is that the range and the offer price tends to be lower vice
versa when there are multiple bookrunners the range as well as the price tends to be higher. Cf. Hu
and Ritter (2007). p. 4; Draho, J. (2004), p. 216; London SE (2010), p. 64.
104
Based on a study of Ljungqvist between 1997 and 2010, 80% of all IPOs outside North America and
94% in Germany use bookbuilding accounts. Cf. Ljungqvist, A. et al. (2003), p. 72.
105
Cf. Draho, J. (2004), p. 217; Lerner, J. et al. (2008), p. 386; Ahrens, G. (1998), pp. 20-25.
106
Cf. Draho, J. (2004), pp. 216-217; Lerner, J. et al. (2008), p. 386.
Details
- Pages
- Type of Edition
- Erstausgabe
- Publication Year
- 2014
- ISBN (eBook)
- 9783954897957
- ISBN (Softcover)
- 9783954892952
- File size
- 3.8 MB
- Language
- English
- Publication date
- 2014 (June)
- Keywords
- phenomenon underpricing european stock markets
