Explain the process of an Initial Public Offering (IPO). Critically appraise the various theories that have been proposed to explain the apparent 'underpricing' of IPOs

Résumé du document

When a company decides to sell stock for the first time (to "go public"), this operation is called Initial Public Offering (IPO). The target of the IPO is to: - Raise capital for the company and enable the first investors to realize their investment (VC Firms). The IPO practice requires the intervention of both company and investors, and specialist advisers. Furthermore, the IPO process implies many considerations that overtake the obvious gain of liquidity operated by a company, once the stock is traded to the public. It is a really complex procedure for entrepreneurs. With these benefits come costs which are classified as direct (auditing and underwriting fees) and indirect (time dedicated to carry out the IPO process, ?under-pricing', the gap between the offering price and the stock value in the market, soon after the initial sale to investors). Actually, if direct costs (the ?spread', received by underwriters) can be precisely evaluated, the reasons for ?under-pricing' are much more ambiguous. We will explain first, the most influencing steps of an IPO process, in order to analyze the ins and outs, and identify the different actors of that complex procedure. This accurate description will help us then to take a critical stand on the different approaches of the IPOs ?under-pricing'.

Extraits

[...] By this way, ownership of the company is dispersed, and the liquidity of the stock is increased. ‘Underpricing' is very costly, and all the previous reasons couldn't account for so much money left on the table. The ‘spinning' hypothesis has been largely defended over the last years. During the bookbuilding stage, underwriters can allocate shares to some people without revealing their identity. Issuing firms managers can therefore have a stake in investing in their own IPO (through friends and family accounts), if this one is underpriced (which is tantamount to high returns). [...]

[...] In the UK: From Buckland and Yeomans (1981), to Levis (1990), all studies show a high frequency of large initial returns on the first trading day. Similar observations have been raised in Australia (Noti and Hadjia in 1983), in Japan (Dawson and Hiraki in 1985), Singapore (Sunders and Lim in 1990). The average ‘underpricing' seems to be even more in emerging markets, if we refer to Dawson studies in Malaysia (1987), who observes that Malaysian new issues produce a very large return of 166 percent on the first day of trading. [...]

[...] This accurate description will help us then to take a critical stand on the different approaches of the IPOs ‘underpricing'. I - The IPO Process IPOs enable companies to put big amounts of money in their reserves, and it's a source of wealth for company insiders and investors. But, above all, it is a long and tricky process, which can last six months or more. In other respects, conducting an IPO can be a very costly operation, with a major risk to miss one's goal and withdraw the offering at the last moment. [...]

[...] The goal is to build a ‘book of demand', and trigger the interest of investors, namely institutional investors, who account for a large proportion of the equity trading volume, nowadays. h. Pricing: information gathered during the due diligence leads underwriters and issuers to advance in the understanding of the firm's true value. They may take into account: - Conditions of the market - Price of other similar offerings - Projected cash flows earned by the issuing company at the time of the offering - Ratios price/earnings of comparable companies in the same industry may also be considered - Other elements can be used, such as the risk of the considered industry on its market, the trading goals in the aftermath of first sale, the growth expectations. [...]

[...] These three explanations of the new issues market price fall in the long run, from Jay Ritter, are not exclusive, but they are mainly admitted: - The divergence of opinion hypothesis: the price of new issues falls in the long run as a consequence of converging estimations between optimistic and pessimistic investors. Both get more information along the life of the equity, and therefore, as more information is available, a precise price of the equity is drawn. - The impresario hypothesis: Underwriters are alleged to practice low offer prices, so as to attract investors. As a result, high returns observed are artificial, and companies whose initial returns are high may also have low returns in the long run. [...]