Recent developments in IPOs: returns, regulation and techniques

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Recent developments in IPOs returns,
regulation and techniques

• Tim Jenkinson
• Saïd Business School, Oxford University

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outline

• IPOs have been subject to huge amounts of
  research in the last few decades, mainly due to
  their systematic under-pricing
• we will review the existing IPO evidence and
  theories which attempt to explain underpricing
• two main developments are then examined
• new innovations in issuing techniques that try to
  align more fully the interests of the issuing
  company and investment banks
• The trend towards exchanges introducing
  low-regulation segments, and their success in
  attracting IPOs and existing companies

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IPO underpricing
Source Jay Ritter (available from his website)
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money left on the table

• underpricing in most developed countries averages
  10-20 in less developed countries underpricing
  can average 50-160
• while the investment banks can sometimes convince
  issuers that leaving money on the table is a sign
  of success, sophisticated repeat IPOers, such as
  private equity funds, resent big first day jumps
• this results in large amounts of money being left
  on the table for the initial investors, at the
  expense of the issuing company
• for instance, underpricing in the US averaged 22
  over 1990-2007, resulting in 117bn being left on
  the table
• these figures are hugely inflated by the IPO
  bubble in 1999 2000 when underpricing averaged
  71 56 respectively
• in more normal times, US IPOs are underpriced by
  around 12

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how do firms conduct IPOs?

• in many countries, fixed price offerings were
  predominant until the mid-1990s
• over the last decade bookbuilding has been
  introduced, and has rapidly become established as
  the main IPO method in most countries
• US banks were the early pioneers, but the
  technology is simple and was quickly adopted by
  others
• an initial price range is set, and then investors
  bid within the range the price range can be
  amended
• bookbuilding gives considerable discretion to the
  investment bank over allocation and pricing

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IPO timelines
pre-filing period
waiting period
post-effective period
US time-line
Registration statement filed preliminary
prospectus (red herring) issued with price
range
Bookbuilding period
Issue price set registration becomes effective
statutory prospectus issued allocations
determined
Analysts produce research
Trading begins
Marketing management road show, sell-side
contacts investors
European time-line
Analysts produce research
Pre-marketing sell-side contacts investors
Preliminary (pathfinder) prospectus issued with
price range
Book-building
Issue price set final prospectus issued
allocations determined
Trading begins
Marketing management road show
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why are IPOs systematically underpriced three
views

• information revelation
• allocations of underpriced IPOs are a reward for
  revealing information that is valuable in pricing
  an issue (if so, when?)
• rent seeking
• investment banks use their discretion to allocate
  to investors who will generate selling
  commissions, or to their affiliated mutual funds,
  or other quid pro quos
• long-term investors
• underpricing creates excess demand that enables
  issuers to target allocations towards long-term
  holders away from flippers

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which view is right?

• testing the alternative theories is difficult
• these views are not mutually exclusive (e.g. are
  long-term investors generally better informed?)
• the key data on IPO allocations is guarded
  extremely tightly, especially by US investment
  banks
• . as is information on the extent of broking
  business between investors and investment banks
• . and the trading activities of investors
  immediately post-IPO
• if valuable information is produced and revealed,
  when does this happen? It could be during
  pre-marketing or bookbuilding
• given these constraints, survey evidence may be
  the most promising way to advance our
  understanding
• investors are pivotal and, unlike investment
  banks, are quite candid and do not fear Elliot
  Spitzer (or similar manifestations)

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ask the investors

• most of the theories assign a key role to
  informed investors and yet very little is known
  about what investors do during IPOs
• IPO allocations are extremely valuable to
  investors, and IPO mandates are very lucrative to
  the investment banks who act as bookrunners, who
  enjoy considerable discretion over allocation
• we (Jenkinson Jones RFS 2009) surveyed
  institutional investors about
• their role in generating incremental information
  and sharing it with investment banks
• how they bid during the bookbuilding phase
• what factors they perceive impact on obtaining
  favourable allocations
• this provides some new and interesting evidence
  about the IPO process and the relevance of the
  existing theories

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the survey

• was conducted with London-based investors, during
  June-Sept 2005, with the support of the
  Investment Managers Association who distributed
  it to their 300 members
• members include all the major asset management
  companies, and many smaller companies and hedge
  funds
• the survey was in four parts
• information about the respondent and their AM
  company
• pre-bookbuilding information production and
  exchange
• bidding during the bookbuilding
• perceptions of the key determinants of allocation

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what factors influence allocation?

• the final part of the survey asks investors for
  their views on the factors that influence
  allocation
• 12 separate factors are identified, which can be
  categorized into 3 broad groups
• interaction with the sell-side, in particular
  participation in meetings
• bidding behaviour during the bookbuilding, such
  as the type and timing of bids
• investor characteristics, such as size, being
  perceived as a long-term investor, being a
  regular subscriber to the IPOs of the bookrunner,
  and the extent of broking business with the
  bookrunner

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normalised responses
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determinants of allocation

• participating in the various meetings is
  perceived to have only a marginal impact on
  allocation
• relative to the other factors, bidding during the
  bookbuilding phase is perceived to be the least
  important
• investor characteristics are perceived to be the
  most important determinants of allocation
• large investors, frequent investors in the IPOs
  of the bookrunner and those perceived to be
  long-term investors all benefit
• but the single most significant factor
  influencing allocation is perceived to be the
  extent of broking relationships with the
  bookrunner

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recent responses to conflicts issues

• the concerns about potential conflicts of
  interests has resulted in some interesting
  innovations in IPO techniques
• there is renewed interest in alternatives to
  bookbuilding for IPOs, especially the use of
  auction mechanisms but few examples to date
• multiple bookrunners may keep each other honest
  since they fear the co-bookrunner whispering to
  the issuer in cases of dodgy behaviour
• the number of multiple bookrunners has been
  increasing significantly in both the US and
  Europe with some evidence that underpricing falls
• another possible response is to make the fees
  paid to investment banks contingent on results
  but some difficulties in practice
• or not committing to a particular investment bank
  by delaying the award of the bookrunner mandate
  until much nearer the IPO known as competitive
  IPOs

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the old game

• the beauty parade of investment banks happens
  around 6 months before the IPO, although can be a
  year or more in some issues
• banks bid for leading role in the syndicate, on
  the basis of league table positions, all-star
  analysts, and valuation
• but at the time of the beauty parade the
  valuations have no status, and are often changed
  nearer the issue the bait and switch strategy
• the early award of the mandate gives the
  bookrunners a monopoly position, and little
  control for issuers e.g. by writing incentive
  compatible contracts
• all this is potentially problematic as investment
  banks face significant potential conflicts of
  interest, with buy-side clients being large
  customers via trading
• this has got more worrying as the economic
  significance of hedge funds and the prime
  brokerage relationship has risen for ibanks

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the new game

• Investment banks under pressure as companies
  play a new IPO game
• FT 10/10/05
• split the advisory and distribution roles
• assign the advisory (including preparation) role
  early possibly excluding the advisor from the
  distribution role
• make banks compete for a distribution role a few
  weeks before the IPO, make them compete on
  pricing and set incentives not to renege on their
  valuations
• use advisor to monitor the distributors and their
  conflicts of interest reduce information
  asymmetry between investment banks and issuer
• make much of the fee performance related, both in
  terms of getting customer orders and pricing
  this is easier due to their late appointment

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case study Pages Jaunes IPO

• the IPO of PJ took place in July 2004, and the
  issuer had an unusual interest in the pricing
  being accurate
• France Telecom was the majority owner of Wanadoo,
  and Wanadoo was 100 owner of Pages Jaunes
• in April 2004 FT announced a buy-back of Wanadoo
  shares and a partial sale of PJ via an IPO
• by July 2004 FT owned 96 of Wanadoo, and
  announced a squeeze out of the minorities
• the price of PJ was a sensitive issue FT
  committed to pay the Wanadoo minorities extra if
  the IPO value exceeded its estimate (3.96bn
  euros), but underpricing would be very clearly
  money left on the table
• the result was that the owners wanted the issue
  price to be as close as possible to the market
  price

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deal structure

• 15 banks were invited to participate in the
  beauty parade
• they were each given a list of institutions and
  asked to pre-market the issue to these investors
• after this pre-marketing they would be asked to
  propose a narrow price band for the IPO
• bookrunner roles would be assigned on the basis
  of pre-marketing efforts and a sensible price
  range
• FT would then set a price range based on the
  suggestions of the banks
• the majority of the fees would only be paid if
  the final price was within the price range, and
  would be lower if the price was at the bottom of
  the range
• an entirely discretionary element to the fee was
  also included which would be based on marketing
  efforts

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pricing incentives

• the original proposal was that the base fee of
  1.75 would only be payable if the final price
  was within the range suggested by each individual
  bank
• this was later changed such that the fee was
  payable if the price was within the bookbuilding
  range not so good for truthful revelation, but
  not really a problem for FT
• an additional 1 fee was payable if the final
  price was in the top third of the bookbuilding
  range (this was not achieved, but the condition
  was changed to a linear payout rather than
  binary)
• a final 0.5 was entirely discretionary, based on
  perceived efforts of the banks and feedback from
  investors
• in the event 92 of the incentive fees were paid

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outcome

• the Pages Jaunes IPO was a success, and resulted
  in trading prices equal to the institutional
  offer price
• it combined a number of features that together
  reduced the power of the banks
• separating advisory from distribution roles, so
  mitigating information asymmetries
• arranging syndicate selection in two competitive
  phases
• only choosing the final syndicate after the
  pre-marketing
• tying the fees of the banks more directly to
  performance, in particular regarding pricing
  accuracy
• some of these features had been used before, but
  overall the Competitive IPO reduced the bait and
  switch problem significantly, incentivised
  information production, and created a high degree
  of alignment between issuer and the syndicate
• there have been variations on the theme since
  some private equity firms now say they only will
  do Competitive IPOs

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regulatory trends

• many countries have tightened their regulation of
  public companies
• Sarbanes-Oxley Act in the US
• European Unions Financial Services Action Plan
• but has regulation gone too far? Overseas IPOs in
  the US have collapsed since Sarbanes-Oxley, and
  other exchanges have benefitted as a result
• lightly regulated market segments have become
  more popular
• Alternative Investment Market (AIM) in London
• Alternext market launched by Euronext.
• First North in the Nordic region, part of OMX.
• AIM, in particular, has attracted a huge
  proportion of recent IPOs, including many
  overseas companies

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but controversial

• SEC commissioner Roel Campos, AIM . . . feels
  like a casino to me, and I believe investors will
  treat it as such Financial Times, 9 March 2007
• Michael Snyder, chairman of the Corporation of
  Londons policy and resources committee, This
  comment by Campos is completely outrageous ...
  In any form of equity there is risk, whether
  fully listed on the NYSE or the LSE ... AIM is
  clearly the junior, more innovative but its
  well regulated Guardian, 9 March 2007
• John Thain, then NYSE chief executive, AIM lacks
  stringent corporate governance requirements for
  listed companies and should keep raising its
  standards Financial Times, 27 January 2007
• Chairman and Chief Executive of Arbuthnot Banking
  Group, AIM ... offers a lighter regulatory touch
  ... it will provide some relief from the
  regulatory onslaught that is costing us 1.25m a
  year - a lot for a company whose profits last
  year were 5.5m Financial Times, July 14, 2005

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London two markets, different regulation

• Main Market of the LSE
• firms must satisfy formal listing requirements of
  the UK Listing Authority (UKLA).
• a Regulated Market under European securities
  laws.
• AIM
• firms do not satisfy UKLA requirements.
• not a Regulated Market, rather, an Exchange
  Regulated Market
• key role played by nominated advisors (nomads)
• both market segments have the same trading
  technology, and all companies are subject to
  normal UK law.
• firms have been switching in growing numbers
  between the two market segments, and the dominant
  flow is down to AIM.

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not just IPOs, companies are switching markets
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what is attractive about AIM?

• low regulatory and reporting burdens
• no requirement to comply with corporate
  governance codes
• no requirement for quarterly reporting
• flexible (no rules regarding minimum size of
  issue or proportion sold), low cost and quick
• for any country or region thinking about
  attracting IPOs AIM is worthy of careful study
• but clearly a key issue is reputation and
  investor acceptance such markets given that
  they tend to attract more early stage companies
  can be undermined by a few IPOs that turn out to
  be dogs
• London provides an interesting controlled
  experiment how do investors react when
  companies switch market?

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returns around announcement of a switch to AIM
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conclusions

• in recent years most countries have converged on
  the bookbuilding approach to conducting IPOs
• the original belief was that this should reduce
  the long-established underpricing of IPOs, but
  this did not happen
• since the IPO bubble of 1999/2000 more attention
  has been paid to alternative IPO techniques that
  may overcome the potential conflicts of interest
  faced by integrated investment banks
• these conflicts got more acute with the growth of
  hedge funds
• Competitive IPOs are one interesting response
  that could take off in other countries if issuers
  are prepared to flex their muscles
• as well as IPO techniques, attention has recent
  focused on regulation
• although the IPO market has been relatively
  depressed in recent years, the one success story
  has been the low-regulation markets such as AIM,
  alongside the collapse in US competitiveness
  post-SOX
• suggests more regulation of markets is not
  necessarily better