Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on the registration statement and a preliminary prospectus has been distributed to interested investors, the investment bankers organize road showsin which they travel around the country to publicize the imminent offering. These road shows serve two pur- poses. First, they attract potential investors and provide them information about the offering.
Second, they collect for the issuing firm and its underwriters information about the price at
Issuing firm
Lead underwriter
Investment Banker A
Private investors
Investment Banker D Investment
Banker B
Investment Banker C
Underwriting syndicate Figure 3.1
Relationship among a firm issuing securities, the underwriters, and the public.
CONCEPT C H E C K
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QUESTION 1
Why does it make sense for shelf registration to be limited in time?
which they will be able to market the securities. Large investors communicate their interest in purchasing shares of the IPO to the underwriters; these indications of interest are called a bookand the process of polling potential investors is called bookbuilding. The book pro- vides valuable information to the issuing firm because large institutional investors often will have useful insights about the market demand for the security as well as the prospects of the firm and its competitors. It is common for investment bankers to revise both their initial es- timates of the offering price of a security and the number of shares offered based on feed- back from the investing community.
Why would investors truthfully reveal their interest in an offering to the investment banker? Might they be better off expressing little interest in the hope that this will drive down the offering price? Truth is the better policy in this case because truth-telling is re- warded. Shares of IPOs are allocated to investors in part based on the strength of each in- vestor’s expressed interest in the offering. If a firm wishes to get a large allocation when it is optimistic about the security, it needs to reveal its optimism. In turn, the underwriter needs to offer the security at a bargain price to these investors to induce them to participate in bookbuilding and share their information. Thus IPOs commonly are underpriced com- pared to the price at which they could be marketed. Such underpricing is reflected in price jumps on the date when the shares are first traded in public security markets.
The most dramatic case of underpricing occurred in December 1999 when shares in VA Linux were sold in an IPO at $30 a share and closed on the first day of trading at $239.25, a 698% one-day return. Similarly, in November 1998, 3.1 million shares in theglobe.com were sold in an IPO at a price of $9 a share. In the first day of trading the price reached $97 before closing at $63.50 a share.
While the explicit costs of an IPO tend to be around 7% of the funds raised, such un- derpricing should be viewed as another cost of the issue. For example, if theglobe.com had sold its 3.1 million shares for the $63.50 that investors obviously were willing to pay for them, its IPO would have raised $197 million instead of only $27.9 million. The money
“left on the table” in this case far exceeded the explicit costs of the stock issue.
Figure 3.2 presents average first-day returns on IPOs of stocks across the world. The re- sults consistently indicate that the IPOs are marketed to the investors at attractive prices.
Underpricing of IPOs makes them appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some view this as unfair discrimination against small investors. However, our discussion suggests that the apparent discounts on IPOs may be no more than fair payments for a valuable service, specifically, the information con- tributed by the institutional investors. The right to allocate shares in this way may con- tribute to efficiency by promoting the collection and dissemination of such information.1
Pricing of IPOs is not trivial, and not all IPOs turn out to be underpriced. Some stocks do poorly after the initial issue and others cannot even be fully sold to the market. Under- writers left with unmarketable securities are forced to sell them at a loss on the secondary market. Therefore, the investment banker bears the price risk of an underwritten issue.
Interestingly, despite their dramatic initial investment performance, IPOs have been poor long-term investments. Figure 3.3 compares the stock price performance of IPOs with shares of other firms of the same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs is dramatic, suggesting that on average, the in- vesting public may be too optimistic about the prospects of these firms. (Theglobe.com, which enjoyed one of the greatest first-day price gains in history, is a case in point. Within the year after its IPO, its stock was selling at less than one-third of its first-day peak.)
1An elaboration of this point and a more complete discussion of the book-building process is provided in Lawrence Benveniste and William Wilhelm, “Initial Public Offerings: Going by the Book,” Journal of Applied Corporate Finance9 (Spring 1997).
IPOs can be expensive, especially for small firms. However, the landscape changed in 1995 when Spring Street Brewing Company, which produces Wit beer, came out with an Internet IPO. It posted a page on the World Wide Web to let investors know of the stock of- fering and distributed the prospectus along with a subscription agreement as word-pro- cessing documents over the Web. By the end of the year, the firm had sold 860,000 shares to 3,500 investors, and had raised $1.6 million, all without an investment banker. This was admittedly a small IPO, but a low-cost one that was well-suited to such a small firm. Based
Percentage average initial return
100 80 60 40 20 0
Malaysia Korea Brazil Thailand Portugal Taiwan Sweden Switzerland Spain Mexico Japan New Zealand Italy Singapore Australia Hong Kong Chile United States United Kingdom Germany Belgium Finland Netherlands Canada France
Figure 3.2 Average initial returns for IPOs in various countries.
Source: Tim Loughran, Jay Ritter, and Kristian Rydquist, “Initial Public Offerings: International Insights,” Pacific-Basin Finance Journal2 (1994), pp. 165–99.
Annual percentage return
20
15
10
5
0
Non-issuers IPOs
Fifth Year Fourth
Year Third
Year Second
Year First
Year
Figure 3.3 Long-term relative performance of initial public offerings.
Source: Tim Loughran and Jay R. Ritter, “The New Issues Puzzle,” The Journal of Finance50 (March 1995), pp. 23–51.
on this success, a new company named Wit Capital was formed, with the goal of arranging low-cost Web-based IPOs for other firms. Wit also participates in the underwriting syndi- cates of more conventional IPOs; unlike conventional investment bankers, it allocates shares on a first-come, first-served basis.
Another new entry to the underwriting field is W. R. Hambrecht & Co., which also con- ducts IPOs on the Internet geared toward smaller, retail investors. Unlike typical invest- ment bankers, which tend to favor institutional investors in the allocation of shares, and which determine an offer price through the book-building process, Hambrecht conducts a
“Dutch auction.” In this procedure, which Hambrecht has dubbed OpenIPO, investors sub- mit a price for a given number of shares. The bids are ranked in order of bid price, and shares are allocated to the highest bidders until the entire issue is absorbed. All shares are sold at an offer price equal to the highest price at which all the issued shares will be ab- sorbed by investors. Those investors who bid below that cut-off price get no shares. By al- locating shares based on bids, this procedure minimizes underpricing.
To date, upstarts like Wit Capital and Hambrecht have captured only a tiny share of the underwriting market. But the threat to traditional practices that they and similar firms may pose in the future has already caused a stir on Wall Street. Other firms also distribute shares of new issues to online customers. Among these are DLJ Direct, E*Offering, Charles Schwab, and Fidelity Capital Markets. The accompanying box reports on recent develop- ments in this arena.
Nothing gets online traders clicking their “buy” icons so fast as a hot IPO. Recently, demand from small investors using the Internet has led to huge price increases in shares of newly floated companies after their initial pub- lic offerings. How frustrating, then, that these online traders can rarely buy IPO shares when they are handed out. They have to wait until they are traded in the mar- ket, usually at well above the offer price.
Now, help may be at hand from a new breed of Inter- net-based investment banks, such as E*Offering, Wit Capital and W. R. Hambrecht, which has just completed its first online IPO. Wit, a 16-month-old veteran, was formed by Andrew Klein, who in 1995 completed the first-ever Internet flotation, of a brewery. It has now taken part in 55 new offerings.
Some of Wall Street’s established investment banks al- ready make IPO shares available over the Internet via electronic brokerages. But cynics complain that the tiny number of shares given out is meant merely to publicize the IPO, and to ensure strong demand from online in- vestors later on. Around 90% of shares in IPOs typically go first to institutional investors, with the rest being handed to the investment bank’s most important individ- ual clients. They can, and often do, make an instant killing by “spinning”—selling the shares as prices soar on the first trading day. When e-traders do get a big chunk of shares, they should probably worry. According to Bill
Burnham, an analyst with CSFB, an investment bank, Wall Street only lets them in on a deal when it is “hard to move.”
The new Internet investment banks aim to change this by becoming part of the syndicates that manage share-offerings. This means persuading company bosses to let them help take their firms public. They have been hiring mainstream investment bankers to establish cred- ibility, in the hope, ultimately, of winning a leading role in a syndicate. This would win them real influence over who gets shares. (So far, Wit has been a co-manager in only four deals.)
Established Wall Street houses will do all they can to stop this. But their claim that online traders are less loyal than their clients, who currently, receive shares (and promptly sell them), is unconvincing. More debatable is whether online investors will be as reliable a source of demand for IPO shares as institutions are. Might e-trad- ing prove to be a fad, especially when the Internet share bubble bursts?
Company bosses may also feel that being taken to market by a top-notch investment bank is a badge of quality that Wit and the rest cannot hope to match. But if Internet share-trading continues its astonishing growth, the established investment banks may have no choice but to follow online upstarts into cyberspace. Even their loyalty to traditional clients may have virtual limits.
Source: The Economist, February 20, 1999.
3.2 WHERE SECURITIES ARE TRADED
Once securities are issued to the public, investors may trade them among themselves. Pur- chase and sale of already-issued securities take place in the secondary markets, which con- sist of (1) national and local securities exchanges, (2) the over-the-counter market, and (3) direct trading between two parties.