FOF1

• Initial capital 50.000€

• Business plan and organizatinal structure

• Investment conditions

• Details of the investment strategies

• Qualification of the management

The investment bank managing the IPO along with the company going public suggest the starting/offer price.

• a states education level

• economic climate (freedom)

• Degree of urbanization

• Whether a state has a major financial center

The number of new IPOs as well as the number of public companies have been broadly declining in Germany since the 1950s. Simultaneously, the number of delisting has increased. The same holds true for the US.

• Carve-out: Parent company sells shares in its subsdiary to the public. -> Creating a new independent public listed company out of an exisiting parent company.

  One example is Porsche and VW.

• Spin-off: Separate listing of part of an exsting listed company. -> Creating a new independent public listed company out of an existing parent company.

  An example is E-On and its spin-off Uniper.

• Direct Listing -> company shares become public without a formal IPO.

  No investment Bank (less regularity, faster process).

  No issue of new shares (limited number of shares).

• SPAC -> Company formed for the exclusive purpose of raising money through an IPO. It uses the money to acquire and merge with a private company.

With both a carve-out and a spin-off, a new independent publicly listed company is created from an existing parent company.

However, in a *carve-out*, new shares of a subsidiary are *sold* to the public. A recent example of this is the IPO of Porsche.

With a *spin-off* on the other hand, the shares are *distributed* to the existing shareholders of the parent company. A recent example is Daimler Trucks.

• Issuing company

• Investment banks

• Investors

• Regulation Authorities

• Brokers

• Derivative Markets

• New Capital: almost all companies go public primarily because they need money for new projects (or the reduction of leverage)

• Image: Public firms tend to have higher profiles than private firms

• Future Capital: once public, firms can easily go back to the public markets to raise additional cash

• Loss of confidentiality: Going public could destroy the business if the company has to disclose its technology or profitability to its competitors

• Loss of control: Outsiders could take control and even fire the entrepreneur

• Stronger agency problems: New shareholders have more different motives than former owner/managers

Employee compensation: Having a public share price makes it easy for firms to give employees a formal stake in the company.

According to the Modigliani/Miller theorem and the Efficient Market Hypothesis, issuing new securities via an IPO should not, on average, provide a positive net present value (NPV) opportunity for the company. This is because, in an efficient market, the new shares will be priced fairly based on all available information.

ChatGPT: Der Zeitpunkt einer finanziellen Entscheidung sollte keine Rolle spielen, weil laut der Theorie der effizienten Märkte alle verfügbaren Informationen bereits im aktuellen Preis eines Finanzinstruments enthalten sind. Das bedeutet, dass es keine systematischen Vorteile durch zeitliche Planung gibt, da Preise sich zufällig und nicht vorhersehbar ändern.

• Private shareholders in public firms are much better diversified than those in private firms. -> Large investors in private firms have considerably more bargaining power against the entrepreneur than small private investors in a public company.

• In public companies a much larger group of investors must be convinced about the quality of the firm’s projects (and the firm’s management). -> In equilibrium, any such costs expended by outsiders in evaluating the firm’s projects will be borne by the firm in form of a lower share price.

• When a firm goes public, the common price at which the shares are sold is publicly observable by all outside investors – the total costs involved in the outsider’s evaluation of the firm’s projects will be reduced somewhat: many unsophisticated investors being able to free ride

Companies tend to take on debt with longer repayment periods due to improved public information and stronger bargaining positions.

When a firm goes public, the common price at which the shares are sold is publicly observable by all outside investors – the total costs involved in the outsider’s evaluation of the firm’s projects will be reduced somewhat: many unsophisticated investors being able to free ride

(Konsequenzen von vorigen Folien?)

• When a pioneer company in an industry successfully goes public, it provides valuable market information about the industry's valuation and reduces the uncertainty for other companies. This makes subsequent IPOs easier and more attractive, as investors have a benchmark for assessing the value of similar companies​.

• High valuations or strong market sentiment in a specific industry can prompt multiple companies to go public simultaneously. These conditions allow firms to capitalize on higher offer prices, reducing the dilution of control for existing owners and maximizing the funds raised​.

• Main factor affecting the probability of an IPO is the market-to-book ratio at which firms in the same industry trade!

• Second most important determinant is the size of the company: Larger companies are more likely to go public

• Firms with projects that are cheaper for outsiders to evaluate, and operating in industries characterized by less information asymmetry are more likely to go public.

Because firms of the same industry that go public later in time are able to free ride on the costly information generated by those in the industry that have gone public ahead of them. Information asymmetries were closed by the pioneers. For example, the valuation of the company.

Underpricing = money left on the table -> Difference between the offering price and the market price at the end of the first day/weeks of the offering date. „Money left on the table”

• With a higher offer price, proceeds of the offering would have been higher by an amount equal to the money left on the table-> the same proceeds could have been raised by selling fewer shares -> less dilution for shareholders.

• Money left of the table can be 2 times the fees of investment bank or 3 years of aggregate profits

There is asymmetric information between all parties of an IPO (issuer, investor, underwriter). This results in the following hypothesis:

• Winners curse: two types of investor:

  • informed investors: They know the real value of the company; therefore they only buy underpriced shares

  • uninformed investors: They dont kow the true value of the company

  Good offerings: Informed investors are more likely to buy underpriced shares, while less informed investors get only a limited allocation of the most desirable shares. This leads to strong demand but not necessarily underpricing. Less informed investors may be at a disadvantage.

  Bad offerings: Less informed investors receive full allocations, often resulting in lower-than-expected returns (Winners curse).

  IPOs need to be sufficiently underpriced on average to compensate for allocation bias.

• Market Feedback Hypothesis explains that IPOs are deliberately underpriced to incentivize investors to reveal their true valuations.

  • Problem: Investors withhold positive information to benefit from low initial prices.

  • Solution: Underpricing compensates investors for sharing information, leading to more accurate pricing.

  • Mechanism: Through bookbuilding, IPO share allocations are tied to bid prices. Honest and higher bids secure larger allocations and higher profits, motivating investors to disclose their true valuations.

  • Empirical Evidence: Greater underpricing occurs with positive price revisions; institutional investors benefit from larger allocations due to their valuable information.

  Underpricing and bookbuilding together optimize price discovery and maximize total proceeds in the long term.

• Signalling Hypothesis: Strategy: Underpriced IPOs create a good impression, allowing firms to sell shares at higher prices in future SEOs.

  Signalling Hypothesis:

  • Underpricing signals high quality.

  • Low-quality firms cannot afford the loss and thus cannot imitate high-quality firms.

  Criticism:

  • No clear link between underpricing and SEOs in empirical studies.

  • Extreme fluctuations in equity issuance volumes challenge the theory.

  • The success of an SEO depends on favorable market conditions.

Advantages of Underpricing:

1. Investor Appeal: Low initial prices attract investors with high first-day returns, boosting interest in future offerings.

2. Signaling Quality: Signals high quality, as companies may recoup losses in future equity sales (SEOs).

Disadvantages of Underpricing:

1. "Money Left on the Table": The company raises less capital due to undervalued offering prices.

2. Dilution: More shares need to be sold to raise the same amount, reducing original owners' control.

Advantages of Overpricing:

1. Maximized Revenue: Higher prices raise more capital with fewer shares sold.

2. Market Value Signal: Can signal confidence and strength in the company.

Disadvantages of Overpricing:

1. Negative Market Reaction: Overvaluation may deter investors, leading to first-day price drops.

2. Reputation Risk: Consistently overpriced offerings harm trust in the company and its underwriters.

• No observable market price prior to the offering.

• Many of the issuing firms have little or no operating history.

• If the price is set too low, the issuer does not get the full advantage of its ability to raise capital.

The Winner’s Curse occurs in IPOs due to information asymmetry:

• Informed investors only buy underpriced IPOs.

• Uninformed investors often get larger allocations of overpriced IPOs, leading to lower average returns.

Example: 2 types of IPO, good (20% underpricing) and bad (-5% return on first day). Both are equally likely, probability of 50%. Total volume of IPO 1500.

Order Volume of well-informed investors: 500 for good IPOs, 0 for bad IPOs.

Order Volume of less well-informed investors: 1500 for good IPOs, 1500 for bad IPOs

Good IPO - Order volume is 1500+500=2000

Less well-informed investors only get 1500/2000=75% of order volume (ich glaube die well-informed investors kriegen dann auch nur 75%?)

Bad IPO - Order volume is 1500, IPO volume is 1500.

Less well-informed investors get 100%. expected return for less informed investors:

The Market Feedback Hypothesis explains IPO underpricing as a mechanism to gather truthful valuation information from investors. By offering underpriced shares, issuers incentivize institutional investors to reveal positive information during the IPO process. This practice maximizes expected proceeds by ensuring a more accurate pricing of shares.

Decision to go public: firm typically sells 20-40% of its stock to the public

Beauty Contest and IPO Pitches: Issuer (firm) hires investment bankers to assist in pricing and marketing the stock

Selection of Underwriter(s): An issuer will generally choose a lead underwriter on the basis of its experience, especially with IPOs in the same industry

Definition the IPO structure: For young companies, most or all of the shares being sold are typically newlyissued (primary shares), with the proceeds going to the company.

Preparation of documents & filings, company valuation and analysis: In cooperation with outside counsel, the investment banker will also conduct a “due diligence” investigation of the firm, write the prospectus, and file the necessary documents with the supervisory authorities.

Roadshow and Bookbuilding: After the preliminary prospectus (in the US: ‘red herring,’ since on the frontpage certain warnings are required to be printed in red) is issued, the company management and investment bankers conduct a marketing campaign for the stock

Order taking, Price setting: Most companies prefer an offer price of between $10.00 and $20.00 per share, firms frequently conduct a stock split to get into the target price range

Allotment: ?

Price Support ?

• For young companies, most or all of the shares being sold are typically newlyissued (primary shares), with the proceeds going to the company.

• With older companies going public, it is common that many of the shares being sold come from existing stockholders (secondary shares).

• Does the Underwriter play a role in underpricing?

  • Higher underwriter reputation leads to higher underpricing

  • This effect reduces when there has been a relationship between underwriter and issuer before the IPO

  • Also evidence that social ies between the investment bank and the firm prior to the IPO play an important role for ultimate outcome of an IPO.

  • An investment bank is more likely to be included in the underwritig syndicate if social ties exist between the firm and the bank prior to the IPO

• Can regulation reduce underpricing?

  • The Sarbanes Oxley Act of 2002 leads to a reduction in underpricing of shares

• Does venture capital reduce IPO underpricing?

  • Yes – Evidence that venture capital backed IPOs with high R&D spending experience lower underpricing than non-venture capital backed IPO

• Does the institutional and legal environment influence underpricing?

  • Yes – Differences in the legal and institutional environment potentially play an important role when it comes to the height of the initial underpricing.

Evidence that venture capital backed IPOs with high R&D spending experience lower underpricing than non-venture capital backed IPOs

Venture capital seems to be reducing information asymmetries and therefore provide a positive signaling effect and suggesting that the company has a higher quality.

Higher underwriter reputation leads to higher underpricing.

Analyst coverage became more important -> More reputable underwriters can provide superior analyst coverage, higher underpricing as a “fee” for better analyst coverage.

There is evidence that social ties between the investment bank and the firm prior to the IPO play an important role for the ultimate outcome of the IPO.

An investment bank is more likely to be included in the underwriting syndicate if social ties exist between the firm and the bank prior to the IPO

1. classical 2. decoupled

Firm and underwriter do the marketing phase and set the price range

“decoupled process” = Marketing and order taking phase simultaneously + price range is set before marketing

“coupled process” = Marketing and order taking phase separate +price range is set before marketing

Main differences to previous procedures are in the underwriters role in all stages of the IPO:

• During the road show underwriters market the offering to potential investors

• The underwriter has much more price-setting power than in other procedures.

• Underwriters allocate shares in a discretionary manner.

Pre-marketing:

• Preparation of research reports and “equity story”

• Underwrites talk informally to investors

• Price indication from first feedback of investors

• Initial price range set

Fixed Price Offer:

• Advantages:

  • Simple and predictable process for investors.

  • Lower transaction costs for issuers.

• Disadvantages:

  • Potential for high underpricing due to fixed prices being set conservatively.

  • No mechanism to reward investors who provide useful market information.

Auction (e.g., Dutch Auction):

• Advantages:

  • More transparent as it reflects true market demand.

  • Can reduce underpricing compared to other methods.

• Disadvantages:

  • Risk of over-complicated processes deterring institutional investors.

  • High volatility in IPO pricing due to reliance on bidder behavior​

Allocation Methods in IPOs

1. Fixed Price Allocation:

   • Explanation: Shares are offered at a predetermined fixed price. Investors submit requests for a certain number of shares at this price. If demand exceeds supply, shares are typically rationed on a pro-rata or lottery basis.

     A fixed-price offer has the offer price set prior to requests for shares being submitted.

     The longer the time that elapses between the time a fixed offer price is set and trading begins, the higher is the average first-day return.

   • Timeline: Valuation by investment bank -> Offer price published -> Subscription period -> Pro rata allocation to subscribers -> Placement risk is taken by the investment bank

   • Advantages:

     • Simple and predictable for investors.

     • Relatively low administrative complexity.

   • Disadvantages:

     • Difficult to allocate shares efficiently

     • Risk of underpricing due to inflexible price setting.

2. Auction-Based Allocation (e.g., Dutch Auction):

   • Explanation: Investors submit bids specifying the quantity of shares and the price they are willing to pay. The final price is set to clear the market or slightly below the market-clearing price. All successful bidders pay the same price.

   • Advantages:

     • Encourages truthful bids reflecting actual demand.

     • Reduces underpricing compared to fixed-price mechanisms.

   • Disadvantages:

     • Process complexity can deter participation, especially by institutional investors.

     • Volatility in pricing due to variations in bidding behavior​.

3. Bookbuilding:

   • Explanation: Investment banks or underwriters conduct a "roadshow" to gauge investor interest and gather non-binding bids. Based on this feedback, they set a price range, accept binding bids, and allocate shares discretionarily, focusing on strategic investors.

   • Advantages:

     • Allows issuers to gather market insights and adjust pricing dynamically.

     • Provides flexibility in allocating shares to preferred investors (e.g., long-term institutional investors).

   • Disadvantages:

     • High transaction costs due to marketing and underwriting activities.

     • Potential for favoritism in allocation decisions​.

4. Hybrid Models (e.g., French "Offre à Prix Minimal"):

   • Explanation: Combines elements of auctions and bookbuilding, allowing for non-discretionary allocation within a predefined price range.

   • Advantages:

     • Balances transparency and flexibility.

     • Discourages speculative bidding by setting realistic price caps.

   • Disadvantages:

     • Moderately complex to implement and execute.

     • Limited use outside specific markets like France​

1. Timing of Order The timing of when an investor submits their bid is important. The notes indicate that on average, 56% of all demand arrives in the three-day period prior to closing the book. Earlier or later submission can influence allocation.

2. Investor Quality and Rating The slides explicitly mention that the "rating" of the investor is a critical criterion in the allocation process. This suggests that underwriters assess and rank investors based on various qualitative factors.

3. Bid Characteristics Several bid-related factors influence allocation:

• Larger bids have a stronger influence on price setting

• Bids from investors who frequently participate in bookbuilding exercises carry more weight

• Limit prices submitted by bidders strongly influence the final price, with the price often set close to the quantity-weighted average of limit prices

1. Distribution Objectives of the Issuer The allocation decision depends not just on technical factors, but also on the broader distribution objectives of the company issuing the shares. This implies that strategic considerations about who ultimately holds the shares can play a role.

2. Price of the Bid The demand and the price at which it is computed are interconnected. Underwriters effectively choose the level of oversubscription when setting the issue price, which in turn affects allocation.

According to the lecture notes, before bookbuilding, the most commonly used method was the Fixed Price Offering (also known as open offers, universal offers, or simply "the IPO method").

Problems with Fixed Price Offerings:

1. Pricing Limitations

• Offer price was set prior to receiving share requests

• No flexibility in pricing mechanism

• Difficult to accurately value the shares

1. Allocation Issues

• If excess demand existed, shares were typically rationed

• Investors had to commit money without knowing if they would receive shares

• Requests for large share numbers were often cut back more than moderate requests

1. Information Asymmetry

• No way for the underwriter to reward investors who provide information

• Underwriters could not effectively gauge market demand

1. Systematic Underpricing

• Example: In Japan before April 1989, a mathematical formula was used to set prices

• Despite this formula, average initial returns were extremely high at 62.1%

1. Investor Constraints

• Investors were required to put up money to buy shares without knowing:

  • How many shares they would actually receive

  • The true market value of the shares

1. Limited Market Adaptation

• The method became increasingly inadequate, especially for large privatizations

• Countries were forced to try new methods like auctions and bookbuilding

• Particularly challenging when floating extremely large companies that couldn't be absorbed by local markets

1. If there is excess demand, shares are typically rationed on a pro rata or lottery basis

2. Requests for large numbers of shares are often cut back more than requests for more moderate numbers of shares

3. There is no way for the underwriter to reward investors who provide information

4. In most countries, fixed-price offerings were the predominant form of allocation until the 1990s

5. Investors had to put up money to buy shares without knowing whether they would receive many shares

1. Stabilizing Bid

• Underwriters post a stabilizing bid to purchase shares at a price not exceeding the offer price

• This method postpones a potential price drop (referred to as "pure" stabilization)

1. Short Position Method

• Underwriters initially sell shares in excess of the original amount offered, creating a short position prior to the offering

• This short position can be covered by: a) Exercising the overallotment option (Greenshoe option) b) Short covering in the aftermarket

Additional key points about price stabilization:

• Underwriters do not formally commit to price support (it's only mentioned as a possibility in the prospectus)

• Stabilizing activities are not publicly disclosed

• Stock prices tend to be extremely rigid at and below the offer price

• Stabilization typically lasts for a short period (in Germany, 30 calendar days)

The slides emphasize that "pure stabilization" is rarely done, and aftermarket short covering is the principal form of stabilization, with almost no disclosure requirements.

Based strictly on the lecture slides, the Greenshoe option contributes to price stabilization in two scenarios:

Scenario 1: Positive Share Price Performance

• If the offering is strong and the stock price goes up

• The underwriter covers its short position by exercising the Greenshoe option at the original offering price

• The underwriter receives an additional gross margin on the proceeds from the overallotted shares

Scenario 2: Negative Share Price Performance

• If the offering is weak and the stock price goes down

• The underwriter does not exercise the Greenshoe option

• Instead, the underwriter buys back all or part of the extra 15% of shares in the market

• This action supports the stock price

Key characteristics of the Greenshoe option:

• Allows underwriters to sell 115% of the firm's shares at the offering

• Provides buying support for shares without exposing the underwriter to excessive risk

• Gives the underwriter a maximum of 30 days to exercise the option and stabilize prices

• Enables the underwriter to have buying power in the aftermarket to support the newly traded security's price

The slides emphasize that this mechanism is part of the underwriter's larger responsibility to support the issue's price.

What can be seen in the graphic:

• The graphic shows the profit (Y-axis) in relation to the stock price (X-axis)

• It depicts three different payoff lines:

  1. Payoff of the short position in stocks

  2. Payoff of the Greenshoe option

  3. Total payoff of the Greenshoe option and the short position

Explanation of the effect:

• The graphic demonstrates how the underwriter's financial position changes depending on the stock price movement after the IPO

• It shows the flexibility of the Greenshoe option in different market scenarios

• The total payoff line indicates how the underwriter can mitigate risk and potentially profit

Reasons:

• The Greenshoe option provides a risk management mechanism for underwriters

• It allows for price stabilization by giving underwriters the ability to:

  1. Support the stock price if it falls below the issue price

  2. Profit from additional share sales if the price rises

• This mechanism helps protect both the issuing company and investors from significant price volatility immediately after the IPO

1. Substantial direct costs (average 7% of IPO volume in the US)

2. Long-term underperformance (e.g., IPOs showing -19.3% performance after three years)

3. Complex process involving underwriting syndicates and fees

1. A period during which existing shareholders agree not to sell their shares

2. Typically lasts 180 days (approximately 6 months)

1. Reassure the market that key employees will continue to apply themselves

2. Provide a credible signal that insiders are not cashing out before bad news

3. Aid underwriters' price support efforts by constraining share supply

1. 20% management fee to lead manager (for due diligence, prospectus, pricing, etc.)

2. 20% underwriting fee (for placement risk and price stabilization)

3. 60% selling concession (commission for shares sold by syndicate members)

1. US: Average 7% of IPO volume

2. Other countries: Approximately 3.5% (about half of US costs)

1. Large jump in trading volume on expiration date (61% larger than pre-event)

2. Average 1.15% stock price drop on lock-up expiration

3. Permanent volume shift of around 38%

4. Largely driven by venture capital-backed firms

5. More negative returns when insiders disclose share sales

1. This contradicts the empirical evidence, which shows that 77.5% of IPOs underperform

2. The slides indicate most IPOs are underpriced initially but perform poorly long-term

Less reputable underwriters result in:

• Lower initial underpricing (0.6% compared to 9.1% for top-10 underwriters)

• Worse long-term performance (average three-year returns of -22.1%)

These characteristics increase the likelihood of eventually being included in an index (like S&P 500):

• High-reputation underwriter

• Larger firm size

• Higher Return on Assets (ROA)

• High-tech industry company

• Venture capital backing