Initial Public Offerings (IPOS) (Finance)

In contrast to a seasoned offering, an IPO is the offering of shares of a company that are not publicly traded. The most common are IPOs of fixed-income securities, equity securities, warrants, and a combination of equity shares and warrants (“units” ). The term IPO is often used to refer only to equity or unit offerings, and the remainder of this entry concentrates only on equity and unit offerings in the United States.

In “best-effort” IPOs, underwriters act only as the issuer’s agent; in “firm-commitment” IPOs, underwriters purchase all shares from the issuer and sell them as principal. In the USA, virtually all IPOs by reputable underwriters are sold as firm commitment. Other special IPO categories are (domestic tranches of) international IPOs, reverse leveraged buyouts (where company shares had been traded in the past), real estate investment trusts (REITs), closed-end funds, and venture-capital backed IPOs, etc. Most IPOs begin trading on Nasdaq.

Most IPOs typically allow a company founder to begin to “cash out” (secondary shares), or begin to raise capital for expansion (primary shares), or both. (Issuers sometimes constrain shares granted to insiders from sale for a significant amount of time after the IPO in order to raise outside demand.) Direct underwriter fees and expenses of the IPO typically range from 7-20 percent (mean of about 15 percent). Auditor fees range from US$0-80,000 (mean of about US$50,000), lawyer fees from US$0-130,000 (mean of about US$75,000). In addition, issuers must consider the cost of warrants typically granted to the underwriter, a three- to six-month duration to prepare for the IPO, the costs and time of management involvement, prospectus printing costs, and subsequent pub lic release requirements. Consequently, many firms avoid IPOs despite the advantages and prestige of a public listing, relying instead on private or venture capital, banks, trade credit, leases, and other funding sources. Even IPO issuers tend to issue only a small fraction of th e firm, and return to the market for a seasoned offering relatively quickly.

In the USA, numerous federal, state, and NASD issuing regulations have attempted to curtail fraud and/or unfair treatment of investors. Among the more important rules, in section 11 of the 1993 Securities Act, the SEC describes necessary disclosure in the IPO prospectus. Issuers are required to disclose all relevant, possibly adverse information. Failure to do so leave not only the issuer, but also the underwriter, auditor, and any other experts listed in the prospectus liable. The SEC rules prohibit marketing or sales of the IPO before the official offering date, although it will allow the underwriter to go on roadshows and disseminate a “preliminary prospectus” (called “red herring” ). Further, underwriters must offer an almost fixed number of shares at a fixed price, usually determined the morning of the IPO. (Up to a 15 percent over-allotment (“green shoe”) option allows some flexibility in the number of shares.) Once public, the price or number of shares sold must not be raised even when after-market demand turns out better than expected. Interestingly, although US underwriters are not permitted to “manipulate” the market, they are allowed to engage in IPO after-market ”stabilization” trading for thirty days.

Some countries (such as France) allow different selling mechanisms such as auctions. Other countries (such as Singapore), do not allow the underwriter the discretion to allocate shares to preferred customers, but instead require proportional allocation among all interested bidders.

There are two outstanding empirical regularities in the IPO market that have been documented both in US and a number of fore ign markets: on average, IPOs see a dramatic one-day rise from the offer price to the first aftermarket price (a 5-15 percent mean in the USA) and a slow but steady long-term underperformance relative to equivalent firms (a 5-7 percent per annum mean for three to five y ears after the issue for 1975-84 US IPOs). Prominent explanations for the former regularity, typically referred to as “IPO underpricing,” have ranged from the winner’s curse (in which investors require average underpricing because they receive a relatively greater allocation of shares when the IPO is overpriced), to cascades (in which issuers underprice to eliminate the possibility of cascading desertions especially of institutional investors), to signaling (in which issuers underprice to “leave a good taste in investors’ mouths” in anticipation of a seasoned equity offering), to insurance against future liability (to reduce the probability of subsequent class action suits if the stock price drops), to preselling (where underpricin g is necessary to obtain demand information from potential buyers). The consensus among r esearchers and practitioners is that each theory describes some aspect of the IPO market. Empirical findings related to IPO underpricing also abound. For example, IPOs of riskier offerings and IPOs by smaller underwriters tend to be more underpriced, and both IPOs and IPO underpricing are known to occur in “waves” (while 1972 and 1983 saw about 500 IPOs, 1975 saw fewer than 10 IPOs; 1991-94 saw about 500 IPOs per year). Noteworthy is the hot market of 1981, which saw an average underpricing in excess of 200 percent among natural resource offerings.

Table 1 Total Firm Commitments IPOs

Explanations for the long-term underperformance have yet to be found. This poor performance is concentrated primarily among very young, smaller IPO firms. (Indeed, IPOs of financial institutions and some other industries have significantly outperformed their non-IPO benchmarks.) Many of the smaller IPO firms are highly illiquid and thus more difficult to short, preventing sophisticated arbitrageurs from eliminating the underperformance. Because once the IPO has passed, shares of IPOs are tradeable, like other securities, the long-run underperformance of IPOs presents first and foremost a challenge to proponents of specific equilibrium pricing models and efficient stock markets.

Other theoretical and empirical work among IPO firms has concentrated on the role of the expert advisors and venture capitalists in the IPO, subsequent dividend payouts and seasoned equity offerings, institutional ownership, etc . Information on current IPOs is regularly published in the Wall Street Journal, the IPO Reporter, Investment Dealers Digest, and elsewhere. Securities Data Corp maintains an extensive data base of historical IPOs. Institutional and legal details on the IPO procedure can be found in Schneider et al. (1981).