corporate valuation and financing
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Introduction
Equity Financing Initial Capital
» Very early stage “Family, Friends and Fools”, notion of Angel Investors» Venture capital firms=> specialized in raising capital for young firms» => often diversification benefits» =>possibility to benefit from expertise» => substantial costs in terms of control» Private Equity Firms
Invest in firms already existing» Institutional Investors (pension funds, insurance companies etc…)» Corporate Investors» Outside Investors
One general point of attention: the exit strategy
Prof H. Pirotte 2
Introduction
Introduction The natural evolution of firm’s capital
» Association of founders» Incorporation (shares owned by founders, key-employees and some early
investors)» Bank and private loans» Going public, mainly through an IPO a strategic decision
Steps» Awareness and preparation
Cleansing Manage as a public firm Change marketing strategy Develop key contacts
» The offer» The new corporate life
Primary vs. secondary issues
Going public Prof H. Pirotte 3
Introduction
Ex-ante Examination
» Realities, limits, willingness and HR requirements Don’t neglect other alternatives (is it a good timing for us?) Is it a good timing for the market?
» Estimation of the new cost structure» Advantages:
Diversifying founders’ wealth Establishing a market value of the firm Easier future operations Better visibility Better liquidity (?) Ready (+ -) to raise additional funds
» Disadvantages Direct costs (spread) and indirect costs (confidentiality) Loss of control Consequences of the information being revealed and public Suppression of implicit advantages for founders-entrepreneurs Liquidity depends on the market mechanisms and the type of the exchange
Going public Prof H. Pirotte 4
Introduction
Ex-post Evidence
» Any decision will be judged by the market» Rumours, internal and external events will have an impact» Never neglect your shareholders» You must keep the contact with the market» The management activity must be more structured, ready to justify any decision» Keep enough breath to guarantee the continuity of the strengths of the firm
Going public Prof H. Pirotte 5
Introduction
The Market It is highly dependent on the state of the economy and it generally concerns
» Firms of “new economies” and birth of “new markets”» Firms deciding to go public» Privatisations» Spin-offs
In Switzerland
IPO process
IPO en Suisse
0
5
10
15
20
25
30
1997 1998 1999 2000 2001 2002 2003
Le marché des IPO en Suisse
24%
24%13%9%
6%
5%
19%CSFB
UBS Warburg
Bank Vontobel
ZKB
Bank J ulius Bär
ABN Amro
Autres
Prof H. Pirotte 6
Introduction
Process Preliminary phase
» After approval of the Board of Directors, the managers ask for an “underwriter”. Role:
Advisory / Pricing / Sale of shares / Syndication» Selection of the investment banker: “competitive bid” or “negotiated offer”» Appraisal of fundamental data of the firm
Long-term planning and future opportunities» The firm uses the services of lawyers and expert accountants (via the investment
banker) to write the preliminary prospectus (“red herring”). Due diligence
» Follow-up of market conditions» Pre-marketing: analysis of attractiveness, price sensitivity, feedback
Final phase» Roadshow: presentation of the “equity story”» Once the corrections made following the comments of the regulatory commission,
the final prospectus is issued. “Tombstones” are used before and after the issuance (marketing the IPO)
» Bookbuilding and the book
IPO process Prof H. Pirotte 8
Introduction
Types of placements Usually, need of an underwriter
Nature» Cash offer» Rights offer
Market» Public placement» Private placement
Distinction between primary offering (new shares) and secondary offering (existing shares)
Modalities» Best efforts (commissioned, often with all or nothing clauses)» Firm commitment (bought deal)» Auction IPO (Open IPO) => bidders bid, offer is made at the price of the lowest bid allowing the sale of the
number of shares planned
Sherman (2005) => sealed bid IPO almost gone, mostly book building… because of risk reduction offered by the second method (number of investors evaluating the offering)
The process lasts several months and is concluded on the day of the issuance
IPO process Prof H. Pirotte 9
Introduction
Price and costs 3 main actors
» the issuing firm, the investment banker and the (potential) investors
How do the firm and banker price the issue?
What are the direct costs incurred by the firm?» Preparing: audit and accounting fees, legal fees, salaries, director’s fees, …» Offering: underwriter’s fees, audit and accounting fees, legal fees, road show,
printing costs, …» After!
Indirect costs» Underpricing
offering prices determined by the investment banking firm are systematically set below the fair market value of a security
» Announcement effect» Diversion of management
IPO process Prof H. Pirotte 10
Introduction
Short-term performance (underpricing)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
IPO underpricing Prof H. Pirotte 12
Introduction
Short-term performance (underpricing)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
IPO underpricing Prof H. Pirotte 13
Introduction
Short-term performance (underpricing)
Ritter & Welch (2002), A REVIEW OF IPO ACTIVITY, PRICING AND ALLOCATIONS, Yale Working Paper
IPO underpricing Prof H. Pirotte 14
Introduction
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
IPO underpricing Prof H. Pirotte 15
Introduction
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
IPO underpricing Prof H. Pirotte 16
Introduction
Short-term performance (underpricing)
Source: ECMI Paper, n°2, August 2006
IPO underpricing Prof H. Pirotte 17
Introduction
Short-term performance (underpricing) Various studies
Paper Period Abnormal Return (1st month)
Ibbotson [1975] 60-69 11.4 %
Ibbotson & Jaffe [1974] 60-70 16.8 %
Ritter [1984] 77-82 Firm commitment 14.8 %Best efforts 42.8 %
Paper Conclusion
Loughran & Ritter [1995] 5y 30% underperformance against benchmark
Brav and Gompers [1997]
Even with benchmark
Fama [1998] IPOs are typically small high-growth stocks and they all have low returns in the post-1963 period.
IPO underpricing Prof H. Pirotte 18
Introduction
But in the long-run… While all studies show a positive average of 19% abnormal return at the end of
the first trading day based on unadjusted returns, they show a negative abnormal performance in the long-run, underperforming the market by 23% over the next 3 years, or underperforming a benchmark portfolio of similar size and book-to-market ratio by 5%.(Copeland, Weston and Shastri 2005)
Puzzle?
Paper Conclusion
Loughran & Ritter [1995] 5y 30% underperformance against benchmark
Brav and Gompers [1997]
Even with benchmark
Fama [1998] IPOs are typically small high-growth stocks and they all have low returns in the post-1963 period.
IPO underpricing Prof H. Pirotte 19
Introduction
Evidence…
Paper Conclusion
Hickman [1953], Marsh [1982], Taggart [1977]
Fluctuations of outside finance raised via equity.
Firms issue equity after their own stock has risen relative to the market
Choe, Masulis & Nanda [1989] Negative reaction to announcement of an equity issue is smaller when volume of all equity issues is high.
Krigam, Shaw and Womack [1999]
First day winners continue to be winners over the first year.First day dogs continue to be relative dogs.Exception for extra-hot IPOs that provide the worst future perf.Large “informed” traders “flip” IPOs that perform the worst in the future. IPOs with low flipping perform well during the first 6 months. Flipping is predictable and underwriters pricing errors are intentional.1988-1995: 1’232 large-capitalization IPOs12%: +30% or more on the first trading day25%: closed at or below the offer price
IPO underpricing Prof H. Pirotte 20
Introduction
Evidence… (2)
Krigam, Shaw and Womack (1999), The Persistence of IPO Mispricing and the Predictive Power of Flipping, Journal of Finance.
IPO underpricing Prof H. Pirotte 21
Introduction
Why? Offer and demand (banker’s explanation) Truncated distribution (because of flipping…) Regulation
» Maximum issuing price must be filed with the SEC 2 weeks in advance of the actual offering creates a situation of “heads I lose, tails you win” for the underwriter
Information asymmetry and the winner’s curse (Rock [1986], Beatty & Ritter [1986], Carter & Manaster [1990])
Underpricing provides both protection and compensation for the se o the underwriter’s reputational capital (Booth and Smith [1986])
Insurance to protect underwriters against potential due diligence legal liabilities (Tinic [1988]) Signal by a more informed issuer to indicate firm value and variance of E(R) to less informed
investors (Greenblatt & Hwang [1989]) Other impacts tested through empirical evidence
» Trading mechanism
But the debate persists among researchers whether the systematic short-term underpricing of IPOs is rational or not.
IPO underpricing Prof H. Pirotte 22
Introduction
The winner’s curse The Medium guy and the Smart guy…
» Since prices tend to rise during the first hour of trading, Medium invests an equivalent amount in all IPOs. Can Medium obtain an abnormal return?
» Example Smart can take 1’000 shares
Medium can take 1’000 shares, and invests 100 shares by IPO A is an undervalued firm: Smart asks for 1’000 shares, Medium asks for 100 shares
But only 110 shares are issued: 100 for Smart and 10 for Medium. B is an overvalued firm: Medium asks for 100, Smart for 0.
» To avoid this phenomenon, issuing prices are understated by 30-40% to ensure a minimum riskfree rate to Medium.
IPO underpricing Prof H. Pirotte 23
Introduction
Rock (1986) Assumptions
» Prices and volumes are fixed» If demand > offer rationing» The firm wants to issue N shares» Each share has a value v (random variable, know probability density function f )» 2 types of investors
Uninformed: U investors owning 1€ each, don’t know v. Informed: total wealth of I, they know v.
» The firm doesn’t know v, but chooses p, the issuing price.» I < N E(v) the firm must attract uninformed investors» The demand of the uninformed investors depends on p, not on v.» Demand of informed investors
I if v > p 0 if v p
IPO underpricing Prof H. Pirotte 24
Introduction
Rock (1986) - 2 Model
» The profit of uninformed investors, if they invest is given by
» Uninformed investors receive more shares when v < p winner’s curse» To attract uninformed investors, the company must choose a price lower than E(v)
such that E(U) = 0
where
( ) ( - ) ( ) ( - ) ( )U
v p v p
UE v p f v dv v p f v dv
I U
max U such that E( ) 0 ( ) ( ) ( ) 0v p
p E V p v p f v dv
UI
I
IPO underpricing Prof H. Pirotte 25
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