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Initial public offerings 2
Published on January 18, 2015 36 min
Other Talks in the Series: Corporate Financing
Traditional theories of capital structure: trade-off versus pecking order
- Prof. Vidhan K. Goyal
- Hong Kong University of Science and Technology, Hong Kong
Raising funds in the secondary markets a brief review of the academic research related to Seasoned Equity Offers (SEOs)
- Prof. Ajai Singh
- Lehigh University, USA
All right, so we've talked a little bit about the US IPO market in general, and we talked about Twitter in particular. Let's talk about some of the interesting aspects of IPOs.
Let's start with underpricing, which is probably the most interesting one. Again, what did we see? We saw Twitter was offered at $26 a share, and it closed on the first day of trading at roughly $45 a share. So, investors that were able to buy at $26 a share made a lot of money. We saw from Jay Ritter's information that he collected that IPO initial returns on average are roughly 18%. So, even if you didn't get the 70 plus percent rate of return associated with buying the Twitter IPO, if you just buy a typical IPO, you're making a pretty good amount of money over a very, very short period of time. So, what I want to talk about is this Rock winner's curse model. It was published back in 1986, and by the way there's going to be a list of all these papers and citations, and you'll be able to see these articles and where to find them. So, the Rock winner's curse model basically notes that IPOs are underpriced. If you can buy at the initial offering price, you can make a pretty good amount of money. If we think about the 18%, on average IPOs are underpriced by 18%, but that's just on average. Some IPOs are underpriced by much more than 18%, Twitter was an example. But a lot of IPOs have lower initial returns, and a significant number of those are negative. So, on average you make 18%, sometimes more, sometimes less, Rock points out, and this makes sense, that there are two types of participants in the IPO market. There are informed investors, people that have a pretty good feel for what these IPO stocks are really worth, and maybe a bunch of uninformed investors that don't have a good feel for what the stock is worth. The question is if I'm uninformed, if I don't bother to do any research and I just simply say, look, IPOs in general make 18%, I'll just buy a whole bunch of them. And through the process of diversification, sometimes I make more, sometimes I make less. And I'll just make 18% on average, that's a really good rate of return, so I'll just participate in the IPO market simply by buying every single IPO that I see out there. Does that work? Will I earn 18% on average by placing orders to buy every single IPO? There's a problem with that. A lot of IPOs are oversubscribed, meaning that, going back to the Twitter IPO, you might have orders to purchase many, many more shares than the 70 million being offered. You might have, say 140 million shares that people want to buy, and only 70 million that are being issued. So you have oversubscription. The question is, what you do when you have oversubscription? So, maybe the fairest thing to do is have a pro-rata allocation. So, if there is 140 million shares bid for, requested, and 70 million shares being sold, you just give everyone half of what they requested. So if I requested 200 shares, I get 100 shares. The problem is that if you have informed and uninformed investors out there, the uninformed investors are just making bids to purchase every single IPO, but the informed investors are only placing orders to purchase what they view to be the underpriced IPOs. So, they would look at Twitter and say, that's likely to be an underpriced IPO I'm going to purchase that particular offering. But an offering that I think is overpriced, I'm not going to place a bid to buy that. So what ends up happening is uninformed investors receive very, very large allocations. They receive close to their requested allocation for the overpriced IPOs, and very small allocations for the underpriced IPOs. Basically, they're crowded out by the informed investors. So, they're not making 18% on average, they're getting a large portion of the overpriced IPOs, where they're losing money, and a very low allocation on the underpriced IPOs, where they make money. Rock assumes there's not enough informed investors to meet demand of the IPO market. Basically, you need uninformed investors to complete the market. So, why do you have underpricing? You have underpricing on average to induce uninformed investors participate. You need to underprice because of this allocation schedule where they get a larger proportion of the bad offering. So, you need to underprice on average so that at least they break even on their purchases.