1.3 ‘Going public’
For many companies a point may be reached, particularly if the company has grown significantly in size and has aspirations for further expansion, to seek equity finance through an initial public offering of shares (IPO).
In a recent research paper (Kim and Weisbach, 2005) the question was asked: ‘do firms go public to raise capital?’ Can you think of any reasons other than capital raising that would induce a company to ‘go public’?
The company may find that its (private) shareholders, including those in company management, want to realise at least part of their investment so seeking refinance through a public offering may become necessary. Alternatively, companies may ‘go public’ to raise their profile in the business world and assist with the marketing of their products. The key reason, as Kim and Weisbach's research confirmed, is to raise capital, even if their findings showed that the funds raised through a public offering of shares were often saved and then subsequently used over several years.
Table 1: The world's major stock exchanges
|New York||www.nyse.com, accessed 19 April 2007|
|Tokyo||www.tse.or.jp, accessed 19 April 2007|
|London||www.londonstockexchange.com, accessed 19 April 2007|
|Frankfurt||www.deutsche-boerse.com, accessed 19 April 2007|
|Paris||www.euronext.com, accessed 19 April 2007|
|Hong Kong||www.hkex.com.hk, accessed 19 April 2007|
The process of raising finance through an equity issue involves the following activities.
The initial decision for the company would normally be to appoint a ‘lead’ bank – or possibly a small number of ‘co-leads’ – to advise it through the listing process and to manage the sale of shares to investors. These banks would usually be expected to underwrite the transaction – in effect committing to buy those shares not subscribed to by investors on the launch date. Simultaneously the company would appoint legal advisers to take charge of the documentation requirements. It is also possible at this stage that other banks would be invited into the transaction to work under the lead or co-leads – this would be the case if the IPO was of a large size.
Broking firms may also be used to lead or co-lead share offerings. Currently, though, it is common for banks – particularly investment banks such as HSBC – to lead these transactions.
Next, the company must decide which stock exchange to list on. Among the key determinants of this will be the relative costs, where the company is domiciled and – particularly in the case of a multinational company (MNC) – where it conducts the largest amount of its business. Other factors will be influential though, including the size and diversity of the investor base which can be tapped through listing on a particular exchange – a factor that may encourage a listing on the largest exchanges – New York, Tokyo and London (see Table 1). Additionally, the regulatory and reporting requirements of a listed company vary between exchanges and this could encourage some companies to seek a listing where such requirements are less onerous or to list on a ‘subsidiary’ exchange like the Alternative Investment Market (AIM) in London or NASDAQ in the USA. (Established in 1994 the AIM was developed by the London Stock Exchange to enable small growing businesses to go public. With access rules less restrictive and reporting requirements less onerous – particularly in respect of previous financial performance – AIM had attracted 1,000 companies from around the world to go public by January 2005. The European stock exchanges, including Germany and Switzerland, have similar initiatives to AIM.)
The next stage of the process involves the compilation of an issuing prospectus that has to be reviewed by the relevant regulator (e.g. in the USA this would be the Securities and Exchange Commission, the SEC). The information contained in the prospectus would include details of the company's financial performance in the recent past – normally up to five years – and projections for future business performance. Part of the process of producing the prospectus involves what is known as ‘due diligence’ where the company's financial performance, current financial standing and future plans are subject to review by the banks who are underwriting the transaction. Particular focus is placed on the viability of the company's business plan since the success (or otherwise) of this will critically influence both the company's share price and dividends in the years after the IPO. Supporting the information provided will be a report from the company's external auditors confirming that the details of the financial status and performance provided in the prospectus are accurate.
This process of ‘due diligence’ also gives the lead bank (or co-leads), and others who may have been brought in to advise on the transaction, the opportunity to assess the quality of the company's management – often a good guide to the probability of the company achieving the forecast financial goals set out in the prospectus. The depth of scrutiny involved in the ‘due diligence’ process varies in line with the risk to the investor. With equity issues the investor has a highly subordinate position among creditors and so the due diligence process is necessarily extensive and forensic in nature. (Equity investors normally rank behind all other creditors – including bondholders – in the event of the liquidation of a company.)
Once this review has been completed satisfactorily the prospectus can be issued to prospective investors who can then form their view on whether they wish to invest in the company and, after a review of the assessed risk, the price they would be prepared to pay for the shares. Simultaneously, but separately, a report may be produced by the lead bank which gives its own assessment of the company and the worth of investing in it. It is necessary for this report to be prepared by a unit of the lead bank which is independent of the team that is marketing the shares to investors to avoid the risk that the coverage in the credit report becomes biased towards engineering a successful IPO. Indeed, in recent years some investment banks in the USA have been accused of producing unduly favourable reports to support company IPOs.
Ahead of the launch, the company and the lead bank would be likely to ‘road show’ the issue by making presentations to groups of institutional investors. After assessing market sentiment, the lead bank and others in the syndicate of banks can advise on the appropriate price to offer the shares. This is often a range rather than a specific price. The underwriting banks can see how much interest there is from investors and where, within the price range, they are prepared to buy. The ‘book’ of bids for the shares at prices within the range can then be built up. In doing this the company will know where it has to price to sell its shares – so the exact price can then be set and the issue launched.
This process of book building to determine the share price is a practice that has spread to the other major financial markets from the USA – perhaps no surprise given how the US investment banks dominate the international markets. In 1999 book building accounted for 90 per cent of European IPOs compared with 30 per cent in 1994. The process is in contrast to the traditional UK approach where the shares are offered at a fixed price that has been predetermined by the lead banks.
Much interest has been shown by analysts in the apparent underpricing of shares offered through IPOs. How would this be evidenced and why do both the US book building and the UK fixed price methods, explained above, risk this occurring? Are there any practices that could prevent underpricing?
Underpricing is evidenced by the price of shares rising (often sharply) in the immediate aftermath of the launch. Many traders known as ‘stags’ try to take advantage of this common phenomenon.
The fixed price method may encourage the banks leading the deals to set the offer price at a level where they are confident that all the shares will be sold to investors. This will mean that those underwriting the issue are not left to purchase a large proportion of the offer. With the book building method, investors – knowing that the lead banks want to see a successful launch – may indicate a ‘low’ price to the lead banks to force the issue price down as far as possible. Both methods thus often result in unmet demand at the final offer price with the resultant surge in the traded share price after launch.
The use of a when-issued market in forthcoming share offers (also known as the ‘grey market’) helps to limit underpricing. This is because the trade in a when-issued market establishes a pre-launch indication of what the post-launch price of the shares will be. Alternatively, a ‘Dutch auction’ could ensure that shares are not underpriced at launch – but this method is not without flaws: see Case Study 3 (later in this section) on Google's IPO.
Market conditions are critical for securing an effective equity issue. Companies will want to issue when conditions – particularly those for the sector in which the company operates – are conducive to a smooth launch with share prices at least stable and, ideally, rising. The banks underwriting the transaction have a clear interest here since favourable market conditions make it less likely that shares will be left unsold and have, as a consequence, to be bought and held by them. It should be noted, though, that the banks involved in the transaction may wish to hold on to a small proportion of the shares to provide liquidity in what is known as the ‘secondary market’ after launch. (Note: the ‘primary market’ relates to the trade in newly issued shares and securities. The ‘secondary market’ is the term used for trading in shares and securities after their launch.)
So how well do those managing new share issues perform in judging when to list? Evidence compiled by Henderson et al. (2003) indicates considerable success in this regard. They found ‘that firms successfully time their equity issues when the stock market appears to be overvalued’ and ‘that stock market returns are abnormally low following periods of high equity issues’. The authors acknowledge the role in this successful judgement of agency factors: companies may not necessarily have expertise to predict future movements in equity prices; they will, however, have sufficient knowledge – including an inside view of the robustness of their profit forecasts – to assess when their company is being fully valued or overvalued by the market.
This analysis of IPOs leads to the conclusion that while companies may not get the highest price possible at the point they go public due to the vagaries of the price-setting process, they have a tendency to ‘get it right’ with the timing of their issue due to their informed position about the performance of the company.
Case Study 2: Admiral – an admirable debut on the London Stock Exchange
Established in 1993, Admiral is a specialist motor insurer based in the UK. Admiral's IPO was one of the largest on the London Stock Exchange in 2004. The company was cash rich – so why did it need to raise finance through an IPO? The reason was that Admiral wanted to allow certain existing private venture shareholders, including Barclays Private Equity and XL, to sell their holdings in the company. The flotation also facilitated a windfall payment – averaging £37,000 – to Admiral's employees. With its team of advisers, led by Merrill Lynch International, Admiral offered 32 per cent of their total equity to institutional investors and indicated a price range for the shares of £2.45 to £3.00. The offer generated considerable interest from fund managers and a £1.5 billion ‘book’ of bids for the shares was built up – covering the size of the issue six fold. This enabled shares to be allocated in full at above the minimum of the range indicated by Admiral. The final issue price of £2.75 valued Admiral at £711 million.
The IPO was judged a success by the markets. Why?
The size of the book and the ability of Admiral to launch in the middle of the indicated price range – in market conditions which were less favourable than those seen during the boom time for IPOs in the late 1990s – suggested a well-marketed and well-managed launch. The steady, although unspectacular, growth of the share price subsequent to launch – during improving conditions in global equity markets – again suggested that the issue had been priced appropriately at launch. After two months the shares were trading at £3.09 leaving Admiral and the investors happy with the outcome: the former had not sold their shares too cheaply; the latter had seen a modest return on their purchase.
Periodically, planned issues are withdrawn at short notice when weakness or uncertainty – for example in the aftermath of 9/11 in 2001 – prevails in the equity market. Such a withdrawal does avoid the risk of an equity issue being undersubscribed and, as a result of a low launch price, undervaluing the company. The alternative risk is that such a withdrawal – particularly if it comes close to the planned launch date of the equity issue – is viewed by investors as a sign that the company lacks confidence and this impression might be difficult to overcome if, and when, the company does come back and conclude its equity issue.
Case Study 3: Google – an unconventional IPO
The internet search engine company Google adopted a very different approach to their IPO on the NASDAQ stock exchange. (NASDAQ is the largest electronic screen-based equity securities market in the USA.) Established in 1998 the company launched its IPO in August 2004. Controversy accompanied the run-up to the launch with Google encountering problems with SEC regulations for public offerings by issuing shares to staff prematurely and by talking about the issue to Playboy magazine. The company also declined to market the issue by ‘road showing’ it to potential investors – something that is commonplace when companies enter a market for the first time. The greatest interest, however, focused on Google's approach to pricing their IPO: they decided to use a Dutch auction to allocate the shares. With this method, shares are distributed to investors whose bids are at or above the price that sells all the shares available. In effect, Google was asking investors to say what they thought was the right price for the shares, rather than vice versa. In theory, this method should mean that at launch the issuer extracts the maximum proceeds possible. Did this work?
After a late decision to cut the number of shares offered from 25.7 million to 19.6 million, Google set a price range of $85 to $95 (below the range previously indicated). The Dutch auction allocated the shares at $85 – the base of the indicated range. But once the shares started trading their price rose above $100 and after three months they were trading above $169. This was not entirely surprising since the Dutch auction appears to have been flawed: at $85 there was unmet demand for Google's issue, with one quarter of the bids for shares being unsuccessful.
Despite the fact that equity markets were on the upturn in autumn 2004, it appears that Google underpriced its IPO. The complexity of the Dutch auction may have deterred investors from bidding for shares at the launch, thereby constraining the issue price.
The conventional process of marketing and book building would almost certainly have yielded the company more from its IPO – but Google is anything but a ‘conventional’ company.
In addition to providing an interesting case study of an IPO, the subsequent sharp rise in Google's share price prompted – not for the first time – interesting questions about the valuation of a technology company. Shortly after the issue, Allan Sloan of the Washington Post wrote:
The stock market is valuing Google at almost $30 billion, or almost 87 times the $1.26 per share profit it reported for the 12 months ended June 30 . Google earned $7 million on $86 million in revenue in 2001, its first profitable year, and $191 million on revenue of $2.26 billion in the 12 months ended June 30. But the company's not a small start-up anymore. To keep up this growth rate, Google will have to earn $5 billion on revenue of $60 billion in 2006. That's clearly not going to happen.
Source: Sloan (2005)
For the time being, at least, Google has dumbfounded the doubters. In April 2005 it announced profits of $369 million for the first quarter of the year, up from $64 million for the same period in 2004. The consequent surge in its share price resulted in Google overtaking Time Warner to become the world's largest media company – despite the fact that its sales were less than a tenth of the value of those of Time Warner.
Clearly this is a company and a share price to watch closely.
Having studied IPOs, in the next section we look at why and how a company may return to the market to raise more equity finance.