IPOs and Venture Backed IPOs

F. Philipp Ghadri IPOs and Venture Backed IPOs A Theoretical and Practical Code of Practice plus Implication Nomos

F. Philipp Ghadri IPOs and Venture Backed IPOs A Theoretical and Practical Code of Practice plus Implication 2.Auflage Nomos

Bildnachweis Titel: Florian Liebisch Die Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the Internet at http://dnb.d-nb.de. ISBN 978-3-8329-7166-3 1. Edition 2012 Nomos Verlagsgesellschaft, Baden-Baden 2012. Printed in Germany. This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically those of translation, reprinting, re-use of illustrations, broadcasting, reproduction by photocopying machine or similar means, and storage in data banks. Under 54 of the German Copyright Law where copies are made for other than private use a fee is payable to»verwertungsgesellschaft Wort«, Munich.

Contents List of Figures 13 List of Tables 15 Acronyms 15 Abstract 17 1 Introduction 21 1.1 Proceeding 28 2 Literature Review 31 2.1 IPO Literature 31 2.1.1 The Company s Perspective 31 2.1.2 The Market Perspective 32 2.1.3 The Underpricing Perspective 35 2.1.4 Venture Backed IPOs 36 2.2 Game Theoretical Literature 40 2.3 Conclusions 43 3 IPO Fundamentals 45 3.1 IPO Process Overview 45 3.2 Technical Fundamentals Germany 50 3.3 Technical Fundamentals USA 54 3.4 Most important Fundamentals 59 3.4.1 Motives for Going Public 59 3.4.1.1 Financing 60 3.4.1.2 Increase in Publicity 61 3.4.1.3 Shares as Currency 61 3.4.1.4 Possible Disadvantages 62 3.4.2 Disinvestment of partners 62 3.5 Is the Company mature enough for the Markets? 65 3.5.1 Corporate Governance 67 3.5.2 External Reporting 68 3.5.3 Internal Reporting 69 3.5.4 Prospectus 69 9

3.5.5 Related Costs 71 3.6 The Emission Process 72 3.6.1 Timing of the Emission 73 3.6.2 Origin of the Stock 74 3.6.3 Market-Segment and Exchange 74 3.6.4 Finding an Underwriter 75 3.6.5 Placement 78 3.6.6 Valuation and Emission Price 79 3.6.6.1 Relative Valuation Multiples 80 3.6.6.2 Absolute Valuation Discounted Cash Flow 83 3.6.6.3 Equity Costs- The CAPM 85 3.6.6.4 Shareholder Value 86 3.6.6.5 Constraints of Valuation Models 87 3.6.7 Final Price Determination 88 3.6.7.1 Fixed Price Method 89 3.6.7.2 Bookbuilding 90 3.6.7.3 Auction 91 4 Signalling Structure of an IPO 93 4.1 Introducing Uncertainty 93 4.2 The Company s Signalling 95 4.3 Information Feedback 96 4.4 The Equilibrium State 96 4.5 The Welfare Perspective 102 4.6 Implications 105 5 IPOs and Underpricing - The Transaction from a Game Theoretical, Behavioral and Literature Perspective 111 5.1 Mispricing from a Game Theoretical Perspective 111 5.1.1 Fundamental Values and Prices 112 5.1.2 Higher Order Beliefs 114 5.1.2.1 Finite Bubbles with Short Sale Constraints and Asymmetric Information 116 5.1.2.2 Short Overview of Variables and Formulas 116 5.1.2.3 The Model 117 5.1.2.4 Necessary bubble/overvaluation conditions 120 5.1.2.5 An Example with Heterogeneous Beliefs 121 5.1.2.6 Conclusions 128 5.1.3 Simple Finite Horizon Bubbles Robust to Higher Order Knowledge 129 5.1.4 Noise Traders and Herding 131 10

5.1.4.1 Short Overview of Variables and Formulas 133 5.1.4.2 Herd Behavior, Bubbles and Crashes 134 5.1.4.3 Conclusion 141 5.1.5 Summary 142 5.1.6 Outlook 143 5.2 Behavioral Finance 144 5.2.1 Redefining Utilities- Prospect Theory 144 5.2.2 Overconfidence and High Attention 146 5.3 Conclusions 147 6 Practical Findings and Outlook 149 6.1 Outlook 153 7 IPOs - Just Momentum or an Asset Class? 157 8 Conclusions and Critical Remarks 167 9 Hypotheses 173 A Appendix 183 11

Abstract Over the last decades IPO related phenomena like IPO waves, underpricing and oversubscription have been discussed extensively and the huge body of literature suggests that some major issues still remain unsolved. All of these issues are interconnected and that is one reason for the depth and complexity of the discussion. However, one node connects all of the relevant IPO issues. If one breaks down IPO phenomena informational asymmetries constitute the heart of the different phenomena. Thus, in my master thesis I want to provide the very essential roots (the connecting node) of the problem by focusing on the mispricing problem that arises in most IPOs because the determinants which influence the market pricing of IPOs are manifold. The company and its underwriter market a company s shares and set a price range. All these factors (and many more) serve as signals which are delivered to analysts and potential analysts. However, signals are noisy information that have to be interpreted by outsiders. Hence, informational asymmetries arenoteasilyovercomebysignallingandinmanycasessignalsdonotevenmean to deliver valid information but are rather used as profit maximizing mechanisms by the owners of a company and underwriters who signal only favored information. In order to capture the topic of information asymmetries in IPOs I will take several subsequent steps. First I will discuss an IPO and its signalling foundations in order to provide essential fundamentals of what signals really are and how a signalling mechanism works. Subsequently I will explain how informational asymmetries (the connecting node) determine sentiment and mispricing. I will show how mispricing can arise even if all investors are completely rational by applying game theoretical models to the IPO framework. Even if informational asymmetry is weakened the mispricing can persist. The last of three subsequent models will show that noise (which can be interpreted as signalling noise) which affects prices through noise traders might result in a consequent mispricing situation. This finding draws the line between noisy signalling, investor sentiment and mispricing. One aspect that I will refer to several times in this thesis are venture backed IPOs because venture capitalists exhibit very unique features in an IPO transaction. They are more insiders than outsiders, they are active monitors with an inside perspective and they follow their own interest while having more influence (providing equity) than other creditors who provide capital (providing dept). Thus, the existence of venture capitalists provides unique signals. Additionally I will draw lines between the game theoretical approaches and behavioral ones. The aspect of noise and noise traders introduced by game theory 19

can be described in detail by behavioral finance. Furthermore due to persisting underpricing I will look at IPO stocks as an asset class of its own because of its very unique return features that correlate stronger with hedge fund returns than it doeswithequityindices. Thus,stocksthatareontheedgeofbeingpubliclytraded (within the bookbuilding phase) are not completely private nor completely public. These unique characteristics support the hypothesis that IPO shares should rather be treated as an asset class of its own. This is especially interesting considering the fact that IPO issues tend to underperform the market on the middle term (5 years after issuance). 20

1 Introduction Currently global IPOs are taking up speed again. Merely in the first two quarters of 2010 the number of 192 global IPOs exceeds the full years 2008 (121) and 2009(177)byfar. 1 Therearemanysignsatthehorizonthatthisdevelopmentwill sustain. The Chinese market is one driving determinant of this movement. For example the Chinese government owned Agricultural Bank which mainly involves in commerciallendingwaspricedinaugust2010. 2 Withanissuingvolumeof$23.4 Bill. the state owned bank is the largest IPO in history with an over-subscription which amounts to 17 times. The Agricultural Bank of China just displaced the IPO of the Industrial and Commercial Bank of China which went public in 2006 as the worlds largest IPO. The Chinese government follows two main objectives by listing state owned companies: Capital inflow and installing a more efficient management structure. This development is likely to sustain for a while. 3 However, the IPO market in Europe is also on the upturn. After this market was outperformed by China and the USA in 2008 and 2009 (with an assigned market share of27%oftheglobalipovaluein2009)itoutperformedtheusmarketinthefirst two quarters of 2010. Though, overall these figures are still behind the figures of the boom phase before the financial crisis. 4 There have always been cycles determining the IPO markets and academic literature detected these fluctuations of IPO activity over time in several papers. 5 Figures 1.1 and 1.2 give an indication where the structural development of the IPO universe is heading. As the first day returns have been increasing over time I will supply explanations of how IPO prices are affected by different variables under uncertainty. Considering the growing first day returns of IPOs, the importance of price determination increases significantly because persistent underpricing shows that either the market does not set prices efficiently enough or the price detection process lacks applicability. As I will outline informational asymmetry constitutes the core of this discussion. The dot-com bubble emphasized that there is still a significant amount of uncertainty during the process of an IPO facing investors and companies which can lead to massive mispricings. Underpricing is clearly the most challenging result of 1 Takenintoaccount areipos above $100 Mio. 2 Renaissance Capital LLC(2010) 3 Li/Hovey (2009) 4 PriceWaterhouseCoopers (2010) 5 Ritter(1984), Lowry/Schwert (2002) 21

this kind of uncertainty. From a risk taking perspective many stand-alone theories do not provide feasible instruments for supplying a whole picture of uncertainty within the IPO process. Of course, many theories deliver significant results which shedlightonpartsofthepuzzlebuttheissuethatremainstobesolvedisconnecting several theoretical disciplines. There has not been an all-embracing approach to solve these problems yet. I conclude that not just one theory but different disciplines might have the power to do so. Therefore in this master thesis I try to emphasize geared issues from multiple disciplines like theoretical finance, game theory and behavioral finance. Game theoretical approaches will constitute the heart of this discussion because they will make clear how fragile pricing actually is considering uncertainty (not only uncertainty about a company s fundamentals but even more important uncertainty about other investors and market sentiment). Figure 1.1.: IPO Turnover Categorized by Time Period and First-Day Return, 1983-2009; National Association of Securities Dealers Association Quotation(NASDAQ), New York Stock Exchange (NYSE) 6 22

An IPO determines a major structural shift in a company s life which impacts the value (or rather the expectations of a value) of a firm significantly. Besides much better financing opportunities, shifts in the ownership structure induce a transformation of the company s and a business character and opportunities. The future prospect of a company changes and valuation fundamentals also develop. For example, ownership structure is a key determinant of potential agency problems which lead to information asymmetries, incomplete contracts and resulting agency costs. Thus, corporate governance criteria are strongly related to ownership structure and a firm that signals poor governance mechanisms might be valued completely different(in the short run) as a firm signalling rich compliance and governance standards. 7 Generally signalling is a key determinant of expectations and therefore also a key determinant of why fundamental values cannot exist as I will show theoretically. Therefore it becomes obvious that an IPO constitutes a situation which is influenced by multi dimensional and interconnected pricing forces that create uncertainty: 1. The price influences related to changes in a company s fundamentals (i.e. ownership, financing opportunities), 2. The price influences related to investor sentiment. In this thesis I will describe the uncertainty connected to these influences in terms of signalling theory, game theory and behavioral approaches. Gathering an understanding how these influences are interconnected is the most important feature of this analysis: Signals (if fundamentally relevant or not) influence sentiment and vice versa. There are many reasons for going public. Besides financing opportunities, venture capitalists search for an exit strategy is one of the most common ones. Gilson/ Black (1997) show that venture capitalists ensure a certain degree of contractual control over the invested companies in order to protect their investment (lock in). Many venture capitalists even hold board seats in their portfolio companies. 8 If control is equal to ownership then the existence of venture capitalists influences ownership structure of a firm. Hence, the signals ex ante to venture backed IPOs are particularly interesting to observe because they imply major changes in financing opportunities and ownership structure and therefore can have a major influence how a company is valued in the short and long run. From a governance perspective the separation of ownership and control plays a major role for an efficient 6 Ritter(2010) 7 In the long run however these negative effects might be internalised by changes in governance structure induced by the shareholders and a new board. 8 Chahine/Goergen (2010) and Lerner(1995) 23

incentive structure (which in turn builds the foundation of an efficient management structure) and therefore especially the signalling of the existence of a venture capitalists within an IPO firm who possess control and ownership can be double edged. Thus, it needs careful consideration how to signal the story behind a venture capitalist within an IPO firm because it will directly influence investor sentiment. Figure 1.2.: Number of Offerings and Average First Day Returns, 1980-2009 9 Venture capitalists and other major investors who are invested in a private company tend to search for a profitable and safe exit strategy at the same time. The exit is one of the most important and most sensitive decisions in the lifespan of a private firm, since it allows the owners to access the public capital markets for the first time in order to satisfy their liquidity need or desire of growth. An IPO often constitutes the most profitable and also an efficient exit opportunity. But there are also many pitfalls to consider ex ante. The venture capitalist hopes for enthusiastic investors to boost the offered stock within the agreed lockup period. It becomes apparent that sentiment plays a key role in this process. Sentiment therefore is an exogenous factor an owner or venture capitalist is not able to control. Thus it is a factor of uncertainty. The dot-com bubble constitutes the perfect example for a sentiment driven and totally irrational market. During the dot-com bubble (1999-2000) 35% of IPOs were executed by venture capital financed companies. 66% of 9 Ritter(2010) 24

thetechcompanieswerefinancedbyoneormoreventurecapitalfunds. 10 Fig.1.3 and fig. 1.4 show the development of venture backed IPOs in comparison to non venture backed IPOs from 1980-2009. The number of IPOs has been especially high during the tech hype which resulted in the dot-com bubble and lost attraction since. Figures 1.2 and 1.4 highlight that the market during the dot-com bubble was characterized by extreme first day returns(underpricing) which are flatter now but still persists constantly. One could argue from two perspectives. Either venture capitalists used market sentiment (extreme underpricing) in order to generate as high profits as possible or venture capitalists partly determined market sentiment as a quality signal which would explain the extreme underpricing to some extend. As massive underpricing still persists even after the new market era (see fig. 1.1) and venture capitalists still back IPOs both arguments might hold at least partly. However, the understanding of market sentiment and its determinants like signals and other rational and irrational forces is crucial for understanding the mechanisms behind IPO phenomena like underpricing. Figure 1.3.: Number IPOs from 1980-2008 categorized by venture capital backing 11 At least partly sentiment is frequently connected with irrationality. Irrationality however liquidates the strongest economic assumption and consequently disqualifies most theoretical finance models. This situation gives space for other ap- 10 Ritter(2010) 11 Ritter(2010) 25

proaches like behavioral and psychological models. Obviously the need for different approaches and more applicable solutions exists. It is however not advantageous or realistic to rule out theoretical models by loosening the assumption of total rationality. New approaches should rather support models of rationality and boundedrationality. 12 Theseapproachesshouldenteriftheboundariesofrationality are broken by evidence. Of course, theoretical finance models which are relying on somewhat strict assumptions still are the most important source of knowledge and therefore in this study I try to draw lines between different disciplines like game theory(rationality, bounded rationality), theoretical finance(rationality) and behavioral finance (irrationality) in order to find applicable solutions for phenomena like IPO underpricing and the signalling structure within the IPO process. However it will also be shown that from a theoretical standpoint seemingly irrational phenomena like mispricings can exist under the assumption of total rationality. That means mispricing is able to persist even though every trader knows that an asset is mispriced. The introduction of noise constitutes the gateway between rationality and irrationality by implying investor sentiment into the discussion. Investor sentiment can be explored from different perspectives. From a monitoring point of view empirical studies are able to prove the existence of the phenomenon and test its relations to different factors. Traditional theoretical models of rationality and perfect information (Efficient Market Hypothesis (EMH)) simply cannot justify strong deviations from fundamental values. Hence, IPO underpricing and ensuing huge price movements on the first trading day have to result from different mechanisms. 13 There are also game theoretical models of sentiment which are subject to strong assumptions like rationality. Thus, the models of herding, higher order beliefs and noise traders will be introduced. However, in contrast to the EMH game theory will demonstrate that there are no fundamental values, even under total rationality. Under- and overvaluations result from a certain amount of informational asymmetry. Additionally one can look at sentiment from a behavioral perspective. Behavioral economics has been underestimated or neglected in huge parts of finance literature. Pertaining to investor sentiment behavioral approaches have abandoned the assumption of full rationality. Of course behavioral approaches do not abandon rationality entirely but allow for irrational behavior, i.e. noise. Many of the findings in behavioral science deliver superior explanations about phenomena which cannot be explained by traditional approaches 12 Simon (1959) 13 Another example that cannot be explained exclusively by fundamentals are the price movements resulting from a firm s insertion or elimination from an index like the S&P 500. When Yahoo was added the stock jumped by 24% in a single day and went from $ 115 before theinclusionto$210 amonthlater. Barberis/Thaler(2003), p. 10 26

relying on the rationality assumption. However, as I will show that sentiment driven mispricing can exist even under the rationality assumption, one might assume that the topic of mispricing is one of the richest and most complex issues in financial research. It becomes obvious that the processes behind IPOs are multidimensional and affect much more research areas than only finance and accounting. Therefore this thesis will outline a big picture (without losing profoundness) about the most important facts concerning an IPO in general and the special (but not unusual) case of venture backed IPOs. This type of IPO is of particular interest because it amplifies some signalling mechanisms that result from unique interest and incentive structures. Figure1.4.:FirstDay ReturnsofIPOs1980-2008 14 I finally give an outlook for new topics that are relevant for further research by forming hypotheses. 14 Ritter(2010) 27

1.1 Proceeding First I will discuss the related literature of the IPO universe and of the game theoretical background research in chapter 2. This part will outline how rich the discussion of IPO related issues really is. Many aspects discussed contribute to a puzzle which still remains to be solved. Therefore these finding shape this thesis because the approaches I will deliver will contribute to a basic understanding of the connection between many findings. Major empirical findings will be introduced in order to discuss the phenomena related to an IPO. IPO Waves, Market Timing, ownership structure and underpricing will be discussed by exploring the literature. These findings will guide through the most important issues of an IPO transaction and therefore serves as a state of the art. However, the literature view supplements the game theoretical and behavioral chapters by making providing a broad overview concerning IPO activity and mispricing. The body of literature supplies very interesting results that supplement the framework discussed in the previous chapters. Chapter 3 describes the IPO transaction from a technical perspective. A rather technical insight into the IPO process will be delivered. Starting with the theoretical fundamentals of the decision making and the time frame I will proceed by describing the valuation process and the legal rights and duties resulting from an IPO. Compliance management and corporate governance issues are more and more characteristics of legislature and capital markets. Therefore, this part will be essential for understanding the factors that are fundamentally related. The fundamentals of an IPO transaction are of particular interest because they constitute the signals and signalling instruments which might determine the success of an IPO for the emitter and the market. In chapter 4 the signalling model by Spence (1973) will be transferred from the job market to the IPO market. The signalling structure is of particular interest because signals are the tool to overcome the informational asymmetries between the company insiders and potential investors. Thus, signalling determines the fair market valuation of a company and therefore an efficient signalling structure determines a constant, stable and sustainable stock price development. Additionally the signalling mechanisms clarify the importance of an understanding how fundamental instruments of the valuation process, the ownership structure and the equity story are able to influence market sentiment. Anticipation of signals also plays an important role within the market signalling processes. Chapter 5 shows game theoretical approaches to enlighten the theoretical background of mispricing and market sentiment. Behavioral approaches will be introduced quickly in order to gain a deeper understanding of irrational investors and market over- and underreactions(noise). This chapter will clarify how mispricings 28

can be explained from a theoretical perspective and how informational asymmetry determines mispricing. Models from game theory will show that even rational investors can cause mispricing under asymmetric information. Two game theoretical approaches will show that mispricing is not necessarily due to irrational behavior. Higher Order Beliefs and Rational Herding make clear that even completely rational players might be subject to misvaluations even if the players know about the fundamental value of the asset. This has major implications for companies which are planning to go public because these results emphasize the importance of high level symmetric information and high quality signalling (minimizing noise) between the company and its investors prior to an IPO. The behavioral approaches will highlight the importance and sensitivities of information and signal supply. Behavioral finance will show results that weaken the assumption of rationality and therefore provide rich information concerning anomalies that do not fit into the theoretical framework of full rationality. Chapter 5 goes beyond usual explanations of IPO phenomena and focuses on the market perspective and the interaction between fundamentals and expectations. Chapter 6 supplies practical insights into the underpricing phenomenon by analyzing the relationship between investors and underwriters. The signalling instruments and rational and irrational forces of mispricing have been discussed into detail and therefore this chapter implements these findings into real world cases. Additionally it shows the negative effects of conflicts of interests connected with informational asymmetry which leads to potential moral hazard and market failure. Chapter7willtakeonanewperspective. Duetothenonprivateandnonpublic characteristics of IPO shares during the bookbuilding phase and due to the persistent underpricing phenomenon, IPO shares will be suggested as being an asset class of its own. Chapter 8 will conclude and will post some critical remarks. Additionally some processes will de introduced that might be subject to further research. Chapter 9 will contain hypotheses that result from the findings of the thesis and which will try to enhance the understanding of IPO mispricing. These hypotheses try to enrich future research concerning the topic. 29