The IPO Market Jay R. Ritter University of Florida March 2006

Terminology: First-day return = 100% x (Closing price – offer price)/offer price First-day return a.k.a. “underpricing” Money on the table = number of shares sold x (closing price – offer price)

Academic explanations for underpricing The “winner’s curse” or “Groucho Marx theorem” (Rock) If you are unsure of the fair value of shares being sold, and there is excess demand, the most optimistic investors are likely to get the shares Thus, conditional on getting the shares, you find out that you are probably overoptimisitic The need to give institutions an incentive to investigate a company and buy its shares (Benveniste and Spindt)

These are good explanations if we were seeking to explain why, on average, underpricing is 5-10% These are not good explanations when we are trying to explain why underpricing is 15% or more

Table 2 The Effect of Underpricing on the Wealth and Ownership of Pre-issue Shareholders Assumptions: Pre-issue shares outstanding:15.6 million shares Gross proceeds of IPO:$78 million Post-issue market cap:$280.8 million # of shares sold by pre-issue shareholders:zero Strategy 1 Strategy 2 Offer price and number of shares offered: 7.8 m at $ m at $13.00 Post-issue shares outstanding:23.4 million21.6 million Market price per share:$12.00$13.00 Money left on the table:$15.6 millionzero Post-issue wealth of pre-issue shareholders:$187.2 million$202.8 million Post-issue % of firm owned by pre-issue shareholders: 66.7% 72.2%

Underpricing and allocations are related There are three frameworks for viewing discretion in allocations The information acquisition view (Benveniste and Spindt) Underwriters favor regular investors who provide information about demand, resulting in more accurate pricing The “pitchbook” view, in which underwriters seek out buy-and-hold investors The rent-seeking view, where underwriters trade money left on the table for quid pro quos (commission business) Biased analyst recommendations appeal to issuing firms and make them willing to leave money on the table

Why do issuers put up with severe underpricing? On internet IPOs, underwriters knew they were overpriced But why did their analysts put out “buy” recommendations? Issuer stupidity The publicity is worth it Capital can be raised in a follow-on offering Prospect theory When people get good news about their wealth increasing, they don’t bargain as hard at the pricing meeting Analyst lust and spinning Issuers seek out underwriters where influential analysts will be bullish Spinning of hot IPOs to executives

Scandals: Spinning: Allocating hot IPOs to the personal brokerage accounts of top executives in return for company business Global settlement bans spinning by major underwriters Laddering: Requiring the purchase of additional shares in the aftermarket in return for IPOs Analyst conflicts of interest: Giving “buy” recommendations in return for underwriting and M&A business Commission business in return for IPOs: Underwriters allocated IPOs primarily to investors that generated a lot of commissions on other trades

Example of kickbacks with commission business: Credit Suisse First Boston (CSFB) received commission business equal to as much as 65% of the profits that some investors received from certain hot IPOs, such as the December 9, 1999 IPO of VA Linux The VA Linux IPO involved 5.06 million shares Offer price: $30.00 Closing market price:$ Capital gain:$ Gross spread: $2.10 If the investor then traded shares to generate commissions of one-half of this profit the total underwriter compensation per share was $2.10 plus $ , or $

According to paragraph 58 of the SEC’s January 22, 2002 settlement with CSFB, an institutional customer that had received a 12,500 share allocation of VA Linux from CSFB paid CSFB at least $565,000 by engaging in the following transactions:

Commission Business in Return for IPOs: What if a mutual fund pays 5¢ per share for trades with Goldman Sachs rather than 2¢ per share with an ECN?

Example of spinning: Salomon Smith Barney's allocations of IPOs to Bernie Ebbers, other WorldCom execs, and other telecom execs Ebber'sOfferMarketFirst-day IPODateShares PricePrice Profit McLeod6/96200,000$20.00$25.13$1,026,000 Tag Heuer9/965,000$19.55$20.00$2,250 Qwest Communications6/97205,000$22.00$28.00$1,230,000 TV Azteca8/971,000$18.25$19.19$900 Box Hill Systems9/975,000$15.00$20.62$28,100 Nextlink Communications9/97200,000$17.00$23.25$1,250,000 China Mobile HK10/972,000$30.50$28.00-$5,000 Metromedia Fiber10/97100,000$16.00$21.38$538,000 Teligent11/9730,000$21.50$25.63$123,900 Earthshell3/9812,500$21.00$23.56$32,000 Rhythms Netconnection4/9910,000$21.00$69.13$481,300 Juno Online5/9910,000$13.00$11.63-$13,700 Juniper Networks6/995,000$34.00$98.88$324,400 Focal Communications7/995,000$13.00$19.50$32,500 Williams Communications10/9935,000$23.00$28.06$177,100 Radio Unica10/994,000$16.00$27.44$45,800 Chartered Semiconductor10/995,000$20.00$33.19$66,000 UPS11/992,000$50.00$67.38$34,800 KPNQwest11/9920,000$20.81$29.81$180,000 Tycom Ltd7/007,500$32.00$37.00$37,500 Signalsoft8/005,000$17.00$21.88$24,400

Where have the NASD and SEC been?

While IPOs tend to go up on the first day of trading, in the long run, on average they have tended to underperform. But there is a strong cross-sectional pattern: IPOs that had annual sales of less than $50 million severely underperform, whereas those that had achieved annual sales of $50 million don’t underperform. Buy-and-hold stock returns are skewed: there are some big winners, but most stocks underperform. This is especially true with young companies, where there is even greater right skewness.

Annual returns in the five years after going public for 6,858 IPOs from , with returns through December Style-matched firms match on market cap and book-to-market.

Summary Hot and Cold markets will continue Long-run underperformance is restricted to companies going public with less than $50 million in annual sales In the U.S., auctions are becoming more common Regulatory reform has changed the game a little Spinning has been nearly eliminated Tying of loans to underwriting is controversial Analyst lust will continue Issuers still put up with underpricing Commission business in return for IPOs is still allowed Underwriters still have an incentive to underprice The academic literature still focuses too much on asymmetric information models rather than agency models