The Role of the Underwriter in the Initial Public Offering Process

Content

1. Introduction

2. Going Public
2.1. Advantages of Going Public
2.2 Disadvantages of Going Public
2.3. Legal Requirements

3. The Initial Public Offerings Process
3.1 Choosing an Investment Banker
3.2 Registration
3.3 Marketing
3.4. Pricing of the Stocks
3.5. Theories for Underpricing
3.5.1. Problems with the underpricing
3.6 The Offering

4. After-market Stabilizing Activities of the Underwriter

5. Conclusion

References

List of Figures

Figure 1: Source: PricewaterhouseCoopers

Figure 2: An Example for “Tombstone” announcement

Figure 3: Ranking according to proceeds Source: Thomson Financial

Figure 4: An example for a “Red Herring

Figure 5: Source: Carter, Dark, Singh, “Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks”, The Journal of Finance, February 1998, pages 285-311

Figure 6: Average annual returns for the five years after the offering date

Figure 7: Source: Carter, Dark, Singh, “Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks”, The Journal of Finance, February 1998, pages 285-311

List of Tables

Table 1: Direct and Indirect Costs

Table 2: Mean first-day returns and money left on the table

Table 3: Analysts Ratings for an IPO stocks for the period January 2001- July 2002Source: http://bear.cba.ufl.edu/ritter/publ_papers/The%20IPO%20Quiet%20Period%20Revisited.pdf , visited on 05 July 2005

1. Introduction

The world of finance is complex. There are many aspects, which cannot be fully explained and still confuse the researchers. One of the most discussed topics is that of Initial Public Offerings (IPO) mainly because of the intricate connections between investment bankers (underwriters), issuers and buyers. This paper will try to summarize the whole process of going public and emphasize on the role of the (lead) underwriter in it.

The paper discusses mainly the American “way” of going public, but the procedure is generally the same for the European market with some differences that are explained in the text. The advantages, disadvantages and the legal requirements for going public are enlightened, in order of understanding the important role, which the underwriter plays in the whole process. The structure and the legal consequences of the due diligence process are presented. The types of agreement between the underwriter and the issuer are described, with the consequences that originate from them. The ways of determining the price and the advantages and disadvantages of any of them are presented, with respect to the importance of the underwriter’s role in them and the liabilities that she has. The problem with the underpricing is discussed more detailed, since this is one of the big challenges in the IPO process. Some theories that explain this phenomenon are briefly discussed, showing the mechanism that is behind the underpricing problem. Some of the unlawful allocation practices are listed, with examples that show that even the top underwriters use prohibited actions to ensure the successful completion of the IPO process. The importance of the pre-opening period for the determination of the right market price and the active participation of the underwriter in the bidding during the first day of the offering is emphasized, as well as the fact that the reputation of the underwriter is one of the most important qualities that she possesses, with respect to the choice of underwriter, the initial returns and the long-run underperformance of the IPO stocks.

2. Going Public

A firm is said to “go public”, when it offers securities to the general public for a first time. Usually the securities offered are unissued ones, but there can be small amounts of securities held by the present owners. The moment in time of going public is very important. There are the so called “hot issue periods” (periods of high average initial returns and rising volume)^[1], which are characterized with excess supply of funds and which are the best time to go public. Since, the market changes really fast, the timing of the actions is crucial. Once the decision to go public is made, the time is scarce, thus rapid actions are needed. Therefore, the “shelf registration” could be very useful in “catching” the hot issue periods. The “shelf registration” is a process that allows the firms to fill their pre-IPO registration requirements up to two years before going public. In return for this option, the company must fill quarterly and annually reports with the Securities and Exchange Commission (S.E.C.).^[2]

2.1. Advantages of Going Public

The decision to go public must be well considered. There are some reasons why firms go public:

- to raise money for expansion;
- to increase market value- due to the increased liquidity and available information;
- to attract and retain employees (general traded securities are good compensation for the employees);
- to diversify personal holdings;
- to provide liquidity for the shareholders (the shares are subject to the general public)- Microsoft;^[3]
- to enhance company’s reputation (public listed companies are more credible than private held ones);
- an IPO increases the company’s net worth, does not need to be repaid and permits additional borrowings;
- there is a possibility for a future mergers and acquisitions, using securities instead of cash;
- increased access to capital and financial markets
- an IPO among with the other reasons can be used as a marketing tool, attracting the customers to the products of the company (Amazon).^[4]

2.2 Disadvantages of Going Public

The main disadvantage of the IPO process is that it is expensive (see Table1). The underwriters’ spread is the major direct cost for the issuer (around 7 % of the proceeds).^[5] It may sound not so much, but if for example a company raises € 10 0 00 capital in shares, the underwriter’s spread is € 0 00. The other direct expenses are for legal, accounting, and printing actions. There are more indirect expenses, which arise when the company has already gone public. Such are administrative and investor related costs, such as quarterly and annual financial reports and costs for the obligatory shareholders’ meetings. The underpricing (problem, which will be discussed later) is also indirect expense, since the issuers do not get all the proceeds from the issuing of the securities. The loss of privacy is the next disadvantage. Once a firm went public, it has an obligation to provide freely financial statements, which can be used from the competition. There is also a problem with the “myopic” behavior, since the shareholders expect short-term profits, and (usually) the manager aims to a long-term success; therefore the manager must balance between short- and long-term goals. Such a myopic behavior could drop the net value of the company and it is a classical example for an “agency problem”. The loss of shareholders’ voting rights, because of the new shareholders (dilution) could be another problem, which can be overcome by issuing non-voting shares or shares of different classes, bearing different voting rights. The loss of control is another potential trouble. If the owners sell most of the shares, the shareholders could vote the removal of the owner (Apple Computers). The time and the efforts of the managing team that must be devoted to the preparation of the whole process and consequently to the research, needed for the quarterly and annual financial statements are also a large disadvantage.

By the rule of thumb, a firm should go public if the advantages of IPO are more than the disadvantages. If not, there are lots of alternatives to the IPO process, (asset-based lending, venture capital, private placement etc.). In 2004 in U.S.A 179 operating companies went public.^[6]

2.3. Legal Requirements

There are some legal requirements that are needed to be fulfilled when a firm decides to go public. The most important rules that govern the IPO process are the Securities Act of 1933 (requires the revelation of material information about the securities, which will be sold to the public and prohibits the omission or misrepresenting of this material information), the Securities Exchange Act of 1934 (the power of the S.E.C. to register and regulate the participants in the securities market and the right to receive periodic information from the publicly traded firms) and the Sarbanes-Oxley Act of 2002 (increases the company responsibility, oversees the activities of the auditing business)^[7]

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Table 1: Direct and Indirect Costs

3. The Initial Public Offerings Process

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Figure 1: Source: PricewaterhouseCoopers^[8]

3.1 Choosing an Investment Banker

Rarely a firm decides to go public without an intermediate. The intermediate, usually an investment banker (underwriter), facilitates the whole process. The choice of the lead underwriter is a serious task and is done, based on several criteria; such as, the reputation of the underwriter, her experience in marketing and after-market activities, her knowledge of the market conditions and institutional and retail investors, the experience in the right pricing of the stocks, experience and quality of the research in the issuer’s industry and the presence of an analyst, who can perform adequate stabilizing policy in the after-market.

There are several measures of the underwriter’s reputation. For example, Carter and Manaster (CM)^[9] have developed a system for measuring the underwriter’s reputation according to theirs relative placement in the stock offering “tombstone” announcement, just like in a movie poster.^[10] The main underwriters are written from left to right, according to their positions. An example for such an announcement is shown in Figure 2. The top underwriters are evaluated on a ten-tier system, where the top underwriters are in the range eight-ten.

Another, new type of measuring the underwriters’ reputation is described in a paper from Cooney Jr., Hill Jr., Jordan and Singh. They use the ELO coefficient (the coefficient used in assessing the chess players’ ratings) in measuring the underwriters’ reputation.^[11]

The reputation of the underwriter is the most important criteria on which one should be chosen. If the reputation is good and the underwriter is in the “bulge bracket” (the top underwriters, according to the measurement of the underwriters’ reputation, developed by Johnson and Miller),^[12] this fact can boost further the selling of the securities. Also, the better the reputation of the underwriter, the less is the underpricing in the short-run.^[13] But it not only that the firm will choose its investment banker- the process of choosing is a two-way procedure. The underwriters also choose carefully what kind of firm they will represent, because of their reputation. If the firm they represent is a risky one and the IPO is not successful the reputation of the underwriter can be seriously damaged. Usually, firms that will raise an IPO of more than 50 millions dollars, as well as firms, offering unique products, products, interesting to the public or companies with a capable management, have the chance of signing a “bulge bracket” underwriter.

The top 5 IPO underwriters for 2004, ranked by proceeds are Morgan Stanley, Goldman Sachs, Merrill Lynch, JPMorgan and Citigroup.^[14]

The ranking by proceeds of the underwriter for the first quarter of the 2005 compared with the first quarter of 2004 are shown in Figure 3

There are two alternatives of the way of choosing an investment banker, which the issuer can use. The first is called competitive offer based, by which the issuer chooses the underwriter, who bids the most for the securities. This method is not commonly used, since, as it was said before, there are many other factors, except the proceeds from the issuing, which have impact on the choice. This type of choosing is common only for public utilities companies. The second type is called negotiated offer based. With this type of assessing the underwriter, the whole strategy of going public has been considered. The problem with it is that it is more expensive than the first one, but it represents a deal with the underwriter, in which the other factors, such as the reputation and the ability to attract more investors are leading in the process of choosing the underwriter. This is the most commonly used method.

illustration not visible in this excerpt

Figure 2: An Example for “Tombstone” announcement

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/ipo_files/image009.gif, visited on 20 June 2005

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^[1] Ritter, J., “Initial Public Offerings”, http://bear.cba.ufl.edu/ritter , visited on 05 July 2005

^[2] www.sec.gov , visited on 06 July 2005

^[3] Utal, “Inside the deal that made Bill Gates $350,000,000”, Fortune July 21 1986 p.23-31

^[4] Song, Rhee, Adams, “The Initial Public Offering as a marketing tool”, Business horizons, vol.44,no.4, p. 49-54

^[5] Chen, H., Ritter, J., “The Seven Percent Solution, Working Paper”, Journal of Finance 55, 1105-1131

^[6] http://bear.cba.ufl.edu/ritter/work_papers/Some%20Factoids%20about%20the%202004%20IPO%20Market.pdf , visited on 26 June 2005

^[7] http://www.sec.gov/about/laws.shtml , visited on 06 July 2005

^[8] http://www.pwcglobal.com/Extweb/industry.nsf/8b9d788097dff3c9852565e00073c0ba/6c831937e4b42883852568b70052c9dc/$FILE/IPO+trifold.pdf , visited on 08 July 2005

^[9] http://bear.cba.ufl.edu/ritter/rank.pdf for ranking, according to the CM measure for the period 1980- 2004, visited on 27 June 2005

^[10] Carter, Dark, Singh, “Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks”, The Journal of Finance, February 1998, pages 285-311

^[11] Cooney Jr, Hill Jr., Jordan, S., “Who is #1? A new approach to ranking U.S. IPO Underwriters,” http://mba.tuck.dartmouth.edu/ pecenter/events/pdfs/70_Who_Is_1.pdf. , visited on 24 June 2005

^[12] Johnson, J., Miller, R., “Investment Banker Prestige and the Underpricing of Initial Public Offerings”, Financial Management 17, 1988, 19-29

^[13] Carter, Dark, Singh, “Underwriter Reputation, Initial Returns, and the Long-Run Performance of IPO Stocks”, The Journal of Finance, February 1998, pages 285-311

^[14] Morgan Stanley Annual Report 2004, http://morganstanley.com, visited on 20 June 2005