MBF1223 Financial Management Lecture 5: -Initial Public ... · PDF fileLecture 5: -Initial Public ... Investors buy or sell shares based on their valuation of the stock ... • Note

MBF1223 Financial Management

Lecture 5: -Initial Public Offerings -Rights Issue

Trends in Global Equity and Bond Markets, 2001 - 2009

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2001 2002 2003 2004 2005 2006 2007 2008 2009

World Equity and Stock Markets (Trillions of USD)

StockMarket

DebtMarket

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Initial Public Offering

• The process of selling stock to the public for the first time is called an

initial public offering (IPO).

It is also referred to as “going public” or “unseasoned new issue”.

• The shares sold at an IPO may either be new shares that raise new capital,

known as a primary offering, or existing shares that are sold by current

shareholders, known as a secondary offering.

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The IPO Process

Appointment of Advisers

• A number of professional firms are involved in IPO exercises:

Investment Bank as Principal Adviser

Legal Firm (provide advice on all legal matters in relation to your application)

Accountants (prepare the Accountants’ Report as well as undertake the due diligence on the application documents)

Property Valuer (if company’s listing exercise involves any property, plant, machinery an equipment that have been or to be revalued)

Issuing House (will oversee the balloting, issuance and allotment process of your company’s shares)

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The IPO Process

Step 1: Appointing Professionals

Step 2: Implementing Organisational Changes

Step 3: Appointing Independent Directors

Step 4: Method of Listing and Valuation

Step 5: Preparing Documents for Submission

Step 6: Submission and Review

Step 7: Approvals

Step 8: Registration of the Prospectus

Step 9: Investor Briefings

Step 10: Balloting Process

Step 11: Listing

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The IPO Process

• The approval IPO process differs from to country to country. In Malaysia, the applications

are submitted to the Securities Commission and Bursa Malaysia (the Malaysian stock

exchange).

• Subsequent to the above approvals, a Prospectus must be issued by the company to

investors.

• A prospectus is a document setting out the terms of its equity issue.

• It provides information on the company, and financial performance of the company so that

investors are able to make informed decisions about whether to invest.

• The must be lodged with authorities (with the Securities Commission in Malaysia).

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The Approval Process

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Pricing

• Pricing The offer price is determined by the lead underwriter together with the

issuer During the road show, the number of shares demanded at various prices

is assessed

• The investment bank and underwriters will work with the company to come up with a price that they believe is a reasonable valuation for the firm and the price at which the company’s shares will be offered to investors.

• Two ways used to value a company:

Estimate the future cash flows and calculate the present value; or Examine comparable companies.

Also take into account the net assets of the company, PE ratio, future

prospects etc

Transaction and Costs

• Transaction costs Advisory fees (Investment Bank, legal firm, accountants, and other

professionals) Underwriting fee

• In the US the issuing firm typically pays 7 percent of the funds raised (M’sia: 3-4%)

• The lead underwriter typically forms a syndicate with other firms who receive a portion of the transaction costs

• Lock-up provision/moratorium Prevents the original owners from selling shares for a specified period

• Prevents downward pressure • When the lockup period expires, the share price commonly

declines significantly

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Investor Participation in the Secondary Market

• How investor decisions affect the stock price Investors buy or sell shares based on their valuation of the stock

relative to the prevailing market price Investors arrive at different valuations which means there will be

buyers and sellers at a given point in time As investors change their valuations of a stock, there is a shift in the

demand for and supply of shares and the equilibrium price changes

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Investor Participation in the Secondary Market

• How investor decisions affect the stock price Investor reliance on information

• Favorable news increases the demand for and reduces the supply of the security

• Unfavorable news reduces the demand for and increases the supply of the security

• Investors continually respond to new information in their attempt to purchase or sell stocks

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Type of Investors

• Types of investors Individual investors typically hold more then 50 percent of the total

equity in a large corporation • Ownership is scattered

Institutional investors have large equity positions in corporations

and have more voting power • Can influence corporate policies through proxy contests • Insurance companies, pension funds, and stock mutual funds are

common purchasers of newly issued stock in the primary market • The collective sales and purchases of stocks by institutions can

significantly affect stock market prices

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Monitoring by Investors

• Managers serve as agents for shareholders to maximize the stock price

• Managers may be tempted to serve their own interests rather than those of investors

• Shareholders monitor their stock’s price movements to assess whether the managers are achieving their goal – When the stock price declines or does not rise as high as

shareholders expected, shareholders may blame the weak performance on the firm’s managers

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Shareholder activism

Communication with the firm • Shareholders can communicate their concerns to other investors

to place more pressure on managers or its board members • Institutional investors commonly communicate with high-level

corporate managers and offer their concerns – Institutional Shareholder Serves (ISS) Inc. is a firm that

organizes institutional shareholders to push for a common cause

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Shareholder activism

Shareholder lawsuits • Investors may sue the board if they believe that the directors are

not fulfilling their responsibilities to shareholders • Lawsuits are often filed when corporations prevent takeovers,

pursue acquisitions, or make other restructuring decisions that shareholders believe will reduce the stock’s value

• When directors are sued, courts typically focus on whether the director’s decision seems reasonable, rather than on whether the decision led to higher profitability

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The Corporate Monitoring Role

• If managers believe their stock is undervalued in the market, they may take actions to capitalize on this discrepancy

• Stock repurchases – Use excess cash to purchase shares in the market at a low price – Stock prices respond favorably to stock repurchase announcements

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The Corporate Monitoring Role

• Market for corporate control A firm may engage in acquisitions to increase the value of a target

firm • Can also create synergistic benefits

A high stock price is useful to exchange acquirer shares for target

shares

Share prices of target firms react very positively

Leveraged buyouts • LBOs are acquisitions that require substantial amounts of borrowed

funds

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Barriers to corporate control

Antitakeover amendments are designed to protect shareholders

against an acquisition that will ultimately reduce the value of their investment in the firm

• e.g., may require at least two-thirds of shareholder votes to approve a takeover

Poison pills are special rights awarded to shareholders or specific managers upon specified events

• e.g., the right for all shareholders to be allocated an additional 30 percent of all shares without cost whenever a potential acquirer attempts to acquire the firm

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Barriers to corporate control

A golden parachute specifies compensation to managers in the

event that they lose their jobs • e.g., all managers have the right to receive 100,000 shares of the

firm’s stock whenever the firm is acquired

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Globalization of Stock Markets

• Barriers between countries have been removed or reduced Firms in need of funds can tap foreign markets Investors can purchase foreign stocks

• Foreign stock offerings in the U.S.

Large privatization programs in Latin America and Europe can not be digested in local markets

By issuing stock in the U.S., foreign firms diversify their shareholder base

SEC regulations may prevent some firms from offering stock in the U.S.

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• International placement process Many U.S. investment banks and commercial banks provide

underwriting services in foreign countries Listing on a foreign stock exchange:

• Enhances the liquidity of the stock • May increase the firm’s perceived financial standing • Can protect the firm against hostile takeovers • Entails some costs

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• Global stock exchanges Stocks outside the U.S. have been issuing stock more frequently The percentage of individual versus institutional ownership varies across

countries

• Emerging stock markets: Enable foreign firms to raise large amounts of capital by issuing stock Provide a means for investors from other countries to invest their funds May not be as efficient as the U.S. stock market May exhibit high returns and high risk May be volatile because of fewer shares and trading based on rumors

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• Methods used to invest in foreign stocks Direct purchases involves directly buying stock of foreign companies

listed on the local stock exchanges International mutual funds are portfolios of international stocks

created and managed by various financial institutions World equity benchmark shares represent indexes that reflect

composites of stocks for particular countries that can be purchased or sold

Advantages and Disadvantages of Going Public

Advantages: • Greater liquidity • Better access to capital

Disadvantages: • Equity holders become more widely dispersed resulting in loss of control • Must satisfy requirements of public companies like securities commission

and stock exchange regulations

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IPO Puzzles

Four characteristics of IPOs which puzzle financial economists: 1. On average, IPOs appear to be underpriced: The price at the end of

trading on the first day is often substantially higher than the IPO price. 2. The number of IPOs is highly cyclical: When times are good, the market is

flooded with IPOs; when times are bad, the number of IPOs dries up. 3. The costs of the IPO are very high: It is unclear why firms willingly incur

such high costs. 4. The long-run performance of a newly public company (three to five years

from the date of issue) is poor: That is, on average, a three- to five-year buy and hold strategy appears to be a bad investment.

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IPO Puzzles

1. Underpriced IPOs

• Generally, underwriters set the issue price so that the average first-day return is positive.

• Studies have examined the underpricing of IPOs and found that, on average, they are underpriced by 10-15%.

• Note that, although underpricing is a persistent and global phenomenon, it is generally smaller in more developed capital markets.

• Who wins and who loses because of underpricing?

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IPO Puzzles

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Average first-day returns

IPO Puzzles

2. “Hot” and “Cold” IPO Markets • As with all market activity, trends related to the number of IPO issues are

cyclical with large magnitude of swings.

• It appears that the number of IPOs is not solely driven by the demand for capital.

• Sometimes firms and investors seem to favour IPOs; at other times firms appear to rely on alternative sources of capital.

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IPO Puzzles

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Number of IPOs in Australia, 2003-07

IPO Puzzles

3. High cost of issuing an IPO • In the US, the discount below the issue price at which the underwriter

purchases the shares from the issuing firm is 7% of the issue price.

• The typical spread in Australia is abut 4%.

• This fee covers the cost to the underwriter of managing the syndicate of managers and helping the company prepare for the IPO.

• Still, this fee is large, especially considering the additional cost to the firm associated with underpricing.

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IPO Puzzles

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Relative Costs of Issuing Securities

IPO Puzzles

4. Poor post-IPO long-run share performance • Newly listed firms appear to perform relatively poorly over the following

three to five years after their IPOs – so why do investors pay as much as they do for the hares when they begin trading?

• Possibly that underperformance might not result from the issue of equity itself, but rather from the conditions that motivated the equity issuance in the first place.

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Secondary Stock Offerings

• A secondary stock offering is:

A new stock offering by a firm whose stock is already publicly traded

Undertaken to raise more equity to expand operations

• Existing shareholders often have the preemptive right to purchase

newly-issued stock (Rights issue)

Raising Additional Capital: The Seasoned Equity

Offering

• A firm’s need for outside capital rarely ends at the IPO as profitable growth opportunities occur throughout the life of the firm.

• Seasoned Equity Offering (SEO): When firms return to the equity markets and offer new shares for sale:

1. General cash offer: The firm offers new shares to investors at large.

2. Rights offer: The firm offers the new shares only to existing

shareholders. Each shareholder is issued rights to buy a specified number of new shares from the firm at a specified price within a specified time, after which the rights are said to expire.

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Rights Issue

• A rights issue is an issue of rights to buy additional securities in

a company made to the company's existing security holders.

• It is a way to raise capital.

• With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the company at a specified price within a specified time.

• Rights Issue basis –rights shares are offered in a proportion to the existing shares held by a shareholder. Eg. Rights issue on the basis of 1 shares for every 2 shares held (1:2) For a shareholder who holds 10,000 shares in the company, under the RI he will receive 5,000 rights issue shares. 35

Rights Issue

• Calculating theoretical ex-rights price

• TER price is market price that a stock will theoretically have following a new rights issue.

• Eg. ABC Berhad undertakes a rights issue on the basis of 2 rights shares for every 5 shares held,

an an issue price of RM1.30. The market price of the company’s shares is RM1.60.

• Calculation:

2 rights shares @ RM1.30 (2x1.30) RM2.60 5 existing shares @ RM1.60 (5x1.60) RM8.00 --- -----------

7 RM10.60 === ÷7 ----------- TER price RM1.51 =======

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Dilution of Percentage Ownership

• Dilution of percentage of ownership occurs when a shareholder does not take up his entitlements under company’s share issue.

• Illustration: Global plc, a company listed on the stock exchange, currently has 10,000,000 share outstanding. John hold 1,000,000 shares in Global. Thus, Mark holds 10% shareholdings in Global. Global undertakes a rights issue of 5,000,000 shares on the basis of 1 share for every 2 shares held. Hence, Global’s oustanding shares will increase to 15,000,000 shares. If Mark takes up his rights entitlement, his shareholdings will increase to 1,500,000 shares, but his percentage shareholding will be maintained at 10%. However, if Mark does not take up his rights entitlement, his shareholding will remain 1,000,000. However, his percentage shareholdings will decrease to 6.67% (1,000,000/15,000,000).

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Global Equity Market: Recent Trends

(1) Stock exchanges becoming public traded organizations Historically stock markets were private organizations.

However, in February of 2001 Germany’s stock exchange, the

Deutsche Stock Exchange went public;

In July of 2001, both the London Stock Exchange and Euronext went public;

In 2006, the NYSE went public.

• Implications of publically traded exchanges: Inclusion in investor portfolios.

Possibility of take-overs

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(2) Consolidations (mergers and acquisitions) among independent stock exchanges.

On September 22, 2000, Euronext Stock Exchange was formed through

the merger of the national stock exchanges of France, Belgium, and the Netherlands. In December 2001, Euronext acquired the shares of the London International Financial Futures and Options Exchange (LIFFE), in 2002 it acquired the Portuguese Stock Exchange.

On April 4, 2007, the New York Stock Exchange and Euronext merged to form NYSE Euronext.

In February 2011, NYSE Euronext and Deutsche Börse announce that they were engaged in "advanced merger talks.” On April 1st, NASDAQ countered with a higher bid for NYSE

Euronext (19% over Deutsche’s offer); however, the offer is rejected by NYSE Euronext as not “strategically attractive.”

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• In 2006 and 2007 NASDAQ twice attempted a hostile takeover of the London Stock Exchange. Both takeover attempts were rejected by LSE shareholders.

• In late 2010, Singapore offered to buy out the Australian Securities Exchange for $7.8 billion The offer was recently rejected by the Australian Government.

• In February 2011, the London Stock Exchange announced a merger with the Toronto Stock Exchange.

• Why are exchanges merging? (1) cost reductions (to the exchanges themselves through economies of

scale). (2) to expand global capital raising benefits (IPOs) to corporations and (3) to provide liquidity (turnover) and global outreach benefits to investors.

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(3) Increasing number of national stock markets around the world.

John Thain, 2006, CEO, NYSE: “Most countries have an army, a flag, an airline, and a [stock] exchange.”

Today there are approximately 300 stock exchanges. Many emerging countries have their own stock markets.

• Part of their privatization process.

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