By Jan-Matthias Jetter
Initial Public Offerings (IPOs) in Vogue
Initial Public Offerings (IPOs) are back in vogue as companies seek to take advantage of the substantial liquidity provided in the market and the resulting attractive public company valuations. 2020 has been the most active year for IPOs since 2007 with $331 billion raised across 1,591 listings globally, which represents a 42% increase compared to the previous year (see Appendix 1). Given this amount of public attention and wealth transfer, issuers selling their shares at IPO have recently expressed high levels of frustrations with the traditional IPO process, with some market participants calling the process untransparent and broken. These frustrations can be encapsulated in the following points:
- The traditional IPO process does not use market mechanisms to efficiently match supply and demand, by either using electronic systems or a broad auction process typically found in M&A processes. Instead the IPO underwriter hand-picks the offering price.
- The IPO underwriter also selects the investors who get to buy at the fixed offer price. Most interested buyers of the stock are not admitted an IPO allocation.
The consequences of this inefficiency have been dramatic for issuers (see Appendix 2). Looking at US IPO data between 1980-2019, the mean first-day return was 20.7%, which represents $198bn of value left on the table for shareholders. For 2020, the numbers are even more dramatic: the average company that went public in the US was underpriced 48%, equating to almost a $30bn one-day wealth transfer. For the company’s shareholders this represents a total cost of capital of above 50%, assuming a 4-7% gross spread that underwriters earn.
The underlying mechanism that explains this underpricing can be explained by the multiple principal problem. This problem arises when one agent acts on behalf of multiple principals that have competing interests. In this case, the incentives of underwriters are misaligned with those of the issuers because the underwriter of the IPO is also the broker to the buy-side of the stock. While issuers want the highest price for their shares, the buy-side naturally wants the lowest possible price. These competing interests at investment banks have been revealed in an several e-mail exchanges. I specifically highlight one from Goldman Sachs: “Exclusive access to GS hot deals might be a critical competitive tool to keep customer acquisition costs low and encourage larger clients to move to our site from a competitor’s” (see Appendix 3).
Naturally, the question arises why underwriters are willing to underprice if a higher offer price leads to higher underwriter revenue. Jay Ritter, an equity capital markets researcher from the University of Florida, believes investment banks underprice for two reason: 1) lower offer prices reduces the need to do extensive marketing for the underwriters as it is easier to find buyers; and 2) potential IPO investors are willing to pay a higher commission to improve their chances of getting an IPO allocation. Jay Ritter summarizes this with the following calculation: “If hedge funds and other IPO investors overpay on commissions (soft dollars) by 30 cents for every dollar of money left on the table that they get, when underwriters raise an offer price by $1 per share they gain 7 cents in gross spread revenue but lose 30 cents in soft dollar revenue.”
With these skewed incentives, underwriters intentionally underprice the IPO with the following strategy: After the road show, ECM bankers tell clients that they need a 97% “hit-rate” for the IPO to be successful; that is 97% of investors the issuer meets on the road-show should express interest in purchasing the offering at the price that the underwriter communicates. When orders are then put in by prospective investors, the “optimal” over-subscription target ought to be 30x, which means that the issuer needs 30x more orders than they actually plan to sell. Once the orders are in, underwriters start book-building and allocate the underpriced shares to their most profitable buy-side investors (i.e. those that are willing to pay the highest commission for IPO shares).
For many years, corporate executives have not been particularly bothered by the amount of money that is left on the table at IPO day. In fact, academic studies have shown that issuing firms in the past have not considered the large amounts of money left on the table an important consideration in choosing the underwriter for any subsequent follow-on share offerings. Two possible reasons could explain this phenomenon. First of all, issuers of IPO shares face a trade-off between the big “pop” on the first day of trading versus more cash proceeds. Indeed, a jump of the share price on first day of trading could have positive side-effects, such as broad media coverage and boost in morale, potentially leading to higher employee productivity and bolstering recruitment efforts. A second reason for issuers’ obliviousness to foregone cash proceeds could also be explained by a behavioural model called prospect theory developed by Nobel-winning economists Daniel Kahneman and Amos Tversky; that is issuers focus more on the relative change of their wealth than their absolute wealth. Issuers will remain insensitive to money lost on the table if the wealth gain from first-day returns is larger than the wealth loss from the first-day share price pop. Shareholders, however, may start to voice concern about wealth left on the table if the underpricing reaches a critical threshold.
With average underpriced shares of 48%, 2020 could mark a turning point in how companies consider to go public. In fact, two alternative routes to going public have become popular recently by corporate executives. Namely, DPOs (Direct Public Offering) and SPACs (Special Purpose Acquisition Companies).
Direct Public Offerings
The first company to go public via a DPO was Spotify in April 2018 (see Appendix 4 for timeline of events). Barry McCarthy, then CFO at the time, was one of the first executives to publicly question the traditional IPO process, even calling it “moronic”. Since 2018, several other companies have gone public via a DPO, namely Slack, Palantir and Asana among others. The essential difference to the IPO process is that shareholders in a DPO directly list their shares (including sale of secondary shares) without issuing primary shares. For financial advisors the DPO is a much simpler service offering: in the absence of the underwriting capacity, investment banks advise on preparation of registration statements, public communications and consult with the stock exchange’s market maker about the company’s shareholder selling interest (as required by the USA direct listing rules). Proponents of the DPO name the following the advantages:
- DPOs uses the supply and demand matching system from the NYSE using the price-time algorithm (also known as FIFO algorithm). This algorithm prioritizes buy orders of the stock with the same maximum price based on the time of bid until an agreed upon single price is found.
- The stock at opening day is available to all market participants with a brokerage account.
- DPOs are up to 2-3x cheaper than IPOs, as no gross spread fees are paid to underwriters
- No lock up period of 90-180 days typically found in IPOs, enabling greater liquidity for shareholders
Despite the above mentioned benefits, the DPO process bears significant risks that should also be considered. Indeed, the DPO in its current format only suits a select number of companies. First of all, it is suitable for companies that have no need to raise additional capital as they area already cash-rich. In fact, regulators currently have not allowed the issuance of primary shares in a DPO process. Secondly, the shareholder base ought to be large and diversified enough to provide sufficient supply-side liquidity on first day of trading. Lastly, these companies must already have significant media attention to spare the need for a road-show.
At the moment, these prerequisites are fulfilled mostly by tech-companies that have previously raised large amounts of money in private markets through venture capital and have generated enough media attention organically. In fact, most companies have used the DPO to create liquidity events for early investors (founders, venture capital and private equity investors) as opposed to raising new capital. For many lesser known companies with complex business models active in niche markets, DPOs are a much riskier endeavour, argues John Mullins, an associate professor at London Business School. First of all, the marketing preparation and investor network that investment banks provide can support the necessary market interest to achieve a strong valuation. With a DPO, there is great uncertainty over how many shares will sell and at which price. In addition, as there is no lock-up period in a DPO, price stability in the short to medium-term is not guaranteed. The issuer surrenders control and assumes all the risk, without having raised any primary capital to fall back on.
Despite the underpricing risks associated with traditional IPOs, DPOs have seen limited activity for the reasons mentioned above. However, in December 2020, the SEC approved a series of regulatory changes for the direct listing process by the New York Stock Exchange, potentially paving the way for more DPO activity. One of the significant changes is that primary shares will be allowed to be issued in a direct listing without the need of an underwriter. In fact, this has been a main concern with DPOs for companies when choosing to go public. Another change the SEC approved was decreasing the minimum common equity required to be sold on first day of trading from US$250 million to $100 million. The SEC reiterated that the change “will facilitate the orderly distribution and trading of shares, as well as foster competition.” Despite these changes, the DPO process will remain an instrument for companies that have a diverse shareholder base, easy to understand business models and broad media attention that they generate organically.
Special Purpose Acquisition Companies
While DPOs have received much fanfare from the Silicon Valley community to accelerate their own liquidity events, SPACs have proven to be the much more common alternative to going public. 2020 has been a landmark year for SPACs, with US$83 billion in total gross proceeds across 248 SPAC IPOs in the US market. In the first month of 2021 alone, there have been 91 SPAC IPOs, having raised US$25 billion (see Appendix 5). The sheer volume of this financial asset has been bolstered by regulatory ease (compared to traditional IPOs) and abundancy of liquidity in the market.
The SPAC structure works the following way (see Appendix 6 for more details): Investors take a “blank check” shell corporation public by raising cash, and then have two years to search for a private company, which it will reverse merge into the SPAC legal entity. The SPAC sponsors, typically hedge funds or private equity firms, issue redeemable shares to investors and provides warrants (options for investors to buy more stock of the issuing company at a fixed price at a later date). The redeemable shares means that if a SPAC investor does not like a proposed merger, they have the right to get back the full investment, plus interest. According to a study by Michael Klausner from Stanford Law School, the annualized return for redeeming investors has been 11.6%. Investors usually keep the warrants for free after they have redeemed their shares, so this annualized return represents a de-facto “risk-free” return. The investor redemption rate in 2020 was as high as 75% in 2020. The SPAC sponsor now in need of cash to finance the reverse merger will go to the market and issue new shares through PIPEs (private investment in public equities). To finance its operations between IPO and merger of the company, the SPAC will demand an underwriting fee at the time of their IPO.
Commentators have named the following advantages of SPACs:
- SPACs are a much faster way of going public company compared to traditional IPOs and DPOs (2-3 months vs. 6-8 months).
- SPACs gives the company more control over negotiations. Especially in the current highly liquid market climate, companies have the upper hand in the negotiation table. As of December 2020, dry powder of SPACs reached over US$200 billion, with all looking bring the most attractive companies public.
- SPAC sponsors help in the communication of the equity story of the company as they also help them raise primary capital through a PIPE if some investors activate their right to not contribute to the merger.
- Some commentators have argued that the SPACs have a lower cost of capital compared to traditional IPOs, if one includes the cost of underpricing.
There are a few important aspects of the SPAC that companies should consider before choosing this route of going public. First of all, there is inherent dilution that is accompanied with most SPACs due to the dynamics explained above. The redeemable shares and warrants reduce the share value at the time the SPAC merges the company into its blank check entity, often imposing a high cost on the shareholders of the company the SPAC takes public. This is exacerbated by the fact that the SPAC sponsor pay nominal amounts of 20% of the SPAC shares before the IPO, leading to further loss of equity for the company. There is also a reputational and risk the company bears if most SPAC investors redeem their shares, causing the SPAC to go back into the market for new investors for PIPEs, which could put downward pressure on the merger pricing and lead to more dilution.
In addition, due to the abundancy of dry powder in the SPACs, sponsors often rush to take a company public, overlooking important financial and commercial considerations in their due diligence. In fact, many shareholders of sub-performing companies are enticed by SPACs to go public without considering the risks of their own shareholding. The three-month return post-merger of SPACs has been as low as -14.5%. Six-month and twelve-month returns are even worse still, at -23.8% and -65.3%, respectively. However, if one segments SPACs into high quality and low quality sponsors (as per Michael Klausner), one will find much better returns for high-quality SPAC sponsors (see Appendix 7). The three-month average return after the merger for high quality sponsors was 31.5%. In addition, high quality SPACs will also have fewer redemptions, and hence lower dilution for companies.
It is not clear whether the SPAC offers a cheaper and more efficient way to go public compared to traditional IPOs. Michael Klausner finds that SPACs are equally expensive (c. 50%) as traditional IPOs when considering the underpricing in the cost of capital. With its current dilutive structure, SPACs will remain an instrument for companies that already have a strong financial performance and who can therefore negotiate good terms with high-quality SPAC sponsors that offer strategic guidance after going public.
