RESEARCH

Investment Insights: Should you Buy IPOs? Rising equity markets have brought an increase in initial public offerings (IPOs) coming to market. These new issuers, when compared to other public companies, are often younger and smaller, and are looking to raise capital for expansion. In this article, we take a critical look at IPOs to understand the benefits and drawbacks of buying these securities.

• What are the typical first-day IPO returns? What is an Initial ? IPOs are new shares sold to the market for the first • How is performance after the first day? time that are issued by a company listed on a Despite the allure of buying IPOs, in our view the costs exchange. The public offering process enables a outweigh the benefits for an individual investor for previously private company to become public. The periods of up to two and a half years after going public. first modern IPO was the Dutch East India Company After that period, an IPO behaves no differently than in 1602. At the time, the chartered shipping company other that have been listed on an exchange for required large quantities of capital to fund shipping some time. The remainder of this document provides and trading operations. The corporation offered additional detail on the questions raised above. shares to the public to obtain the required capital. Understanding the IPO process Companies go public for a number of reasons. Young There are a series of steps that a manager of a pre-public firms like the Dutch East India Company require capital to firm needs to complete before going public. First, the fund investments in positive net-present-value projects firm must have an accounting firm review and prepare or to make external acquisitions. Issuing shares to public standardized, audited financial statements detailing markets is often a cheaper alternative to obtaining capital the financial health of the firm. The firm then selects than a . Additionally, the process an investment bank to underwrite the new issue. For of going public is typically well publicized in the press larger IPOs, there are often multiple underwriters that and may lead to greater visibility not only with potential form a syndicate, with one or two underwriters serving investors, but also with customers. For managers, as the lead underwriter. The underwriter fees paid to entrepreneurs, and early investors such as venture the investment banks for going public are often 7% of capitalists, an IPO is a liquidity event representing an the gross proceeds generated by the sale of . The opportunity to monetize their initial investment. next step after choosing an underwriter involves filing a registration statement with the SEC. This document, One of the potential concerns when buying a newly known as a “red herring prospectus,” is sent to potential minted IPO is whether the insiders of the company know buyers of the IPO. The contents of the prospectus include: more than you do. While the process of going public is designed to minimize such information problems, it’s • Business overview and risk factors hard to know as an investor if you are getting a fair price • Purpose of the issue (and use for the proceeds) when buying shares in an IPO. • Underwriter fees and expenses When evaluating an equity investment in an IPO, it’s • Percentage of shares sold by insiders and expected net important to understand why a firm is going public. proceeds to the issuing company Specifically, it’s helpful to know the following: • Financial statement information

• How does the IPO process work? • Last three years of earnings (if available)

• If I submit an order for an IPO will it always get executed? • Management and director biographical information • List of stockholders who own at least 10% of the firm Is the IPO price fair? • Legal opinion on the issue Historically, lead underwriters have underpriced offerings, leading to high first-day returns when IPOs are initially • Copies of the articles of incorporation of the issuer traded on an exchange. Exhibit 1 reports average first-day While the prospectus provides valuable information, one returns for IPO firms from 1980 to 2013. The first column of the potential challenges faced in valuing IPOs is limited reflects the average first-day return, while the second operating and financial history. Often these firms are column shows the average first-day return weighted by going through a transition, and thus past fundamentals the dollar proceeds from an IPO. The average first-day are a poor predictor of future expectations of growth returns for each year are consistently positive, peaking and income. The underwriters of an IPO often set up a in 1999 with an average equal-weighted return of 77%, “road show”, which is a series of meetings giving senior and proceeds-weighted return of 57%. Over the entire executives of the firm an ability to meet large investors period, average “underpricing,” or first-day return face-to-face. The road show enables the lead underwriter earned by investors that purchase the IPO, is 15.6% and to obtain indications of interest, which they will use to 13.0%, respectively, for equal-weighted and proceeds- recommend a price for the IPO shares to the issuer. weighted returns. The most common way that IPOs are offered to the public Given the very high returns earned by investing in IPOs, is through a best-effort contract, in which the underwriter should an investor buy IPOs from an underwriter at the attempts to sell as many shares as possible at the offer price? offer price. The offer price reflects a price at which the For the price to be fair, two requirements need to be satisfied: syndicate’s lead manager is prepared to offer shares to the public for the first time. If demand for the IPO is high, 1. Transparent information on the expected price at which the price generally rises on the first day. In this situation, a security is bought or sold the underwriter may have a “green shoe” option to sell 2. High expectation that securities can be bought and as much as 15% more shares to the public. If demand for sold at that price an IPO is low, the price usually falls. In this situation, the For public securities that trade on an exchange, the underwriter is often required to buy shares in the offer to Bid reflects the market’s expectation for the price at stabilize the price during the first few days an IPO begins which a security can be sold, and the Ask is the price to trade on an exchange. Primary shares are new shares for which a security can be purchased. Market orders issued by the IPO firm; secondary shares are shares sold that are sufficiently small in size will be executed at or by shareholders of the newly public firm.

Exhibit 1: Equal-weighted and Proceeds-weighted First-Day IPO Returns by Year from January 1980-December 2013 (%) 80 Equal-weighted Proceeds-weighted 70

60

50

40

30

20

10

0 1981 1991 2011 1980 1982 1983 1984 1985 1986 1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2001 2010 2012 2013 2000 2002 2003 2004 2005 2006 2007 2008 2009

Source: Jay Ritter’s website: http://bear.warrington.ufl.edu/ritter

2 Gerstein Fisher near the Bid and Ask prices. For IPO firms, there is often Are IPO stocks good long-term investments? a range provided by the underwriter for the offer price. A second, related question is whether IPOs are suitable The underwriter, however, can set an offer price that is investments after a firm has gone public and shares outside of this range. Since the price is not known at the are being actively traded in the market. Executives and time an IPO order is submitted to the underwriter, IPOs owners of the pre-public firm are restricted from selling fail the first criterion for prices to be fair. shares in the IPO after the firm begins trading on an exchange for periods of six months to up to one year. IPOs also fail on the second criterion. For a high-demand When the lock-up expires, there is evidence that the IPO, orders may not be fully executed if the supply of share price falls, as these insiders are now allowed to sell shares available is not sufficient to meet demand. Thus, shares in the market.1 while an investor will still benefit from a high initial- day return, he will often not get the number of shares IPO’s have historically been for smaller and more growth- in which he had indicated an interest in purchasing. oriented companies. Prior academic research has found For a low-demand IPO, orders will often be executed evidence that small growth stocks have poor performance. in full. Since supply exceeds demand, prices for these To control for size and value characteristics, each month IPO stocks generally fall during the first day. Exhibit we compared the return of an IPO to the return of existing 2 illustrates a hypothetical example of both types of publicly traded firms that have similar Size and Book-to- demand. In the example, an indication of interest for Market ratios. (See Exhibit 3). We then divided IPOs into 1,000 shares for a high-demand issue with an offer three groups by their market capitalization: Microcap, price of $10 that rises 40% may be given (allocated) Small Ex-Micro, and Large. The results are reported in only 100 shares, leading to a profit of $400, instead event time (time since the IPO), and abnormal returns of a profit of $4,000 if the entire indication had been (relative to a size/value matched benchmark) for IPOs are allocated. For a low-demand IPO, the stock price drops averaged across all IPOs in that size group. For example, 10% from an offer price of $10. Since the supply of new quarter six for Microcap is the average abnormal return six shares is higher than the demand, the full indication of quarters, or one and a half years, after the firm has gone interest will be allocated, leading to an unrealized loss public and reflects all IPOs. The cumulative performance of $1,000. In this example, if the investor invests in a since the IPO (Quarter zero) is displayed in Exhibit 3. high-demand IPO and in a low-demand IPO, his average unrealized gain (loss) across both IPOs is -$300. The Exhibit 3: IPO Cumulative Returns lack of a fair price and knowledge of how many shares January 1, 1980-July 31, 2009 will be executed for an IPO order make it difficult for an (%) investor to know whether the high initial-day returns to 10 investing in IPO is achievable. 5

Exhibit 2: Hypothetical First-Day Return Example of 0 High- and Low-Demand IPOs -5 High Demand Low Demand Shares Indicated 1,000 1,000 -10 Cumulative Return Cumulative Shares Allocated 100 1,000 -15 Offer Price $10 $10 -20 Micro First-Day Return 40% -10% Small ex-Micro -25 Large First-Day Unrealized Profit (Loss) $400 -$1,000 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Post-IPO Quarter

Data for IPO firms are taken from Jay Ritter’s website. Information on stock returns, market capitalizations is taken from the Center for Research and Security Prices. Size-based breakpoints are taken from Ken French’s website. Sources: Jay Ritter’s Website, CRSP, Ken French’s Website, and Gerstein Fisher Research

1 For more information, please see Field and Hanka (2001)

Research 3 Over the first 10 quarters, or two and a half years, the Conclusion performance of all IPOs trails the style-based benchmark. In this article, we examine the merits of investing in One potential explanation for IPO underperformance IPOs. Our findings suggest that while first-day returns is that managers of firms issue equity when they know for IPOs are quite high, they are unlikely to be achievable their firm is overvalued. Over time, the market learns the for investors due to the way IPO shares are allocated. true value of the firm and the stock price falls. A second Our research also shows that IPOs have historically potential explanation is downward selling pressure by underperformed for up to two and a half years after current owners of the firm after the six-month to one-year going public. For that reason, we do not recommend lock-up period expires. The results show that both Small investing in IPOs. ex-Micro and Micro IPOs tend to perform better after the first two and a half years. The underperformance has been longer for Large IPOs, which continues even after the two-and-a- half-year mark.

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FALL 2014