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Ipos) and Direct Public Offerings (Dpos Underpricing of Initial Public Offerings (IPOs) and Direct Public Offerings (DPOs) Abstract This paper examines the difference in underpricing between initial public offerings (IPOs) and direct public offerings (DPOs). The data set consists of 4,484 companies that went public between the 1st of December 2012 and the 1st of December 2017 in the U.S. For this sample I find no significant difference between the types of offering on the level of underpricing. Keywords: IPO, DPO, initial return, underpricing. Student: Martin van Dieten Number: 11022329 Program: Economics and Business Track: Economics and Finance Supervisor: Shivesh Changoer Credits: 12 Date: 12 June 2018 1 Statement of Originality This document is written by Martin van Dieten who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents. 2 1. Introduction An initial public offering (IPO) is an event where a company raises external capital from the public, by listing itself on the stock exchange (Berk & DeMarzo, 2013). When the price of the offering turns out higher than the offer price at the day of issuing, investors who purchases the shares can make significant returns. This scenario is called underpricing and reduces the capital raised by the issuing firm. According to Ibbotson (1975), Baron and Holmstrom (1980) and Baron (1982) IPOs are on average underpriced. This underpricing is costly, due to underwriter fees, time and effort and results in less revenues for the issuing firm, including the shareholders (Ritter & Ibbotson, 1995). Therefore, different types of offerings exist to minimize these type of costs. One of these types is a direct public offering (DPO). Direct public offerings are a type of offering on the stock exchange without an underwriter managing the offering (Gregoriou, 2008). DPOs have several advantages. The main advantage is that issuing firms are not forced by an underwriter to underprice the offering. Underwriters have namely the incentive to set a lower offer price, because it has a commitment of buying the leftover shares, which will provide substantial costs (Baron & Holmstrom, 1980). A second advantage of DPOs is that issuing companies can avoid paying high fees for underwriters and other commissions within the process (Gregoriou, 2008). Another advantage is that firms that are small, have insufficient economic success or have bad growth prospects have the possibility to list on the exchange via a DPO. Furthermore, companies that are rejected by underwriters to take the company public can use a DPO (Gregoriou, 2008). To examine whether DPOs are less underpriced than IPOs I examine if there is a significant difference in underpricing between Initial Public Offerings (IPOs) and Direct Public Offerings (DPOs). The answer on this question concludes if a DPO is more advantageous than an IPO. Data are obtained from the Thomson One database between the 1st of December 2012 and the 1st of December 2017 in the U.S stock market. For my sample of 4,484 firms I find no significant difference in underpricing between IPOs and DPOs. This finding adds to prior research that there is no free lunch when conducting a DPO instead of an IPO and therefore, DPOs are not more advantageous even though no underwriter fees have to be paid. Several studies have been done about the underpricing of IPOs. Studies from for example Loughran & Ritter (2004), Ibbotson (1975) and Baron & Holmstrom (1980) show that there is, on average, underpricing of initial public offerings. Nonetheless, there has been little 3 research done about DPO underpricing compared to IPO underpricing. This is because traditionally only a handful of small companies in industries such as food and biotech have gone public via DPO every year. Therefore, my research extends the research that has been done about IPO underpricing by testing if there is a significant difference in underpricing between an IPO and a DPO. In the following section the literature and background information on IPOs are discussed. The third section contains the hypothesis and literature on DPOs. The method and data are described in section 4. The descriptive statistics, correlations, univariate and multivariate regressions are reviewed in section 5. In section 6 a sensitivity analysis is done. Section 7 contains the conclusion of the thesis. 2. Literature and background information 2.1.IPOs An Initial Public Offering (IPO) is an event whereby a company offers its common stock for the first time on a public stock exchange (Berk & DeMarzo, 2013). Initial Public Offerings are managed by an investment banker called an underwriter, who manages the offering and outlines its structure (Berk & DeMarzo, 2013). Between the period of 1980 and 2001 there was more than 1 IPO per business day in the U.S (Ritter & Welch, 2002). However, this amount varied between a minimum of 100 and a maximum of 400 IPOs from year to year (Ritter & Welch, 2002). These IPOs had an average deal size of 78 million dollars, with a total of 488 billion dollars in gross proceeds (Ritter & Welch, 2002). According to Ritter & Welch (2002) the underpricing was on average 18.8 percent after one day of trading. Within 3 years the underpricing increased to 22.6 percent. The two biggest advantages of IPOs, with respect to staying private, are an increase in liquidity and better access to capital (Berk & DeMarzo, 2013). Furthermore, founders and shareholders are given the possibility to convert their capital into cash at a future date (Ritter & Welch, 2002). The fact that companies increase their publicity with an IPO plays mostly a minor role (Ritter & Welch, 2002). Besides that, there are advantages when comparing an IPO to a DPO. According to Gregoriou (2008) issuing firms can signal their quality by the chosen underwriter. Another advantage is that underwriters can stake out investors or confirm the quality of the securities (Anand, 2003). The disadvantages consist of direct and indirect costs. These direct costs include mostly legal, auditing and underwriter expenses (Ritter & Ibbotson, 1995). The indirect costs are the time and effort from conducting the IPO (Ritter & Ibbotson, 1995). Another disadvantage 4 according to Ritter and Ibbotson (1995), is the possibility for dilution of shares, because the shares are being sold to the public at, on average, a lower offering price. As mentioned before, some companies find these costs expensive. One of the types that does not incur these cost is a direct public offering, which will be elaborated in section 3. 2.2 IPO underpricing Underpricing of an initial public offering is one of the most researched phenomena regarding IPOs, see for example Loughran & Ritter (2004), Ibbotson (1975) and Baron & Holmstrom (1980). The mentioned studies show that there is, on average, underpricing of initial public offerings. This means that the issuing firms leave money on the table (Loughran & Ritter, 2004). If there is a positive initial performance it indicates that offerings are underpriced. This means that the share price turned out greater than the offer price set by the underwriter (Ibbotson, 1975). According to Baron and Holmstrom (1980) the main reason why IPOs are underpriced are incentives of the underwriter. Issuing companies asks underwriters to set an offer price, because the underwriter has better information on the demand of the securities and the condition of the capital market (Baron & Holmstrom, 1980). The underwriter uses this freedom to set a lower offer price, because it has a commitment of buying the leftover shares, which will provide substantial costs (Baron & Holmstrom, 1980). This way the underwriter has an incentive to limit these costs and advice an offer price below the interest of the issuer. This ensures that the shares will be sold easily and will limit the loss for the underwriter (Baron & Holmstrom, 1980). Loughran and Ritter (2002) further investigate the conflict between the freedom of the underwriter and the issuing firm. As mentioned before, the discretion in share allocation of the underwriter is not used in the best interest of the issuer. According to Loughran and Ritter (2002) underwriters deliberately underprice the offering to sell shares to favoured buy-side clients. This to gain quid pro quos (Loughran & Ritter, 2002). Baron (1982) supports this theory. He argues that, when the underwriter has better information regarding market demand prior to the contracting, the underwriter sets the price below the first-best offer price to limit the costs and risks for the underwriter (Baron D. P., 1982). Benveniste and Spindt (1989) also assumes that there is asymmetric information. They argue that, when investors are more informed than the issuers underwriters can use bookbuilding to obtain information from investors. To truthfully reveal the demand of the investors, underwriters offer to underprice offerings (Benveniste & Spindt, 1989). 5 Another theory is based on the assumption that there is asymmetric information. It is assumed that issuers are better informed than investors. This causes rational investors to fear a lemons problem (Ritter & Welch, 2002). This implies that only issuing firms with a below average quality want to sell the shares at an average price (Ritter & Welch, 2002). Therefore, high-quality issuers try to signal their quality by underpricing. There are also theories based on symmetric information. Hughes and Thakor (1992) argue that issuing firms wants to underprice the offering to reduce their legal liability. This is because overvalued IPOs have a higher chance to be sued (Hughes & Thakor, 1992). Therefore, to avoid subsequent lawsuits issuers want to leave money on the table. (Hughes & Thakor, 1992).
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