© Cumming & Johan (2013) Exits Overview Divestment Cumming & Johan (2013, Chapter 19) 1.

© Cumming & Johan (2013) Exits Overview

Divestment

Cumming & Johan (2013, Chapter 19)

1


Chapter Objectives

• Review the economics of initial public offering (IPO) markets

• Describe the array of exit outcomes: IPOs, acquisitions, secondary sales, buybacks, and writeoffs

• Describe the performance of venture capital-backed IPO and acquisition exits

2


IPOs & Stock Exchanges

Economics of IPOs

Venture Capital Exit Outcomes

Summary

Why are IPOs Underpriced in the Short-run and Overpriced in the Long Run?

3


Time Horizon for IPOs

Economics of IPOs


Summary

IPO FactsST UnderpricingLT OverpricingImplications and VCsOther Interesting Facts

PreliminaryProspectus

(Can’t canvas clientsuntil prelim prospectus)

Waiting Period

(can canvas clients)FinalProspectus

(Underwriter and issuer signunder “firm commitment”)

Selling

4


Definitions

Economics of IPOs


Summary


• “Best Efforts” Underwriter puts forth best efforts Underwriter is a sales agent for the issuer Typically used for small & risky issues Short term underpricing tends to be greater

• “Firm Commitment” Underwriter agrees to sell X shares Underwriter takes the risk they buy the issue and sell it to

the public E.g. “bought deal”

5


IPO Empirical Regularities

Economics of IPOs


Summary


1. Systematic oversubscription demand > supply

2. Short-term (ST) underpricing end of 1st day price > issue price

3. Long-term (LT) overpricing end of 1st year price < issue price

4. Cyclical in # and in degree of ST underpricing

5. Ability of VCs to time public markets e.g., skilled VC higher degree of LT overpricing

6


Country Source Sample Size Time Avg. Period

Initial Return

Australia Lee, Taylor & Walter; Woo 381 1976-1995 12.1%

Austria Aussenegg 83 1984-2002 6.3%

Belgium Rogiers, Manigart & Ooghe; Manigart 86 1984-1999 14.6%

Brazil Aggarwal, Leal & Hernandez 62 1979-1990 78.5%

Canada Jog & Riding; Jog & Srivastava; 500 1971-1999 6.3%

Kryzanowski & Rakita

Chile Aggarwal, Leal & Hernandez; Celis & Maturana 55 1982-1997 8.8%

China Datar & Mao; Gu and Qin (A shares) 432 1990-2000 256.9%

Denmark Jakobsen & Sorensen 117 1984-1998 5.4%

Finland Keloharju; Westerholm 99 1984-1997 10.1%

France Husson & Jacquillat; Leleux & Muzyka; 571 1983-2000 11.6%

Paliard & Belletante; Derrien & Womack; Chahine

Table 18.1 International Evidence on IPO Underpricing

Source: Jay Ritter’s webpage http://bear.cba.ufl.edu/ritter/

7



Initial Return

Germany Ljungqvist 407 1978-1999 27.7%

Greece Kazantzis & Thomas; Nounis 338 1987-2002 49.0%

Hong Kong McGuinness; Zhao & Wu; Ljungqvist and Yu 857 1980-2001 17.3%

India Krishnamurti & Kumar 98 1992-1993 35.3%

Indonesia Hanafi; Ljungqvist & Yu 237 1989-2001 19.7%

Israel Kandel, Sarig & Wohl; Amihud , Hauser & Kirsh 285 1990-1994 12.1%

Italy Arosio, Giudici & Paleari; Cassia, Paleari & Redondi 181 1985-2001 21.7%

Japan Fukuda; Dawson & Hiraki; Hebner & Hiraki; 1,689 1970-2001 28.4%

Hamao, Packer, & Ritter; Kaneko & Pettway

Korea Dhatt, Kim & Lim; Ihm; Choi & Heo 477 1980-1996 74.3%

Malaysia Isa; Isa & Yong 401 1980-1998 104.1%

Mexico Aggarwal, Leal & Hernandez 37 1987-1990 33.0%

Netherlands Wessels; Eijgenhuijsen & Buijs; 143 1982-1999 10.2%

Ljungqvist, Jenkinson & Wilhelm

Table 18.1 International Evidence on IPO Underpricing (Continued)

Source: Jay Ritter’s webpage http://bear.cba.ufl.edu/ritter/ 8



Initial Return

New Zealand Vos & Cheung; Camp & Munro 201 1979-1999 23.0%

Nigeria Ikoku 63 1989-1993 19.1%

Norway Emilsen, Pedersen & Saettern 68 1984-1996 12.5%

Philippines Sullivan & Unite 104 1987-1997 22.7%

Poland Jelic & Briston 140 1991-1998 27.4%

Portugal Almeida & Duque 21 1992-1998 10.6%

Singapore Lee, Taylor & Walter; Dawson 441 1973-2001 29.5%

South Africa Page & Reyneke 118 1980-1991 32.7%

Spain Ansotegui & Fabregat; Otero 99 1986-1998 10.7%

Sweden Rydqvist; Schuster 332 1980-1998 30.5%

Switzerland Drobetz, Kammermann & Walchli 120 1983-2000 34.9%

Taiwan Lin & Sheu; Liaw, Liu & Wei 293 1986-1998 31.1%

Thailand Wethyavivorn & Koo-smith; Lonkani & Tirapat 292 1987-1997 46.7%

Turkey Kiymaz; Durukan 163 1990-1996 13.1%

U.K. Dimson; Levis; Ljungqvist 3,122 1959-2001 17.4%

United States Ibbotson, Sindelar & Ritter 14,840 1960-2001 18.4%

Table 18.1 International Evidence on IPO Underpricing (Continued)



Why ST Underpricing?

Economics of IPOs


Summary


1. Deficient information; compensate buyers for risk

Issuer signals superior quality by underpricing Then in subsequent equity offerings the

market has more information and the issuer does not need to underprice as much

10



Economics of IPOs


Summary


• Empirical evidence on #1Firms with greater IPO underpricing go back to

public market sooner and more often to raise additional capitalSEO subsequent equity offeringIncrease in price after IPO should go back to the

market for a SEO because the market “loves you”!

11



Economics of IPOs


Summary


• Related to #1Underpricing is more pronounced among

industries that have a lot of publicity (e.g., internet IPOs)

Need to underprice more to distinguish quality because bad firms can mimic good firms in times where there is excessive publicity

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Economics of IPOs


Summary


2. Conflict of Interest #1Underwriter protects its own interest at the

expense of the issuer to flog the issueCostly for the issuing firm

13



Economics of IPOs


Summary


3. Conflict of Interest #2Favour with institutional clientsInstitutional clients are the main purchasers of

IPOsRepeated gameUnderwriters give deals to their institutional

clients to keep them happy(Problem with this story: underwriter selling its

own stock same degree of underpricing)

14



Economics of IPOs


Summary


Related to #3Japan: underpricing because IPOs sold to

politicians!Great way to pay a bribe!

15



Economics of IPOs


Summary


4. Partial Adjustment PhenomenonImplicit bargain between underwriters and

institutional clientsUnderwriter needs to gather info to price

securitiesDifficult to gather info!Hard to forecast revenues!Continued…

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Economics of IPOs


Summary


4. Continued…Underwriter goes to institutional clients and

asks “what is a reasonable price”Underwriter (implicitly) agrees to underpricingInstitutional clients do not want to truthfully

reveal infoIndirect fee in form of underpricing to

truthfully reveal what they think it is worth

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Economics of IPOs


Summary


5. Winner’s CurseFirst noticed in sale of oil leases by oil

companiesOn average oil companies pay too much for

leases from gov’t – over decades!Every oil company makes a private estimate

(s.t. error)Error those that make the largest error pay

too much and win the bid!

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Economics of IPOs


Summary


6. Fear of Legal LiabilityInterest of issuers and underwriter

underprice to avoid legal liabilityIssuer: absolute liabilityUnderwriter: negligence liability1996 US Congress: made it more difficult for

class action lawsuits because too many – not justified on the facts (crybabies)

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Economics of IPOs


Summary


7. Information CascadesMarket for IPOs inefficientKeynes: stocks priced in securities markets –

like judges in a beauty contest! – pick the person who you think the other people will judge who the best person is

Dynamic: information cascade – issuer and underwriter don’t want this to happen so they underprice

20



Economics of IPOs


Summary


8. Regulatory Factors in some countriesE.g., Japan – price based on earnings multiples

of firms currently already trading

21



Economics of IPOs


Summary


9. ST Underpricing is an Illusion Price stabilization – permitted in US and Canada (but cannot

purchase above offer price – manipulation of share prices can lead to imprisonment)

In relation to IPOs, price stabilization works by the underwriter buying in the market in 1st 2 weeks

If price falls the underwriter enters the market and buys to increase the price (“stabilize the price”)

Market manipulation! Allowed to assist issuers selling securities

22



Economics of IPOs


Summary


Mean withoutstabilization

Mean withStabilization

23


Why LT Overpricing?

Economics of IPOs


Summary


• NSADAQ Index is typically the base index for which IPO LT overpricing is compared Smaller firms on NASDAQ – smaller market capitalization NASDAQ has a lot of technology stocks

But regardless of the benchmark, IPOs are bad long term performers (problematic for efficient market theorists!)

24


Countrv Author(s)Number of

IPOsIssuing Total abnormal years

return

Australia Lee, Taylor & Walter 266 1976-89 -46.5%

Austria Aussenegg 57 1965-93 -27.3%

Brazil Aggarwal, Leal & Hernandez 62 1980-90 -47.0%

Canada Jog and Srivistava 216 1972-93 -17.9%

Chile Aggarwal, Leal & Hernandez 28 1982-90 -23.7%

Finland Keloharju 79 1984-89 -21.1%

Germany Ljungqvist 145 1970-90 -12.1%

Japan Cai & Wei 172 1971-90 -27.0%

Korea Kim, Krinsky & Lee 99 1985-88 +2.0%

Singapore Hin & Mahmood 45 1976-84 -9.2%

Sweden Loughran, Ritter & Rydqvist 162 1980-90 +1.2%

U.K. Levis 712 1980-88 -8.1%

U.S. Loughran & Ritter 4,753 1970-90 -20.0%

Table 18.2. International Evidence on Long-Run IPO Overpricing



Why LT Overpricing?

Economics of IPOs


Summary


1. The divergence of opinion hypothesis: Large differences between optimistic and pessimistic investors can dampen long run performance, since the divergence of opinions narrows over time (which in turn lowers market prices if optimistic owners find less optimistic potential buyers) (Miller, 1977; Morris, 1996).

26


Why LT Overpricing?

Economics of IPOs


Summary


2. The impresario hypothesis: IPOs are often subject to fads and market swings. Only 25% of investors do any fundamental analysis of the firm before investing in an IPOs (Ritter, 1998).

27


Why LT Overpricing?

Economics of IPOs


Summary


3. The windows of opportunity hypothesis: Firms go public in “hot markets”, which in turn creates the appearance of overpricing in the long run as market levels taper off. As newly listed firms are typically more sensitive to market swings, the decline in market activity tends to have a more pronounced effect on newly listed firms relative to the market (Schultz, 2003). The highly volatile nature of the IPO market in the United States is examined in Ritter (1998) and Lowry (2003).

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Why LT Overpricing?

Economics of IPOs


Summary


4. Costs associated with going public relatively greater burden on smaller firms hurts LT performance Legal and accounting costs

$500,000 for a $25million IPO Underwriter commission

5-7% for larger offeringsSmaller IPOs have greater percentages because underwriter

bears greater risk<$1million IPO 50% commission!

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Proceeds ($ millions) 1

Gross Spreads2

Other Expenses3

Total Direct Costs4

Average Initial Return5

Average Direct and

Indirect Costs6

Number of IPOs

Interquartile Range of Spread

2-9.99 9.05% 7.91% 16.96% 16.36% 25.16% 337 8.0-10.0%

10-19.99 7.24% 4.39% 11.63% 9.65% 18.15% 389 7.00-7.14%

20-39.99 7.01% 2.69% 9.70% 12.48% 18.18% 533 7.00-7.00%

40-59.99 6.96% 1.76% 8.72% 13.65% 17.95% 215 7.00-7.00%

60-79.99 6.74% 1.46% 8.20% 11.31% 16.35% 79 6.55-7.00%

80-99.99 6.47% 1.44% 7.91% 8.91% 14.14% 51 6.21-6.85%

100-199 6.03% 1.03% 7.06% 7.16% 12.78% 106 5.72-6.47%

200-499 5.67% 0.86% 6.53% 5.70% 11.10% 47 5.29-5.86%

500-up 5.21% 0.51% 5.72% 7.53% 10.36% 10 5.00-5.37%

Total 7.31% 3.69% 11.00% 12.05% 18.69% 1767 7.00-7.05%

Direct and Indirect Costs, in Percent, of Equity IPOs, 1990-94, in the United States



Direct IPO Costs as a Per Cent of Total Proceeds(Figure reproduced from Shutt and Williams, 2000)(by size category, U.S. $ millions)

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What Does this Mean for Regulation and Disclosure?

Economics of IPOs


Summary


• Simplified formal prospectus• United States

SCOR prospectusQ&A formatEach issuer can complete on own without legal

advisorsJust fill in the blanks – that’s it!5 years audited financial statementsDoesn’t harm investor protection

32


VC Backed IPOs

Economics of IPOs


Summary


• Does VC’s ability to time IPO markets (recall chapter 10) imply more or less LT overpricing? Why?

• Long-run underperformance is not observed for United States venture capital-backed IPOs, which has been explained by the value-added that venture capitalists provide to their investee firm prior to the IPO (Brav and Gompers, 1997, Gompers and Lerner, 2003).

• Relatedly, Gompers and Xuan (2007) examine the characteristics of acquisition of private firms by public firms. They find that compared to the acquirers of other non-venture backed private firms, those public firms that acquire private venture capital-backed firms tend to be larger and have better long-run performance.

33


Economics of IPOs


Summary


Additional Interesting Stock Exchange Issues and SMEs

34


January Effect

Economics of IPOs


Summary


• Returns in January are the greatest!• ¾ of the gains in any given year occur in January!• Reasons:1. Tax loss selling at year end

but don’t observe share prices decreasing in December January effect existed prior to capital gains taxes

35


January Effect

Economics of IPOs


Summary


2. Portfolio manager dressing up before annual reportBut no fall in share prices in December

3. Santa EffectBut again, no Dec fall in prices

36


P/E Effect

Economics of IPOs


Summary


• Where P/E low, firm has high returns on a risk-adjusted basis

• P/E ratio is additional info that isn’t in the CAPM beta

37


Small Firm Effect

Economics of IPOs


Summary


• CAPM does not work well for SMEs

38


Neglected Firm Effect

Economics of IPOs


Summary


• When few institutional shareholders• Neglected firms outperform non-neglected firms• Risk factors – more costly because risk aversion

• Note: small firm effect may actually just be a neglected firm effect

• P/E effect may also be a neglected firm effect

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January Effect Neglected Firm Effect?

Economics of IPOs


Summary


• Degree of neglect is lower in January because more information on firms

• More information on all firms in January lower uncertainty increase in price of small firms

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Mode of Venture Capital Exit

Economics of IPOs


Summary

• Exit = The means by which venture capitalists dispose of their investments

• Exit Types» IPO» Merger/Acquisition» Secondary Sale» Buyback» Writeoff

41


What Drives Choice of VC Exit?

Economics of IPOs


Summary

1. Entrepreneurial firm characteristics

2. VC characteristics

3. Cash flow and control rights between VC and entrepreneur

4. Market conditions

5. Legality and institutional factors across countries

• This is the focus of Chapters 20 and 21 for Canadian and European data, respectively

42


Table 19.1. Factors Influencing Exit VehiclesSource: Cumming and MacIntosh (2003b)

IPO Acquisition Secondary Buyback

Ability of New Owners to Resolve Information Asymmetry and Value the Firm

41-2

1 for High-Tech2

1 for equity5 for debt

Ability of New Owners to Monitor and Discipline the Managers

4-55 for High-Tech

1-21 for High-Tech

41 for equity5 for debt

Entrepreneur's Preferences to Go Public 1 5 Indeterminate 1

Transaction Costs of Effecting a 4 2 2 2

Ongoing Costs of Operating as a Public versus a Private Firm 5 1 1 1

Liquidity of Investment to the Buyer 1 Indeterminate 5 5

Liquidity of Exit to Seller: Cash or Cash Equivalent* 1 Indeterminate Indeterminate 2

Managerial Incentives Post Exit 1 4-5 3 1, with variation

Transaction Synergies 1 ` 2-4 5

Must New Capital Be Raised? Yes No No No

High Growth Firms 1 1-2 3 5

Efficiency of Risk Bearing 1 1, with variation Indeterminate 5

Common Form of Exit Yes Yes No No

Common Exit Strategy Usually Usually Ad hoc Ad hoc

Cyclicality of Valuations in IPO Markets Time Dependent Time Dependent 3 3

Fund Termination Date Looms1, if IPO hurdle cleared; 5

otherwise2 2 2

The VC's Reputational Incentives 1 2 4 5

Agency Costs of Debt 1 Indeterminate 3 5

Public Profile of Firm 1 Indeterminate 5 5

* For IPOs, the ability to convert to cash within one year is considered a cash exit

Legend:

1=strongly favours, 2=favours, 3=neutral, 4=disfavours, 5=strongly disfavours 43


Exit Outcomes are Extremely Important to Examine

Economics of IPOs


Summary

• Choice of investment duration

• Choice of exit vehicle

• Important to understand economics of IPO markets

• Important for returns to VC

• Important for future of investee firm

44

© Cumming & Johan (2013) Exits Overview Divestment Cumming & Johan (2013, Chapter 19) 1.

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Transcript of © Cumming & Johan (2013) Exits Overview Divestment Cumming & Johan (2013, Chapter 19) 1.