L9, Advanced corporate finance

Raising Equity Capital

Objectives of the Session

• Understand equity financing mechanisms.

• Learn how Initial Public Offerings (IPOs) and Seasoned Equity Offerings (SEOs) operate.

• Examine post-IPO and SEO performance facts.

Equity Financing (Private Equity)

• Initial Capital Sources:

  • Old adage: "Family, Friends and Fools"; Angel investors are key early-stage investors.

    →private investors specialized in investing in new companies, often with some past experience, they will bring money, expertise, network

• Private Equity Firms:

  • Focus on investing in non-listed companies(so before they go IPO), providing vital capital and expertise.

  • Venture Capital Firms:

    • Raise capital for young firms, offering diversification and expertise.

    • Incur management fees for their services and significant control costs.

  → their main purpose: is to invest into companies(in their asset), on their equity side they have a lot of other private investors(diversification by investing into PE/VC)

  → often pension funds& insurance companies like to invest into private equity, bc very longterm investments should be for longterm projects

• Investor Types:

  • Institutional investors (pension funds, insurance companies), corporate investors, and other entities such as universities.

• Exit Strategies:

  • Essential consideration for all investors, they have to anticipate because for private equity, there is risk of illiquidity (there’s no market, or atleast no fast)

Initial Public Offering (IPO)

• Pre-IPO Considerations:

  • Understand the process is lengthy, costly, and demanding.

  • Requires management changes; necessity of timing and solutions.

  • Existing shareholders must not be sidelined.

  • Weigh pros and cons effectively.

• Advantages of IPOs:

  • Improved access to capital.

  • Enhanced business visibility and awareness.

  • Higher liquidity and diversified ownership.

  • Establishing a market value for the company.

  • Motivational capital access for employees.

IPO Disadvantages

• Ownership Challenges:

  • Diminished ownership concentration, leading to potential loss of control.

• Regulatory Compliance:

  • Adherence to legislation (costly and time-consuming) regarding governance and communications; specific requirements in each country (e.g., FSMA in Belgium, SEC in the US).

• Costs of Going Public:

  • Direct costs (underwriting fees) and indirect costs (loss of confidentiality).

• Market Obsession:

  • Continuous scrutiny from the market on company rumors and actions.

Recent IPO Examples

• Examples of High-Profile IPOs:

  • Aramco (Dec 2019): $29.4 billion raised, valued at $1.7 trillion.

  • Unifiedpost (Sept 2020): $252 million raised.

  • Uber (May 2019): $8.1 billion raised.

  • Other examples include Spotify and Airbnb.

IPO Process

• Role of Underwriters:

  • Investment banks (e.g., Goldman Sachs) act as advisors, manage the structure and pricing.

  • Fees are typically 5% to 10% of proceeds (underwriting spread).

• Offering Types:

  • Distinctions between primary (new shares) and secondary (existing shares).

  • Contracts offered with variations :

    -Best Efforts, to send the stocks to the market, especially for smaller IPOs(often with all or nothing clauses), if not succesful in selling can cancel the operation with underwriter)

    -Firm Commitment, the underwriter is obligated to sell the stocks,

    -Auction IPO

    -direct IPO:less costly but more complicated

  • Lock-up periods restrict existing shareholders from selling shares during set intervals

    → why? to avoid volatility(don’t want too much offer on the market)

Auction IPOs

• Mechanics of Auction IPOs:

  • Bids are taken for shares, determining the offer price based on demand.

• Price Calculation Example:

  • Analyze bids to find demand at various price points.

  • Winning price can be computed based on share demand.

Valuation Concerns

• Determining Offer Price:

  • Challenging without historical prices; key to successful IPOs.

  • Various financial models used (Free Cash Flow, Dividend Discount Model).

• Road Show Importance:

  • Collecting investor interest during a roadshow aids in valuation and book-building.

Underwriters' Risk Management

• Risks for Underwriters:

  • Lowering offer price to ensure equity sale; importance of the book-building stage.

  • Greenshoe option allows for sale of extra shares if needed.

IPO Underpricing

• Market Performance After IPOs:

  • Historically, IPOs open higher than their offer price; average first-day return 18.3% (1960-2003).

  • Factors affecting performance include market conditions and investor sentiment.

• Notable IPOs Example:

  • Counter-examples like Facebook and Uber illustrate challenges in maximizing first-day returns.

Information Asymmetry in IPOs

• Investors' Perspectives:

  • Differences between informed and uninformed investors lead to underpricing.

• Implications of Underpricing:

  • Risks of overvaluation affect investment strategies for market participants.

Closed-End Funds IPOs and Underpricing

• Return Analysis for Closed-End Funds:

  • Initial returns significantly lower due to reduced information asymmetry.

• Average Initial Returns:

  • Data suggests different returns compared to traditional IPOs, impacted by investor knowledge.

Issuers Leaving Money on the Table

• Beneficiaries of Underpricing:

  • Investors gain from first-day trading profits

  • Pre-IPO shareholders face dilution and lost profits due to lowered shares sold.

• Overall Financial Impact:

  • Between 1990-1998, companies lost $27 billion on initial sales to investors due to pricing.

Long-Run Underperformance of IPOs

• Performance Trends:

  • IPOs typically underperform over the medium term (3 years), especially among younger growth companies.

• Determinants of Long-Run Performance:

  • Market conditions and investor overoptimism play significant roles.

Seasoned Equity Offerings (SEOs)

• Core Aspects of SEOs:

  • Similarities to IPOs but with known stock prices prior to offering.

  • Underwriting costs lower, around 5% of proceeds.

• Two Main Approaches:

  • Cash offer: available to all investors.

  • Rights offer: new shares available primarily to existing shareholders, safeguarding against dilution.

Market Reactions to SEOs

• Common Market Trends:

  • SEO announcements often lead to declines in stock prices.

  • Long-term underperformance noted, particularly in smaller firms.