Jos van Bommel, Said Business School, University of Oxford: IPO (Initial Public Offering) - quick access to fresh capital

(Jos van Bommel)

Access to Equity Capital Markets is extremely important for growing economies. When firms grow, their capital needs outpace their cash inflows. This means that external financing is needed. Some of this financing comes in the form of bank lending. Continental Europe has long been a bank-dominated economy. The problem with bank lending is that it is limited, and that it can be expensive, and risky. Banks lend only to firms with collateralizable assets and a proven history of cashflows. Growing firms often lack either. And even if a growth firm has fixed assets that it can pledge as a collateral, or fairly certain cashflows, they typically are small compared with a growth firm’s present value of growth opportunities.

Since the 1990s European public equity capital markets have played an increasingly important role in the financing of high growth companies, even in historically bank denominated economies such as Germany. Stock market listings have given firms several benefits, the most obvious one being access to capital

1. Cash

The main reason for a firm to list on the stockmarket is to raise cash. The raised cash is used for two main purposes. Currently the most important use for IPO proceeds is investment. Firms can increase their value by investing in activities that generate more cash in the future, than the current cash outlay. By a healthy margin of course, because investors have other opportunities, such as bank accounts, or relatively risk free bonds.

A second use of IPO proceeds is to reward entrepreneurs, and their families, for their past efforts. Historically, European firms went public later in life than their Anglo-Saxon counterparts. Many of the first wave of German, French and Italian IPOs involved secondary shares sales. That is, the proceeds of the IPO were not invested in the business, but went to the pockets of the selling founders, or, more typical, their heirs. But even today, this second use of IPO proceeds should not be underestimated. Before going public firms offer rely on funding from private equity investors, either individuals or firms, such as venture capital partnerships. These early stage investors also want a return on their investment, even more so because early stage investments are very risky and very illiquid. Going public offers these investors to cash out, and employ their money elsewhere.

2. Access to More Cash

A second key reason for a firm to go public is to get a foot in the door of the large public capital markets. Once public, a firm is on the radar screen of thousands of analysts, who all follow the firm’s prospects. When a firm needs more cash, their recognition in the capital markets makes it significantly easier to sell more shares. Although investors will always grumble when a firms issues more shares, thereby diluting ownership of existing shareholders, it is much easier for a listed firm to raise capital through a share issue than for an unlisted firm which.

But not only the door to the equity capital market opens through a stock market listing. Exchange quoted firms have also much easier access to bond markets. Several academic studies have found that not only the required return on equity capital decreases, listed firms also pay lower coupons on bonds, and lower interest rates to banks. The reason for this is that a stock market listing is a valuable asset in itself. Researchers have estimated that the value of a stockmarket listing can be 20% of total assets for small firms.

3. Liquidity

Liquidity is extremely important for investors. Not only firms, but also investors face liquidity risk. The risk that they suddenly and unexpectedly need cash. For this reason they place a premium on liquid investments. Investments that can be bought and sold in relatively small parcels. A stock market listing offers investors this opportunity.

Liquidity is a hard to measure characteristic. Researchers and practitioners have been, and are still, trying to find a way to gauge and price liquidity. How much is an additional unit of liquity worth. Hopefully, by the end of the decade we will have a universally accepted answer to this question. Current research suggest focuses on listed stocks, among which liquidity also varies. It has been documented that small, illiquid stocks require returns that are 2-5% higher than their large blue chip colleagues. The illiquidity premium for completely unlisted stock may well be 10 or 20%. If we combine this illiquidity premium with the growth-characteristic of potential IPO firms, we can easily explain how a fairly liquid stock market listing, can easily triple the intrinsic value of a firm. To see this, consider a firm whose profits grow at 6% annually, for ever. On a stock market with a required rate of return of 10%, this stock would be trading at a P/E multiple of 1/(10%-6%) = 25. If it were untraded, and commands an illiquidity premium of 10%, this same stock would be worth only 1/(20%-6%)= 7 times its annual earnings.

4. Reputation

As mentioned, through a stock market listing firms launch themselves on the radar screen of thousands of analysts and investors. This recognition gives them access to future cash, and significantly increases the liquidity of the shares.
However, the firm’s reputation in the product market also benefits. This is especially valuable for firms whose products or service hinge on a long term commitment to their clients or are dependent on export. For example construction companies who bid for a large and long term development project, will find that their comparative advantage increases when they can point at their stock market listing, and the thousands of analysts who follow them. Moreover, the sheer name recognition, from the financial media is valuable for the business itself. An important academic survey on the reasons to go public found that “reputation, name recognition” was the second most important for companies to go public. For many firms it was the single most reason to float.

5. Managerial Incentives

Companies often reward their employees, and in particular, managers for jobs well done. The question often is “what is a job well done”? How do we measure managerial performance. Does a manager who postpones factory maintenance create more shareholder value than a manager who spends millions on an original advertising campaign? The former manager probably books higher profits for the year. And generates higher cashflows..

Most listed companies reward their managers when the stockprice goes up. By paying them in stock options, or restricted stock, for example. The idea behind this is that a “job well done” is defined by increasing the wealth of the owners. This is not necessary the current profits or cashflows, but all future cashflows (discounted at an appropriate rate).

In a reasonably efficient market, investors and analysts will recognize the value of an original advertising campaign and bid up the stockprice so that it reflects this value. Similarly, a firm that does not invest in employee safety (or otherwise endangers future cashflows at the expense of current cashlows), will see its stockprice fall.

Hence, an increase in the stockprice, is a good measure for managerial value added. Only listed firms have access to this efficient value-estimate: the stock price.

6. Market Feedback

Although the firms managers and majority shareholders are likely to know their business much better than the thousands of individual investors and analysts, the stockmarket can still convey important feedback to managers. First we observe that the market price aggregates the information of the thousands of analysts and investors. That is, it incorporates the average of opinion of the capital market participants. Even though individual investors know less about the firm’s business than the firm’s managers, the aggregate opinion is likely to be informative. For example, if, upon announcement of a major acquisition, the acquirer’s stock drops, it may be a signal to the managers that the proposed deal is not a good idea.

Another important piece of information from the market to the mangers concerns the firm’s risk. Portfolio managers continuously gauge a firm’s risk. They use sophisticated risk measures such as the stock’s market-beta, and monitor the equity premium.

Information about a firm’s risk profile is important for its investment decision, where the cost of capital plays an important role. Thanks to a stock market listing firms can estimate their cost of capital more precisely, either through conducting their own analysis on how their stockprice fluctuates, or by just asking analysts during analyst meetings.

So far, we have only looked at the advantages of going public and obtaining a stock market listing. Naturally, there are disadvantages too. Foremost, there are the costs of going public, which can be substantial. Costs come in different forms. Most obvious are the fees that the different intermediaries will charge for their services. But there are also other non-pecuniary costs, such as management time and concentration. Going public is a long process that can occupy managers minds and time during several months, and even years. Then there is the unavoidable discount that needs to be given in order to place the shares. Not surprisingly, in the large capital markets, with thousands of stocks to choose from, investors require a discount for considering your shares. Most IPOs are what we called underpriced. That is, they start trading at a price higher than the offerprice.

Finally there are costs of being a listed companies. Exchanges charges listing fees, and with more and wider dispersed shareholders, firms have to dramatically change their financial reporting. Among others they need so print thousands of annual reports and comply to strict regulations regarding publicly listed firms. For this reason the loss of confidentiality is also an issue. Competitors will also read your financial reports and information given during your roadshow analyst meetings, may also find its way to the product market competitors.

Finally, public equity markets may not always be equally efficient. According to the famous economist John Maynard Keynes stock markets are controlled by animal spirits, instead of fundamental values. Practitioners knew long before agree that capital markets are often governed by irrational investor sentiment, which may be based on herding behaviour.

An implication of this theory is that in overly pessimistic markets the cost of capital for publicly quoted companies may be higher, instead of lower than for unlisted companies. And that managers with stock options are compensated for investor sentiment instead of for value enhancing projects.

Although it is inconsistent with traditional financial theory, recent research has uncovered significant evidence that markets are periodically over- and undervalued. Among others, it has been documented that stock returns are autocorrelated in the long term. Which means that after a period of bad returns. the probability of a period of high returns increases. Moreover it has been documented, that in bear markets, few companies go public. While bull markets see many IPOs. More worrying, companies that sell shares during bullmarkets tend to subsequently underperform, on average, while firms that go public in bear markets outperform the market, and peer groups. This suggests not alone that markets may be periodically misvalued, but that mangers know this and go public in overly optimistic markets and postpone selling shares in overly pessimistic market.

The first half year of 2008 saw relatively few firms going public. Worldwide 236 went floated on the stockmarket in the first quarter of 2008. Approximately €25 billion was raised. Although still substantial, both numbers represent are less than half the IPO volume in previous quarters. Emerging market economies saw the highest volume. Most Mature European markets saw no initial public offerings at all. The relative calm in the IPO market is, of course, due to the global credit crunch. Still, there is no doubt that for many firms and economies the advantages of going public will continue to outweigh the costs, also in the near future. This is evident in the proportion of IPOs we see in emerging markets. The largest recent IPOs come from the BRIC countries. But also fast growing European firms take the plunge. A case in point is Poland, where 17 firms went public this year. The second quarter of 2008 will no doubt see a further decline in IPOs

Regional stock markets also follow this pattern. There have been number of successful IPOs in the region last year, but these activities came to stop this year due to the credit crunch described earlier. The IPO activity in the region will only pick up with general stock markets come back.

All these issues will be covered in my lecture “Initial public offerings” (IPOs). It will be held on Koločep Island from 12th to 14th of September as a part of Dubrovnik Lectures in Banking and Finance (DBF). If you are interested in this topic, you could find more information and register for the course at www.dubrovnik-bf.com.

Jos van Bommel is University Lecturer at the University of Oxford, and Visiting Professor at the Pompeu Fabra University. Dr. van Bommel holds a MSc. degree in Engineering from Eindhoven University, in the Netherlands, an MBA from IESE in Spain, and a PhD. From INSEAD, France. He previously taught at IESE in Barcelona and Babson College, in Boston (U.S.). Dr. van Bommel teaches courses in Corporate Finance to MBA students, graduate students and executives, for which he has received several teaching awards. He also has extensive experience in teaching executives, in intensive short term programs, such as the Oxford Diploma in Finance and Strategy and the Oxford Finance for Executives, and in custom company specific courses. Most recently, he gave two seminars for practitioners at the Capital Markets confer­ence in Bucharest, Romania. His area of specialization is Initial Public Offerings. He is author of numerous academic articles in prestigious academic journals, and presented his research at many conferences. He is particularly interested in the flow of information between the financial markets and managers’ investment decision, and the aggrega­tion of information in public equity markets. He investigates the strategic behavior of informed and less informed investors to better understand how information is revealed in stock prices. Dr. van Bommel has also extensively studied private equity, venture capital, and emerging market.