So now we've gone through the nuts and bolts of the IPO process. Let's turn our attention to a common phenomenon that we observed with the Alibaba float, IPO underpricing. You'll recall from the last session that Alibaba went through an exhaustive process where they were advised by six of the biggest investment banks in the world. And where they conducted an extensive road show where they actively marketed the upcoming $25 billion float to potential investors before finally settling on a subscription price of $68 per share, the day before the shares were listed on the NASDAQ exchange. What happened immediately upon listing? The shares shot above $93 and hovered around $90 for weeks afterwards. So investors who had subscribed to the float at $68 per share were now, a very short time later, holding shares worth over $90. This is a clear example of the phenomenon commonly referred to as IPO underpricing. And the way that we can measure the degree of underpricing is by simply calculating the percentage difference between the subscription price and the final price paid for the share at the close of the first day of listing. So for Alibaba, we get a percentage underpricing level of about 38%, not a bad short-term return. The question is, how widespread is this phenomenon? Was Alibaba a one-off incident? Well, let's first look at historical first-day returns for IPOs in the US market. So what we can see from this chart, which documents the average first-day return for firms listing in the US market, and there's about 12,000 firms in this sample. Is that the average level of underpricing is about 17%. We also see that there are many months where the average level of underpricing actually exceeds 100%. But you'll also note that there are a few months here where the average level of underpricing is negative, indicating that the subscription price was set too high. How widespread is this effect internationally? Is this just a US phenomenon? Let's have a look at some international evidence. When we look at worldwide research into IPO underpricing, we see that China has an average first-day return of 118%. That is that IPOs that list in China. The average first-day return Is 118%, and then we see it decline down to a still very significant 89% for India, 56% for Malaysia, and down we go. In the Australian market, about 22% on average, working our way down to Argentina, about 4%, but still significant and positive. The underpricing phenomenon is real, and it's widespread. And it's persisted through time. So what are some reasons for IPO underpricing? The first relates to information asymmetry and the so-called Winner's Curse. So imagine firstly that investors come in one of two categories. We have informed investors who are able to judge whether an IPO is over or underpriced. Then we have uninformed investors, who aren't able to judge the relative pricing of IPOs. As each IPO comes to the market, who's going to bid for overpriced IPOs? Clearly only the uninformed investors. Informed investors will only step in the when the IPO is underpriced, and indeed they'll crowd out the uninformed investors if that's the case. To ensure that uninformed investors stay in the market, IPOs need to, on average, be significantly underpriced. And the argument is that's what we're observing in practice. The second reason for underpricing is known as investment banker monopsony power. Now recall your coffee delivery service that was going to IPO. The first step was that you had to engage an investment bank. The investment banker assisted you in advising on the subscription price. This creates a potential conflict of interest for at least two reasons. Firstly, by encouraging you to underprice the float, it can make their own cost lower in the sense that they don't have to expend as much effort marketing the float. Secondly, and this is a little bit more devious, is that by underpricing the float, investment bankers, the argument goes, can foster relationships with other clients. So, for example, if your own float is underpriced to the tune of, let's say, 20%, then they'd be able to tip another client that that was an IPO that they should be investing in to reap an immediate return of 20%. This is what's known as IPO spinning. It's illegal in most jurisdictions. The third reason for IPO underpricing is what's known as lawsuit avoidance and the purchase of implicit insurance. So if we think about it, the prospectus is in large part, a marketing document, although it does have legal protection as well for investors. And there's a chance that perhaps, some of the claims, some of the forecasts in the prospectus might be a little bit, let's say, biased. Well, underpricing ensures that subscribers enjoy a gain from their investment. And so, this provides protection to directors, who otherwise might be sued for any misstatement or malfeasance in the production of the actual prospectus. But who pays for that insurance? Ultimately, it's the original owners of the firm, who have sold the firm's share off at too low a price. The fourth reason for underpricing is just part of a much larger strategy. As CEO, you know that the IPO is only the next stage in a multi-stage strategy for expansion. So you know that in the future, you'll have to go back to the market to raise more capital. The argument goes that by underpricing this time, you can leave a good taste with investors, so that next time you go to market, they'll line up around the block to purchase shares in your company. The fifth and final reason for IPO underpricing is ownership dispersion. And follow the train of thought here. The higher the level of underpricing, the more interest there will be by a broader group of investors. And so you'll have a much more dispersed ownership base. This has two effects, or at least two effects. Firstly, much greater liquidity in this stock. The more people that hold the stock, the easier it is to buy and sell the stock without incurring much of a price penalty. The second reason, the second effect of much greater dispersion, is managerial entrenchment. The broader the ownership base, the much harder it is for the shareholder base to actually get organized and kick management out of their job. So you may see IPO underpricing as an example of an agency problem within the firm, where management has become entrenched and is unable to be removed by a very dispersed ownership base. So in summary, IPO underpricing occurs where the subscription price for a float is set below the true market value of the shares. It's a world-wide phenomenon that's been documented over an extended period of time. Reasons for IPO underpricing include information asymmetry and the Winner's Curse, investment banker monopsony power, lawsuit avoidance and implicit insurance, underpricing to leave a good taste through signaling with investors, and ownership dispersion. So we've now considered raising equity as via an IPO. Now what about debt? That's what we're going to cover in the next session.
