Initial Public Offerings (IPOs) have a very special place in contemporary economics and finance. They represent the entrance on a deep and liquid market with access to almost unlimited reserves of capital from all over the world. But IPOs appear also as a short-term fund-raising tool, especially used during the high tech bubble of the late 1990s from new, innovative and invincible-looking start-up companies from the Silicon Valley. In those years, investment bankers (who set up IPOs for the companies going public) thrived and were sacred “kings of capitalism” by The Economist. Since then, the euphoria vanished but IPOs continued at a respectable pace.
Between 1980 and 2001, the number of IPOs in the US exceeded one per business day. The distribution was not equal: in 1999 and 2000 alone, 900 companies went public. What is more, the IPO business has reached global importance, raising $167 billion around the world in 2005 with 1537 operations. During the period 1998-2004, North America represented 27% of the global market, Europe, Africa and the Middle East combined 42% and Asia-Pacific 31%. The trends of globalization are thus reflecting on the IPO business worldwide: dominance of the US market (on a country basis comparison) and rise of East Asia (especially China).
In a system dominated by market financing, flotation appears often to be a mandatory step in the life of a company above a certain size. We do not discuss in this paper IPOs under this perspective of structural necessity; rather we question the short-term stakes of going public. Besides the strategic choice to be listed on the stock market, what are the immediate objectives of an IPO? It has certainly become, especially since the internet bubble, a corporate financing tool, along with private equity and mergers and acquisitions, aimed at raising funds in a short period of time. Thus, we consider here IPOs under this aspect of short-term financing, even if it has obviously much broader implications.
We can define the objectives of an IPO for a company as follows: raise the maximum value possible through the flotation, and assure a stable and, if possible, increasing price in the aftermarket. The second objective depends partly on the first one, which is basically the direct result of the sale price. Setting the price of the stock to be traded publicly is the greatest challenge in the IPO process, as it determines the equity allocation among investors and the subsequent trading price on the market. Financial theories give no final answer as to what method is the best. Hence the perpetuation of the academic debate.
We have chosen to envision IPOs, the challenges they pose to efficient markets and the theoretical answers to those, through game theory. This approach allows us to detect where inefficiencies occur, what the different motivations of the actors involved are and what possible solutions have been proposed and tested. Game theory appears to us as the best tool to study market inefficiencies by offering a special opportunity to have a critical outlook on market mechanisms and the effects of strategic interaction upon them.
Therefore, we will first present the challenges which IPOs pose to efficient markets (section one). Then we will detail an alternative mechanism for setting the price in an IPO process – auctions: what are their advantages and drawbacks (section 2)? Finally, we will study the flotation of EDF, one of the greatest IPOs in the world in the last years, a rare example of overpricing and also a subject of polemics in France (section 3).
[...] But banks have another opportunity to realize huge profits in IPOs: when the demand for new stock exceeds the predetermined quantity offered, if the contract with the firms allows it, the bank can offer for sale 15% more stocks of the company going public and capture entirely the corresponding value an option called “greenshoe”. The incentives for the banks to realize successful IPOs are thus enormous. But to understand the central role of investment bankers between the issuer and the investors, we must have a closer look on the most used process of going public for a company, called book-building. [...]
[...] In other words, unequally distributed information creates market inefficiencies resulting in distorted prices Distortion Mechanisms and Waste of Value through Underpricing Here, we detail the mechanisms that transform the basic characteristics of an IPO, asymmetries of information and multiplicity of actors and interests, into unsatisfactory pricing and allocation of shares. We will focus on three main explanations: informational cascades, adverse selection and winner's curse. The first two explanations are founded on the assumption of asymmetries of information among investors. Informational cascades[3] occur when all investors are gathering information independently according to their means, but some are waiting for others to take an action susceptible of unveiling their belief on the stock's value, before making their own decision. [...]
[...] They decided not to participate in the initial public offering and this denial to participate could have been at the beginning damaging for Google. Hence the “poisoning” of the Google IPO: there were some complains that the banks, instead of undertaking the same efforts to market the transaction as they would do for the other IPOs, undermined Google's offering. Indeed, we can understand investment bankers' hostility to the auction IPO model as, beside the issue of control over the entire operation, their margins on stock sales to institutions are much higher than on sales to individuals (more brokers have to be paid in the latter case). [...]
[...] Thus, after an initial phase of optimism due to GDF's precedent and EDF's good public image, speculations on an overpriced IPO and overemphasis of EDF's weaknesses led many private investors, focused on short term returns, either to reduce their term of investment to the very first hours of the floating, or not to subscribe to the offer at all. The major banks, aggressively promoting the IPO, were seen with distrust because of their conflict of interest in this affair. Therefore, on D day (November 21st) EDF's stock price plummeted during the first hours of the trading and the underwriters guaranteeing the operation had to intervene to avoid a collapse; eventually, EDF closed at nearly its opening price, which was This scenario enhanced the critics of the government for overpricing the offer, and the subsequent decrease of EDF's stock price in the following days and weeks in the beginning of December) angered even more individual investors, who felt misled by their bankers. [...]
[...] Moreover, we have attempted a first outlook on an overpriced IPO with the theoretical tools available to us by studying the EDF case, a flotation which animated scores of discussions among economists in France during and shortly after its launching, but not (to our best knowledge) with a game theory approach. However interesting the conclusions, we do not believe that overpricing could be a successful strategy in any normal situation, with a market free of state intervention. BIBLIOGRAPHY Allen, Franklin and Stephen Morris, Finance Applications of Game Theory, Advances in Business Applications of Game Theory by Kalyan Chatterjee and William F. [...]
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