September 19, 2014
Alibaba's IPO
Posted by Usha Rodrigues

Despite a delayed start, Alibaba's IPO seems to have gone off without the technical glitches that have marred some recent public offerings.  Priced at the very top of its range at $68, it opened at $92.70.  That's some kind of pop!

Investors apparently aren't listening to Harvard Law's Lucian Bebchuk, who earlier this week expressed governance worries about the firm, particularly its control by insiders.

In Alibaba, control is going to be locked forever in the hands of a group of insiders known as the Alibaba Partnership. These are all managers in the Alibaba Group or related companies. The Partnership will have the exclusive right to nominate candidates for a majority of the board seats. Furthermore, if the Partnership fails to obtain shareholder approval for its candidates, it will be entitled “in its sole discretion and without the need for any additional shareholder approval” to appoint directors unilaterally, thus ensuring that its chosen directors always have a majority of board seats.

For my money (or lack thereof--not a penny of mine is going to Alibaba), the bigger concern is the VIE structure whereby Americans can invest.   As Dealbook explains, "the company that is going public is technically an entity based in the Cayman Islands that has contractual rights to the profits of Alibaba China, but no economic interest."

The concern is that Chinese courts will fail to honor these contractual rights. Dealbook quotes a U.S. lawyer who has worked in China as saying "“It’s prohibited for foreigners to own an Internet company of any kind in China — not discouraged, but prohibited” ... “Every lawyer agrees that if this goes to court in China, those contracts are void; they’re illegal.”

 In a letter to the SEC, Senator Bob Casey tried to link VIEs to fraud-plagued Chinese reverse mergers of the past.  This comparison misses the mark.  In a reverse mergers a shell corporations that is publicly traded acquires a pre-existing Chinese corporation.  The Chinese firm avoids the IPO process entirely, hence the colloquial "back-door IPO" moniker.  It turns out that many of these firms had shoddy accounting practices, and some U.S. investors got burned.

The risk of accounting fraud appears to me to be a risk that you run when investing in any publicly traded comany where you know that the firm's main asset never got that initial SEC scrutiny and, while subject to the '34 Ac'ts periodic disclosure requirements, operates overseas in a country where corruption and fraud are widespread.  That seems...risky.  Whereas with Alibaba you're buying into a structure knowing that the Chinese government could declare it illegal and worthless at any time.  That an act of faith.

Mark Mobius of Franklin Templeton and the WSJ editorial page share my skepticism about the VIE structure. Let's see how it goes.

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March 21, 2014
The Effect of the JOBS Act on Underwriting Spreads
Posted by Usha Rodrigues

Back in October I posted about a fantastic conference at the University of Kentucky on the Securities Act at 80.  I've just posted my article on SSRN, abstract below.  Any guesses on which JOBS Act change had an effect on underwriting spreads?  You'll have to download to find out!*

U.S. underwriting fees, or spreads, have somewhat inexplicably clustered around 7% for years, a phenomenon that some have suggested evidences implicit collusion. The goal of Title I the JOBS Act of 2012 was to make going public easier for smaller firms; certain provisions specifically should make the underwriters’ task less risky, and thus less expensive. Presuming these provisions are effective, then one would predict that underwriting spreads would decrease as the costs to the underwriter for a public offering declined. Admittedly the prior presumption is a big one: it may be that the JOBS Act reforms were largely ineffective, and thus could be expected to have little effect on underwriter cost. This article is the first to examine post-JOBS Act underwriting spreads to determine whether spreads have in fact declined. A finding that underwriting costs stayed constant might be evidence of either collusion or that the JOBS Act was ineffective at reducing the cost of going public. I find that one provision has lowering the spread, thus suggesting elasticity in the spread and offering at least some evidence of the Act’s effectiveness.


*OK, that was kind of obnoxious, I'll just tell you.  I find a statistically significant correlation between emerging growth companies that file a confidential draft registration statement and a lower gross spread.  But go read the whole thing and tell me what you think.

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March 08, 2014
New Paper on SSRN (Mine): Pricing Disintermediation: Crowdfunding and Online Auction IPOs
Posted by Christine Hurt

Good morning!  Were you looking for some beach reading material as Spring Break draws nearer?  I just posted my latest paper, Pricing Disintermediation:  Crowdfunding and Online Auction IPOs.  Were you wondering what the future holds for raising equity online after Proposed Regulation Crowdfunding?  Have you ever thought that maybe the quick birth and death of the online auction IPO could inform that question?  Moreover, have you ever thought that maybe the social entrepreneurship crowdfunding space might fare differently?  That corporate finance might solve the mission drift problem, not corporate governance?  Have I got a page-turner for you!

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November 08, 2013
Did Twitter's IPO have anything to do with 12(g)?
Posted by Usha Rodrigues

It's unlikely, but not impossible. Twitter was a big lobbying force for the JOBS Act provision that changed the Section 12(g) of the Exchange Act's threshold from 500 to 2000 investors.  And we know from this prospectus that it went public with 755 shareholders (p. 155) of record.  But 12(g) has a second threshold: you have to register under the Exchange Act if you have 500 or more unaccredited shareholders.  I was curious whether Twitter would break out the number of unaccredited shareholders in its prospectus, but it doesn't.  To be fair, I don't suggest it has to: the regulations don't require it, at least as far as I know.  

We know Twitter was approaching that magic 500 number when JOBS was passed, but JOBS changed the rules regarding counting: employee stockholders who gain their shares via vesting of stock options don't count in the tally.  Presumably once Twitter excluded these stockholders it was well under the 500 unaccredited threshold.  But it would be interesting to know.

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October 14, 2013
Twitter and Underwriter Gross Spreads
Posted by Usha Rodrigues

Ever had that experience of presenting a paper at a conference and coming home to a front-page WSJ article on your topic?  Me neither.  Until now!  The paper I presented at the Kentucky symposium (which was amazing-- I felt honored to be in such company) was very much a work in progress.  It asks a simple question: did the JOBS Act affect underwriter IPO fees?  The question I'm still mulling over is whether we would expect it to.  And behold, this morning I awoke to an article on Twitter's underwriting fees! 

Telis Demos' WSJ article focuses on Twitter's "squeezing" its underwriting banks in two ways: first, by securing a $1 billion credit line from its bankers, and second, by negotiating a discount on the underwriting fee itself.  Taking the second point first, in a firm-commitment IPO the underwriter buys the shares from the company at a discount, and then turns around and sells them to the public at full price. That discount, also called the gross spread, is the underwriter's overt compensation, and there's been a lot of literature about how it clusters at 7% for small and mid-sized IPOs. 

The Journal reports that the banks' spread is 3.25%--not as low as Facebook's 1.1%, but pretty low.  Suprisingly low?  That's the question.  Everyone agrees that as IPOs get bigger, the spreads should decline.  It's just not that much more expensive to market a big deal versus a small deal, so economies of scale kick in.  So is Twitter's low spread the function of its size, or has it really put the squeeze on the banks?   

I examined U.S. IPOs from the passage of the JOBS Act through July 27, 2013.  My sample excludes banks, S&Ls, REITs, ADRs, unit issuers, and closed-end funds.  One problem is that Twitter is a really big IPO, with few comparables out there.  During that period no emerging growth companies launched a Twitter-sized IPO (remember, Twitter is an EGC).  The very biggest EGCs ranged from $430-630 million, and that spread averaged 5.67%. So 3.25% is obviously a much cheaper IPO price tag, but that could just be economies of scale kicking in.

Besides Facebook, there is one big non-EGC IPO, Zoetis, that raised north of $2.2 billion.  Its spread was 3.7%. Which could suggest that perhaps Twitter did snag a deal--half the offering size, and yet a smaller discount rate.  But that's just one data point, and a non-EGC company to boot.  Hardly apples to apples.

Moreover, there's a lot going on with underwriting fees.  As the WSJ article points out, Twitter also got what might be a sweetheart deal on its loan terms.  And it might be that issuers are willing to pay more for sector expertise, or analyst coverage, marketing prowess, or plain old reputation.  There's also the presence of underpricing, which may act as sub rosa compensation.  And the fact that you may not want to pay rock bottom for underwriting--I don't remember anyone particularly highlighting the 1.1% spread during the fallout from Facebook's IPO debacle.  But one wonders if you can cut the spread too low.

Watch for more from me on this topic once I can revise my draft.  And let me know if you have any thoughts.



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October 09, 2013
More Twitter: Why an IPO?
Posted by Christine Hurt

IPOs are hard and expensive.  IPOs expose issuers to all kinds of liability pre- and post-IPO and require ongoing disclosure.  The JOBS Act opened up the capital raising world by lifting private placement restrictions, most notably the ban on "general solicitation."  Usha announced it just the other day here.  I wondered if anyone would ever have an IPO after the ban was lifted here.  So why is Twitter going through an IPO? 

The alternative for Twitter is a private placement with general solicitation under Rule 506 (Reg D).  But, the comparison isn't IPO v. new 506, it's the "emerging growth company" IPO v. new 506.  As Usha pointed out, Twitter took advantage of the confidential registration provision of the emerging growth company exemptions.  Here is a blog post from Bob Thompson summarizing other items in the registration statements that an emerging growth company can avoid.  But, the registration process is still a pain, and it's still very expensive.

In a "new" 506 private placement, Twitter could tweet about its private placement all day long (unlike in an IPO pre-filing and pre-effective date) as long as it only sold to "accredited investors."  I'll go out on a limb and say that most IPO shares will be sold to "accredited investors," a definition that has gone unchanged for quite a long time.  With all that freedom and the same capital raising potential, it seems like a no-brainer.  The only hitch would be the expanded 2000 shareholder rule.  Twitter already has 2000 employees, so the probability that the number of shareholders would exceed 2000 is pretty high.  But let's put that aside for now.

Even without the 2000 shareholder rule, the general solicitation 506 may not be a great idea from the perspective of the current owners of Twitter -- the VCs, the founders, the insiders.  One of the benefits of an IPO is that it creates liquidity for the pre-IPO owners; in other words, they can cash out.  For the founders and other early executives, the ability to cash out at least part of your holding is a great option; for the venture capital firms backing the IPO firm, cashing out is a must.  However, if the shares are not registered, then shareholders would have to sell the restricted securities themselves under Rule 144, which is going to put a 1% of the public float condition on affiliates/control persons, which may encompass executives and large shareholders.  Twitter's S-1 leaves blank how many shares individuals plan on selling in the IPO, but 4 officers own over 1% (Evan Williams owns 12%) and five VCs own over 5%.  And, the purchasers of those shares would take them as restricted shares, so the  price would be discounted for that.  For cashing out, IPOs, even with lock-ups, are the better route.

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October 03, 2013
Twitter IPO!
Posted by Christine Hurt
The Twitter Form S-1 is officially public, and the former confidential draft registration statements are available for viewing on Edgar.  (I guess Edgar is an essential government function.)  I don't feel like going back and reading the previous versions, and even the current S-1 reads a lot like the Google S-1 and the Facebook S-1.  Many of the "risk factors" are identical or substantially so two provisions in one or both of the other registration statements: 
"Our financial results will fluctuate from quarter to quarter, which makes them difficult to predict" (FB); "If we fail to effectively manage our growth, our business and operating results could be harmed" (GOOG);"If we are unable to maintain and promote our brand, our business and operating results may be harmed" (both); "Our corporate culture has contributed to our success, and if we cannot maintain this culture as we grow, we could lose the innovation, creativity and teamwork fostered by our culture, and our business may be harmed" (GOOG); "Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand" (GOOG); "We are currently, and expect to be in the future, party to intellectual property rights claims that are expensive and time consuming to defend, and, if resolved adversely, could have a significant impact on our business, financial condition or operating results" (GOOG), etc.
But here's a good one, which actually appears in some other S-1s, including Yelp's:
We have incurred significant operating losses in the past, and we may not be able to achieve or subsequently maintain profitability.
That's definitely not puffery. There is also language about San Francisco earthquakes (also in Yelp's), and NOLs and anti-takeover devices. Perhaps those last two things may go together before the articles of incorporation are amended.

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September 13, 2013
What Twitter's Confidentially Submitted S-1 Means
Posted by Usha Rodrigues

You've probably heard by now that Twitter tweeted news of its confidential submission of an S-1 for SEC review.  DealProfessor Steven Davidoff laments this JOBS-Act-enabled secrecy.  Broc Romanek has some thoughts, including a reflection on the amusing question of the meaning of "..." in the context of corporate communication.

I've been doing some empirical research on IPOs (of which more later) that cleared up a misunderstanding I'd had about the emerging growth company IPOs.  I'm posting about it in case others labored under the same misconception.  I had thought that if a company filed a confidential S-1, it was never seen--a free look, so that the first public S-1 was a polished S-1.  But that's not the case.  When the first official S-1 is filed, any prior confidential S-1s and amendments must be disclosed.  Immediately following the JOBS Act, draft registration statements were disclosed as an exhibit to the public S-1.  Now the SEC has a DRS tag to identify them. The net effect is of disclosure delayed, not disclosure denied--as long as the company eventually files a public S-1. 

 Unpersuaded by the reassurance that everything in the draft S-1 will eventually come out, Davidoff writes:

Yet there might be value in having the regulator’s critique of a company’s I.P.O. occurring more or less simultaneously in the public eye. For example, both Zynga and Groupon received pushback from the agency over their accounting methods. This arguably allowed the investing public to better assess the financial results...But for Zynga and Groupon, the experience probably wasn’t so great, because it led to sharp criticism of their filings and put their stock offerings on a back foot. In both cases, the S.E.C. process raised warning signs that turned out to be accurate about these companies.

But if Zynga and Groupon had used JOBS' confidential S-1 filing, the market would eventually have learned about the SEC's concerns about their accounting.  I guess the question is one of how much momentum matters in a public offering, whether bad news at the outset is somehow worse than bad news once the ball is rolling.  The Google IPO certainly suggests that little setbacks along the way can have a big cumulative effect, even if the IPO is a hot one.

I'm wondering if others have an opinion on this.  Is disclosure delayed disclosure denied? 


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August 14, 2013
Davidoff on SPACs
Posted by Usha Rodrigues

DealProfessor Steven Davidoff wrote a piece on SPACs yesterday that seemed unduly harsh to me.  Admittedly I have a something of a soft spot for this odd duck entity, having written two papers about it (here and here).

Steven's main beef is that SPACs are good for their promoters and for hedge funds that invest in them, but maybe not for the average Joe.  Let's examine those claims.

Silver Eagle Acquisition Corp.'s recent $325 million IPO is the launching point for the piece.  Steven takes SPAC promoters to task for claiming, like their private equity cousins,

up to 20 percent of the equity mostly for finding the target company. The fee is similar to that of a private equity firm, as is the idea of picking a company, but a SPAC is not as safe or rewarding as private equity. SPAC investors take all of the risk in one company instead of a portfolio of companies held by a private equity firm.

As we show, however, the recent trend in SPACs has been to condition some of the 20% equity promoters receive on certain performance targets.  In that respect Silver Eagle seems to be at the low end, with an "earnout" of 5% of the total equity contingent upon the stock reaching levels of $12.50 and $15.00.  Many recent SPACs tie up considerably more (or all) of the promoter's equity.

Next Steven offers a little history: "In the 1980s, they were rife with fraud, and briefly disappeared from Wall Street in the wake of stricter federal regulation. But, like zombies, they reappeared in the mid-2000s. Before the credit crisis, these vehicles accounted for nearly 25 percent of all I.P.O.’s."

Steven paints with too broad brush.  The 1980s were a time of bad hair, legwarmers, peerless teen movies, and blank check companies that indeed operated sketchily at best.  But the SPAC was an invention of the 90s that strove to differentiate itself by offering two notable features: 1) it gave shareholders and up or down vote on any proposed acquisition, and 2) a trust account that kept shareholders' money safe.  The promoters couldn't access the money unless and until the vote had occurred, and even if the acquisition was approved, they could elect to redeem their shares and get (most of) their cash back.  Indeed, even if a majority of shareholders voted for the acquisition, if a lower threshold (say 25%) of the shareholders redeemed their shares, then the acquisition would fail.  This supermajority veto set up unintended consequences that the form had to evolve to deal with, but the point is, SPACs have mechanisms in place to rein in the promoters.

SPACs only have 2-3 years to make an acquisition; otherwise they have to liquidate and return their cash to shareholders. Steven is absolutely right that this sets up the incentive for poor 11th hour acquisition choices.  But SPACs' trust account offers unique downside protection that makes it hard to compare them with a typical stock.  For example, Steven calls one SPAC's 6% return unspectacular, which is true.  But that return was on a stock that promised to redeem the $10 shares for $9.97. A 6% return on a stock where the most you're guaranteed to lose is 3 cents might not be a bad deal, all things considered.

In sum, SPACs are good for promoters, but if shareholders don't like the acquisition the promoters propose, they can exit.  And the trust account may offer a safe haven attractive enough to compensate for reduced return. 

Over the years people have asked me what I think of SPACs as an investment, and I confess I'm still not sure.  They fascinate me as in example of creative contract design that evolved quickly as the market changed. But I haven't invested any of my own money in SPACs.  Then again, I'm a pretty boring, index fund investor, so you can't extrapolate too much from that!


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June 12, 2013
IPOs in the News
Posted by Usha Rodrigues

I've been thinking about IPOs, and the potential lack thereof, quite a bit in connection with my next project.  Today's WSJ decribes the current IPO market as hot: 

U.S.-listed companies and their financial backers have sold $19.6 billion in stock this year, putting the IPO market on track for one of its biggest years since the financial crisis, according to Dealogic. Just 25% of this year's deals have priced below companies' expectations, the lowest since 2009.

How much of the new action is due to the JOBS Act?  Not much, says DealProf Steven Davidoff.  He recounts the Act's failure to do increase small IPOs:

The act was intended to help spur a moribund market in small I.P.O.’s. But for offerings that raised less than $100 million, there were actually fewer after the JOBS Act. According to Dealogic, there were an average of 15 such I.P.O.’s per quarter in the year before the new law versus an average of 13 per quarter the year after.

Which begs the question: how many IPOs (small or large) should there be, anyway?  And what, if anything can or should the government do about it?


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May 15, 2013
How Many IPOs Should We Have Each Year? How Do You Know?
Posted by Usha Rodrigues

The titular questions have been swirling in the back of my head for the past month or so.  Spoiler alert: I don't have the answer.  But Jeff Schwartz' post in the CLS Blue Sky blog on the SEC Advisory Committee on Small and Emerging Companies' proposal to create a separate market for small and emerging companies, open only to accredited investors--more or less a public SecondMarket/SharesPost--has me asking it again.

This strikes me, unlike Jeff, at first blush as a bad idea, but let's ignore the merits of the proposal and focus on one of its premises.  One of the arguments the Committee makes in favor of it is that "providing a satisfactory trading venue" for these companies might encourage IPOs of their securities.  

First question: Really?  Isn't it just as likely that, if a robust market exists for these companies, they're less likely to go public?  Isn't obtaining liquidity one big reason for going public in the first place?

Second question: How many is the right number of IPOs, anyway?  The WSJ told me yesterday IPOs are set to raise the most cash since 2007.  Jay Ritter argued in a recent paper that IPOs have dried up not because of heavy-handed government regulation but because times have changed.  Now getting big fast is the way to go, and going public and being a small independent company isn't as attractive to a young firm being acquired by a bigger player.

As Ritter writes, "If the reason that many small companies are not going public is because they will be more profitable as part of a larger organization, then policies designed to encourage companies to remain small and independent have the potential to harm the economy, rather than boost it."    Ritter's prescriptions to help IPOs are to encourage auctions over bookbuilding (here's yet more evidence that the underwriter spread is too big), discourage class action lawsuits, and reform the copyright and patent system.

Ritter closes with: "I do not know what the optimal level of IPO activity is in the United States or any other country, nor do I think that it should necessarily be the same now as it one was."  

Right now I'm with him. 

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January 01, 2013
Venture-backed IPOs in 2013?
Posted by Gordon Smith

VentureBeat has created a list of leading IPO Candidates for 2013, and there are some exciting prospects. Box, Dropbox, Eventbrite, LivingSocial, Square, Survey Monkey, and Twitter are some of the familiar names on the list. Still, in a recent survey by the National Venture Capital Association, VCs and CEOs were rather restrained in their outlook. The outlook for VC investment is also muted, and I am wondering: will Fred Wilson make an investment in 2013?

P.S. If you are interested in whether the JOBS Act will have any effect on startup financing, you might be interested in the Hot Topics Program at AALS entitled "Jobs," the JOBS Act, and the Future of Small Business Finance and the U.S. Equity Markets. It is scheduled for this Sunday at 10:30 am, and speakers include Glom friends Steve Davidoff, Joan Heminway, Kristin Johnson, Jeff Schwartz, and Bob Thompson.

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September 06, 2012
Absentee Grownups at the Facebook IPO
Posted by Usha Rodrigues

Who's ultimately to blame for the fact that the Facebook IPO was colossally overpriced?  So much so that it's lost $50 billion of market cap in 3 months?  Andrew Ross Sorkin made a compelling case earlier this week for Facebook's CFO, leading with a killer two-sentence paragraph:

It is David Ebersman’s fault. There is just no way around it.

Sorkin's DealBook piece is well worth a read, but left me ultimately unconvinced.  Here's why.  In general, our securities laws view firms wanting to sell stock to the public with suspicion.  What's to keep fly by night companies from lying about their assets, inflating their worth, and then getting while the gettin's good? 1929 and all that. 

The bankers, that's who.  The rather elegant mechanism of the Securities Act of 1933 is to put a deep-pocketed repeat player, with reputational capital as well as cold hard cash at stake, on the hook.  Cue the investment banks.  Sorkin may be exactly right to blame Ebersman because

[h]e signed off on the ever-increasing offer price, which ended up at $38 after the company had originally planned a price range of $28 to $35.He — almost alone — pushed to flood the market with 25 percent more shares than originally planned in the final days before the offering.

But there's at least an argument that he was acting in the company's best interests by pushing for a high stock price, not leaving money on the table, etc.  The fact that the 25% of extra shares came not from the company but from Facebook's investors weakens this argument, but a high price range still benefited the company.  Morgan Stanley was supposed to be the grown-up here, stepping in and saying, "Not so fast, the market might not bear this price, let's look at demand, let's look at the fact that Facebook shares have been trading on the secondary market for a while." 

But Morgan Stanley appeared so delirious over having hooked the IPO of the decade that it forgot its role in the IPO: it was supposed to be the grownup. 

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August 24, 2012
SPACs: The Finance Article (Part 2, The Underwriter Discount)
Posted by Usha Rodrigues

Last week I posted the first of a three-part series on my new article with Mike Stegemoller on SPACs.  In this post I'll discuss our second finding, which relates to underwriter discounts, or the gross spread.  In a normal IPO, the nominal way an underwriting bank makes money is by buying stock from the company at a discount, and then turning around and selling it to the public at full price.  The difference, or "spread" between the purchase price and the sale price, is the investment bank's official compensation for bringing the fledgling firm to market. Some scholars would point to underpricing--and the banks' corresponding ability to curry favor with client--as the true compensation for underwriting, but we covered underpricing last week.

What do underwriters do to earn their discount?  Well, they expend a lot of effort trying to value the firm correctly (I'm looking at you, Morgan Stanley), because in a firm-commitment offering they take on the "risk" that they won't be able to unload the shares they buy from the company and offer to the public.  "Risk" is in quotation marks because the underwriters build a "book" of pre-sale offers of interest, and generally won't agree to take the firm public without being sure all of its shares will sell.  The underwriter does face a real risk of liability for false statements in the offering documents, however, and the spread may also compensate the bankers for this risk. 

A curious fact about traditional U.S. IPOs is that the gross spread is sticky--underwriters almost always buy company shares at a 7% discount, as documented in this fabulously named Chen Ritter paper, shouting out to Sherlock Holmes, no less.  As Chen & Ritter, describe, the clustering of spreads around 7% is 1) a relatively recent phenomenon, 2) specific to the U.S., and 3) roughly twice as high as in other countries.1 

Suspicious. After all, shouldn't some firms be riskier to underwrite than others, and thus command a higher spread?  And others by the same token be surer bets, with a correspondingly smaller spread?  Chen and Ritter conclude that most spreads for firms over $30 million are above competitive levels and discuss explanations ranging from implicit or explicit collusion to reducing underpricing.

SPACs, essentially piles of cash, should be easier to value than the typical company.  The information asymmetries that characterize the average company just aren't there.  Moreover, bookbuilding should be an easier process because there isn't much of a "story" needed to persuade potential customers to buy.  By the same token, SPACs should be less risky to underwrite, since the trust fund creates a floor price below which the stock should not drop.  As a shell company, disclosures are boilerplate and close to risk-free for the underwriter.  So we hypothesize that the spread should be lower than 7%. 

Yet the mean and median underwriting discount for our sample is 7%.  We argue this offers further evidence that spreads are above competitive levels.  Moreover, as the SPAC form evolved, investment banks began to accept a portion of the spread as deferred compensation.  Meaning that the nominal discount remained 7%, but some of that cash was tied up in escrow, and only released to the bank if and when a subsequent acquisition occurred.  The fact that the SPAC underwriting discount initially clustered around 7%, but all of the banks quickly proved willing to sacrifice nearly half of their compensation, without demanding any increase in overall spread as compensation for the delay in payment, is further evidence that a 7% spread is not the product of a competitive market.  In other words, if competition is fierce enough, underwriters can apparently operate at spread levels much lower than 7%.

That sticky 7% is looking curiouser and curiouser...


1 The Chen Ritter study is from 2000, but Abrahamson, Jenkinson, and Jones (2011) confirm their findings.

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August 15, 2012
SPACs: The Finance Article (Part 1)
Posted by Usha Rodrigues

Faithful Glommers know that I've been thinking and writing about SPACs for a while now.  For those who don't remember, SPACs (short for special purpose acquisition corporations) are essentially one-shot private equity funds, where the managers raise a pile of money via IPO and then park it in a trust account. They then have 3ish years to search for a target, at which point shareholders get some sort of say on whether they want the acquisition to occur.  If no deal occurs or if they veto it, they get back their share of the trust account (an average of 96.4 cents on the dollar in our sample).  Mike Stegemoller and I studied a sample of SPACs from 2003-11.  Our first piece, Special Purpose Acquisition Corporations: A Public View of Private Equity, forthcoming in the Delaware Journal of Corporate Law, traced the evolution of the form from a contract design perspective.

We recently posted our second piece, What All-Cash Companies Tell Us About IPOs and Acquisitions, on SSRN.  It's a more finance piece, intended for a peer-reviewed journal, so I thought I'd use a few posts to translate our findings for the law crowd.  Plus you can draw more conclusions and make bigger claims in a blog post than in a finance article, and that's always fun. 

So SPACs are interesting in and of themselves, but that's our first paper.  This one is about using SPACS as a tool to see how two major events of a firm's life--the IPO and making an acquisition--work.  The cool thing about SPACs is that they're essentially a pile of cash, with all the extraneous "noise" (capital structure, industry-specific characteristics, heterogeneous goals, etc.) that typically plague empirical studies stripped away.  Because of SPACs' cookie-cutter nature, we can make more definitive conclusions about the mechanics of these events.  As a preview, we have 3 main findings, regarding IPO underpricing, underwriter gross spreads, and acquisition announcement returns.  I'll devote a post to each, beginning today with underpricing. 

I've already blogged about underpricing in the context of the Carlyle IPO.  For those not familiar with this phenomenon, Facebook and Carlyle notwithstanding, most IPOs are underpriced by the investment banks that sell them to the general public.  In other words, those wizards at Goldman or Citigroup or Morgan Stanley (ahem!) spend months evaluating what price the public market for the company's stock will bear, price it accordingly, and yet by the close of the first day of trading the stock price generally rises, sometimes substantially. 

So what gives?  The company is leaving money on the table by offering the shares to IPO buyers at a bargain, and letting those buyers enjoy the runup in stock price.  As I wrote in May:

There are 2 dominant stories for IPO underpricing, one sinister and one innocent.  Both hinge on the fact that in an IPO investment banks act as intermediaries, buying the company's shares at a discount and then turning around and selling them to the public.  The sinister story blames greedy investment bankers that strong-arm companies into asking too little for their shares so that the bankers can curry favor with their clients.  The innocent one chalks underpricing up to information asymmetry: it's hard to gauge the true price of a stock that hasn't been traded, and uninformed investors will shy away from the market entirely unless they can be enticed in with the prospect of a sure thing.  (Steven Davidoff has a characteristically incisive review of all the underpricing theories here).

A variant of the first explanation is that managers may willingly underprice in order to get favorable analyst coverage from the banks down the road.  With SPACs we have a case where the information asymmetries should be almost precisely zero.  Meaning I don't have a degree in finance, but even I can probably value an offering of 100,000 shares that will raise $50,000,000 for a shell company.  And SPAC managers generally exit after the acquisition, so they don't have the incentive to retain investment banker goodwill that the operating company managers do. So we predict that SPAC IPOs will not be underpriced.  And (drum roll, please)...

They're not.  Well, they are a little bit (0.9%), as compared with 11.8% from 2001-09 for conventional firms (Gao, Ritter, and Zhu (2011).  What little underpricing we find relates to the rank of the lead underwriter.  Lower ranked underwriters underprice their SPAC offerings more than do higher rank underwriters.  It may be that higher risk SPACs select lower-reputed underwriters.  Or it may be that, regardless of the underlying quality of the SPAC, lower ranked underwriters have to price their product to sell to convince investors to buy, in a way that the Goldmans of the world do not. 

Either way, the small amount of underpricing might lead one to conclude that our findings support the innocent story (information asymmetry), rather than the sinister one (greedy banks).  However, sinister proponents could argue that the greedy banks underprice IPOs for the average firm, they just can't get away with it in the transparent world of SPAC valuation. That's a limitation of using a sui generis beast like the SPAC to study underpricing. 

Luckily, SPACs' idiosyncratic nature actually makes our findings on the underwriter spread and acquisitions more compelling.  Tune in soon for more on those topics...or if you simply can't wait, read about them here.

 Update: Post 2 is here.

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