Traditional solutions: 2.

Marketing the issure: “Road Shows”:

• Usually underwriters syndicate: several underwriters participate.
• During road show, underwriters and firm's management explain and
try to sell IPO to institutional investors. Those give non-binding
“expressions of interest”.
3. Pricing the Issue:
at the beginning, firm and underwriter decide on how to price the
issue. Two ways: Firm Commitment 包销 and Best Effort 代销
Book-building / Formal Auction
IPO short-run underpricing. On avg, on issuance day, stock price
rises substantially above the issue price thus implying large returns
Short-term returns:
- 16% DAY 1 return on avg
– underpricing varies w/ uncertainty abt the stock’s value: •
Larger firms underpriced less. • Underpricing smaller for older firms.
– International results similar
Why are IPOs Underpriced?
Underwriter price supports; Benefit the underwriter; Risk averse
owners; Information asymmetry (Winner’s Curse)
Winner’s Curse

PE funds: most PE is invested via partnerships of a limited duration

Role of LP agreement: solve conflicts between investors and funds

GP-LP relationship: Fund contract set to align GP-LP incentives:
Profit sharing gives incentives to choose right investments and
monitor them; Profit sharing on pool instead of single deals reduces
gambling; Skin-in-the-game (1-3% invested with GP own money)
Ownership term(“Skin-in-the-game”) give: Focus and urgency;
Incentives to perform because track record affects future fundraising
Drawbacks: Expensive; Management fees give little incentive other
than hoarding assets?; Carry structure makes leverage too attractive
to GP; Incentives to overinvest
PE can add value by:
1. Overcoming info prob by selecting firms with worthwhile
investment projs 2. Structuring investments to ensure incentives are
aligned and capital structure max value 3. Managing investments via
governance and operational expertise 4. Exiting investments
Effects of VC investment on portfolio companies:
VC-backed companies add value to companies through strategy
development; VC-backed companies grow faster and take products
faster to market compared to similar non-VC-backed startups; VC-
backed firms innovate more; VC value-added increases likelihood of
firms going public
IPO Process.
1. The Registration Statement and Prospectus: On avg, when u win a lot of allocation, it means it’s a bad IPO.
• Presents audited financial statements and complete description of Expected return is negative. In order to break even, u bid at a discount
firm's business: Products, prospects, and possible risks. IPO long run underperformance. WHY?
• Underwriters are legally responsible for accuracy. It is just noise; Investors are over optimistic abt young growth firms;
• SEC has to approve the offering. We are missing some characteristic of these firms that make them
safe, so should have low return
IPO Benefits: Merger types: horizontal: firms in same industry and same stage of
Funds for investment; Diversify the initial investors; Exit strategy for production process; vertical: firms in same industry but at different
VCs and other investors stages of production process; conglomerate: firms in diff industries
IPO Costs: Takeovers: friendly: board of directors of two firms agree to combine
Monetary Costs (Administrative Costs, Underwriting Costs, and seek shareholders’ approval for combination (generally >50%);
Underpricing); Disclosure requirements; Loss of freedom hostile: raider can make offer to board of directors/directly to
Seasoned Offerings shareholders (tender offer), often result in the firm being sold to a
friendly third party—white knight
Reasons for merger waves: economic, industry, technological shocks
(eg interest rates, liquidity, etc); “eat or be eaten”
Payment methods: cash deals; stock deals; combination of cash and
stock. It doesn’t matter in MM world no frictions, but does in reality
The market prefers cash
Having multiple bidders is good for sellers but bad for bidders
Target should receive most of the gains. Relative size makes
percentage division of gains deceptive. Targets are typically much
smaller than acquirers.
Rights Issue Example:
Free-rider problem: example

IPO Cash Flow

Only raider can unlock extra value in target firm. But current
shareholders will wan to freeride on raider’s efforts. So raiders
overpay, reducing profits or no raid happens.
Reasons for takeovers: valid reasons for source of value:
restructuring (cost-effective), increased market power (undercut
competitors), synergies/strategic benefits and economies of scale
(higher CF), economies of scope, corporate tax economies, improved
management; dubious reasons for source of value: lowering
financing costs (get cash), risk reduction through diversification,
increasing earnings-price ratio, empire building / CEO
overconfidence (overestimate potential gains)
Valuation: Estimating merger gains:
𝐆𝐚𝐢𝐧 = 𝑷𝑽𝑨𝑩 – (𝑷𝑽𝑨 + 𝑷𝑽𝑩 ) = ∆𝑷𝑽𝑨𝑩
𝑪𝒐𝒔𝒕 = 𝒄𝒂𝒔𝒉 𝒑𝒂𝒊𝒅 − 𝑷𝑽𝑩
𝑵𝑷𝑽 = 𝒈𝒂𝒊𝒏 = 𝒄𝒐𝒔𝒕 = ∆𝑷𝑽𝑨𝑩 − (𝒄𝒂𝒔𝒉 − 𝑷𝑽𝑩 )
Start w/ target’s stand-alone market value PV(B) and concentrate on
changes in CF that would result from the merger. Add value only if
u can generate additional economic rents
Estimating merger costs: if the merger is financed by acquirer’s stock,
and sellers receive N shares in merged company. Cost depends on the
value of shares in company: 𝑪𝒐𝒔𝒕 = 𝑵 × 𝑷𝑨𝑩 − 𝑷𝑽𝑩 . Due to
asymmetric info, optimistic managers prefer finance mergers to cash
IPO underpricing cost is much higher than direct costs
Investment banks take &% of proceeds
Lecture 14: Merger & Acquisition
Merger 合并: Several firms consolidated into a single firm
Takeover 收购: One firm buy sufficient # of shares of another firm
to gain control
Buyout 杠杆收购: A (public) firm is bought and taken private
d) What will the stock price reaction be once the investment is
announced? Explain.
Will the existing debt holders be willing to waive the seniority
covenant?