While underpricing varies greatly from transaction to transaction, it represents a significant opportunity cost for firms undergoing the IPO. Ritter’s research found that, from 1977-1982, the average underpricing (“initial return”) was 14.8% for firm commitment IPOs and 47.8% for best efforts IPOs. While Ritter’s analysis showed a significant difference in underpricing for the two different IPO processes, the important takeaway is that underpricing is both present and sizeable for IPOs, regardless of the type. The combination of these direct and indirect costs reflects a significant negativefor companies undergoing an IPO. Before even beginning the IPO process, shareholders of a privately held firm must choose between going public or staying private as the company matures. The opportunity to cash out, raise capital for new undertakings, pay down debt, or significantly increase liquidity motivates private shareholders to “go public”, even though going public is often associated with the costly and lengthy process of an IPO. An important alternative route to get access to the public market is sometimes ignored by shareholders and management teams. Instead of an IPO, a company can undergo a reverse takeover (RTO). According to the SEC, a reverse takeover, also known as a reverse merger, is a transaction where “an existing public ‘shell company,’ which is a public reporting company with few or no operations, acquires a private operating company – usually one that is seeking access to funding in the U.S. capital markets” (Securities and Exchange Commission [SEC], 2011, p.1). These public firms usually are companies that were left from previous transactions where certain operations were sold, that entered bankruptcy, or that were simply created
with the sole purpose of eventual acquisition. As outlined in the SEC investor bulletin Reverse Mergers and illustrated in Figure 2, a RTO occurs when: Shareholders of the private operating company accumulate a majority of the public shell company’s outstanding shares Now, the private company’s shareholders have a controlling interest in the public shell company. At this point, typically the public company’s board of directors is replaced with that of the private company The public company’s assets and business operations now reflect those of the formerly private company (Optional) File to have the public company’s stock ticker changed and restructure the public entity accordingly
2011 117 Total 1,112 Table 2 – IPO transactions with shares listing in the US While Table 1 shows that reverse takeovers do in fact occur somewhat regularly, the process has long received somewhat of a stigma due to its association with fraudulent companies, particularly Chinese ones. Listing in the US became a popular option for Chinese companies that were unable to secure loans from Chinese banks, which have traditionally favored state-owned enterprises. Chinese companies listing in the US via the reverse takeover process typically quote their shares on the OTCBB Bulletin Board). While compliance costs are lower for the OTCBB than other US exchanges like NYSE or NASDAQ, all companies still must follow the rules of public companies as outlined by the Securities Exchange Act of 1934. Over the years there have been numerous Chinese RTO companies involved in questionable accounting practices and problematic corporate governance. Some of these Chinese RTO companies have used smaller American auditing firms, “which may not have the resources to meet auditing obligations when all or substantially all of the private company’s operations are in another country.” (SEC, 2011, p.2) As a result, the enforcement and divisions of the SEC have launched investigations into how accountants, lawyers, and bankers have helped Chinese companies list onto American stock markets through manipulations of data and filings. Despite the belief that reverse takeover transactions receive little notice from the media and general public, there have been several notable transactions in recent years, such as: finance
“A model of the demand for investment banking advising and distribution services for new issues” (Baron, 1982) presents an interesting model to explain IPO underpricing. Baron theorizes that the investment banker is better informed about capital market conditions and demand for the new issue. Such asymmetry often leads to “adverse selection and moral hazard problems.” (p.955) Baron ultimately concludes that IPO offer prices are lower than the levels that would be seen in the absence of asymmetric information. Years later Muscarella and Vetsuypens (1989) evaluated Baron’s model in their paper, “A simple test of Baron’s model of underpricing”. Looking at 38 investment banks that completed IPOs and participated in the issue’s distribution from 1970-1987, they observed “statistically significant underpricing of about 7 percent on the first day of trading.” (p.135) In fact, underpricing was greatest in cases where the bank had a dominant impact on pricing its own stock. The authors thus conclude that Baron’s model does not hold and instead, that “underpricing is a pervasive phenomenon that cannot be explained solely by information asymmetries between issuers and underwriters.” (p.135) One of the leading economists currently interested in the study of the IPO market is Professor Jay Ritter of the University of Florida. In his “Equilibrium in the IPO market” (2011) paper, Ritter addressed the underpricing of IPOs and the decrease in total volume since the end of the technology bubble in 2000. While part of the decrease is attributable to regulatory hurdles, he argues that there has been a structural change in the equilibrium of the IPO market. One of the main problems with the state of the market is that underwriters consistently underprice. However, listing companies seem content with allowing this practice, as the underwriters have developed somewhat of an “oligopoly power” (p.28) due to the fact that there are a limited number of underwriters with