Initial Public Offerings Increase in 2006: Are We Entering a “Hot Period”?

A recent report by Renaissance Capital shows that IPO volume increased to $43 billion in 2006, a 26% increase over the previous year. Since offerings reached a peak of $97 billion in 2000, public offerings have been fairly slight, reaching a low of just $15 billion in 2003. But after a small drop-off in 2005, offerings substantially increased last year. The report points to several interesting dynamics in the current public offering market–and a number of potential implications for corporate governance.

First, the report shows that investors in IPOs were rewarded with above-market returns for the fourth straight year. From 2003 to 2006, investors in IPOs at the offering price have earned no less than 18%, and as much as 34%, in total return. Even aftermarket returns–the returns on IPO shares purchased at the close on the day of the offering–reached as high as 21% during this period.

The “underpricing” phenomenon has been a subject of considerable academic debate. An SEC study in 1963 showed that U.S. offerings consistently resulted in abnormal post-offering returns. and on this basis it has been suggested, in litigation and elsewhere, that the IPO process works to the detriment of shareholders and issuers. (Especially because issuers definitionally leave millions on the table when the IPO later proves underpriced.)  Since the 1963 SEC report, finance academics have shown that the abnormal returns phenomenon is not limited to the United States; for example, IPOs in the United Kingdom between 1959 and 1992 were underpriced by about 12%. In a 1989 Journal of Finance article, Franklin Allen and Gerald Faulhaber at Wharton argued that underpricing serves a valuable signaling function in the IPO market.  More recently, academics have explained these returns by noting that IPO issues have limited liquidity.

As these returns continue to rise, we can expect that they will receive increased attention from regulators and academics.  In particular, since 1975 the underpricing literature has offered substantial evidence that underpricing is not a consistent phenomenon over time, but varies substantially, increasing during “hot periods” and decreasing when markets are “cold.”  More recent analysis has confirmed that view.  This year’s returns of 26% (13% in the aftermarket) lead me to ask: are we returning to a “hot” period for initial public offerings?

Second, the increase in offerings will no doubt lead to further research, and continued debate, as to the effects of corporate governance on IPO returns. Empirical results on that question have been mixed. Some academics have argued that the presence of antitakeover measures in a majority of IPO charters suggests that governance is less relevant at the IPO stage than we might think. But a recent study of public offerings in the REIT context concludes that governance structure has a significant impact on initial value at the IPO stage and longer-term firm performance.  Especially given Google‘s high-profile IPO–which featured a dual-class structure that gave shareholders virtually no governance control–we can expect that this year’s IPO activity will lead to more research and analysis on governance decisions at the IPO stage.

Third, the Renaissance report offers a ranking of IPO underwriters for 2006, led by Goldman Sachs, which underwrote more than $9 billion in IPO stock last year.  Goldman and Credit Suisse dominated the IPO market last year; between them, they issued $17 billion in IPO stock in 2006, or about 40% of the total. The role of the underwriter has long been a source of controversy in IPO scholarship. Recent work suggests that there may be a relationship between underwriter reputation and IPO returns, perhaps explaining issuers’ willingness to pay substantial underwriter fees.  And a study during the last IPO “hot period” found that higher underwriter fees led to higher inital offering prices.  As Goldman and Credit Suisse continue to grow their market share, and underwriter fees continue to rise, regulators and academics will pay greater attention to the role of underwriters in the IPO process.

Finally, a quick scan of the top performers among 2006 issuers shows that the IPO market, particularly at the end of the year, featured a number of technology and healthcare issuers, usually the province of venture capitalists and private equity firms. A number of sources in late 2006 speculated that private equity firms, which have been buying firms at a record pace, have been exiting rather slowly.  If the IPO market is now amenable to these types of issuances, we would expect private equity exits to increase in 2007.  Sure enough, the New York Times Dealbook has coined a new term, the “LIPO,” or leveraged IPO, to describe private equity-backed IPOs, which are ordinarily quite leveraged.  As private equity firms seek to exit via public offerings in 2006, investors will be paying close attention to how many of those deals can be absorbed by the public markets.

Given the growth in last year’s issuances, and the possibility that private-equity firms will fuel the fire in 2007, the coming year should be quite telling for those interested in what IPOs can tell us about corporate governance and the roles intermediaries play in financial markets.

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