initial public offerings || getting ipo pricing right

12 Getting IPO pricing right: vive laFrance?Edel Barnes

Abstract

Typically, initial public offering (IPO) shares are significantly underpriced when theycommence trading and frequently closing prices on the first trading day reflect substan-tial average initial returns to investors. The particular method chosen to effect an IPOdepends both on the market environment into which the firm will sell its shares and thecharacteristics of the firm itself. The popularity of bookbuilding for IPOs has grown inthe last decade, despite the greater costs involved. This study adds to the extant litera-ture on new issues pricing through an examination of new issues on the French SecondMarché over the 1999 to 2001 period, arguably the height of the recent hot IPO issuesmarket. While IPO auctions are typically associated with low mean excess returns toinvestors and bookbuilding with substantially greater mean underpricing, it appears thatFrench firms coming to market on the Second Marché increasingly combine the book-building approach with another pricing mechanism, resulting in more efficient price set-ting. This hybrid approach thus works to the benefit of both issuers and investors byreducing the aggregate costs of issue associated with other IPO mechanisms.

12.1 Introduction

Globally, the late 1990s were characterized by very active markets in initial publicofferings (IPOs), the mechanism whereby organizations obtain a first public listing oftheir shares. During the run-up to and the actual boom years of the late 1990s, activ-ity in global IPO markets ranged from busy to frenetic. This was in part due to thehuge volume of technology and Internet-related businesses that sought funding forgrowth opportunities, but it seems that firms in virtually every industrial and servicessector were coming to the market for finance. The hype that surrounded new issuesgenerally, together with the availability of significant amounts of investor capital seek-ing superior returns, ensured that demand for shares in companies coming to the mar-ket remained buoyant and that such shares traded at lofty levels only loosely relatedto fundamental values. Since the bursting of the Internet-related market bubble, IPOshave received global bad press and investment bankers have stood accused of dubiouspricing, while investors have departed the market in droves to lick the wounds causedby the market crash and the consequent poor long-run returns from initial share offer-ings. Indeed, before the recent hot issues market, long-run performance of new issueshas been disappointing (Ibbotson et al., 1994), which calls into question the efficiencyand effectiveness of the various approaches to pricing initial public offerings of shares.

A number of methods are available to firms to conduct an IPO. The particularmethod chosen depends both on the market environment into which the firm will sell

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its shares and the characteristics of the firm itself (Chemmanur and Liu, 2003).However, the key objective from the perspective of the issuing firm is to successfullymarket all shares on offer and to optimize the proceeds of the sale, but therein lies atradeoff. Typically, very little is known about startup firms and from an investor’sperspective information acquisition is costly. If there is substantial uncertainty regard-ing a firm’s activities and prospects and resolving this uncertainty is associated withsignificant costs, investors will either not subscribe to a new issue so that an offer failsor alternatively they will subscribe only if offered new shares at a discount, whichreduces the net proceeds to the issuing firm. This offer price discount has resulted insubstantial initial day returns or IPO underpricing, although typically such returnshave varied across markets. Loughran et al. (1994) undertook an analysis of interna-tional IPO underpricing in 25 separate markets over a variety of periods and docu-mented empirical evidence that illustrates this particular point, their results indicatingmean excess initial returns over all markets studied of 31%, albeit with a range of4.2–80.3%.

By definition, no prior market price is available to guide prospective investorsregarding issuing firm value, and substantial uncertainty and information asymmetrywill surround such new firms, about which little may be known. The problem forinvestment bankers who back and/or frequently underwrite such issues is to commu-nicate true value to the market. The offer price is thus key to ensuring a successfulissue, but if set too low it results in significant underpricing, whereby investors earnhigh initial returns but where the opportunity cost to the issuing firm of foregoneshare capital can be considerable. In the USA, Loughran and Ritter (2002) reportedthat the hot issues market of 1999 and 2000 was associated with initial day returnsof 65% on average, and although returns were not so pronounced in other worldmarkets, initial returns of the order of 20–30% were not uncommon. IPO under-pricing also varies over time, a factor which Loughran and Ritter (2002) attribute tochanges in the characteristics and composition of firms going public, together withchanges in objectives and incentives of firm owners and prospective investors.

12.2 IPO pricing methods

The various methods of bringing new issues to market differ largely in terms of theirrisk of undersubscription and the costs they impose on investors in acquiring firm-specific information. Bookbuilding, fixed offer price, and auctions are the most com-monly used IPO mechanisms, and while some countries are associated with the useof just one mechanism, typically firms have a choice. Generally, public information isnot completely incorporated into the final offer price for IPOs and firm risk is posi-tively related to the extent of underpricing and/or initial returns to investors.

In bookbuilding, firms hire an underwriter to certify the new issue as regards firmquality and fair pricing. The fundamental assumption underlying the use of thismechanism is that the underwriting firm has the best understanding of market con-ditions and access to potential investors. The underwriter will research the issuingfirm; the firm and underwriter will subsequently engage in a roadshow to elicit non-binding indications of interest in the new issue from investors, many of whichwill be large institutions with formidable financing potential. Once this period ofbookbuilding is over, the underwriter and firm will agree a final offer price and the

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underwriter has complete discretion in the allocation of shares once this price is set.Notwithstanding the substantial fees charged by underwriters for this service, themechanism is utilized by the vast majority of issuing firms worldwide, perhapsbecause it is well understood by investors. Sherman (2002) noted that there has beena major world trend towards the use of bookbuilding at the expense of auctions forIPOs, a trend she attributed to differential public domain information regarding theissuing firm. Indeed, the bookbuilding approach is used to the virtual exclusion ofother mechanisms in the USA. This is largely because it allows issuing firms to con-trol spending on information acquisition and minimizes the risk to the issuing firm ofoffer failure; this risk is borne by the underwriter, typically an investment bank. Thereduced risk of offer failure comes at a price; usually, IPOs conducted by the book-building mechanism are associated with significant underwriting or direct costs.Incentives for underwriting investment houses to favor privileged clients in hot IPOsand to price new issues attractively to guarantee high initial returns adds to the costto the issuing firm of utilizing the bookbuilding mechanism.

Under a fixed offer price regime, the number of IPO shares and the price at whichthese shares will be issued to the public is set and advertised approximately a weekbefore the actual IPO date, this price being the result of negotiations between an issu-ing firm and its underwriter. Potential investors submit their orders for new shares atthis fixed price and shares are allocated on a pro-rata basis. Again, underwriters incurcosts of acquiring information about the issuing firm; these costs are levied on theissuing firm in the form of underwriter fees/compensation. Because the offer price isset before information regarding investor demand is known, the underwriter bearsthe risk of undersubscription and must buy any unsold shares, so typically the offerprice will stand at a substantial discount to true value to ensure full subscription –that is, a successful offer. In consequence, fixed offer price IPOs are associated withgreater underpricing than other mechanisms on average (Loughran et al., 1994),which imposes an indirect cost on the IPO firm. Because efficient price discoveryrequires some adjustment of offer price to demand, this fixed offer price mechanismis commonly regarded as one of the less efficient pricing mechanisms and conse-quently is not extensively used.

IPO firms can bring their shares to market via a Dutch auction approach (some-times referred to as a uniform price auction), where investors are invited to submitbids indicating both the number of shares required and the price they are willing topay. IPO shares are then sold to the highest bidders, with a uniform price set at thelevel of the bid of the lowest winning bidder. This standard uniform price equatessupply of shares with demand by investors. Underwriters may engage in informationacquisition before the offer price is set but, unlike the bookbuilding mechanism, issu-ing firms do not control spending on company research and investor demand deter-mines expected issue proceeds. Auctions also carry a much higher risk ofundersubscription than the alternative approaches and the offer price that clears themarket is generally well below a fair value, particularly for companies and in indus-tries that are not well established or understood. A further risk is that it may be pos-sible for bidders to tacitly collude by placing demand functions such that themarket-clearing price is very low, if aggressive bidding to gain market share were topush prices too high to yield attractive initial returns to investors. These attributes ofthe auction process have been cited as a rationale for the decline of this price-settingapproach worldwide. Lin et al. (2003) reported a diminishing role of auctions in the

Getting IPO pricing right: vive la France? 179


Taiwan market, for example, noting that institutional investors prefer bookbuilding,where they typically receive larger allocations than is the case with the auctionprocess. Chemmanur and Liu (2003) similarly documented a reduction over time inthe relative proportion of IPOs being conducted by auction in the US market.

In France, a variation on the Dutch auction approach, ‘offre à prix minimal’, isused. Here the underwriter and issuing firm set a minimal acceptable offer priceapproximately one week before the IPO date. On the date prior to issue, investorsmake price and quantity bids, which are collected and used to assess investor demandby the French market authority, the protector of investor interests. Underwriter andfirm negotiate with this authority on offer maximum prices, based on this demand.The maximum price is chosen to eliminate unrealistically high bids. This collection ofbids encourages investors to reveal their assessment of firm value, and shares are sub-sequently allocated on a pro-rata basis to bidders at a uniform offer price that liesbetween the acceptable minimum and maximum prices which clear the market.

12.3 IPOs and the French stock market

Three main stock markets operate in France: the Premier Marché, the SecondMarché, and the Nouveau Marché. The Premier Marché is the primary French mar-ket, where securities of the largest French companies are traded. Listing requirementsare stringent and typically only the largest companies are in a position to absorb thesubstantial costs of trading in this market. The Second Marché is a subsidiary Frenchmarket that commenced trading in 1983 to allow smaller firms to obtain a listing andto go public. Listing requirements on this market are less stringent than those of themain exchange, ‘la cote officielle’. The Nouveau Marché commenced trading inDecember 1995 and is based on the model of the US market, the Nasdaq. The aim of this market is to attract startup companies, especially those in high-technologyindustries.

Giudici and Roosenboom (2002) included an examination of the French NouveauMarché in their comparative analysis of IPO underpricing in European high-tech-nology, high-growth markets, differentiating their sample by country and approachto IPO adopted. For their sample of 482 IPOs, 96.7% were priced using the book-building procedure, 2.7% utilized a fixed price offer, and just 0.6% were conductedby auction. Overall mean initial underpricing was 38%, with the French NouveauMarché being associated with the lowest level of underpricing of 17.5% on average.These authors attributed intra-country differences in initial underpricing to differe-ntials in institutional settings and market maturity. Derrien and Womack (2003)undertook a closer examination of the French markets, their objective being toaddress the issue of which IPO pricing approach, selling, and underwriting proced-ures might be most efficient in controlling the extent and volatility of initialmispricing. The French stock market is somewhat unique in that three basic and sub-stantially different issuing mechanisms operate in juxtaposition: auctions, book-building, and fixed offer price issues. Thus, it merits a closer examination with aview to assessing the relative efficiency of the various approaches. Derrien andWomack’s (2003) sample studied 264 French IPOs, which were brought to marketon the French Nouveau and Second Marchés over the period 1992 to 1998. Theyreported an overall average level of underpricing of 13.23% across all mechanisms



for the French stock market as a whole, with average initial returns of 16.9%, 8.9%,and 6.5% being reported for bookbuilding, fixed offer price, and pure auctionsrespectively. This suggests that pure auctions may be optimal for issuing firms con-cerned with minimizing underpricing and optimizing the proceeds of issue. TheFrench auction mechanism is market driven rather than underwriter driven, isassociated with fewer frictions, and reflects investor valuations more completely inthe offer price relative to other approaches. Furthermore, it was found to adjustmost completely for recent market conditions in the pricing of IPOs, given that peri-ods of high (low) IPO activity have been found to be associated with less (more)underpricing. Biais and Faugeron (2002) developed a theoretical model to analyzeand compare the performance of a number of different IPO pricing mechanisms andconducted an analysis of 92 IPOs on the French Second Marché over the period1983 to 1996, which utilized the ‘offre à prix minimal’ (French auction) pricingtechnology. They reported mean initial underpricing of 13.23% across the newissues they analyzed, which is significantly lower than initial returns earned whenother pricing approaches were adopted. These authors recognized the importance ofinvestment banks and institutional investor-driven information flows in the adjust-ment of offer price and concluded that the French auction approach can be struc-tured to represent the optimal pricing mechanism. Chemmanur and Liu (2003)confirmed the finding that auctions tend to be associated with lower underpricingthan other IPO methods. Derrien and Womack’s (2003) study results are based onan examination of the French Nouveau and Second Marchés together, and given thatthe Nouveau Marché is designed to attract listings for startup and high-technologycompanies, one would expect underpricing to be higher for that market. Giudici andRoosenboom (2002) reported an average level of underpricing for the NouveauMarché (17.5%) that exceeds Derrien and Womack’s (2003) metric where both mar-kets are examined together, which suggests that there may be differentials in pricingefficiency across these two markets.

12.4 Study motivations, data, and analysis

A logical question regards the type of selling and underwriting procedure that mightbe preferred for controlling the amount and volatility of underpricing, given that itimposes such a significant cost on firms coming initially to market by IPO. The globalexperience illustrates that investor gains in IPOs varied substantially across marketsand by pricing mechanism chosen. The study by Loughran et al. (1994) of the inter-national evidence on IPO underpricing indicated an average level of underpricingacross all 25 countries studied of 31% over a variety of periods. Malaysia recordedthe greatest underpricing due to binding governmental constraints on the setting ofoffer price and France reported the lowest average initial returns of 4.2%. High ini-tial returns were generally associated with regulated markets such as Malaysia andthose characterized by high marginal tax rates on income such as Sweden.Underpricing was typically greater when offer price was set before information oninvestor demand was known, as is the case for the fixed offer price mechanism, andlower for auction-like mechanisms, where the market-clearing approach equatesdemand and supply. Bookbuilding was associated with intermediate underpricing,but imposed substantial direct costs on issuing firms.



Nevertheless, in excess of 90% of IPOs adopted this approach. Despite its popu-larity it has been argued, and there is anecdotal evidence to this effect, that the book-building approach to bringing new issues to market is inefficient largely due to themarket power of underwriters and privileged investors who exercise significant con-trol over the setting of the offer price. Underwriters may allocate shares in a hot newissue disproportionately to favored investors in exchange for commissions and/or setthe offer price at a steep discount to ensure attractive initial returns to such investors.

Evidence on initial returns suggests that the auction-like approach (offre à prix mini-mal) utilized in France may be the most efficient in terms of minimizing underpricing. Inconsequence, we might expect this approach to dominate in a market where a number ofdiverse issuing mechanisms are simultaneously available. Is there any evidence that (a) theapproach actually dominates new issue activity and (b) that French auctions represent themost efficient issue technology? The pursuit of answers to these questions, together withthe differential in initial pricing across French markets documented by Derrien andWomack (2003) and Giudici and Roosenboom (2002), motivated this analysis of FrenchIPOs in the Second Marché, where a greater variety of technologies are utilized in bring-ing new firms to market than is the case for the French Nouveau Marché, where book-building is most typical of new issues. We also note, consistent with the empiricalevidence from other world markets, that while French auctions are indeed efficient in thatthey are associated with few of the conflicts of interest typically associated with book-building, nevertheless bookbuilding has been gaining in popularity in this market.

This study examines 55 new issues which were brought to the Second Marché dur-ing the period 1999 to 2001. Thirty-one firms came to market in 1999, 16 in 2000,and just nine in 2001. At 31 January 2001, two stocks had de-listed, but there wasactive trading in the remaining 53 firms’ shares. Eighteen different sectors are repre-sented with two sectors, Technology and Computer Services, each accounting for16% of the total sample. Traditional sectors such as Food/Drink, Transport, andRetail are well represented, accounting for 13%, 15%, and 11% of the total samplerespectively. Primark Global Access, which publishes prospectuses for most Frenchnew issues, was the main source of data on IPO method, while specific price data onissuing firms was obtained either from the French Stock Exchange’s website or fromthe Datastream Advance database. The data requirements in respect of each new list-ing included opening and closing prices for the first day’s trading and the specificmechanism utilized to determine initial price. In order to compute initial returns rel-ative to performance of the underlying market – that is, abnormal returns – marketindex closing prices were obtained for days (t�1,t) relative to listing date. A variety ofapproaches are commonly utilized to compute abnormal or excess returns, the mostfrequently applied methods including the Index Model, the Market Model, and theCapital Asset Pricing Model. Armitage (1995) noted that the different models pro-duce similar but not identical results and that the Market Model is generally the mostreliable in that it is at least as powerful as the next best alternative. Because histori-cal raw returns are not available for new listings, the Index Model was chosen hereto compute initial price changes for this sample, in light of Brown and Warner’s(1980) conclusion that the Index Model, though simpler, performs no worse than theMarket Model, and Strong’s (1992) contention that accurate identification of eventdate is relatively more important than sophistication of the chosen model or statisti-cal technique. Strong also notes that the main assumption underlying use of the IndexModel is that ex-ante expected returns are equal for all securities and therefore equal



in any period to the expected return E(r) in that period. The market-adjusted orexcess return metric for any given security j is therefore:

ARjt � Rjt � Rmt,

whereARjt � excess return for security j at time tRjt � raw return for security j at time tRmt � market return at time t.Mean initial excess returns are simply the sum of all abnormal returns scaled by

the number of firms in the sample. Wilcoxon (nonparametric) signed-rank test statis-tics for the hypothesis are also reported to test that median sample abnormal returnsare insignificantly different from zero.

12.5 Results and discussion

Table 12.1 reports the pattern of IPO approaches utilized by the issuing firms overthe period studied (1999 to 2001 inclusive), together with mean and median initialreturns for each pricing mechanism.

Interestingly, just four issues used the pure auction approach and three issues uti-lized the pure bookbuilding method. Forty-eight firms utilized a hybrid approach and51 issues incorporated some aspects of the bookbuilding technology. This pattern con-trasts with earlier studies of the French market, where relatively substantial propor-tions of IPOs were conducted by auction and were associated with significantly lowerunderpricing than other mechanisms. Derrien and Womack (2003), for example,reported a 31% incidence of pure auctions for the sample they study (1992 to 1998)against an incidence of pure bookbuilding of 52%, and their analysis revealed averageinitial excess returns to investors of 17.5%, with higher mean returns being earned byinvestors in Nouveau Marché issues than was the case for the Second Marché.However, these authors failed to separately examine the different French markets for new issues. The Nouveau Marché is designed for startup and high-technologycompanies, where higher initial underpricing might be expected. Giudici and


Table 12.1 IPO mechanisms for the French Second Marché (1999 to 2001)

Pure Pure 80% bookbuilding 80% bookbuilding Fullauction bookbuilding 20% fixed price 20% auction sample

Total 4 3 29 19 55% of all 7.3 5.5 52.8 34.4 100Mean excess 1.5 12.5 9.0 7.9* 6.3*

returns (%)Median excess 1.9** 10.2* 6.1* 5.4* 1.0*

returns (%)p-value 0.035 0.01 0.001 0.001 0.001

Asterisks indicate significance at the 1% (*) and 5% (**) levels respectively.


Roosenboom (2002) documented mean initial returns for the Nouveau Marché thatexceed those for the Second Marché. It is also noteworthy that new issues in theFrench Nouveau Marché occurred exclusively via the bookbuilding mechanism, whichis associated with greater underpricing.

The analysis here clearly indicates differentials in relative pricing efficiency of theavailable pricing mechanisms in the French Second Marché, with the pure auctionapproach resulting in significantly lower initial excess returns than is the case eitherfor the sample as a whole or for the alternative pricing methodologies, and the purebookbuilding mechanism yielding substantially greater initial returns to investors.Despite its pricing efficiency, however, this analysis suggests that the auction mechan-ism seems to be losing popularity over time, to the benefit of the more costly book-building-type approach and indeed to hybrid pricing methodologies. When the sampleconsidered here is differentiated across pricing methods, it seems clear that the hybridapproach favored by French investors in the Second Marché nevertheless results inmore efficient pricing from the perspective of issuing firms than is the case for thebookbuilding approach that dominates many international markets for new issues.The results indicate that, over the period of study, the French Second Marché and itsassociated use of hybrid pricing mechanisms continued to be associated with loweraverage underpricing than that documented for other markets where bookbuildingdominates. The finding also appears to be independent of technological classification– when the sample is partitioned on this basis no difference is found in mean or medianexcess returns, although the dispersion of excess returns across issuing firms is mar-ginally greater for technology stocks. Neither is any meaningful difference in initialpricing methodology uncovered for technology stocks vis-à-vis non-technology firmissues. Notwithstanding the relatively small sample size, which precludes further, morerigorous analysis, it seems clear that the French Second Marché choice of hybrid pri-cing results in less extreme mispricing than has been documented for pure pricingapproaches, yet incorporates many of the informational and transparency benefits ofbookbuilding with the pricing efficiency of auctions/fixed price offers.

12.6 Conclusion

Differential initial pricing efficiency has been documented across world markets, withinitial excess returns to investors, and in consequence cost of issuance to IPO firms,being influenced importantly by the mechanism adopted to determine the opening offerprice. In particular, documented initial returns to investors in the French market fornew issues have been significantly lower than is the case for other markets (Derrien andWomack, 2003), a finding that is reinforced here. A resolution of this seemingly newissues pricing puzzle may lie in the ability of French IPO firms to benefit from thedemand-revealing attributes of bookbuilding while avoiding the costly conflicts ofinterest associated with underwriting–investor client relationships. Were it possible toavoid such costly conflicts, it has been argued that bookbuilding could be just as effi-cient a pricing mechanism as the French auction-like approach. Certainly, pure book-building is an underwriter-driven mechanism and too much power in the hands ofunderwriters may result in substantial underpricing. It is noted here that a greaterproportion of French firms enjoy relationship banking than is the case in the USA, UK,and other markets, and French IPO firms tend to choose their main creditor bank as



underwriter when going public. Thus, underwriters know and understand the issuingfirm prior to IPO, need to engage in considerably less information acquisition, are lesslikely to abuse the underwriting role with a client firm, and will both require andchoose less underpricing to successfully market a new issue than in other global mar-kets. This reduction in underpricing costs allows French firms to use hybrid issue mech-anisms that incorporate both the beneficial attributes of bookbuilding (research,investor roadshows, access to potential investors) and the demand-revealing auction orfixed offer technologies, in preference to the pure auction mechanism, to attract foreigninvestors who are perceived to less fully understand the French auction-like approachbut to better understand the bookbuilding process. This approach has resulted in aver-age IPO underpricing of just 6.3% on the French Second Marché while the FrenchNouveau Marché, which utilizes only pure bookbuilding, has been characterized byunderpricing of the order of approximately 17.5% on average (Giudici andRoosenboom, 2002). The inescapable implication is that the French Second Marchémay be applying the bookbuilding IPO method optimally, avoiding the conflict-relatedcosts associated with other jurisdictions and continuing to enjoy significantly lower newissue mispricing. In a period of volatile markets, dismal returns, and government pri-vatization plans, looking forward, the evidence suggests that French investors fare onlyreasonably well in early IPO markets but may avoid the disappointing price reversalsand consequent poor longer-run returns earned by investors in other markets. Althoughthe age-old adage ‘caveat emptor’ (let the buyer beware) still applies, the French expe-rience of IPO markets may not be quite so unhappy as global statistics imply.

Acknowledgments – I would like to acknowledge the valuable research assistancefrom Derek Beatty, B.Comm., MBS (University College Cork).

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