Cheap debuts, poor performances

Going Public
January 24, 1997

Privatisations and the rush to the equity market by private-sector businesses have led to a significant growth in the number of publicly listed companies in many parts of the world. While continental European countries still have relatively small equity markets compared with the Anglo-Saxon stock exchanges, the evidence presented here suggests that public equity as a source of investment funding is growing in popularity.

The thesis is that different countries with different practices and regulations can offer insights into the development of more effective ways to fund investment through public offerings. Important economic, corporate governance and public policy issues around the "going public" phenomenon are also reviewed in this accessible and digestible research monograph.

Drawing on international evidence and the experience of companies engaging in initial share offerings, the authors critique the capital-raising function of stock markets and evaluate the costs and benefits of raising new equity finance, for the economy as a whole and for individual businesses. They marshal evidence to suggest that new public offerings are systematically underpriced (whatever the country's offering mechanism) and that companies financed in this way under-perform other companies over the longer term. The book helpfully summarises the theoretical explanations for these market failures, tests these against particular institutional and regulatory regimes around the world, and concludes by outlining proposals (if somewhat perfunctorily) to improve the efficiency of the process and the functioning of stock markets.

While an element of underpricing represents a return to risk necessary to underpin the primary equity market for investors (who would otherwise buy shares in the after-sale market), this is not the whole story. Such is the size of the typical "discount" that Tim Jenkinson and Alexander Ljungqvist look elsewhere to account for the phenomenon. Economists' usual suspects - informational asymmetries and institutional factors - are identified as the source of much of the problem.

There is also a very relevant and highly topical discussion on the motivations and actions of those involved in the public offer process, everyone from City underwriters to the managers and owners (whether governments or individual entrepreneurs) of the companies concerned.

Clearly, there is enormous potential for conflict between the competing objectives of the actors in a flotation drama: the financial advisers' need to conclude a successful sale and minimise underwriting risk; the owners' hope of maximising their rewards; managers' need to be incentivised with a realistic opening share price; and investors' desire to have some protection against possible price falls.

Pricing decisions at initial offering are further complicated in privatisations, where political objectives may also intrude. The general reader will find the book's focus on the objectives of European privatisations, and the various arrangements and techniques for selling publicly owned companies particularly interesting.

Reviewing the United Kingdom's privatisation experience, the authors show that revenue-raising objectives have increased in importance over the desire to spread share ownership. In consequence, the UK sale process has become more sophisticated, with book-building techniques (where investors bid for a fixed number of shares, whatever the eventual price) tending to be more prominent in recent years, for example in the secondary offerings of BT, PowerGen and National Power.

The apparent tendency of new issues to under-perform over the long term is less well understood. The empirical evidence for long-run under-performance is not clear cut and unfortunately the book offers no new insights or firm conclusions. The review of the existing economic and behavioural theories will, however, be helpful to the nonspecialist reader.

Throughout, the authors compare and contrast the US offer and after-sale process with those in Europe and these differences are used to show why the theoretical preoccupations of economists on either side of the Atlantic tend to vary.

The book makes a strong case that there are indeed important changes occurring in traditional patterns of corporate finance. It successfully synthesises the existing theoretical and empirical evidence and highlights areas for further research. Students of economics and finance, as well as practitioners, will find many fresh perspectives and insights in this study.

Tim Walsh is director of international business strategy, Royal Mail. He writes in a personal capacity.

Going Public: The Theory and Evidence on How Companies Raise Equity Finance

Author - Tim Jenkinson and Alexander Ljungqvist
ISBN - 0 19 8290772
Publisher - Clarendon Press, Oxford
Price - £25.00
Pages - 174

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