Initial Public Offering: A High Level Summary

One of the exit strategies for a private equity investment is the initial public offering (IPO).  The company hires a group of investment banks (the syndicate group) to issue equity shares that will be publicly traded on an exchange.  The cash generated in the offering goes to the company with a fee going to the banks.

The fee is usually 6%-7% of the size of the offering.  One of the banks will be the lead underwriter or bookrunner of the IPO.  Other members of the syndicate will take lesser roles.  For a large deal, there may be co-bookrunners but, honestly, only one firm can be the lead.  This can be determined by looking at the offering documents and seeing which bank is on the top left.  Besides the lead managers, there are also underwriting and selling groups that have lesser levels of responsibilities during the IPO process.  The managers and the issuer company choose which firms will participate in the deal and at what level.  At times, issuers have thrown out banks that have displeased them.

The fee is distributed among the three levels in the syndicate group.  There is a 20% management fee for the managing underwriter for determining the structure of the IPO, running the marketing program, doing due diligence on the prospectuses and creating the syndicate.  An underwriting fee of 20% is for the managing underwriter and banks in the underwriting group for assuming transaction risk.  They are buying shares from the issuer company and selling them to their investors.  If any shares remain on their books, the banks have to keep them.  The selling concession is 60% of the fee and goes to all three groups.  It's a finder's fee for getting investors to buy the IPO.  The terms of the deal may have a strict or flexible allocation.  In the latter case, the buyside investors allocate the fees among the different members of the syndicate.

To start the process, the issuer company must register with the SEC and file a preliminary prospectus commonly know as the red herring.    The registration statement contains a description of the issuer's business, information on company officers (names, addresses, salary and five year biographies) and their ownership levels, market capitalization of the firm, description of how the proceeds will be used (i.e. to pay down debt or expand the business) and any legal proceedings.  The preliminary prospectus has the information in the registration statement plus:

• Offering price range
• Option agreements
• Underwriting commissions and discounts
• Balance sheet
• Last three years of earnings

After the documentation is filed, there is a 20 day cooling-off period between filing and approval dates.  Here the issuer and syndicate group cannot discuss the IPO outside of the information in the preliminary prospectus.  The final prospectus is created when the SEC confirms that all the information needed is in the document.   This includes everything in the preliminary prospectus plus the final offering price.  While waiting for approval, the banks are asking buyside investors for their indications of interest to get an estimate of demand and the best price for the deal.

Leading up to the first day of the IPO, sales management and the capital markets desk allocate shares to the institutional investors.  For an oversubscribed or hot deal, not everyone will be getting their entire indication.  Actually, that can be said of any deal.  To ameliorate some of the demand, a greenshoe or over allotment option that gives the banks the right to sell an additional 15% of the shares is exercised.

The day before the IPO's effective date, the issuer company and lead underwriter determine the offer price and number of shares distributed.  After these terms are finalized, the final prospectus is published and sent to the investors.  The deal is closed three days later when the issuer receives the proceeds and delivers the stock to the bank.  The bank then sends it on to the investors.

On the first thirty days of trading, the banks are on the hook for stabilizing the market for the IPO.  In the case that the shares go down in price, they are repurchased.  The banks use the over allotment option to hedge for this event.  The bookrunner has the largest market share for any secondary trading of the IPO.  

After the offering is completed, the banks in the syndicate cannot initiate any research coverage on the issuer for forty days.  Afterwards, they, especially the lead underwriters, will write a report - usually with a buy rating.

This is a summary of a regular IPO.  The Google deal was a dutch auction IPO and will be dealt with in a later article.