Principal Financial Group

115,000,000 Shares Common Stock

Price $18.50 Per Share

97,750,000 Shares ftiBDcrtiyi a<it4i)ievWfi is Pe^s WB.Wifl iret/rHstf SSIBSAK rte irxforimra'

Goldman, Sachs & Co.

Credit Suisse First Boston

Merrill Lynch & Co.

Salomon Smith Barney

Banc of America Securities LLC Bear, Steams & Co. Inc.

A.G. Edwards & Sons, Inc. Fox-Pitt, Kelton Inc.

JPMorgan Lehman Brothers

Ramirez & Co., Inc. UBS Warburg


Goldman Sachs International

Credit Suisse First Boston

Merrill Lynch International

Salomon Smith Barney

Banc of America Securities Limited Bear, Steams International Limited A.G. Edwards & Sons, Inc. Fox-Pitt, Kelton

JPMorgan Lehman Brothers

Ramirez & Co., Inc. UBS Warburg

ABN AMRO Rothschild BNP Pari bas

Commerzbank Securities Crédit Lyonnais interested investors, the investment bankers organize road shows in which they travel around the country to publicize the imminent offering. These road shows serve two purposes. First, they generate interest among potential investors and provide information about the offering. Second, they provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities. Large investors communicate their interest in purchasing shares of the IPO to the underwriters; these indications of interest are called a book and the process of polling potential investors is called bookbuilding. These indications of interest provide valuable information to the issuing firm because institutional investors often will have useful insights about both the market demand for the security as well as the prospects of the firm and its competitors. It is common for investment bankers to revise both their initial estimates of the offering price of a security and the number of shares offered based on feedback from the investing community.

Why do investors truthfully reveal their interest in an offering to the investment banker? Might they be better off expressing little interest, in the hope that this will drive down the offering price? Truth is the better policy in this case because truth telling is rewarded. Shares of

3 How Securities Are Traded 63

IPOs are allocated across investors in part based on the strength of each investor's expressed interest in the offering. If a firm wishes to get a large allocation when it is optimistic about the security, it needs to reveal its optimism. In turn, the underwriter needs to offer the security at a bargain price to these investors to induce them to participate in bookbuilding and share their information. Thus, IPOs commonly are underpriced compared to the price at which they could be marketed. Such underpricing is reflected in price jumps that occur on the date when the shares are first traded in public security markets. The most dramatic case of underpricing occurred in December 1999 when shares in VA Linux were sold in a IPO at $30 a share and closed on the first day of trading at $239.25, a 698% one-day return. Similarly, in November 1998, 3.1 million shares in were sold in an IPO at a price of $9 a share. In the first day of trading the price reached $97 before closing at $63.50 a share.1

While the explicit costs of an IPO tend to be around 7% of the funds raised, such underpricing should be viewed as another cost of the issue. For example, if had sold its 3.1 million shares for the $63.50 that investors obviously were willing to pay for them, its IPO would have raised $197 million instead of only $27.9 million. The money "left on the table" in this case far exceeded the explicit cost of the stock issue. This degree of underpricing is far more dramatic than is common, but underpricing seems to be a universal phenomenon.

Figure 3.3 presents average first-day returns on IPOs of stocks across the world. The results consistently indicate that IPOs are marketed to investors at attractive prices. Underpricing of IPOs makes them appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some view this as unfair discrimination against small investors. However, this analysis suggests that the apparent discounts on IPOs may be in part payments for a valuable service, specifically, the information contributed by the institutional investors. The right to allocate shares in this way may contribute to efficiency by promoting the collection and dissemination of such information.2

Pricing of IPOs is not trivial and not all IPOs turn out to be underpriced. Some do poorly after issue and others cannot even be fully sold to the market. Underwriters left with unmarketable securities are forced to sell them at a loss on the secondary market. Therefore, the investment banker bears the price risk of an underwritten issue.

Interestingly, despite their dramatic initial investment performance, IPOs have been poor long-term investments. Figure 3.4 compares the stock price performance of IPOs with shares of other firms of the same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs is dramatic, suggesting that, on average, the investing public may be too optimistic about the prospects of these firms. (, which enjoyed one of the greatest first-day price gains in history, is a case in point. Within the year after its IPO, its stock was selling at less than one-third of its first-day peak and in November 2001 was at about 5 cents a share.)

IPOs can be expensive, especially for small firms. However, the landscape changed in 1995, when Spring Street Brewing Company, which produces Wit beer, came out with an Internet IPO. It posted a page on the World Wide Web to let investors know of the stock offering, and distributed the prospectus along with a subscription agreement as word processing documents

'It is worth noting, however, that by December 2000, shares in VA Linux were selling for less than $9 a share, and by December 2001, less than $2 a share; similarly, by December 2000 was selling below $1 and in December 2001, below $.05. These examples are extreme, but as we will see, the long-term investment performance of IPOs has actually been below average.

2An elaboration of this point and a more complete discussion of the bookbuilding process is provided in "Going by the Book," by Lawrence Benveniste and William Wilhelm. See the References appendix at the end of the text for a complete citation.

Bodie-Kane-Marcus: Essentials of Investments, Fifth Edition

I. Elements of Investments

3. How Securities Are Traded

© The McGraw-H Companies, 2003

Part ONE Elements of Investments

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