The Advanced Financial Management (AFM) syllabus now includes alternative methods which can be used to obtain a stock market listing and introduces the following new topics, which are examinable from September 2023 onwards:
- Dutch auctions
- special purpose acquisition companies
- direct listings.
This article begins with a brief summary of the method which companies have traditionally used to achieve a stock market listing, ie an initial public offering (IPO), and then discusses each of the alternative approaches highlighted above, including their advantages and disadvantages.
IPO
This topic is included in the Financial Management syllabus and is assumed knowledge for the AFM exam.
An IPO is the most common route for a private company to obtain a listing. These are often highly publicised events and the publicity can help attract new investors. An IPO will allow a company to access a much wider pool of capital and raise the funds required to take advantage of future growth opportunities.
An IPO is typically underwritten by one or more investment banks. The underwriter evaluates the risks associated with the IPO and effectively guarantees the share issue. This concept of underwriting a share issue is a critical component of the initial public offering process but it can be expensive, typically 2% to 7% of the issue proceeds.
In periods of economic uncertainty, an IPO may not be successful in attracting potential investors and may even have to be abandoned mid-way through the process. Market sentiment can change quite quickly and if an IPO is cancelled, it means a lot of time and money will have been wasted without anything to show for it.
An IPO can also take a long time, typically between one and two years, mainly due to the legal requirements associated with a listing and the need to build interest amongst potential investors. An underwriter which provides bookbuilding services will determine the price at which shares must be sold after estimating investor appetite but this can be time consuming because it will involve a series of sales pitches to various institutional investors in the form of a roadshow. This price discovery process can also sometimes be unreliable. For example, LinkedIn shares were priced at $45 for its IPO but closed at $94.25 at the end of the first day of trading. Such an increase implies the IPO was significantly underpriced and when this happens, it means the issuing company loses out because it ends up raising less capital.
Dutch auction
A Dutch auction is a price discovery process which is used to minimise the potential for mispricing in an IPO. Once a company has decided on the number of shares it wishes to sell, interested investors will submit a bid stating the quantity and price at which they are willing to purchase those shares. The final share price for the IPO is based on the highest price at which all the shares can be sold. Since all bidders will pay the same share price it means some bidders may end up paying less than the amount they were initially willing to pay. However, at least in theory, the price is set at the maximum level which ensures demand equals supply and the entire share offering is sold.
Advantages of a Dutch auction
There is evidence to suggest that Dutch auctions may result in a premium being paid to the issuing company compared to the proceeds from a more traditional IPO. This reduces the spread between the final offer price and the actual market price on the first day of trading.
For bidders, there is a trade-off between price and certainty in a way that favours the issuing company. If a bid is too low, the bidder may lose out but the nature of a Dutch auction means it is protected if it bids too high since all bidders ultimately pay the same market clearing share price. A Dutch auction therefore incentivises more aggressive bids, which benefits the company being listed.
A Dutch auction reduces the involvement of the underwriters which results in lower transaction fees for the issuing company.
Often in a traditional IPO, the underwriter will market the offer to institutional investors first and retail investors are only allowed to participate after the company is admitted to trading. However, Dutch auctions allow retail investors to compete against the institutional investors because shares are sold to the highest bidder, effectively democratising public offerings.
Disadvantages of a Dutch auction
As previously discussed, the share offer price in a traditional IPO is determined by the issuing company and its underwriter, typically following a roadshow where the shares are marketed to institutional investors. In a Dutch auction, the underwriter loses this ability to direct the share price because ultimately it is the potential investors who determine the final price since this is fixed by the market at a level which maintains the balance between supply and demand.
In exactly the same way that a traditional IPO can be undersubscribed, the possibility remains that the listing based on a Dutch auction will also be unsuccessful if demand is weaker than anticipated.
Retail investors are less sophisticated than institutional investors and may not conduct sufficient due diligence on the issuing company. There is therefore a risk they might pay an excessively high price. As a result, they may attempt to liquidate their holdings as soon as trading commences and cause the share price to plummet.
Special purpose acquisition company (SPAC)
Another way for a private company to become publicly traded is by merging with an already listed SPAC. A SPAC starts off as a private shell company which undergoes an IPO to become listed. The SPAC is usually formed by people with relevant industry experience who provide the initial capital prior to the SPAC being listed. These people are known as the SPAC sponsors. The purpose of the listing is to raise sufficient funds from other investors to acquire a controlling stake or purchase outright an existing private company in a target industry, although at the time of the IPO, the target company is often unknown to investors. Even though there is usually a target industry in mind when the SPAC is formed, there is typically enough flexibility built into the agreement to allow opportunities in other sectors to be pursued too. After the SPAC has obtained a listing, it normally has up to two years to identify a suitable target or it is closed down and the funds are returned to the investors.
Advantages of a SPAC listing
One of the main advantages of a SPAC transaction is that it can take significantly less time to complete compared to an IPO, typically completing within three to six months. There is also a significant cost advantage. Once acquired, the target company becomes a publicly traded company without paying the fees and underwriting costs associated with an IPO since these are covered before the target company is ever involved. The target company also sidesteps the legal and regulatory obstacles associated with an IPO and the need to generate interest amongst potential investors since the SPAC is already listed when the deal is executed, which saves further time and expenditure.
With an IPO, the share price depends on the market conditions at the time of the listing whereas with a SPAC transaction the target company is in a position to negotiate before the deal is executed. This provides greater certainty about the pricing of the shares. In theory, the target company will therefore not have to worry about the funds raised being insufficient. In a volatile market, this can be a key advantage compared to an IPO and might explain the significant growth in SPAC transactions during the early stages of the pandemic.
The SPAC sponsors typically include individuals with relevant financial and industrial experience, who can draw on their expertise and even take on a role themselves on the board. The SPAC sponsors may also have experience of listing requirements and therefore in theory may be in a position to guide the target company through the process, including any post-admission compliance issues.
Disadvantages of a SPAC listing
The terms of a SPAC transaction are negotiated between the SPAC sponsors and the target company. Depending on the outcome of those negotiations, there may be changes made to the target company’s management team. This contrasts with a traditional IPO, where an offering is typically built on the reputation and success of the historical management team. Any change in the composition of the management team may result in cultural or strategic dissonance which could lead to a failure in execution.
Although there have been SPAC transactions that seem to have added value to shareholders, there is evidence to suggest that many SPAC transactions underperform relative to initial expectations. One of the possible reasons suggested for the mixed track record is that the knowledge and expertise attributed to the SPAC sponsors is sometimes overstated and of limited benefit to the target company post-execution.
Although one of the main advantages of a SPAC is to be able to achieve a listing within a compressed timeline, a company going public must meet the same regulatory requirements as any other public company, regardless of the route to market. For a SPAC this task must be accomplished in a matter of months rather than the year or two that a traditional IPO can take. In theory, the SPAC sponsor may help with the regulatory and compliance issues but in practice the target company often takes on most of the burden and within a much shorter timeline.
The target company will need to do thorough due diligence on the SPAC sponsors and advisors. This will involve investigating the sponsors’ track record and the source of the funds raised and ensuring the merger agreement does not contain any terms and conditions which are detrimental to the target company. It will also be important to ensure the shell company was set up properly and is compliant with regulatory requirements.
The SPAC is obligated to put the potential merger to a shareholder vote. The SPAC shareholders normally have a right to redeem their shares and have their funds returned if they do not approve of the final business combination. The SPAC may then have to turn to the debt markets or raise additional equity to make up the shortfall, which will cost further time and money.
Direct listing
In a direct listing a private company’s shares are admitted to trading on a public market, allowing its existing shareholders to sell their shares directly to the public. The end result is essentially the same as the outcome of an IPO in the sense that a formerly private company becomes traded on a public exchange. However, the route a direct listing takes to get there is different from a traditional IPO since a direct listing involves listing only the company’s existing shares rather than issuing new ones. And since no new shares are issued, there is no need for an underwriter. Once listed, however, it is worth noting that all companies enjoy the same liquidity benefits of being publicly traded, regardless of their route to market.
A direct listing therefore provides an exit route for the private company’s early investors, potentially including its directors and employees, but unlike an IPO, no new capital is raised since no new shares are issued.
Advantages of a direct listing
A direct listing provides a much more cost-effective route to market since it bypasses the need for an underwriter and the transaction fees associated with a traditional IPO. Companies that do not need to raise capital may prefer this method since it also avoids the time delays associated with an IPO. This also minimises the risk of the listing being abandoned since it sidesteps the need for a bookbuilding process and the potential for the sort of unforeseen economic events which can trigger a sudden shift in investor appetite.
A direct listing allows companies to access a broader shareholder base, including institutional and retail investors, without the restrictions on trading which are associated with IPOs. This feature may be particularly attractive to early investors who may want to sell their shares on the first day of trading which is typically not possible with an IPO due to the requirement for a lockup period. Since no new shares are issued, this method can also help avoid a dilution of the existing shareholders.
There is a lower risk of mispricing with a direct listing since the process of price discovery is determined by the opening auction on the first day of trading.
Disadvantages of a direct listing
A direct listing is not the most suitable option for a company that needs capital to finance its future growth plans. Without an underwriter, there is also no guarantee the shares will sell. If the listing is to be successful, any company using a direct listing will therefore need to be confident that there is sufficient investor appetite to allow a market to develop for its shares. This explains why companies that use this route to market typically have strong brand recognition eg Spotify. The availability of shares also depends on early investors and employees wanting to sell their shares. Without an underwriter, it can also be difficult to protect against volatility and uncertainty in the early days of trading after a direct listing.
Written by a member of the AFM examining team
