My Blog

November 28, 2007

China’s largest heavy truck maker, Sinotruk, raised $1.2 billion in an IPO today in the Hong Kong market.  After its launch, however, the share price immediately fell by 16%.  This was the second China-related IPO in recent weeks whose price performance was so negative – last week Sinotrans Shipping raised almost $1.5 billion but saw its share price drop 13% after launch.

With these two exceptions, in the past months most China-related IPOs have seen their prices surge dramatically – in some cases by well over 100% – in the first day or two after launch.  One of the questions commonly asked in my finance class at Peking University is how do we justify the huge price run-ups we have seen in recent mainland IPOs.  Doesn’t that mean that the issuer got a bad deal by leaving too much cash on the table?  This is the same question that was often asked during the US internet bubble, when IPOs routinely shot up in value on the first trading day.

Aside from answers which imply fraud and insider activity, the only satisfactory answer I can give is based on the structure of the demand for and allocation of shares in any primary offering.  Basically, when an investor puts in a bid for a part of an IPO, his bid is firm (and in China 100% backed by cash), but there is no guaranty that he will receive the amount he bid.  If the deal is very “successful”, that is if it is vastly oversubscribed, the investor may get allocated as little as 1-2% of the amount he bid.

Basically that means that the buyer has given a put option to the arranger of the deal.  If I put in a bid for 100 shares, for example, I have given the arranger the right to sell me any amount from zero shares to 100 shares.  Of course the more successful the deal, and consequently the more allocation I want, the less I get, and vice versa.  If the deal turns out to have been overpriced, I am likely to get all, or nearly all, I asked for, much to my chagrin.

If investors are rational, this option should not be given for free.  In other words for me to justify giving the arranger the option I am granting him, I need to get paid, and the expectation of a run-up in share price after the IPO is what I am effectively being paid.  Imagine that there were no expected run-up in price.  In that case it would make no sense for me at all to participate in the primary offering – I should just wait until the deal is launched and then buy it in the secondary market.  This way I don’t take the risk of getting too little of an undervalued deal and too much of an overvalued one. 

So if we think of the bidder as granting an option, post-IPO pricing surges are not unreasonable.  Of course the more oversubscribed the deal, the greater the required pricing surge.  After all, I wrote an option on 100% of the shares I bid, but since I can only get a profit on the shares I am actually allocated, and I expect to get allocated very little unless the deal suddenly turns into a dog, the lower the expected allocation, the greater the expected pricing surge must be.

The initial post-IPO pricing surge, in short, is what investors are getting paid for providing an option to the arranger, and it is the arranging banks that enforce this payment.  By the way if this is true, we would expect post-IPO surges to be greater for more volatile assets (option premiums are higher on more volatile assets), and also greater the more oversubscribed the deal is expected to be (the premium on the full bid must be paid as a percentage a very small allocation).  Both predictions seem to conform well to the empirical evidence.

The recent slew of surging IPOs may make us forget that the risk provided by bidders in an IPO can be very substantial.  Imagine that I bid in a very hot deal but get allocated only 5% of my bid.  If the deal subsequently rises by 80%, this may seem like a huge profit, but it is actually a much lower return on my total capital at risk.  I have effectively received a profit equal to 4% of the nominal value of the options I granted, or 4% of the capital I put at risk. 

If the deal had turned out to be a dog, I would have been likely to get allocated a large part or even the full amount of my bid.  In the case of Sinotruk, I would have probably have been allocated all or most of my bid.  Assume that I got allocated50% of my bid (I have no idea of what the actual average allocation was), the 16% loss would mean that the options I granted immediately lost 8% in value.

The two recent unhappy IPOs indicate how risky the IPO market can be for investors.  In China, IPO investors typically bid for far more than they want because they expect to get allocated a very small portion of their bid.  In fact there is anecdotal evidence (and corroborating evidence in the performance of short-term interest rates) that many IPO buyers borrow as much money as they possibly can to finance their bids, and expect to sell quickly to repay their loans.  Should any IPO suddenly turn bad, however, these bidders are likely to be left with an excessively large investment in a plunging asset, and they will need to raise money quickly to pay off the debts incurred to buy the IPOs.

With the two recent badly-performing IPOs in the Hong Kong markets, I think the risk of poor performance in Shanghai or Shenzhen has risen substantially.  This may translate into unacceptably large losses for some unfortunate investors.

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