Fama Weighs in on IPOs during 'Fireside Chat'

“Going public is not everyone's cup of tea. For a start, 70-plus percent of the investor universe is comprised of institutions who tend to focus on quarterly performance, which is a challenging adaptation for many private companies,” Harry T. McMahon, ’80, executive vice chairman, Bank of America Merrill Lynch, observed in a "Fireside Chat" with Eugene F. Fama, Robert R. McCormick Distinguished Service Professor of Finance. “If you miss a quarter, you’re toast. Companies shouldn’t go public if their financial results aren't reasonably predictable for the next two or three quarters ahead. That’s the implicit bargain that you make and you have to deliver.”

The program, “The Pros and Con of Going Public,” drew more than 300 students to the Bank of America Merrill Lynch Speaker Series on October 28, the first of two talks planned for the academic year. In introducing the speakers, Stacey Kole, clinical professor of economics and deputy dean for the Full-Time MBA Program, noted that more than 150 Booth graduates work at Bank of America Merrill Lynch, that a dozen are employees in Booth MBA programs, and that dozens more are in nondegree programs.

Chicago Booth is an important source for MBA talent, Kole noted. The bank last summer hosted 14 interns and hired 10 members of the Class of 2015 as new associates after they graduate.

McMahon was joined by Nobel laureate Fama, widely recognized as the father of modern finance and the efficient market hypothesis. His work has shaped research and thinking in corporate governance, macroeconomics and monetary policy, and asset pricing, Kole noted.

Fama noted that for private companies, the possibility of going public becomes an issue when the owners are no longer interested in the business or able to continue. They may not need to raise capital, Fama said, “rather it’s a matter of capturing the wealth of the business to do something else.”

Basic supply and demand constraints govern the viability of an IPO, McMahon noted. “Size tends to matter. The largest players such as Fidelity and T. Rowe Price are major factors and want to know that there is enough float to get in and out of the stock,” he said. “They also look to Wall Street to invest in the aftermarket with trading support and often research coverage. This support is costly so scale matters here too."

McMahon noted that 2014 is turning out to be the largest volume year for US IPOs in recent memory, with 230 new issues in the US as compared to some 29 in 2008. One driver has been that these new issues have outperformed the overall market, he noted. To an extent, this near-term outperformance can be seen as a form of IPO discount.

That raised questions for Fama: “Is it inefficient from a valuation perspective to go public? There’s normally a natural discount to entice people—to accept the risk of investing in a new company...but when is it too much?”

That discount is something of a puzzle, Fama responded. It may be more of an issue for small-cap companies that often underperform the market after a year of trading, which suggests that the discount is warranted.

In part, this correlation between size and performance has led to a trend to bringing larger and more mature companies to market. Private companies have raised substantially more capital in advance of their public debut lately, McMahon noted. The average IPO today has $100 million in private capital at pricing versus $40 million in 2008.

When asked about the expansion of the private market, McMahon referenced the Facebook IPO as an early lesson in related pricing anomalies. IPO underwriters typically impose six-month lockups on insiders and large private holders so that new investors are not hurt by a wave of selling. But with a deep private market, it’s harder to impose lockups, and Facebook was plagued by this for its first several weeks.

Commenting on the deal environment generally, McMahon noted that fewer companies are going private, but strategic buyers have led a record pace of M&A activity. In the US, it is up 40 percent from last year. While there are many factors here, including low rates and market receptivity to acquisition prospects, many deals—including spinoffs from eBay, HP, Symantec, and Occidental Petroleum—emanate from a "shrink-to-grow thesis," he said.--Judith Crown