Banking

Initial Public Offerings (IPOs)

1.1 Initial Public Offerings:

The going public decision is an important milestone in the life of a company, especially young. It provides access to public funds and may lower the cost of funding the company’s operations and investment. It also provides an avenue for the trading of the company’s shares, enabling its existing shareholders to diversify their investments and to crystallize their capital gains from backing the company- an important consideration for venture capitalists. There are many attractions of having shares in a company listed on a stock exchange, including the ability to raise additional equity finance, the ability of the original entrepreneurs or investors to create an exit route for themselves and the opportunity to set up employee share option plans. At the same time, the company is burdened with new obligations in the form of transparency and disclosure requirements and becomes accountable to a larger group of highly dispersed shareholders. The first sale of a company’s share to the general public is called Initial Public Offerings. Most companies that go public do so via an initial public offering of shares to investors. Initial Public Offerings (IPO)

1.2 Underpricing of IPOs:

IPOs have interested financial economists for about four decades now. Due to the fact that most companies raise external equity finance only once-by making Initial Public Offering of their shares when they go public, the efficiency of the IPO process and the performance of the companies that have gone public have been the subject of considerable academic research. The important functions of an IPO in providing additional finance to firms and an ‘exit route’ for original investors would be reason enough to justify considerable research interest. However, the scale of academic research has been driven, in large part, by the existence of two apparent anomalies. First, there is now overwhelming international evidence (outlined in detail in Chapter 4) of initial underpricing. The underpricing is measured as the difference between the offer price and first-day closing price of the stock. That is, the shares in firms that go public are offered to investors at prices considerably below the price that they subsequently trade on the stock market. Secondly, there is a growing body of evidence that the shares of the companies that go public suffer long-run underperformance. This means that relative to other listed companies, investors appear to lose out by holding the shares of the companies that have recently gone public. This underperformance appears to last a surprising length of time, with many studies suggesting significant poor returns up to five years after the listing.

It is evident that underpricing is costly to the firm’s owners: shares sold for a personal account is sold at too low a price, while the value of the equity retained after the IPO is diluted. In monetary terms, IPO firms appear to leave billions ‘on the table’ every year.

Financial economists are intrigued and puzzled by these anomalies. The presence of such anomalies has implications for the underlying structure of the financial markets. Various financial intermediaries are involved in the process of IPO, including the investment bank, the underwriters of the issue and the brokers who find buyers for the shares. There is a possibility that conflict may arise between the issuing firm and these intermediaries as intermediaries may pursue their own interests much different from the interests of the issuing firm. These problems are compounded by the fact that financial markets are characterized by imperfect information leading to information asymmetry between issuers and investors.

The second important reason why economists have been perplexed by these apparent anomalies is that both of them violate the fundamental principle of ‘no-arbitrage’. Much of the work on the long-run underperformance indicates that investors should sell the shares almost immediately after they start trading. Consequently, investors fortunate enough to be allotted shares at the time of the IPO would benefit from the initial underpricing but would not suffer the long-run underperformance. If people followed this rule, the dual phenomena would tend to disappear and no-arbitrage profits would exist. Economists are perplexed when such trading rules persist, as they indicate the irrationality of the investors or their lack of information.

The remarkable empirical regularity of underpricing inspired a large theoretical literature in the 1970s, 1980s and 1990s. The resulting theoretical models have been confronted with the data over the past two decades or more. In the following sections the main theories of IPO underpricing have been outlined.

1.3 Explanations of Underpricing:

The theories of underpriced can be grouped under four broad categories which are listed as follows:

  • Asymmetric Information Models
  • Institutional Reasons
  • Control Considerations
  • Behavioral Approaches

1.3.1 Asymmetric Information Models: The key parties to an IPO transaction are the issuing firm, the bank underwriting and marketing the deal and investors. According to the asymmetric information model one of these parties has more information than the others. Baron (1982) assumes that the bank is better informed about the demand conditions than the issuer, leading to a principal-agent problem in which underpricing is used to induce optimal selling effort. According to Welch (1989), issuer is better informed about its true value, leading to an equilibrium in which higher-valued firms use underpricing as a signal of quality. Rock (1986) argues that some investors are better informed than the others and so can avoid investing in overvalued IPOs. The resulting winner’s curse experienced by the uninformed investors has to be mitigated by deliberate underpricing. Benveniste and Spindt (1989) assume that better-informed investors are compensated by underpricing for truthfully revealing their information before the issue price is finalized, thus reducing the expected amount of money left on the table.

1.3.1.1 The Winner’s Curse: The important parties to an IPO transaction are the issuing firm, the bank underwriting the deal and the investors buying the securities. Asymmetric models of underpricing assume that one of these parties knows more than the others. Probably the best known asymmetric information model is Rock’s (1986) winner’s curse. This model is an application of Akerlof’s (1970) lemons problem in the used car market: uninformed buyers will withdraw from a market if their informational disadvantage results in them being presented with an adverse selection from the quality distribution of goods. Applying this to the IPO market Rock (1986) assumes that some investors are better informed than the other investors about the true value of the security leading to a situation where investors informed bid only for attractive IPOs, whereas the uninformed bid indiscriminately. This burdens the uninformed investors with a winner’s curse in such a way that in an unattractive offering they receive all the shares they have bid for, while in attractive offerings, their demand is partially crowded out by the better-informed investors. In an extreme situation, the less informed are rationed completely in underpriced IPOs and receive cent percent allocations in overpriced IPOs, resulting in average returns that are negative. Due to this reason, uninformed investors will be unwilling to bid for IPO allocations, so the market will be populated only with informed investors. Rock (1986) argues that the primary market is dependent on the continued participation of uninformed investors as the informed demand is not sufficient to take up all shares on offer even in an attractive IPO. This would require that conditional expected returns are not negative so that the uninformed investor’s break-even. In other words, all IPOs must be underpriced. This does not remove the allocation bias against the uninformed investors but they will no longer expect to make losses on an average.

One of the most important empirical implication of the winner’s curse model, credited to Ritter (1984a) and formalized in Beatty and Ritter (1986) is that the underpricing will be greater in case the ex ante uncertainty about the value of the IPO firm is greater. This hypothesis has received overriding empirical support, though it is also worth noting that all other asymmetric information models of IPO underpricing also predict a positive relationship between initial returns and ex ante uncertainty. The various proxies that have been used in the empirical literature fall in the four categories: company characteristics, offering characteristics, prospectus disclosure and aftermarket variables.

Popular proxies based on company characteristics include age ( Ljungqvist and Wilhelm 2003; Ritter 1991) and others, measures of a size such as log sales (Ritter 1984a) or the industry the company is from (Benveniste et al. 2003). Among offering characteristics gross proceeds (or inverse) is a popular proxy (Beatty and Ritter 1986). Other proxies include a number of uses of IPO proceed as shown in the prospectus (Beatty and Ritter 1986) and number of risk factors listed in the prospectus (Beatty and Welch 1996). Finally, aftermarket variables such as volatility (Ritter 1984a; 1987) rely on information which was not, in fact, available at the time of the IPO.

1.3.1.2 Information Revelation Theories: If some investors are better informed than the others, eliciting their information before setting the offer price becomes one of the key tasks for the investment bank taking a company public. The challenge for the underwriter here is to devise a mechanism that induces investors to reveal their information truthfully, by making it in their best interest to do so.

Benveniste and Spindt (1989) and Spatt and Srivastava (1991) have shown that bookbuilding can be such a mechanism. Bookbuilding involves underwriters eliciting information from the investors which are then used in setting the final offer price. Benveniste and Spindt’s (1989) model includes both informed and uninformed investors. The institutions can be taken as informed investors and individual can be considered as uninformed investors. They suggest a pricing and allocation rule that resembles bookbuilding with informed investors have given favorable allocations in hot IPOs. In order to induce truthful revelation for a given IPO, the investment banker must underprice issues for which favorable information is revealed by more than those for which unfavorable information is revealed. This leads to a prediction that there will only be a partial adjustment of the offer price relative to the file range contained in the prospectus. That is, those IPOs for which the offer price is revised upwards will be more underpriced than those for which the offer price is revised downwards. (Hanley 1993).

1.3.1.3 Agency Conflict: Information revelation theories emphasize the important role of investment banks in eliciting information that is useful for price-setting and the advantage of giving them discretion over allocation decisions. Loughran and Ritter (2004) have, however, pointed towards the negative side of these institutional arrangements by highlighting the potential for agency problems between the investment bank and the issuing firm. The dot-com bubble of the 1990s has recently revived academic interest in agency models of underpricing. There seem to be two situations where underwriters may benefit from underwriting:

1. As underpricing represents a wealth transfer from the IPO company to the investors it can give rise to rent-seeking behavior leading to a situation where investors compete for allocations of underpriced stock by offering the underwriter side-payments.

2. Investment banks can also allocate underpriced shares to executives at the companies in the hope of winning their future investment banking business. This practice is also known as ‘spinning’.

The theoretical literature linking agency problems and underpricing goes back about 30 years. Baron and Holmstrom (1980) and Baron (1982) construct screening models which focus on the underwriter’s benefit from underpricing. In a screening model, the uninformed party offers a schedule of contracts, from which the informed party selects the one that is optimal given her unobserved type and /or hidden action. The contract schedule is designed to optimize the uninformed party’s objective, which, given its informational disadvantage, will not be the first-best optimal.

Ljungqvist and Wilhelm (2003) provide evidence consistent with monitoring and bargaining in the USA in the second half of the 1990s. They show that first-day returns are lower; the greater are monitoring incentives of the issuing firms’ decision-makers. Ljungqvist (2003) shows that contracting on higher commissions in a large sample of UK IPOs completed between 1991 and 2002 leads to significantly lower initial returns, after controlling for other influences on underpricing.

1.3.1.4 Signal of Firm Quality: The theories that show underpricing as a signal of firm quality argue that if companies have better information of the present value or risk of their future cash flows than investors then underpricing may be used to signal the company’s ‘true’ high value. Underpricing is, of course, a cost but signaling may allow the issuer to return to the market to sell equity on better terms and conditions at a later date (Seasoned Equity Offering). Ibbotson (1975) is credited with original intuition for the IPO signaling literature. He argues that companies underprice in order to ‘leave a good taste in investors mouth’.

Allen and Faulhaber (1989) and more significantly Welch (1989) have contributed theories on the signaling model. One of the most direct empirical tests of the signaling model is credited to Jegadeesh et al. (1993). They find that the likelihood of issuing seasoned equity and size of seasoned equity issues increase in IPO underpricing, as expected. However, they find that these statistically significant relations are quite weak economically. Welch (1996) says that a high-quality firm can afford to wait longer for SEO. Empirically he finds that the time to SEO increases in IPO underpricing while firms that return to market earlier do so after experiencing high post-IPO stock market returns.

However, many empirical studies, most notably Michaely and Shaw (1994), find that the hypothesized relation between initial returns and subsequent equity offerings is not present, if one holds other variables constant, casting doubt on the empirical relevance of signaling as a reason for underpricing.

1.3.2 Institutional Explanations: Institutional theories bring into focus three features of the marketplace: litigation, bank’s price stabilizing activities after the start of the trading and taxes. The basic idea behind the lawsuit avoidance hypothesis is that companies deliberately sell their shares at discount to reduce the likelihood of future lawsuits against the firm. The second institutional approach is based on the practice of price support, intended to reduce price drops after the trading starts. The third approach argues that there may be tax advantages in the IPO underpricing.

1.3.2.1 Legal Liability: Tinic (1988) and Hughes and Thakor (1992) argue that intentional underpricing acts like insurance against securities litigation. Lawsuits are not only directly costly to the companies in the form of damages and legal fees etc. but also indirectly in terms of the potential damage to their reputation. Hughes and Thakor (1992) assume that the more highly overpriced an issue the more likelihood of a future lawsuit. They predict that underpricing also reduces the probability of an adverse ruling in a case the lawsuit is filed and the amount of damages in the event of an adverse ruling.

But many studies find the legal insurance hypothesis inconsistent with the findings. Drake and Vetsuypens (1993) study a sample of 93 IPOs that were sued and compare them to a sample of 93 IPOs that were not sued. They find that sued firms are just as underpriced as the control sample and the underpriced firms are sued more often than overpriced firms.

1.3.2.2 Price Stabilization: Ruud (1993) says that IPOs are not deliberately underpriced. Rather, IPOs are priced at expected market value but offerings whose price threatens to fall below the offer price are stabilized in the after-market trading. Rudd estimates the unobserved unconditional mean of the return distribution in a Tobit model and finds first-day returns close to zero, as her price support hypothesis would suggest.

Schultz and Zaman (1994), report that on the average US underwriters repurchase 21 % of the original number of shares on offer during the first three days of trading. This is further evidence of price support.

1.3.2.3 Tax Arguments: Rydqvist (1997) explores the possibility of tax advantages due to underpricing in the context of Swedish IPOs. Before 1990, Sweden taxed employment income much more heavily than capital gains. This created a situation where paying employees in the form of appreciating assets, like underpriced stock, became more beneficial than salaries. In 1990 the tax authorities made underpricing gains subject to income tax, removing the incentive to allocate underpriced stock to employees. Consequently, underpricing fell from an average of 41% in 1980-89 to 8% in 1990-94.

While it is unlikely that tax alone can explain underpricing, the tax benefit from underpricing may help explain the cross-section of underpricing returns.

1.3.3 Ownership and Control: Going public, in most cases, is a step towards separation of ownership and control. Jensen and Meckling (1976) point out that where the separation of ownership and control is incomplete, an agency problem between non-managing and managing shareholders can arise in that rather than maximizing expected shareholder value, and managers may maximize the expected private utility of their control benefits at the expense of the outside shareholders.

Two main models have tried to rationalize the underpricing issue within the agency cost approach. Their predictions are contradictory, as we will see in the following lines.

1.3.3.1 Underpricing as a Means to Retain Control: Brennan and Franks (1997) argue that underpricing gives the managers the opportunity to protect their personal benefits by allotting shares strategically when taking their company public. The principal testable implication of the Brennan- Franks model is that underpricing results in excess demand and thus greater ownership dispersion. Using detailed data on individual bids and allocations in 69 UK IPOs completed between 1986 and 1989, Brennan and Franks (1997) confirm that large bids are discriminated against in favor of small ones, an effect which is stronger in case the issue is more underpriced and oversubscribed. Booth and Chua (1996), however, argue that owners value a more dispersed ownership structure because it may result in the more liquid secondary market for their shares.

1.3.3.2 Underpricing to Reduce agency Cost: Stoughton and Zechner (1998) observe that, in contrast to Brennan and Franks (1997), it may be beneficial to allocate shares to a large outside investor who is able to monitor managerial actions. To encourage better monitoring, managers may allocate a particularly large stake to an investor. However, if the allocation is sub-optimally large from the investor’s point of view, an added incentive may be offered in the form of underpricing.

The ownership and control dimension is a nascent field in the study of IPO underpricing. More empirical evidence is needed before we can assess the validity of the theoretical contributions.

1.3.4 Behavioral Theories: In the last two decades, underpricing returns have increased considerably. Many researchers doubt whether informational frictions, legal liability or control considerations could be severe enough to warrant underpricing on this scale. This has led to academic interest in the behavioral explanations of underpricing in recent times, though this literature is still in its infancy. Behavioral theories assume either the presence of irrational investors who bid up the price of IPO shares beyond true value or that issuers are subject to behavioral biases and therefore fail to put pressure on the underwriting banks to have underpricing reduced.

1.3.4.1 Informational Cascades: Welch (1992) points out that informational cascade can develop in some forms of IPOs if investors make their investment decisions sequentially: later investors can condition their bids on the bids of earlier investors, rationally disregarding their own information. Welch derives several testable implications for his prediction. Most importantly, compared to locally or regionally distributed IPOs, IPOs managed by national underwriters are predicted to be less underpriced. Although this implication has been tested thoroughly, it relates to the literature on the relation between underpricing and underwriter reputation. The sign on the relation between underpricing and underwriter reputation has flipped since the 1980s which implies mixed support for the cascades model. In conclusion, Welch’s (1992) cascades model remains one of the least explored areas of IPO underpricing.

1.3.4.2 Investor Sentiment: Behavioral finance is interested in the effect on the stock prices of irrational or sentiment investors. The potential for this effect is particularly large in the case of IPOs since IPO companies are mostly young, immature and relatively informationally not transparent and so hard to value. Ljungqvist et al. (2006) were the first to model an IPO company’s response to the presence of sentiment investors. The model predicts that companies going public in a hot market subsequently underperform, both relative to the first-day price and offer price because of the presence of sentiment investors and short-sale restrictions.

1.3.4.3 Prospect Theory: Loughran and Ritter (2002) stress that behavioral bias among the decision-makers of the IPO firm, rather than among investors lead to underpricing. They argue that issuers fail to get upset about leaving millions on the table in the form of underpricing because they tend to sum the wealth loss due to underpricing with the wealth gain, often larger, on the retained shares as prices jump in the after-market.

Ljungqvist and Wilhelm (2005) use the structure suggested by Loughran and Ritter (2002) to test whether the CEOs of recent WO firms make subsequent decisions consistent with a behavioral measure of their perception of the IPOs outcome. Controlling for other factors, IPO firms are less likely to switch underwriters for their SEO when they are deemed satisfied with the IPO underwriter’s performance.

While these tests suggest there is explanatory power in the behavioral model, they do not speak directly as to whether deviations from expected utility maximization determine patterns in IPO initial returns.


Article Collected From:

  • Ansari, R. U. (2011). Performance of initial public offerings in India.
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