MASTER'S THESIS
Investor Sentiment and Short Run IPO
Anomaly:
A Behavioral Explanation of
Underpricing
Ines MAHJOUB
Table of contents
Abstract
..............................................................................................6
INTRODUCTION
.....................................................................................7
Section 1- Short run IPO anomaly and traditional
explanations ......................10
Introduction
.............................................................................................10
I- Underpricing anomaly: a persistent phenomenon that
characterizes IPO market .....11
I-1\ Underpricing definition
......................................................................11
I-2\ A persistent anomaly in time
..................................................................12
I-3\ A persistent anomaly in all countries
.........................................................13
I-4\ A persistent anomaly in all industries
.........................................................15
II- Theoretical explanations of short run
underpricing: A literature review .............15
II-1\ Asymmetric information
..................................................................16
II-1-1\ The issuer is more informed than the investors
.......................................16
II-1-2\ The investors are the most informed
.........................................................19
* Information Revelation Theories
..................................................................19
* Winner's Curse
.....................................................................................22
* Agency conflicts
....................................................................................23
II-2\ Symmetric information
...........................................................................25
II-2-1\ Risk premium
....................................................................................25
II-2-2\ Characteristics of the Initial Public offering
................................................26
* Risk
......................................................................................................26
* Issue size
.............................................................................................27
* Bargaining power
....................................................................................28
II-2-3\ Lawsuit avoidance: legal liability
.........................................................29
II-2-4\ Underpricing as a substitute of marketing expenditures
..............................30
II-2-5\ Internet Bubble
...........................................................................31
II-2-6\ Price stabilization and partial adjustment
................................................32
Section 2- Behavioral explanations
.........................................................34
Introduction
.............................................................................................34
I- Definitions
.............................................................................................35
I-1\The sentiment's notion
...........................................................................36
I-2\ Hot IPO market's phenomenon
..................................................................37
I-3\ Investors typology
...........................................................................40
II- Literature review of behavioral explanations
................................................42
II-1\ Informational cascades
...........................................................................43
II-2\ The prospect theory
...........................................................................43
II-3\ Investor sentiment by Ljungqvist, Nanda and Singh
(2004) ..............................45
II-4\ The use of Grey Market Data
..................................................................47
II-5\ The use of market conditions to value investor's
sentiment ..............................49
II-6\ Discount on closed-end funds as proxy for investor
sentiment ......................51
II-7\ Other proxies and empirical results
.........................................................52
Section 3- The model and empirical
implications ................................................55
Introduction
.............................................................................................55
I- The model and explanatory variables
.........................................................57
I-1\ The model
....................................................................................57
I-2\ The explanatory variables
..................................................................58
I-2-1\ Informational Asymmetry Theory
.........................................................58
I-2-2\ Theory asserting informational symmetry and IPO market
efficiency .............60
I-2-3\ Investor sentiment and Behavioral approach
................................................61
II- Data Description
....................................................................................62
III- Empirical implications and analysis
.........................................................70
CONCLUSION
....................................................................................77
References
.............................................................................................82
List of tables
Table 1. Average first day returns of some studies
................................................14
Table 2. Descriptive Statistics of the Full Sample
................................................65
Table 3. Descriptive Statistics of Firms with Low Underpricing
..............................67
Table 4. Descriptive Statistics of Firms with High
Underpricing ..............................68
Table 5. Average First-day Returns Categorized by Underwriter
prestige, Share Overhang, R&D Intensity, VC Backing, Age, Assets, Sales,
Firm profitability, Industry, Bargaining Power, Individual Investors' sentiment
and Time ................................................69
Table 6. Ordinary Least Squares Regression Results (with
Bullish proportion as investors' sentiment measure)
....................................................................................71
Table 7. Ordinary Least Squares Regression Results (with
Bullish Bearish Spread as investors' sentiment measure)
..................................................................72
Table 8. Ordinary Least Squares Regression Results
.......................................76
Abstract
U
nderpricing phenomenon has intrigued academics and
practitioners over the past three decades, and has generated considerable
research trying to clarify and to understand this short run puzzle: asymmetric
information theories, IPO market efficiency theories and behavioral and
sentiment approach. In this study, I regroup in the same model the most
important explanations advanced earlier to determine which of these
explanations characterizes best the data in the context of a unified framework,
with a contribution in the behavioral approach. I use a direct measure of
investors' sentiment obtained from the survey data of AAII and II, and I
distinguish between the sentiments of the two types of investors: individual
and institutional investors.
Sentiment is a primary driver of underpricing and a relevant
explanation to this anomaly. Moreover, individual investors are those driving
the first day closing prices and are more conducting the short run IPO puzzle
than the institutional investors.
INTRODUCTION
G
oing public constitutes a real driver for the development of a
company, enabling it to increase its equity capital and to overcome the
constraint that its founders are no longer able to provide the capital needed
for its expansion, and enabling it to diversify its sources of financing
without the need for debt. It is also a way to provide liquidity by creating an
opportunity to convert all or some founders and shareholders' wealth into cash
immediately or at a future date. Going public is also an opportunity to clarify
the company's business and strategy and to think about the company's future
growth. Not forgetting the role of going public and being listed in enhancing
the company's credibility and strengthening its image and reputation. When a
company decides to go public, shares offered in the stock market should be
correctly and truly valued. Issuers should also time the Initial Public
Offering to coincide with a favourable period (Hot market) to succeed their
first introduction in the market. But the question is, if the issuing firm's
managers are shrewd enough to value the company's shares and to choose a hot
market period, why underpricing is a persistent anomaly characterizing the IPO
market and why so much money is leaving on the IPO table?
Stoll and Curley (1970), Logue (1973), Reilly (1973) and
Ibbotson (1975), are the first who documented that when companies go public,
the first day closing price is systematically higher than the issue price at
which the public offering was introduced in the market. They are the first who
documented the first day underpricing phenomenon. And Ibbotson (1975) is the
first who offered a list of possible explanations for underpricing, many of
which were formally explored by other authors in later work.
The underpricing phenomenon has inspired a large theoretical
literature over decades trying to give a relevant and a convincing explanation
to this first day anomaly. It has intrigued academics and practitioners over
the past three decades and has generated considerable research trying to
clarify and to understand this phenomenon. The first explanations that were
advanced are based on the informational asymmetry between the key parties of an
IPO: issuing firm, underwriter and investors. These theories have been very
popular among academics and practitioners for decades and have been considered
as the most relevant and convincing explanation to the short run IPO anomaly.
However, other theories have been introduced asserting the informational
transparency and lucidity and the IPO market efficiency, since the first
theories based on asymmetric information are unlikely to give a relevant
explanation to the surprisingly and severe level of underpricing of 63.5%
reached in 1999 and 2000. This severe level of the internet boom years exceeded
any level previously seen. Researches are continuing, and it is fair to say
that this anomaly is not satisfactorily resolved. It is still a puzzle, since
nor the informational asymmetry theories neither the IPO market efficiency
theories are likely to give a convincing and a reliable explanation to this
short run IPO phenomenon.
Many researchers come to the conclusion that IPO future
researches should turn to behavioral approach and sentiment notion. Research
effort should focus more on behavioral explanations to clarify and to explain
the short run IPO behaviour and the underpricing anomaly: a new path trying to
understand and to explain this persistent anomaly. Turning to behavioral
explanations seems to be the most promising area of research to understand the
short run IPO behaviour.
We can say that the underpricing anomaly may be the most
controversial area of IPO research. Research effort has provided numerous
analytical advances and empirical insights, but underpricing is not yet
explained and the research effort is continuing.
In this thesis, I answer these two main problematics:
Ø What are the most relevant and reliable
explanations to the underpricing anomaly from the long list of explanations
advanced?
Ø If we rely on behavioral explanations based on
investors' sentiment to explain this phenomenon, what type of investors is more
conducting the underpricing phenomenon and the first day returns?
To answer these two main questions, I present in a first
section the phenomenon and its persistence in time, for all the countries and
for all the industries. I present the two main categories of explanations:
informational asymmetry and theories asserting the informational transparency
and the IPO market efficiency. I summarize the most important findings and
results of researchers that have considered these theories in their studies. In
a second section, I present the most important studies and papers that have
considered the sentiment explanation and the investors' behaviour as the most
convincing and relevant driver and determinant of IPO underpricing. In this
section, I give an idea about the application of the behavioral and sentiment
approach to clarify and to understand the IPO patterns by numerous researchers
and I shed light on the importance of the sentiment investors in the IPO
market.
Finally, in the third section, I regroup the most important
explanations that have been advanced in the same model to determine which of
these explanations characterizes best a sample of 217 U.S IPOs for 2006 and
2007. In the context of a unified framework and model, I present the three
theories: asymmetric, symmetric and behavioral approach.
For the behavioral approach, I use direct measures of
sentiment obtained from the survey data of American Association of
Individual Investors and Investors Intelligence. I distinguish
between the sentiments of the two types of investors: individual and
institutional investors, to answer the second question.
The main result is that sentiment is a primary driver of
underpricing and a relevant explanation to this short run anomaly. Moreover,
individual investors are those driving the first day closing prices and are
more conducting the short run IPO puzzle than the institutional investors.
Section 1- Short run IPO anomaly and traditional
explanations
Introduction:
The underpricing is a short run anomaly
characterizing the IPO market. This phenomenon has inspired a large theoretical
literature over decades trying to give a relevant and a convincing explanation
to this first day phenomenon. Underpricing anomaly has intrigued academics and
practitioners over the past three decades and has generated considerable
research aimed at explaining the apparent incongruities with rational asset
pricing. While this research effort has provided numerous analytical advances
and empirical insights and a large list of explanations were presented, it is
fair to say that this anomaly is not satisfactorily resolved. It is still a
puzzle sparking much academic attention until now and requiring other
explanations and much considerable research effort.
In this first section, I begin in the first paragraph by a
definition of the underpricing anomaly and an illustration of its persistence
over the time, all over the world and for all the industries, an order to have
a complete idea about this phenomenon. I summarizing in a second paragraph the
most important results and findings reached by the researchers that have been
interested in this field and have been interested in explaining the short run
IPO puzzle. These findings can be classified in two main categories:
Ø Explanations based on informational asymmetry between
the key parties which have been considered the most convincing explanations for
decades by a large number of researchers.
Ø And theories asserting the informational transparency
and lucidity and asserting the IPO market efficiency.
I- Underpricing anomaly: a persistent phenomenon that
characterizes IPO market
I-1\ Underpricing definition:
Before going in details, presenting the
explanations advanced for the short run IPO anomaly, it is logical to begin by
a definition of this notion of «underpricing» to understand this
short run phenomenon:
Early writers that have been interested in IPO market, notably
Stoll and Curley (1970), Logue (1973), Reilly (1973) and Ibbotson (1975), are
the first who documented that when companies go public, the price of shares
they sell tends to jump substantially on the first day of trading. The first
day closing price is systematically higher than the issue price at which the
public offering was introduced in the market. Consequently, IPOs exhibit
positive first day returns on average with no exception to the industry to
which the IPO belongs, to the country and to the period and date of going
public. That has been the first and the most important observation in the IPO
market.
From an issuer's point of view, this phenomenon is usually
called underpricing, as it describes the additional amount of money which could
have been raised by the issuer if the offer price had been set at an
appropriate level. Indeed, if the issuer had been set a higher offer price for
his offering shares, the issue price could have been easily accepted by the
investors interested in purchasing the IPO shares, since a run up is observed
on the first day of trading. The trading begins by the offer price which is
less than the apparent maximum price achievable at the end of the first trading
day. In a way it is an amount of money left on the IPO table from the issuers'
point of view. Therefore, underpricing is an expression used to describe the
issuer point of view, as he thinks that he has not correctly valued the IPO
shares, he underpriced the real value of the shares of his company.
Underpricing is estimated as the percentage difference between
the price at which the shares subsequently trade in the market (the first day
closing price) and the price at which the IPO shares were sold to investors
(the offer price or the issue price) and at which the offering was introduced.
Underpricing is suggesting that firms which go public leave considerable
amounts of money on the table. The amount of money left on the table is defined
as the difference between the closing price on the first day and the offer
price, multiplied by the number of shares sold. In the words of Jay Ritter,
this is the first-day profit received by investors who were allocated shares at
the offer price. It represents a wealth transfer from the shareholders of the
issuing firm to these investors. So, underpricing is a loss, a cost for the
issuers that they want to minimize and a profit for the first investors that
purchase and acquire the IPO shares.
I-2\ A persistent anomaly in time:
In the United States, at the end of
the first day of trading, the shares traded on average at 18.9% above the offer
price at which the company sold them (1990-2007). Underpricing has averaged
21.2% in the 1960s, 9% in the 1970s, and increasing from 7.8% in the 1980s to
14.4% in the 1990s and to a surprisingly and severe underpricing of 63.5% that
exceeded any level previously seen in 1999 and 2000 (reflecting the internet
boom years) before falling to 14% in 2001, averaged 11.8% from 2002 to 2006
before rising to 14% in 2007. These are the average levels of underpricing
observed in the United States IPO market. When we observe these different
levels and percentages of underpricing, we can say that underpricing fluctuates
so much and its level changes over time, but it is persistent over time. This
anomaly is always observed in the IPO market, whatever the industry to which
the offering belongs and whatever the period of going public. The level changes
but this anomaly is persistent.
In dollar terms, IPO firms appear to leave many billions
«on the table» every year in the U.S. IPO market alone. But the
highest amount is in 1999 and 2000, period of internet bubble, this amount of
money left on the table at IPO market has reached 66.63 billion dollars, an
amount that exceeded any level previously seen. It is the period of internet
bubble that attracted the attention of much research effort. Ritter documents
that in 1999 and 2000 only, 803 companies went public in the United States,
raising about $123 billion, and leaving about $65 billion on the table in the
form of initial returns. Loughran and Ritter (2004)1 explain
low-frequency movements in underpricing (or first-day returns) that occur less
often than hot and cold issue markets. On a data for IPOs over 1980-2003, they
find that IPO underpricing doubled from 7% during 1980-1989 to almost 15%
during 1990-1998 before reverting to 12% during the post-bubble period of 2001-
2003, there are some level differences over time but underpricing is
persistent.
1 Loughran and Ritter (2004): «Why Has IPO
Underpricing Changed Over Time?».
I-3\ A persistent anomaly in all countries:
Many researchers have been concentrated in
studying the persistence of underpricing anomaly internationally. The
underpricing phenomenon of Initial Public Offerings (IPOs) has been widely
studied across different stock markets around the world and it is a persistent
phenomenon all over the world.
Loughran, Ritter and Rydqvist (1994)2 documented
that the underpricing anomaly exists in all IPO markets. They collected data
for 45 countries for different periods and found that underpricing is
persistent for all the IPO markets with no exceptions but surely with different
levels.
A comparative study by Jenkinson (1990) examines the
performance of IPOs in Japan as well as IPOs in the U.S. and the U.K., and
concludes that IPOs in these countries are systematically priced at a discount
relative to their subsequent trading price. In the U.S. the discount is around
10% while in the U.K., it is around 7%. But when we see the next figures
presented by Jay Ritter and that represent the underpricing average in 2008 for
many countries, we can see that the level of underpricing has been increased in
comparison to the earlier results that were presented by many researchers.
Figure 1- Underpricing on non-European IPOs (2008)
2 Loughran, Ritter and Rydqvist (1994):
«Initial Public Offerings: international insights».
Figure 2- Underpricing on European IPOs (2008)
Loughran et al. (1994) provide also a comprehensive survey of
companies going public in 25 countries and find that underpricing is a
persistent phenomenon. Ritter (2003) reports the extent of underpricing in 38
countries and finds the same results.
Table 1. Average first day returns of some studies
3
Country
|
Sample size
|
Time period
|
Avg first-day return %
|
Australia
|
381
|
1976-1995
|
12.1
|
Brazil
|
62
|
1979-1990
|
78.5
|
Canada
|
500
|
1971-1999
|
6.3
|
Indonesia
|
106
|
1989-1994
|
15.1
|
Mexico
|
37
|
1987-1990
|
33.0
|
Norway
|
68
|
1984-1996
|
12.5
|
Taiwan
|
293
|
1986-1998
|
31.1
|
UK
|
3.042
|
1959-2000
|
17.5
|
US
|
14.76
|
1960-2000
|
18.4
|
3 This table presents the results of some different
studies that were advanced. It is a demonstration of the persistence of IPO
underpricing for different countries regardless the period of the study, to
insist on the fact that this persistence is not only due to the period of IPOs.
Regardless the period, underpricing phenomenon exists for all countries.
I-4\ A persistent anomaly in all industries:
Underpricing is also persistent for all the
industries: automobile, banks, chemicals, construction, financial services,
food and beverages, industrial, machinery, media, pharmaceutical and health,
software, technology, telecommunications, transport and logistics ... Every
firm, which decides to go public, faces the phenomenon of underpricing, the
price of shares the firm sells tends to jump substantially on the first day of
trading regardless its field of activity. Underpricing is persistent for all
the firms no exception of the activity to which the firm belongs.
Oehler, Rummer, and N. Smith (2005) in their article «IPO
Pricing and the Relative Importance of Investor Sentiment, Evidence from
Germany», for a sample of 410 German firms from 1997 to 2001, they
classify the issuing companies by field of activity. When observing the number
of companies going public and the number of companies having a negative first
returns, we can say that most of companies going public have a positive first
day return and then their shares are underpriced regardless the field of
activity and regardless the industry they are belonging to.
II- Theoretical explanations of short run underpricing:
A literature review
The research effort aimed at explaining the
short run anomaly of the IPO market has provided numerous analytical advances
and empirical insights, and a large list of explanations has been offered.
Ibbotson (1975) is the first who offered a list of possible
explanations for underpricing, many of which were formally explored by other
authors in later work.
The list of explanations that were advanced to clarify and to
understand the underpricing anomaly and to resolve this short run puzzle of the
IPO market is long. The considerable research effort in the field of Initial
Public Offerings market has resulted in many explanations and the list can not
be exhaustive. In this paragraph, I summarize the most important researches and
findings and I classify the different theories and explanations advanced in two
main categories:
Ø Explanations related to the asymmetric information
theory that have been popular among academics and have been considered the most
convincing explanations for decades by a great number of researchers, and
Ø Explanations asserting the symmetric information.
II-1\ Asymmetric information:
The key parties to an IPO transaction are the
issuing firm, the bank underwriting and marketing the deal, and investors.
Asymmetric information models assume that one of these parties knows more than
the others.
II-1-1\ The issuer is more informed than the investors:
Welch (1989) and others assume that the issuer is better
informed about its true value.
* The theory of signalling; Firm quality:
The high quality issuers may attempt to signal their quality
and their true value, and to distinguish themselves from the pool of low
quality issuers, they voluntarily sell their shares at a lower price than the
market beliefs. They leave deliberately money on the IPO table to deter lower
quality issuers from imitating, and to demonstrate that they are high quality
by throwing money. Investors who are less informed about the issue quality and
about its true value will be incited to buy the shares since the price is low
and because they begin to believe on the high quality of the issuer. And the
issuers with some patience can recoup the amount of money left on the table by
future issuing activity. There are some issuers who have the intention to
conduct future equity issues at a later date on better terms (Seasoned Equity
Offerings SEO) (Welch 1989) or they look for favourable market responses to
future dividend announcements (Allen and Faulhaber 1989).
Michaely and Shaw (1994) argue that some issuers voluntarily
desire to leave money on the table in order to create, in the words of
Ibbotson 1975 «a good taste in investors' mouths» as a signal of high
quality, allowing issuers to have more successful Seasoned Equity Offerings in
the future. But, surprisingly, they find that the hypothesized relation between
initial returns and subsequent seasoned new issues is not present. There is no
relation between underpricing and Seasoned Equity Offerings. So, we can say
that the explanation of underpricing based on creating a good taste in
investors' mouths in order to have the investors' confidence in the future and
to conduct future equity issues on better terms and then recouping the amount
of money left on the IPO table, is not relevant and it is not convincing.
Jegadeesh, Weinstein, and Welch (1993), using data on IPOs
completed between 1980 and 1986, find that the likelihood of issuing seasoned
equity and the size of seasoned equity issues increase in IPO underpricing, as
expected. However, they note that these statistically significant relations are
relatively weak economically. But, Michaely and Shaw (1994) refute completely
the existence of this relation between underpricing and SEO.
Guo, Lev and Shi (2006) 4, using a sample of 6010
US IPOs from 1980 to 1995, find that R&D expenditures (using the ratio of
R&D expenditures to sales or to expected market value for the last fiscal
year before IPO as a measure) are the best proxy to informational asymmetry
about the issuer quality and find a positive and statistically significant
relation between the firm quality and underpricing. R&D expenditures are
the intangible investment most extensively researched in economics, accounting
and finance, they have to be disclosed in the corporate financial reports.
R&D contributes to informational asymmetry such as R&D intensive firms
are often undervalued by investors. That is why R&D intensive issuers can
not set a high offer price for their IPOs. Besides, they are more willing to
forgo money on the table at IPO than are no R&D issuers, because they
expect to recoup money left on the table by subsequent issues of seasoned
stocks when the market realizes over time the positive outcomes of their
R&D (in the words of the authors), because as I presented earlier some
studies find no relation between underpricing and SEO.
Guo, Lev and Shi (2006) introduce another measure of firm
quality in their model, the Share Overhang Ratio (the ratio of retained shares
by insiders to the number of shares issued). They find a positive and
statistically significant relation between firm quality and underpricing: the
percentage ownership retained by insiders serves as a signal for firm quality.
Also, Grinblatt and Hwang (1989) report a positive association between the
degree of underpricing and the level of insiders' ownership. For high overhang
ratio and so for high quality issues, the issue price is lower a mean to
demonstrate their quality and a higher level of underpricing is observed:
higher quality firms underprice more than do those of lower quality.
In their article «Why Has IPO Underpricing Changed Over
Time?», Loughran and Ritter (2004) use many proxies for the firm
quality:
4 Guo, R., B. Lev, and C. Shi (2006):
«Explaining the Short- and Long-Term IPO Anomalies in the US by
R&D».
Share overhang which is the ratio of retained shares to the
public float (the number of shares issued) and the Venture Capital a dummy
variable which takes a value of one (zero otherwise) if the IPO is backed by
venture capital. They find a positive and statistically significant relation
between the firm quality and underpricing using the share overhang ratio, but a
statistically insignificant relation using the venture capital as a proxy to
firm quality. The presence of venture capitalists in the IPO firm is expected
to signal issue quality, since their presence reduces the perceived uncertainty
over firm value. Venture capitalists have expertise in particular industries
and they are expected to make superior investments relative to other investors.
In essence, venture capitalists certify the quality of an IPO and their
presence signals that asymmetric information is relatively low for the issue
and that the issuing firm quality is high and hence leads to a higher issue
pricing and to a lower degree of underpricing (Megginson and Weiss, 1991). But
in this article, this variable is found insignificant. The same result of
insignificance using the venture capital backing as a signal of firm quality is
found by Guo, Lev and Shi (2006). A question is then can be asked: Is Venture
Capital backing really a signal of firm quality and an explanatory variable
that can be introduced in the models?
Ben Dov (2003) looks at the level of institutional ownership
shortly after the IPO and finds that high institutional ownership (a signal of
firm quality and a proxy for information asymmetry) forecasts higher returns in
hot markets.
In the same way of informational asymmetry and firm quality,
we can talk about the underwriter reputation (Booth and Smith (1986), Carter
and Manaster (1990), Michaely and Shaw (1994)). Some issuers use the
underwriter reputation as a signal of high quality and want to hire a
prestigious underwriter, since by agreeing to be associated with an offering,
prestigious intermediaries «certify» the quality of the issue. When
an issuer chooses a prestigious underwriter for the book-building mechanism, he
sets a low offer price conducting a high underpricing on one hand, as
compensation to the underwriter and on the other hand, he is sure about full
subscription. He is concerned by quantity rather than price, and a lower
offering price increases the probability of full subscription. It also
increases the positive news coverage and the investors' interest in future
equity offerings, if issuers have the intention to conduct Seasoned Equity
Offerings in later date to recoup the money left on the table. 5
5 All are explanations advanced by researchers to
the underpricing anomaly when issuers choose to hire prestigious underwriters.
Because, logically, hiring a prestigious underwriter is a signal of high
quality and issuers should require high offer prices for their high quality
issues.
This intention of Seasoned Equity Offerings can explain the
mystery that issuers seem to be happy and not upset when leaving money on the
table, they are certain to recoup this money in later date. 6
This explanation of underwriter reputation can take many
senses and will be discussed later in other theories.
II-1-2\ The investors are the most informed:
We are in the case of investors that are more informed than
the other parties about the demand, the price they are willing to pay to
acquire the IPO stocks, ...
* Information Revelation Theories:
To reduce this informational asymmetry, issuers tend to hire
underwriters and to use a «Bookbuilding mechanism». This common
practice of Bookbuilding consists on setting a preliminary offer price range by
the issuing firm, then the underwriter will take the role of trying to collect
private information from investors about the offering which is called
«indications of interest» such as their demand, the price they are
willing to pay to acquire the IPO shares... The bookbuilding mechanism allows
underwriters to extract this private information. During pre-selling period,
the underwriter tries to gauge demand and to have an idea about the price that
potential investors are willing to pay, these indications are then used in
setting the final offer price. If there is strong demand and the investors are
willing to pay a higher price to obtain the IPO stocks, the underwriter will
set a higher offer price and vice-versa.
But, Ritter and Welch (2002) add that if potential investors
know that showing a willingness to pay a high price will result in a higher
offer price, these investors must be offered something in return. They have to
be rewarded for communicating favourable information. Otherwise, if these
investors are offered nothing in return and the issuing firm will go public
with a higher offer price, investors are dissuaded and they will not reveal
their intentions and may even try to reveal wrong information to bias the
underwriter's decision.
6 There is a debate concerning the correlation
between underpricing and SEO, many researchers use the SEO as an explanation
for not requiring high issue prices for their offerings and others refute this
explanation and the relation between SEO and underpricing.
So, to induce investors to truthfully reveal that they want to
purchase shares at a high price, underwriters must offer them some combination
of more IPO allocations and underpricing when they indicate a willingness to
purchase shares at a high price : Benveniste and Spindt (1989), Benveniste and
Wilhelm (1990), and Spatt and Srivastava (1991).
Lee, Taylor, and Walter (1999) and Cornelli and Goldreich
(2001) show that informed investors request more, and preferentially receive
more allocations.
For the issuer, underpricing is on one hand compensation to
the underwriter: Baron (1982) has the same theory which is based on the fact
that issuers are less informed than underwriters, they delegate the pricing
decision to underwriters who possess superior information regarding the demand
for the IPOs, and to induce the underwriter to requisite effort to market
shares, it is optimal that issuer lets some underpricing because he can not
monitor the underwriter without cost. However, we should point out the findings
of Muscarella and Vetsuypens (1989) that when underwriters themselves go public
and then there is no monitoring cost, their offerings are also underpriced. So
underpricing is a necessary cost of going public and not a monitoring cost as
advanced by Baron.
On the other hand, underpricing is compensation to investors
to truthfully reveal their willingness to purchase the IPO shares and with a
higher price.
But we should also mention the fact that underwriters should
not underprice too much to not lose business from issuers. Nanda and Yun (1997)
find that high levels of underpricing lead to a decrease in the lead
underwriter's own stock market value, whereas moderate levels of underpricing
are associated with an increase in stock market value.
In a similar sense, Dunbar (2000) finds that banks
subsequently lose IPO market share if they either underprice or overprice too
much.
As a conclusion for the information revelation theory, we can
say that underpricing can be reduced by reducing the informational asymmetry
between the IPO parties.
And as Ritter and Welch (2002) note, if underwriters used
their discretion to bundle IPOs, problems caused by asymmetric information
could be nearly eliminated.
Underwriters, are intermediaries between issuer and investors,
they advise the issuer on pricing the issue, both at the time of issuing a
preliminary prospectus that includes a file price range, and at the pricing
meeting when the final offer price is set. In the bookbuilding period, they try
to collect the investors' private information which can help in setting the
price and even the volume of IPO shares. Their role is very important in
reducing the information asymmetry by transmitting the investors' private
information to issuers. So, the revelation information theory is based on the
work of underwriters.
I presented in the previous paragraph that underpricing is
positively associated with underwriter reputation. For example, consistent with
evidence from the 1990s (Beatty and Welch (1996)), Ljungqvist, Nanda and Singh
(2004) predict that underpricing increases in underwriter prestige, but that
this relation depends on the state of the IPO market.
Also, Benveniste, Ljungqvist, Wilhelm and Yu (2003) find a
positive relation between underpricing and underwriter prestige in the
1999-2000 hot market.
First, we should present the measures used of underwriter
reputation: Carter and Manaster (1990) provide a ranking of underwriters based
on their position in the `tombstone' advertisements in the financial press that
follow the completion of an IPO. This ranking, since updated by Jay Ritter, is
much used in the empirical IPO literature, it is a discrete underwriter
reputation measure ranging from 0 to 9, where a 9 (0) represents the most
(least) prestigious underwriter.
Megginson and Weiss (1991) measure underwriters' reputation
instead by their market share, and this approach too is widely used.
The fact of using a prestigious underwriter in the
bookbuilding process has an impact on signalling the high quality of the
issuing company as I said earlier, but it has also a great impact on the
information revelation, since prestigious underwriter is a source of confidence
to investors. The prestigious underwriter has a great ability and power to make
investors reveal their private information.
Many explanations were presented to the positive relation:
when an issuer decides to hire a prestigious underwriter, he is sure about a
full subscription, he is concerned by quantity rather than price, and by
setting a low offer price, he tries to increase the probability of full
subscription. There are some other issuers who are concerned by their firm
quality and by hiring a prestigious underwriter, they tend to demonstrate their
high quality and they set a low offer price as a signal of quality and of the
real value of the company. From the point of informational revelation theory,
underpricing and underwriter reputation are positively related because
underpricing is used as compensation to the underwriter (Baron 1982).
In Loughran and Ritter (2004) model, top-tier underwriters are
associated with more underpricing in the 1990s, and especially in the bubble
period.
Loughran and Ritter (2003) argue that prestigious banks have
begun to underprice IPOs strategically, in an effort to enrich themselves or
their investment clients. Another explanation is that top banks have lowered
their criteria for selecting IPOs to underwrite, resulting in a higher average
risk profile (and so higher underpricing) for their IPOs.
But the relation between underwriter reputation and
underpricing is not systematically positive and it is empirically mixed, there
are some researchers who find that the correlation between underpricing and
underwriter reputation is negative: when an issuer hires a prestigious
underwriter, he can set a higher offer price and then lower underpricing will
be observed. For example, Carter and Manaster (1990), and Carter Dark and Singh
(1998) find that more prestigious underwriters are associated with lower
underpricing.
There are also some researchers who have introduced the
underwriter reputation variable in their models and find that it is
statistically insignificant as in Guo, Lev and Shi article (2006). These
authors have introduced the underwriter reputation as an explanatory variable
to explain underpricing and find that it is statistically insignificant.
In practice, results are not very sensitive to the choice of
underwriter reputation measure, but they are highly sensitive to the period
studied.
* Winner's Curse:
Rock (1986) assumes that some investors are more informed than
are other investors in general, the issue firm, and its underwriter. There is
an imbalance of information between the potential investors themselves. These
better informed investors bid only for attractively priced IPOs. In the case of
unattractive offering, the better informed investors will not purchase the
shares and the uninformed investors will have all shares they have bid for
because they bid indiscriminately. But, these uninformed investors are unable
to absorb all the shares offered, that is why underpricing is necessary to
incite informed investors to bid for this offering's shares even if they think
it is unattractive. The lower offer price will incite them to try to have the
offering's shares. This underpricing is necessary also to not result in a
negative return for this offering for the uninformed investors, whose capital
is needed even for an attractive offering. They must be protected in IPO market
to not lose their capital and their participation because in the case of
attractive offerings, informed investors are also unwilling to absorb all the
shares offered and their demand is insufficient. The uninformed investors
should not fear the IPO market, positive returns are required to protect them
and to ensure a continued participation in IPO market.
In the spirit of Rock (1986), Chowdry and Nanda (1996) develop
a model in which price support is used as a complement to underpricing to
reduce the losses supported by uninformed investors and induce them to
participate in the IPO.
In conclusion for the theory of winner's curse of Rock 1986,
which is an application of Akerlof's (1970) lemons problem, underpricing is
necessary to not lose the capital of uninformed investors and to incite
informed investors to take part of an offering allocation even if it is
unattractive. Pricing too high might induce investors and issuers to fear a
winner's curse.
In the same sense of inciting informed investors to
participate in an unattractive offering, Ljungqvist, Nanda and Singh (2001)
find and explain underpricing by the fact that noise traders cannot absorb the
entire IPO because they are wealth constrained. To induce rational investors to
participate in the offering, issuers must set the IPO price below the price
noise traders are ready to pay, to induce underpricing and to make the offering
attractive for the rational investors. These better informed investors can sell
the shares to the irrational investors in the aftermarket and make a profit.
Rock's (1986) winner's curse model turns on information
heterogeneity among investors. Michaely and Shaw (1994) argue that as this
heterogeneity goes to zero, the winner's curse disappears and with it the
reason to underprice.
Tore Leite (2007) in his article «Adverse selection,
public information and underpricing in IPOs» finds that favourable public
information (such as high market returns) reduce the winner's curse problem.
And this induces the issuer to price the issue more conservatively in order to
increase its success probability. The author finds a positive relation between
public information and underpricing.
* Agency conflicts: The agency problems between the
underwriter and the issuing firm.
Underpricing represents a wealth transfer from the IPO company
to investors. These investors compete for allocations of underpriced stock,
they can even try to collude with the underwriter by offering side-payments if
they have underpriced stocks. Such side-payments could take the form of
excessive trading commissions paid on unrelated transactions, or investment
bankers might allocate underpriced stock to executives at companies in the hope
of winning their future investment banking business, a practice known as
«spinning». So the underwriters, seeking for their own interests have
an incentive to underprice IPOs if they receive commission business in return
for leaving money on the table, they will try to underprice the issuer's stock
by not revealing the truthfully information obtained from potential investors
...
The underwriter will use a sub-optimal effort. He will use his
informational advantage over issuing companies to increase his benefit and he
will not do his mission perfectly. The underwriters are given discretion in
share allocation. This discretion will not automatically be used in the best
interests of the issuing firm, and they can also underprice more than necessary
and then allocate these shares to favoured buy-side clients.
In the post-bubble period, increased regulatory scrutiny
reduced spinning dramatically. This is one of several explanations why
underpricing dropped back to an average of 12%.
As a conclusion, we can say that issuing firms who seek out
prestigious underwriters to advice, to look after the IPO process, to bear for
the risk of hot market crashing... can suffer from enormous problems if
conflict of interest problems are not controlled.
Baron and Holmström (1980) and Baron (1982) construct
screening models which focus on the underwriter's benefit from underpricing. In
a screening model, the uninformed party (issuer) offers a menu or schedule of
contracts, from which the informed party (underwriter) selects the one that is
optimal. The contract schedule is designed to optimize the uninformed party's
objective, which, given its informational disadvantage, will not be first-best
optimal. To induce optimal use of the underwriter's superior information about
investor demand, the issuer in Baron's model delegates the pricing decision to
the bank (the underwriter). Given its information, the underwriter self-selects
a contract from a menu of combinations of IPO prices and underwriting spreads.
If likely demand is low, he selects a high spread and a low price, and vice
versa if demand is high. But as we said earlier, underwriter can use this
delegation to increase his own benefit and to think about his individual
interest only. He can collude with the potential investors to the potential
detriment of the issuer.
This agency conflict can be mitigated in two ways:
Ø Issuers can monitor the investment bank's selling
effort and bargain hard over the price,
Ø or they can use contract design to realign the bank's
incentives by making its compensation an increasing function of the offer
price.
Ljungqvist and Wilhelm (2003) provide evidence consistent with
monitoring and bargaining in the U.S. in the second half of the 1990s. They
show that first-day returns are lower, the greater are the monitoring
incentives of the issuing firms' decision-makers.
Ljungqvist (2003) studies the role of underwriter compensation
in mitigating conflicts of interest between companies going public and their
investment bankers (their underwriters). Making the bank's compensation more
sensitive to the issuer's valuation should reduce agency conflicts and thus
underpricing. Consistent with this prediction, Ljungqvist shows that
contracting on higher commissions in a large sample of U.K. IPOs completed
between 1991 and 2002 leads to significantly lower initial returns, after
controlling for other influences on underpricing and a variety of endogeneity
concerns.
So, we can say that by making underwriter's compensation an
increasing function of the offer price or of the issuer's valuation, the agency
conflicts between underwriter and the issuing company could be mitigated.
Underpricing could even disappear if we consider the agency conflicts as the
primary driver and source of underpricing.
As a conclusion for the asymmetric
information theories, we can say that almost informational asymmetry theories
share the prediction that underpricing is positively related to the degree of
asymmetric information, and when asymmetric information uncertainty approaches
zero, underpricing disappears entirely.
II-2\ Symmetric information:
There are some theories and explanations
advanced by a great number of researchers that do not rely on asymmetric
information, this theory that has been very popular among academics and
practitioners for decades and that has been considered as the most relevant and
convincing explanation to the short run IPO anomaly. There are some researchers
that advanced other theories and they explain underpricing by other reasons,
asserting symmetric information between key IPO parties. As hypothesis, all the
key parties of an Initial Public Offering share the same information. We talk
about informational transparency and lucidity and about IPO market
efficiency.
II-2-1\ Risk premium:
Let's begin by the risk premium explanation. Because the hot
market can end prematurely, the sentiment demand may cease and then we face a
market crashing, carrying IPO stocks in inventory is risky.
Ljungqvist, Nanda and Singh (2003) in their article: «Hot
market, investor sentiment and IPO pricing» argue that underpricing
emerges as fair compensation to the regulars for expected inventory losses
arising from the possibility that the hot market ends prematurely. If the
demand is small (in comparison to the issue offer), the issuer needs the
regular investor to hold inventory. So long as the hot market persists, the
regular investor sells this inventory to newly arriving sentiment investors,
but the problem arises if the hot market ceases and the regular investor is
then left with shares priced at the fundamental value (which is less than the
offer price).
The issuer underprices the stock to compensate the regular
investor for bearing the risk of an uncertain sentiment demand. It is a fair
payment for the regular's expected loss. It is a way of compensating the
regular investor for taking on the risk of hot market crashing.
However, Ritter and Welch (2002)7 refute this
explanation since they argue that if the underpricing is simply a compensation
for bearing a systematic or liquidity risk, why do second-day investors not
seem to require this premium, after all fundamental risk and liquidity
constraints are unlikely to be resolved within one day.
As a conclusion for the risk premium explanation based on
Ritter and Welch (2002) point of view, we can say that this explanation is
refuted and can not be considered as a relevant and a convincing explanation
for the underpricing anomaly.
II-2-2\ Characteristics of the Initial Public offering:
* Risk: Risk can reflect either technological or
valuation uncertainty.
Loughran and Ritter (2004) use many measures of risk: the
natural logarithm of the assets and the natural logarithm of the sales which
reflect the issuing firm size and then a risk related to valuation uncertainty,
internet and tech dummy variables which reflect technological uncertainty which
also induces a valuation uncertainty, and the natural logarithm of one plus the
age (years since the firm's founding date to the date of going public and the
date of introduction in IPO market) which reflect the age of the issuing firm.
For a sample including 5,990 US operating firm IPOs over 1980-2003, they find a
positive relation between risk and underpricing.
If the issuing firm is risky from the investors' point of
view, it can not be introduced in the market at a higher price because it will
not be accepted by these investors who are dissuaded about the risky IPO
shares. The offer price is set at a lower level to incite investors
7 Ritter and Welch (2002): «A review of IPO
activity, pricing, and allocations».
to purchase the IPO stocks even if they think it to be
risky.
The risk composition hypothesis, introduced by Ritter (1984),
assumes that riskier IPOs will be underpriced by more than less-risky IPOs.
Riskier firms set a low offer price to incite investors to participate in the
IPO market and to buy the IPO risky shares, and then the underpricing will be
higher. For example, young firms are riskier and the internet bubble period saw
a high proportion of young firms going public and a high percent of
underpricing, which can confirm the explanation of risk.
In the same direction of the risk, we can also talk about the
uncertainty level introduced by Beatty and Ritter (1986). They relate the level
of ex-ante uncertainty surrounding the intrinsic value of an IPO to the level
of underpricing. The higher the uncertainty level about the intrinsic value of
the IPO, the higher is the level of underpricing. It reflects the valuation
uncertainty.
Besides, Bartov, Mohanram and Seethamraju (2003) report that a
dummy variable for risky IPOs has no effect on the setting of the final offer
price, providing evidence for the argument that risk might not be that
important for the pricing of IPOs. So there is no correlation between risk and
underpricing. The notion of risk can not explain the setting of a lower offer
price and then the underpricing phenomenon. This important finding refutes the
prior researches and results about the suitability of the risk as an
explanation to the underpricing anomaly. Risk can not be considered as a
convincing explanation to the short run IPO anomaly since it has no effect on
the setting of a lower offer price, and then underpricing is not induced by
risk.
* Issue size: The issue size or offer size is the
number of shares introduced in IPO market and offered by the issuing company
for sale.
Cornelli, Goldreich and Ljungqvist (2004) argue that when the
issue size is large, the issue price should reflect the greater difficulty of
selling the shares in the aftermarket, and then the issue price should be
lower. They find a negative relation between the size and the offer price of
IPOs: a discount in the offer price by ëS with S the size of IPOs. When
the offer size is large, the offer price will be lower and so underpricing will
be higher. They find that the issue price should be negatively correlated with
the issue size, and it is a negative and statistically significant relation
between size and offer price, so we can talk about a positive and significant
relation between issue size and underpricing.
This relation between issue size and underpricing was studied
briefly in Ljungqvist, Nanda and Singh (2003) article. Supposing VR
the market price of the IPO shares and VS the value sentiment
investors place on the IPO shares and so is the price these investors are
willing to pay for the IPO shares, the authors set VS as a function
of VR and Q which represents the total number of IPO shares (the
offer size), and the relation between VS and Q is negative. The
greater is the number of shares issued, the lower is the price that sentiment
investors are willing to pay, and the greater is underpricing: positive
relation between issue size and underpricing.
Besides, some researchers find a negative relation between the
issue size and underpricing. Guo, Lev and Shi (2006) introduce a different
issue size variable in their model (the natural logarithm of issue proceeds)
and find a negative relation between issue size and underpricing. They explain
this finding by the fact that sizable firms are generally less risky than those
making smaller issues, and they can bargain for a higher offer price conducting
a lower level of underpricing.
* Bargaining power:
Ljungqvist, Nanda and Singh (2003) study the impact of
bargaining power on the first day return and so on underpricing. They use as a
proxy for bargaining power «the ownership structure». A firm with a
highly concentrated ownership, is reflecting a high incentive to bargain hard,
while an increased ownership fragmentation, and an increased frequency and size
of «friends and family» share allocations, make the issuing firm
decision-makers less motivated to bargain for a higher offer price .
Ljungqvist, Nanda and Singh assume that the issuing firm's
ownership structure is such that â of the extracted surplus from the
investor sentiment is captured by the issuing firm and 1-â is
captured by a combination of the regular investor and the investment bank. For
a firm with highly concentrated ownership, they believe â will
be close to 1 reflecting the high incentive to bargain hard over the surplus,
while for a firm with dispersed ownership or other agency problems â will
be significantly smaller than 1.
An issue firm with a concentrated ownership and high
bargaining power requests a higher offer price and faces a lower underpricing.
Ljungqvist and Wilhelm (2003) show that companies with more concentrated
ownership at the time of the IPO suffer lower underpricing, consistent with the
findings of Ljungqvist, Nanda and Singh (2003).
And an issue firm characterized by ownership fragmentation and
so by lower bargaining power, can not bargain hard for a higher offer price.
The issue price will be set at a lower level and underpricing will be higher in
the first day of trading. Tim Loughran and Jay Ritter (2004) 8 also
use the ownership structure as a proxy for bargaining power and find that an
increased ownership fragmentation induces a decrease in the bargaining power of
the issuing firm, a lower offer price is presented inducing a higher level of
underpricing.
The greater the issuing firm's bargaining power relative to
the underwriter, the higher is the offer price and the lower is the first-day
return and vice-versa.
II-2-3\ Lawsuit avoidance: legal liability
Lawsuits are obviously costly, not only directly: damages,
legal fees, diversion of management time, etc, but also in terms of the
potential damage to their reputation capital. Litigation-prone investment banks
may lose the confidence of their regular investors, while issuers may face a
higher cost of capital in future capital issues.
The basic idea of lawsuits avoidance goes back at least to
Logue (1973) and Ibbotson (1975): companies deliberately sell their stocks at a
discount to reduce the likelihood of future lawsuits from shareholders
disappointed with the post-IPO performance of their shares.
Tinic (1988), Hughes and Thakor (1992) and Hensler (1995)
argue that issuers intentionally underprice to reduce their legal liability.
They assume that the probability of litigation increases with the offer price:
the more overpriced an issue, the more likely is a future lawsuit, and that the
solution is underpricing to avoid future lawsuits. Ritter and Welch (2002) give
a simple example for this: An offering that starts trading at 30$ that is
priced at 20$ is less likely to be sued than if it had been priced at 30$, if
only because it is more likely that at some point the aftermarket share price
will drop below 30$ than below 20$.
Tinic identifies a sample of 70 IPOs completed between 1923
and 1930 and compares their average underpricing to that of a sample of 134
IPOs completed between 1966 and 1971. As Tinic predicted, average underpricing
was lower before 1933 (year of securities enactment).
In spite of this, Drake and Vetsuypens (1993) find that
underpricing did not protect issuers firms from being sued, and sued IPOs had
higher and not lower underpricing.
8 Loughran and Ritter (2004) argue that this
argument has little support as an explanation for underpricing.
They study a sample of 93 IPO firms that were sued and compare
them to a sample of 93 IPOs that were not sued, matched on IPO year, offer
size, and underwriter prestige. Underpriced firms are sued more often than
overpriced firms. Then underpricing does not protect firms from being sued and
does not protect them from lawsuits and future legal liabilities.
They also show that average initial returns in the six years
after Tinic's sample period (1972-1977) were actually lower than
between 1923 and 1930 which refute his findings.
Ritter and Welch (2002) think that leaving money on the table
appears to be a cost-ineffective way of avoiding subsequent lawsuits. But the
most convincing evidence that legal liability is not the primary determinant of
underpricing is that countries in which U.S. litigative tendencies are not
present have similar levels of underpricing (Keloharju (1993)):
The risk of being sued is not economically significant in
Australia (Lee, Taylor, and Walter (1996)), Finland (Keloharju (1993)), Germany
(Ljungqvist (1997)), Japan (Beller, Terai, and Levine (1992)), Sweden (Rydqvist
(1994)), Switzerland (Kunz and Aggarwal (1994)), or the U.K. (Jenkinson
(1990)), all of which experience underpricing.
After all these findings which refute the suitability and the
relevance of lawsuit avoidance as an explanation to underpricing anomaly, we
can say that lawsuit avoidance can not be a primary determinant and driver of
underpricing, still, it is possible that lawsuit avoidance is a second-order
driver of IPO underpricing.
II-2-4\ Underpricing as a substitute of marketing
expenditures:
Habib and Ljungqvist (2001) argue that underpricing is a
substitute for costly marketing expenditures. Using a data set of IPOs from
1991 to 1995, Habib and Ljungqvist report that an extra dollar left on the
table reduces other marketing expenditures by a dollar. On the first sight,
underpricing seems to be just a substitute for marketing expenditures since
both have the same cost, but underpricing is much more interesting.
By going public and by underpricing and leaving money on the
IPO table, issuing firms can achieve a total coverage media and good news in
all media, which can be much more costly if the firm chooses to use publicity
and marketing expenditures, mainly because we can not forget the possibility of
recouping this money left on the IPO table if the firm has the intention to
conduct Seasoned Equity Offerings in the future. So, the issuing firm achieves
a large coverage media and an important publicity without spending anything,
since the money left on the IPO table will be recouped later. By underpricing,
the investors who bought the IPO shares have confidence in the issuing firm,
they are satisfied with the gains they retired from the IPO shares and from
underpricing in the first day of trading. Optimistic about the value of this
firm, these investors will easily accept the price the firm set for its
Seasoned Equity Offerings at a later date. Even if the price is higher than
necessary, they will accept it since they have confidence in this firm, and
then all the money left on the table can be recouped by conducting Seasoned
Equity Offerings in the future. 9
II-2-5\ Internet Bubble:
One popular related explanation for the high and severe
underpricing of 65% during the Internet bubble (1999-2000) for the U.S IPOs, a
peak never reached before in the U.S IPO market, is that underwriters could not
justify a higher offer price on Internet IPOs. Even if these firms have a high
potential of profitability in the recent future and they are operating in a new
but very promising field which will generate high returns later, the
underwriters can not justify this and propose a higher offer price. These firms
are seen as young and operating in a new field which means that their offerings
are risky and they propose risky shares. Proposing a higher offer price will
not be accepted by investors and will make them fear the offerings. The issuing
firms have to propose a low offer price to incite investors to participate in
the offerings even if they are thought to be risky. So, we can say on one hand,
the newly issuing Internet firms are very important and are operating in a very
promising field and then will generate high returns, but all this can not be
justified by their underwriters and they do not find the convincing arguments.
On the other hand, and since they are operating in a new field not very known
and they are very young firms without a history of returns, they are thought to
be risky. So, we are in the same explanation of risk due to valuation
uncertainty which was proved to be ineffective determinant and explanation for
the underpricing anomaly.
So to explain the severe level of underpricing during the
dot-com period, only the inability to justify a higher offer price can be
considered as a possible explanation, but the fact of young and so risky firms
can not be used as a relevant explanation.
9 As a support for IPO as a marketing event,
Chemmanur (1993) proposes that this publicity could generate additional
investor interest, and Demers and Lewellen (2003) suggest that the publicity
could generate additional product market revenue from greater brand
awareness.
II-2-6\ Price stabilization and partial adjustment:
Recent studies have also documented the impact of public
information. They find a positive link between the «market
conditions» prevailing at the time of an offering which represent public
information and its subsequent initial return. Favourable market conditions
predict higher underpricing and vice-versa. Derrien and Womack (2003)
show that the initial returns on IPOs in France in the 1992-1998 period were
predictable using the market returns in the three-month period preceding the
offerings. Using U.S. data, Loughran and Ritter (2002) and Lowry and Schwert
(2003) obtain similar results: the initial returns in the first day of trading
for IPOs are predictable using the market conditions prevailing at the time of
the IPOs or at a recent past. Favourable market conditions predict higher
initial returns and so higher underpricing, and critical market conditions
predict lower initial returns and lower underpricing, and for some IPOs
negative initial returns and overpricing.
Bradley and Jordan (2002) include the 1999 `hot issue' market
in their sample and find that more than 35% of initial returns can be predicted
using public information available at IPO date. However, Lowry and Schwert
(2003) find that the effect is economically small.
These favourable market conditions have an impact on noise
traders who will be ready to pay higher IPO prices. They are assumed to be
bullish at the time of the offering since they are very influenced by market
conditions: the more favourable market conditions are, the more favourable
noise traders' sentiment is and the higher the price that they are willing to
pay.
But the mystery and the question that arises automatically is,
why underwriters do not incorporate these favourable market conditions and this
favourable sentiment when pricing the IPO and propose a higher offer price
which reduces the underpricing anomaly and the money threw on the table? Why
market conditions and noise traders' sentiment are only partially incorporated
in IPO offer prices?
The underwriter is not only concerned with the IPO price at
the time of offering, but he is also concerned with the aftermarket behaviour
of IPO shares in the short run as well as on the long run. He is committed to
provide costly price support if the aftermarket share price falls below the IPO
price (the issue price) in the months following the offering. Even if the noise
traders are bullish at the time of offering, they can change their attitude in
the aftermarket.
And a sharp and rational underwriter with a reasonable
attitude should take this into consideration when pricing the IPO. Derrien
(2003) says that the IPO price results from a trade-off: a higher IPO price
increases underwriting fees, but also the expected cost of price support.
This induces the underwriter to set a conservative IPO price
with respect to the short-term aftermarket price of IPO shares. The underwriter
has to incorporate partially the market conditions when pricing IPO to not face
a higher cost of price support if the aftermarket price falls.
When setting the offer price, we can say that the underwriter
is constrained by the cost of price support if the aftermarket price of IPO
shares falls below the issue price (if he overpriced the IPO shares), but he is
also constrained by the lost of IPO market shares if he sets a very low issue
price to reduce the risk of support's price costs inducing very high
underpricing. In this sense, Booth and Smith (1986) claim that the
underwriter's role is to certify that IPO shares are not overpriced. Therefore,
an underwriter that underprices more than necessary the IPOs will lose market
shares on the IPO market and will lose the issuing firms' confidence, this is
confirmed empirically by Dunbar (2000), and an underwriter that overprices the
IPO shares will pay high costs of price support. Legal costs may also refrain
underwriters from blatantly overpricing new issues, even though investors'
demand is very large.
Aggarwal (2000) and Ellis, Michaely and O'Hara (2000) provide
evidence that underwriters intervene to stabilize the price of IPO stocks that
exhibit poor aftermarket performance. The underpricing is important to
stabilize the IPO prices to compensate the long run underperformance of the
issues.
Section 2- Behavioral explanations
Introduction:
Short run IPO anomaly may be the most
controversial area of IPO research. The research effort has provided numerous
analytical advances and empirical insights trying to explain the first day
price run up. Many explanations were introduced and studied, but all these
theories are unlikely to explain the persistent pattern of high initial returns
during the first trading day. It is fair to say that this anomaly is not
satisfactorily resolved and is still a puzzle.
Many researchers come to the conclusion that IPO future
researches should turn to behavioral approach and sentiment notion. Research
effort should focus more on behavioral explanations to clarify and to explain
the short run IPO behaviour, since nor the asymmetric theories neither the
explanations based on the informational symmetry are likely to give a relevant
and a reliable explanation to the underpricing anomaly, mainly after the
surprisingly and severe level of underpricing reached in 1999 and 2000, the
internet boom years. The explanations that have been advanced earlier are
unable to explain the severe percentage of underpricing observed in this
period, and turning to behavioral explanations seems to be a necessity to
resolve this short run IPO puzzle.
Ritter and Welch (2002), for example, advance clearly that
asymmetric information which has been the most convincing explanation for
decades, is not the primary driver of IPO phenomena and asymmetric information
models that have been popular among academics, have been overemphasized. Ritter
and Welch believe that future progress in the IPO literature will come from non
rational explanations.
This argument is supported by Ljungqvist (2004) who comes to
the conclusion that IPO researchers should focus on behavioral approaches to
explain why the extent of underpricing varies so much over time.
Future researches have to focus more on behavioral
explanations and turning to the behavioral approach describing the behaviour of
irrational investors and their sentiment seems to be a necessity since the
explanations and the theories that were advanced earlier are unlikely to
clarify and to explain the short run IPO puzzle, especially after the dot-com
boom. During this period, the IPO market has reached a severe level of
underpricing never seen before. So one can ask about the suitability of
«traditional» explanations and theories, and turning to behavioral
explanations seems to be the most promising area of research. Going further,
Cook, Jarrell and Kieschnicke (2003) conclude that the role of investor
sentiment is more important than previously thought.
The tendency of behavioral approach and investor sentiment is
not a new field not again discovered. The investor sentiment was introduced
earlier in the 1990's by Welch who presented the informational cascade theory.
But this approach has attracted more attention, has intrigued more and more
researchers and has taken all its impetus in this decade. Many researchers
tried to introduce this behavioral approach to explain the short run IPO
anomaly and the research effort is continuing.
In this second section, I present the Behavioral Approach in a
first paragraph by defining important notions as investor sentiment, hot IPO
market and distinguishing between individual investors and institutional
investors. Then, in a second paragraph, I summarize the most important studies
advanced asserting the presence of sentiment investors and sentiment as the
primary and main driver of underpricing phenomenon. I present the most
important findings and the main proxies used by researchers to value the
investor sentiment.
I- Definitions:
The behavioral approach asserts the presence
of «irrational» investors, also called «sentiment»
investors or «noise traders» whose investment decisions, choices,
etc, are conducted by feelings and emotions and based on sentiment which plays
a major role in their decisions.
Before going more in the details, it is reasonable to begin by
presenting some definitions of the most important notions in this section.
Clarifying some notions is important to understand the theories and the
findings of many researchers.
I-1\ The sentiment's notion:
The sentiment represents the anticipations of
the investors that are not justified by the fundamental.
The notion of sentiment characterizes the presence of
irrational investors who show undue interest in an investment opportunity, for
example for IPOs, and who are irrationally exuberant, over optimistic and over
enthusiastic about an investment. This over optimism and over enthusiasm is not
justified by fundamental. Or on the contrary, these investors are over
pessimistic and they are much dissuaded about the issues with any reason or
relevant justification. All the decisions are conducted by sentiments and
feelings.
An optimistic investor (pessimistic) expects returns that are
higher (lower) to those that could be explained by the fundamental indicators.
In other words, the sentiment can be defined by the fact that the investor is
optimistic (pessimistic) without having good (bad) economic reasons for the
being.
The sentiment felt by the investor is very complicated and
very hard to surround, since there are numerous biases that can have an impact
on the investor behaviour. The sentiment also differs from an investor to
another, it is individual and can not be foreseen. It depends on the investor's
personality, his beliefs, his thoughts...
Biases have been studied by psychologists for some time and
financial economists have recently introduced them into formal models of asset
pricing. For example, a large literature reports that people believe their
knowledge to be more accurate than it really is (Odean (1998)), and then they
overweight the information collected by themselves and underweight the
information collected by the others. In the same direction, Kaustia and Knupfer
(2008) on a sample of 57 Finnish IPOs from January 1995 through December 2000,
study the link between past personally experienced outcomes and future IPO
subscriptions. They find that personally experienced outcomes have a greater
effect on behaviour and on future IPO subscriptions, than, say just reading
about the same information without personal involvement. When deciding to
subscript in IPOs, investors overweight their personal experience more than the
information collected by the other investors, which goes in the same direction
as believing in their knowledge and in their own information.
However, there are other possible reasons for systematic
decision errors. In a recent review, Hirshleifer (2001) argues that many or
most familiar psychological biases can be viewed as outgrowths of heuristic
simplification (an imperfect decision making procedure that makes people
have reasonably good decision cheaply). We can also talk about framing
effects (wherein the description of a situation affects judgments and
choices), money illusion (wherein nominal prices affect perceptions),
and mental accounting (tracking gains and losses relative to arbitrary
reference points). We also find overconfidence (a tendency to
overestimate ones ability or judgment accuracy) which may be due to another
bias «self attribution». Experiments have shown that people
tend to attribute favourable outcomes to their abilities and unfavourable ones
and failure to chance or other external factors beyond their control (Daniel,
Hirshleifer, and Subrahmanyam (1998)). This bias is known as «self
attribution» and may even be at the origin of
«overconfidence».
This list of biases is not exhaustive and can be very long.
These psychological biases have a great effect on the
sentiment, and they also differ from an investor to another making the
sentiment a very complicated notion hard to surround or to foresee.
The IPO market presents an environment which is more prone to
investor sentiment and where irrational investors are more likely to exist,
since IPO firms by definition have no prior share price history and tend to be
young, immature, and relatively informationally opaque.
Not surprisingly, therefore, these firms are hard to value,
and it seems reasonable to assume that investors will have a wide range of
beliefs and feelings about their market values. Investors will be very
influenced by feelings and emotions in valuing the IPO and in deciding whether
to invest in.
I-2\ Hot IPO market's phenomenon:
As we said before, by their nature the
Initial Public Offerings are very sensitive to the state of mind of the
investors and to the investor sentiment.
Another characteristic is very important and which ensues of
the first characteristic: the Initial Public Offering market is highly
cyclical. The cyclical nature of this market has sparked much academic
interest. This attention has produced a number of explanations for hot and cold
IPO issue markets based on changing business conditions (e.g., Pastor and
Veronesi, 2005), investor sentiment (e.g., Ritter, 1991), and asymmetry of
information between owners and outside investors (e.g., Myers and Majluff,
1984).
But to explain the notion of «hot IPO market», I
focus on the investor sentiment explanation as an important driver and
determinant of the IPO market cycles, patterns and phenomena and since it is
the object of this thesis.
The phenomenon of «hot IPO market» (Hot market) was
for the first time noticed by Ibbotson and Jaffe (1975). These two authors, as
well as Ibbotson, Sindelar and Ritter (1988), showed the existence of cycles in
the IPO market concerning the monthly number of introductions and the level of
initial returns of the shares introduced. Especially, a hot IPO market is a
market in which recent IPOs have generated strong and positive initial returns
and so high underpricing was observed in the recent past. The sentiment and
irrational investors are over optimistic and over enthusiastic about the IPO
market, they are exuberant and they show undue interest in newly IPOs, since
they have the tendency to project the recent favourable history of the IPO
market on the future. In their mind, this positive and favourable tendency will
continue for sure and they will make large profits. The market appears to be
irrationally optimistic towards IPOs in the short run and so these irrational
and over optimistic investors are more willing to purchase the newly IPOs and
to pay more to have the newly shares. These irrational investors show excessive
demand, they bid up the price of IPO shares beyond true value. The price of
shares tends to jump substantially on the first day of trading, the first day
closing price is systematically higher than the issue price at which the public
offering was introduced in the market, and then IPOs exhibit positive first day
returns and so underpricing will be higher. As a result, strong demand towards
IPOs and over optimism among irrational investors cause the rise of the stock
price during the first trading day. Then, we see the tendency that they have
projected when deciding to invest in newly IPOs is maintained. All this is due
to the bullish sentiment and the investors' over optimism and their irrational
excessive demand, and we talk about a phenomenon much known as a «hot IPO
market».
Therefore, more firms will be incited to go public taking
advantage of this mistaken belief and of the over optimism of these sentiment
and irrational investors. Lee, Shleifer and Thaler (1991), Helwege and Liang
(1996), Rajan and Servaes (1997) and Lowry (1999) showed that the volume of
IPOs is associated to the positively state of mind of the investors and to
their excessive optimism and enthusiasm. The issuing firms are encouraged to go
public at this period and to increase the volume of IPO shares they are
offering in the stock market.
Loughran, Ritter and Rydqvist (1994) go further in claiming
that issuers time their IPOs to coincide with periods of excessive optimism,
consistent with the finding in Lee, Schleifer and Thaler (1991) that more
companies go public when investor sentiment is high.
Baker and Wurgler (2002) argue that firms may even be able to
time their IPO to coincide with periods of excessive valuations which goes in
the same direction of the investors' over optimism and over enthusiasm.
10
Helwege and Liang (1996) and Ljungqvist, Nanda and Singh
(2002) models find evidence of over optimism in hot IPO markets which confirms
the relevance of investor sentiment as a driver of the IPO market cycles, the
explanation advanced by Ritter (1991) for the hot IPO market.
Using German data on IPO trading by 5000 retail customers of
an online broker, Dorn (2003) documents that retail investors11
overpay for IPOs following periods of high underpricing in recent IPOs,
and for IPOs that are in the news.
Consistent with all these findings showing the importance and
the major role of investor sentiment and over optimism in IPO market making it
cyclical, Michelle Lowry (2003)12 advances that the instability and
the movement in Initial Public Offering volume over time both in the number of
IPOs and the total proceeds raised in these offerings, can be explained and
attributed to the variation in investor optimism level. When investors are
overoptimistic, the issuing firms should profit from this period and are
incited to offer large volume of IPO and they are sure that the large volume of
shares will be absorbed by sentiment investors and vice-versa. The
results found by this author indicate that investor sentiment is an important
determinant of IPO volume both in statistical and economical terms. The
variation in IPO volume is primarily driven by changes in investor optimism, as
well as the firms' demands for capital (business cycle), the adverse selection
costs (investors' uncertainty about the true value of the issuing firm) which
are statistically significant but their economic effect appears small.
The end of the nineties 13 was one of the hottest
IPO markets ever. In this period, both the number of initial public offerings
and the level of initial returns have reached unprecedented peaks.
Controversially, the IPO market can be in a cold period, the
investors' sentiment is bearish and the irrational investors are pessimistic.
They observe the recent IPO history which knows
10 Pagano et al. (1998) add that firms
«time» their IPOs to coincide with periods of investor optimism, not
to exploit investment opportunities, but to realign their balance sheets after
large investments and growth.
11 Individual investors
12 Dorn (2003): «Why does IPO volume fluctuate
so much?».
13 The dot-com bubble, internet bubble.
negative initial returns, and they project this on the future.
They think that the newly IPOs are unattractive and they are dissuaded. They
refuse the investment in newly IPOs and they fear the IPO shares which will be
overpriced.
This period is known as «cold IPO market». Issuing
firms should take into consideration this critical period and it is reasonable
to delay their decision to go public until a bull market offers more favourable
conditions and pricing to succeed their introduction in the market. However,
they surely will fail the introduction if they do not take into consideration
the state of the IPO market.
The popular press contains many examples of this viewpoint of
the importance of investors' sentiment to decide whether to go public. For
example, ``the [current] rule in the IPO market seems to be: Buy it at any
price'' (Wall Street Journal, May 20, 1996, p. ) (a period of high sentiment
and over optimism), and ``When [investors] get bearish, you can't go public.
But when they go bullish, just about anyone can go public'' (Wall Street
Journal, April 19, 1999, p. C1.).
Another important remark should be added, if the issuer
succeeds the first sales, he is sure that later sales will be succeeded and
then he succeeds his introduction in the market taking all the advantages that
are related to this success. But if he fails the first sales, taking the
decision to go public in a cold market, the introduction in the market will
fail conducting even a bankruptcy in the recent future, going with the
informational cascades theory of Welch (1992) that I will present in a
following paragraph.
Ljungqvist, Nanda and Singh (2003) present another definition
for a «cold market», they define it as a market in which there are no
exuberant investors and so prices are set by rational investors at fundamental
value, so there are nor optimistic neither pessimistic investors who can
conduct the IPO pricing. The offerings are priced at their fundamental
values.
I-3\ Investors typology:
Many empirical researches examining IPO
allocations focus on the distinction between types of investors: institutional
investors and individual or retail investors.
Institutional investors are different from retail investors,
in that institutions are better informed and more important clients. The
evidence to date suggests that where bookbuilding is used, institutional
investors receive preferential allocations. They are favoured by underwriters
in the IPO allocations compared to retail investors who are uninformed and not
very important clients since they do not buy many shares. Using U.S. data,
Hanley and Wilhelm (1995) and Aggarwal, Prabhala, and Puri (2002) find that
institutions are favoured, as do Cornelli and Goldreich (2001) using U.K. data.
Cornelli and Goldreich (2001) also find that more information-rich requests are
favourably rewarded.
Ljungqvist, Nanda and Singh (2003) 14 present a
model in which they distinguish between the two types of investors, and they
present these definitions:
The retail investors are small, unsophisticated investors who
are prone to episodes of optimistic or pessimistic «sentiment» about
the stock market, especially IPOs, where sentiment denotes incorrect beliefs
about the fundamental value of an asset arising from treating noise as relevant
information (Black (1986)).
The second type of investor holds beliefs that correspond to
an unbiased estimate of the issuing firm's future prospects. Ljungqvist, Nanda
and Singh (2003) regard institutional investors as belonging to this
category.
Ritter and Welch (2002) advance that institutions are
naturally blockholders, potentially capable of displacing poorly performing
management. That is why, this type of investors is favoured in IPO allocations,
and they are able to change and to improve the management and the performance
of the IPOs in which they invest.
Booth and Chua (1996), Brennan and Franks (1997), Mello and
Parsons (1998), and Stoughton and Zechner (1998) all point out that
underpricing creates excess demand and thus allows issuers and underwriters to
decide to whom to allocate shares. Surely, they will favour the institutional
investors for the advantages advanced from which they can take profit. These
institutional investors will monitor the IPO firm's management, creating a
positive externality.
Supporting the argument of favoured institutional investors in
IPO allocations, Ljungqvist, Nanda and Singh (2004), advance another
explanation. They show that value to an issuer is maximized by underwriters
allocating IPO shares to their regular (institutional) investors for gradual
sale to sentiment investors as they arrive in the market over time. Regulars
maintain stock prices by holding IPO stocks in inventory and restricting the
availability of shares.
Underpricing emerges as fair compensation to the regulars for
expected inventory losses arising from the possibility that sentiment demand
may cease.
But these advantages such improving the firm's performance and
management may not be of primary importance for some companies for corporate
control considerations.
14 in their article «Hot markets, Investor
sentiment and IPO pricing»
Retaining control for some managers is the primary and the
most important objective. When they are obliged to go public, they try to
protect their private benefits by favouring the individual investors rather
than institutions, since retail investors are not able to buy large volume of
IPO shares and they end up holding small parts. The managers seek to avoid
allocating large volume of shares for few important investors (institutions),
in order to protect the control of the management. Greater ownership dispersion
implies that the incumbent managers benefit from a reduced threat of being
ousted, because the most important part of the IPO firm still retained by its
managers and the other part is dispersed between many retail investors.
Going further in this point of view (control retain), Brennan
and Franks (1997) argue that managers deliberately underprice the IPO shares,
since underpricing generates excess demand. This gives the managers the
opportunity to protect their private benefits by allocating shares
strategically when taking their company public, favouring the retail investors
and then a greater ownership dispersion. So retaining control can be an
explanation for underpricing anomaly for some companies for which managers
consider their private benefits in the first place.
II- Literature review of behavioral explanations:
As I said before, the tendency of behavioral
approach and investor sentiment is not a new field not again discovered, the
investor sentiment was introduced earlier in the 1990's by Welch who presented
the informational cascade theory. But the Behavioral Approach has sparked the
academics' attention, has intrigued more and more researchers and has taken all
its impetus in this decade. The studies and investigations are more and more
numerous trying to explain the short run IPO anomaly by investor sentiment and
behaviour. The research effort is continuing since the behavioral approach
seems to be a very promising field to resolve the short run IPO phenomenon that
is still a puzzle since the other theories and explanations advanced earlier
failed to resolve it.
I begin by presenting the first explanations and the first
findings that were observed to explain the short run phenomenon by the investor
sentiment.
II-1\ Informational cascades:
If potential investors pay attention not only
to their own information about a new issue, but also to whether other investors
are purchasing or not and they attempt to judge the interest of other
investors, according to Welch (1992) 15, bandwagon effects
or also known as information cascades may develop:
Later investors can condition their bids on the bids of
earlier investors, rationally disregarding their own information. If an
investor sees that no one else wants to buy, he may not buy even when he
possesses favourable information about the issue: Later investors abstain
because earlier investors abstain. In order to prevent this situation from
happening, an issuer may have to underprice the IPO to induce the first few
potential buyers, and later induce a cascade in which all subsequent investors
want to buy irrespective of their own information. They will imitate the first
potential investors even if they have unfavourable and negative information
about the IPO. Since there are some investors interested in the IPO and bought,
other investors will be also interested in the offering and will request shares
even if they think that it is unattractive, their opinion will change and they
will think that it is a hot offering.
So, if an issuer succeeds the first sales, he is sure that
later investors are encouraged to invest in his offering whatever their own
information. Conversely, if an issuer fails the first sales to the earlier
investors, this will dissuades later investors from investing irrespective to
their own information.
In support for this informational cascade explanation, Amihud,
Hauser and Kirsh (2001) find that IPOs tend to be either undersubscribed or
hugely oversubscribed, with very few offerings moderately oversubscribed.
II-2\ The prospect theory:
Prospect theory, developed by Kahneman and
Tversky (1979), asserts that people focus more on changes in their wealth
compared to the level of their wealth.
Loughran and Ritter (2002) apply prospect theory of Kahneman
and Tversky (1979) to IPO market to argue that issuers are more tolerant of
excessive underpricing and that they accept underpricing more than necessary if
they simultaneously learn about an aftermarket valuation
15 Welch's cascades model remains one of the least
explored explanations of IPO underpricing.
that is higher than expected. They are more concerned with an
increase in their future wealth rather than instantaneous and immediate
profits. Loughran and Ritter argue that the issuing firm's executives bargain
less hard for a higher offer price, if they are seeing a personal wealth
increase relative to what they had expected based on the file price range that
they have fixed, and this is when the price is revised upwards during the
bookbuilding process.
Loughran and Ritter explain more this theory by the fact that
insiders of IPO companies consider not only the shares they sell in the IPO,
but also those they retain which benefit from the large initial price
run-up.
Combining prospect theory reference point with Thaler's (1980,
1985) notion of mental accounting, Loughran and Ritter argue that issuers fail
to «get upset» about leaving millions of dollars «on the
table» in the form of large first-day returns because they tend to sum the
wealth loss due to underpricing with the (often larger) wealth gain on retained
shares as prices jump in the after-market. Underpricing and the positive
initial return is perceived as a wealth loss under the assumption that shares
could have been sold at the higher first-day trading price. If the perceived
gain exceeds the underpricing loss, the decision-marker (issuer) is satisfied
with the IPO underwriter's performance at the IPO. He is satisfied even if he
leaves large amount on the table and he accepts the underpricing even if it is
higher than necessary since he can compensate this loss by a larger wealth
gain. He can benefit from the first day price run-up since he will sell the
shares retained at a higher price which will generate a large profit
compensating the loss undergone by underpricing.
Ljungqvist and Wilhelm (2004) use the structure suggested by
Loughran and Ritter's (2002) behavioral perspective to test whether CEOs deemed
«satisfied» with the underwriter's performance according to Loughran
and Ritter's story are more likely to hire their IPO underwriters to
lead-manage later Seasoned Equity Offerings. Controlling for other known
factors, IPO firms are less likely to switch underwriters for their SEO when
they were deemed «satisfied» with the IPO underwriter's performance.
This result confirms what has been advanced by Loughran and Ritter (2002) about
issuers who are not upset about leaving money on the table and about the
tolerance of underpricing believing in a future wealth increase.
Underwriters also appear to benefit from behavioral biases in
the sense that they extract higher fees for subsequent transactions involving
«satisfied» decision-makers.
So, for the literature review of behavioral explanations, I
begin by presenting the findings of the first researchers who tried to
introduce the behavioral approach and the investor sentiment, the informational
cascade introduced by Welch (1992) and the application of the prospect theory
developed by Kahneman and Tversky (1979) to IPO market.
These two theories were the first explanations of the short
run IPO anomaly advanced based on behavioral approach and investor sentiment.
The research effort is continuing and much investigations and studies are
advanced later by the researchers who believe in the behavioral approach and in
the importance of sentiment to explain and to clarify the underpricing anomaly
and to resolve this persistent puzzle over decades in the IPO market.
The behavioral approach has sparked much academic attention
and the research effort has provided numerous analytical advances and empirical
insights trying to explain the first day price run up and the underpricing
anomaly by the investor sentiment.
The effect of sentiment investors has been advocated
particularly strongly for initial public offerings. The short run IPO puzzle
could be due to overenthusiasm and over optimism among investors who may be
less than perfectly rational. And to study the effect of this type of investors
on IPO market and on the short run IPO anomaly, the sentiment should be
measured which is a very hard to not say that is an impossible task.
Many proxies have been advanced and proposed in the literature
to measure the investor sentiment, or at least to approach it since by its
subjective and individual characteristics, sentiment can not be observable, and
then many results have been found. We will see all these proxies that have been
used to measure the investor sentiment and the findings that have been
reached.
So, in the paragraphs that follow, the notion of investor
sentiment will be studied by researchers in more detail and will take another
direction based on the over optimism and over enthusiasm of sentiment and
irrational investors.
II-3\ Investor sentiment by Ljungqvist, Nanda and Singh
(2004):
We can say that the importance of investor
sentiment was introduced and analyzed in the context of the underpricing
phenomenon for the first time by Ljungqvist, Nanda and Singh (2004) in their
article «Hot markets, Investor sentiment and IPO pricing». The work
of these authors is considered the first paper to model an IPO company's
optimal response to the presence of sentiment investors. They give a response
to the question: what should a profit-maximizing issuer do in the presence of
exuberant investor demand and short sale constraints?
They show that underpricing, long-run underperformance and
hot-issue markets can be explained by the presence of sentiment investors.
The sentiment investors' behaviour and stocks demand can not
be foreseen. All is conducted by feelings and individual beliefs, and the hot
market period, characterized by the presence of these sentiment investors who
are exuberant and presenting excessive sentiment demand, can end prematurely at
any time. And because the hot market can end prematurely, carrying IPO stock in
inventory is risky. The optimal mechanism for the issuing firm in the presence
of sentiment investors involves underwriters allocating stock to
«regulars» to hold it for gradual sale to sentiment investors and to
bear the risk of inventory losses in the place of issuers16.
Regulars hold IPO stock in inventory to maintain stock prices
by restricting the availability of IPO shares. And they bear the risk of
expected inventory losses arising from the possibility that sentiment demand
may cease and from the non-zero probability that the hot market will end before
all inventory has been unloaded. Then, they are left with IPO stocks and there
are no sentiment investors to buy these shares. From the point of view of these
authors, underpricing is necessary, it emerges as fair compensation to the
regulars for expected inventory losses arising from the possibility that hot
market period may end prematurely. As regulars are running the risk of
inventory losses in the place of issuers, they require the stock to be
underpriced, as compensation for them. They take profit from this underpricing
as a reward. But generally, a regular will invest in IPOs only if he does not
expect to lose as a consequence. Then underpricing is a necessary cost for the
issuing firms emerging from the fact that sentiment investors' behaviour and
demand can not be foreseen, and issuers need the regulars to take on this risk
in their place and to hold inventory if the demand is small.
So, the optimal selling policy, from the issuer's point of
view, usually involves gradual sales. Such staggered sales can be implemented
by allocating the IPO to cooperative regular investors who hold inventory for
resale in the after-market. These regulars require compensation for bearing the
risk of expected inventory losses if the hot market ends prematurely and this
compensation is IPO underpricing.
Underpricing is then explained by the presence of irrationally
exuberant and sentiment investors whose demand may cease at any time.
16 The risk premium explanation (1st
section): underpricing is compensation for underwriters and regular investors
for bearing the risk of IPO market crashing and expected inventory losses.
If all the investors are rational and their demand is regular,
then it is not necessary to appeal for regular investors to hold stock
inventory.
It is surely undeniable that «Hot markets, Investor
sentiment and IPO pricing» by Ljungqvist, Nanda and Singh, is considered
as the first work that analysed the importance of investor sentiment in the
context of underpricing anomaly. The work of these authors is surely the first
paper to model an IPO company's optimal response to the presence of sentiment
investors. However, these authors did not use a measure for the investor
sentiment in their model or a valuation for this explanation of underpricing to
check its relevance and its statistical and economical significance. They
introduced the investor sentiment as an explanation for underpricing anomaly
but did not try to give a valuation to investor sentiment to use it in an
econometrical model to concretize their viewpoint and their explanation. They
surely presented important ideas and explanations in their article, but did not
quantify and concretize their findings and their explanations using real
data.
In the following paragraphs, I present a literature review of
works and papers that introduce and analyze the investor sentiment as an
explanation for the short run IPO anomaly and that try to value the investor
sentiment used in a model.
II-4\ The use of Grey Market Data:
Cornelli, Goldreich and Ljungqvist (2004) try
to take advantage of the existence of a grey market in Europe to construct a
model on European Initial Public Offerings to look at whether the presence of
sentiment investors affects prices in the post-IPO market and whether
investors' sentiment can explain and be considered as a driver and primary
determinant of underpricing anomaly.
Before going in details and presenting the findings of these
authors, I should begin by defining the grey market and presenting some
assumptions in their model to understand their results.
The Grey Market is a when-issued market for shares to be
issued in an IPO (the definition as given by the authors).
Most European countries have grey markets for IPOs. It is a
Pre-IPO market taking place at the same time as institutional bookbuilding
(before setting the issue price definitively). In this market, retail and
smaller investors speculate on the post-IPO share price, so these investors are
trading IPOs before they are listed on the stock market. The prices at which
they speculate are considered as post-IPO share prices and that is why the grey
market is considered as an opportunity to observe the post-IPO prices and the
opinion of small investors and to foresee their behaviour in the after market.
The grey market is an opportunity to foresee what it will be in the IPO
after-market. It is the unique opportunity to observe the valuation of the
investors who will be buying shares in the aftermarket and to measure the
expectations of sentiment investors directly. It is also beneficial to the
issuers to increase the offer price and then the IPO proceeds. In the U.S,
regulations prohibit the existence of Grey Markets and the speculation of IPO
shares before they are listed on the stock market.
The assumptions used by the authors in this article are the
following:
The grey market investors may overweight the relevance of
their information, so the authors allow for the possibility that grey market
investors are sentiment investors but they do not impose it.
When the publicly observable grey market price is high
relative to fundamental value, bookbuilding investors resell shares to these
smaller investors in the aftermarket, so the offer price and the aftermarket
price will be close to the grey market price. In contrast, when the grey market
price is low, the offer and aftermarket prices will be close to fundamental
value. Because the fundamental value is unobservable, econometricians usually
take the midpoint of the initial indicative price range as a proxy for
fundamental value.
The dataset consists of 486 companies which went public in
twelve European countries between November 1995 and December 2002 and for which
there exist grey market prices. To give a valuation to the investor sentiment,
the authors use the normalized last grey market price before the issue price
was set: PGM / P mid (the midpoint of
the initial indicative price range). They find that there is a positive
correlation between grey market price, issue price and aftermarket price. The
grey market price is more correlated with the issue and the aftermarket prices
when the grey market price is high, although there is a positive correlation
even when the grey market price is low. So this positive correlation confirms
the fact that the presence of sentiment investors has an impact on after market
prices and so on the underpricing anomaly.
In conclusion, Cornelli, Goldreich and Ljungqvist (2004) find
that high pre-IPO prices, which indicate overly optimistic investors, are a
good predictor of high initial returns during the first trading day. And then,
the high investor sentiment valued by high grey market prices, is a primary
driver and determinant of the short run IPO anomaly.
When small investors are excessively optimistic, they are
willing to pay a price above the fundamental value, resulting in a high
aftermarket price (foreseen through the grey market prices), and so in
underpricing. But when these sentiment investors are pessimistic about an
issue, their opinion has less of an effect on the aftermarket and issue prices
that will be close to the fundamental value and not to the grey market, which
suggests that the underwriter and sophisticated investors can identify
sentiment investors. Thus, they consider the opinion of sentiment investors
biased, and they take it into account only when they can profit from it, by
selling shares to them in the aftermarket.
Cornelli, Goldreich and Ljungqvist (2004), are not the first
authors using the grey market in their study to value the investor sentiment
trying to explain the short run IPO anomaly. There are other earlier studies
that are complementary to the findings of these authors. For example, Dorn
(2003) finds that the volume of grey market trading among the customers of a
German retail brokerage is correlated with high initial returns and low
long-run returns. This can be viewed as further evidence that participation by
smaller investors in the grey market can be interpreted as sentiment. Besides
Dorn (2003), two other papers study the grey market in Germany: Loffler,
Panther and Theissen (2002) document that grey market prices are unbiased
estimates of first-day prices. Aussenegg, Pichler, and Stomper (2003) also find
that IPO offer prices are related to prices in the grey market but they show
that the coefficient is smaller than one. Finally, Pichler and Stomper (2004)
model the interaction between bookbuilding and the grey market when grey market
investors have similar information to bookbuilding investors. They ask whether
the existence of a grey market helps or hinders information aggregation in
bookbuilding. In contrast, Cornelli, Goldreich and Ljungqvist (2004), introduce
a class of investors who have different information from bookbuilding
investors, in order to explain certain IPO phenomena and to show how these
(possibly biased) investors affect prices.
II-5\ The use of market conditions to value investor's
sentiment:
François Derrien (2003) explores the
impact of investor sentiment on the pricing and aftermarket behaviour of IPOs,
using a sample of 62 initial public offerings realized on the French stock
exchange between 1999 and 2001. He tests a model in which the first day closing
price of IPOs and then initial returns and underpricing are depending on the
information about the intrinsic value of the company (revealed by institutional
investors and it is private information) and on investor sentiment. These
French offerings used a unique IPO mechanism: a modified book-building
procedure in which a fraction of the IPO shares is reserved for individual
investors. This mechanism was created in 1999 and is unique to the French stock
exchange: the Offre à Prix Ouvert (OPO).
To value the investors' sentiment, Derrien focus on these
individual investors' demand which is related to the market conditions. These
individual investors are typically small and uninformed, that is why they are
considered as sentiment investors and their demand is a direct measure of
sentiment.
The demand for IPO shares submitted by individual investors
varies considerably and is strongly and positively related to a measure of
market conditions prevailing at the time of the offering. When these conditions
are favourable, the investor sentiment is high and individual investors seem to
be overly optimistic, presenting a large demand for IPO shares. This demand
surely influences IPO prices and then the underpricing phenomenon to a large
extent. It leads to high IPO after market prices and then to large initial
returns: the more favourable market conditions, the larger the individual
investors' demand, the higher the investor sentiment and the higher after
market prices, keeping everything else constant.
Loughran and Ritter (2002) and others have provided indirect
empirical evidence of this short run IPO phenomenon using various measures of
market conditions as proxies for investor sentiment. For example, to measure
the market conditions, the return of the industry index the IPO company belongs
to in the recent period preceding the offering can be used. Loughran and
Ritter use the three week period. But in this paper, the author uses a direct
measure of the investor sentiment, namely the demand for IPO shares posted by
individual investors in the French IPOs used in data, these investors are
considered as sentiment investors and so their demand is a direct measure of
sentiment.
Derrien and Womack (2003) show that the initial returns on
IPOs in France in the 1992-1998 period were predictable using the market
returns in the three-month period preceding the offerings. Using U.S. data,
Loughran and Ritter (2002) and Lowry and Schwert (2003) obtain similar results:
in that the initial returns in the first day of trading for IPOs are
predictable using the market conditions prevailing at the time of the IPOs or
at a recent past.
Bradley and Jordan (2002) include the 1999 `hot issue' market
in their sample and find that more than 35% of initial returns can be predicted
using public information available at IPO date. However, Lowry and Schwert
(2003) find that the effect is economically small, the relation between
underpricing and market conditions (market returns) is statistically but not
economically significant.
II-6\ Discount on closed-end funds as proxy for investor
sentiment:
The proxies used in empirical works
investigating in short run IPO anomaly to value the investor sentiment and to
measure its impact on underpricing anomaly are numerous. One of the most
important proxies often used by researchers is the discount on closed-end
funds. The choice by many authors of the discount on closed-end funds as a
proxy of investor sentiment in their works is based on the findings of Lee et
al. (1991).
Lee, Shleifer and Thaler (1991) find that both closed-end
funds and small stocks are mostly held by individual investors who tend to be
noise traders, suggesting that they are more likely than large stocks to be
affected by investor sentiment. Lee et al. find that almost a quarter of the
variation in monthly returns on the smallest decile of firms is explained by
discount changes, even after controlling for general market movements. Their
findings suggest that when investor sentiment is higher, individual investors
pay relatively more for closed-end funds, and the discount is smaller.
Lee, Shleifer and Thaler (1991), and Lowry (2002) document
that «hot issue» periods and «hot IPO market» characterized
by high sentiment and over optimism among individual investors coincide with
low discount on closed-end funds, their measure of noise traders' optimism and
sentiment. They also show that the annual number of IPOs is negatively related
to the closed-end fund discount which they argue is a measure of retail
investor sentiment: the smaller the closed-end funds discount, the higher the
sentiment and optimism among individual investors and the higher the number of
IPOs. Over optimistic and enthusiastic investors are more accepting to invest
in new issues, and companies are encouraged to take advantage of this
opportunity to go public and to offer their shares in the stock market.
Based on these findings, many researchers are convinced that
discount on closed-end funds is a relevant proxy that can be used to value the
investor sentiment and to study its impact on IPO underpricing anomaly that
still a puzzle right now. They use it in their econometrical models.
Ivanov and Lewis (2008) 17 try to identify the
determinants of market-wide issue cycles for initial public offerings (IPOs)
using an autoregressive conditional count model. They consider whether IPO
volume is related to business conditions, investor sentiment, and time
variation in adverse selection costs caused by asymmetric information between
managers and investors.
17 «The determinants of market-wide issue
cycles for initial public offering» (2008)
To value the investor sentiment, they use the quarterly
first-difference in the index of closed-end fund discounts as proposed by Lee
et al. (1991).
II-7\ Other proxies and empirical results:
The list of proxies used by researchers to
value investor sentiment and to study its impact on underpricing anomaly is
very long. I presented the most important proxies in the previous paragraphs:
grey market prices, market conditions, demand submitted by individual investors
and discounts on closed-end funds.
In the present paragraph, I try to give a brief sight on the
other proxies that are used by researchers and the main results found:
Rajan and Servaes (2003) model two different types of
irrational agents, feedback traders and sentiment investors. They proxy for
investor sentiment using the market-to-book ratio and find that it correlates
positively with first-day returns and negatively with long-run returns. So
there is a positive correlation between investor sentiment valued through
market-to-book ratio and underpricing phenomenon.
Other studies have looked at who owns the shares in the
aftermarket: for example, Ofek and Richardson (2003) show that high initial
returns occur when institutions sell IPO shares to retail investors on the
first day.
Similarly, Ben Dor (2003) looks at the level of institutional
ownership shortly after the IPO and finds that high institutional ownership
forecasts higher returns in «hot» markets.
So, these authors use another proxy to investor sentiment: the
holdings of large (institutional) investors. Since these institutional
investors have the possibility to sell the IPO shares to sentiment investors in
the aftermarket in the first day of trading18.
The proxies for sentiment are numerous like the holdings of
large (institutional) investors, put-call ratios, trading volume,
market-to-book ratio, market conditions, grey market prices, closed-end fund
discounts, and the list is not exhaustive. There is an ongoing inconclusive
debate about the effectiveness and explanatory power of many investor sentiment
measures (Qui and Welch, 2004).
18 High institutional ownership shortly after the
offering is indicating the presence of high and optimistic sentiment among
individual investors, and so institutional investors (rich-information
investors) can easily sell the shares to these sentiment investors and making
large incomes and profits.
Oehler, Rummer and Smith (2005) in their article
«IPO Pricing and the Relative Importance of Investor Sentiment-Evidence
from Germany» try to explain the persistent pattern of high initial
returns during the first trading day. They focus on the importance of investor
sentiment and of information gathered by the underwriter before the start of
the bookbuilding process. From their viewpoint, there are only two different
but not mutually exclusive scenarios which could lead to the observable pattern
of high initial returns at the first trading day. First, it could be possible
that the offer price is set too low due to ex-ante uncertainty about the true
market value of the IPOs. Second, the offer price might be on average at a
«fair value» but demand for new issues is overly high and therefore
generating the observed high initial returns. They conclude from the
estimations realized that underpricing is mainly influenced by investor
sentiment and, therefore, by the uncertainty about the demand of potential
investors (the 2nd scenario), and less by ex-ante uncertainty about
the underlying firm's value. Investor sentiment has the dominant influence on
the fluctuations of initial returns and IPO underpricing anomaly.
To value the ex-ante uncertainty about the potential demand
and the investor sentiment, they focus first on the bookbuilding price range
and the subscription period which are set by the underwriter after observing
the potential demand for the stock to be issued, and second on the explanatory
power of pre-IPO trading, stock market performance prior to the issue and the
usage of the so-called Greenshoe option.
In Europe, the length of the bookbuilding period and the width
of the bookbuilding range are set after a pre-marketing period. During this
time span IPO research from sell-side and buy-side analysts is produced and
distributed by syndicate members to institutional clients (Jenkinson, Morrison
and Wilhelm, 2005). As a result, the length of the subscription period and the
width of the bookbuilding range are good indicators of how strong the
underwriter expects potential demand to be. The longer the subscription period
and the wider the initiative price range, the more uncertain is the underwriter
about possible success and the higher is the uncertainty about potential demand
inducing the importance of investor sentiment which plays a dominant role in
influencing the demand. This view is supported by the argument of Jenkinson,
Morrison and Wilhelm (2005) who assert that ceteris paribus less
available information will lead to an increase in the bookbuilding range.
The authors run regressions with the indicative price range
and the subscription period as dependent variables, and find that positive
sentiment for IPOs reduces uncertainty about potential demand and then reduces
the subscription period and bookbuilding price range.
To value investor sentiment, Oehler, Rummer and Smith (2005)
use many proxies: buy-and-hold on the market prior to the IPO which covers a
period of 30 days (market movement), Grey market trading prices, business
climate over the period of one month prior the IPO, usage of the Greenshoe
option which consists in issuing extra shares due to excess demand, and issue
volume (number of issued shares including the exercised Greenshoe multiplied by
issue price). The authors come to the conclusion that investor sentiment and
demand have the dominant influence and impact on initial returns on the first
trading day and thus using many proxies for sentiment which they find very
significant in their results. It is changes in investor sentiment which have
the dominant influence on the fluctuations of initial returns.
They also find another important result that the length of the
subscription period and width of the bookbuilding range have negative effects
on underpricing.
Aggarwal, Krigman, and Womack (2002) introduce another
explanation to first day IPO anomaly. They relate the aftermarket price path to
momentum traders. They focus on the role of research analysts and the media in
creating momentum and in inducing high investors' sentiment. So to value the
investors' sentiment, they focus on the role of media and research analysts:
when they are important and favourable to the issuing company and to the IPO,
this induces high and positive sentiment among individual investors, and then
initial returns are higher and underpricing is more important.
Section 3- The model and empirical implications
Introduction:
The effect of sentiment investors has been
advocated particularly strongly for the Initial Public Offerings' patterns,
since by definition, IPO firms have no prior share price history and tend to be
young, immature, and relatively informationally opaque. So they are very
sensitive to the state of mind of the investors and to investors' feelings and
beliefs. A large literature over the past decades, both theoretical and
empirical, has attributed the IPO pattern and the short run IPO puzzle to the
presence of this type of investors.
The works of researchers who are interested in the behavioral
approach and in the investor sentiment explanation to clarify the short run IPO
puzzle and to understand the IPO underpricing anomaly are numerous. The list is
long and is in continuously growth.
I presented in the previous paragraphs the most important
studies and papers that have considered the sentiment explanation and the
investor's behaviour as the most convincing and relevant driver and determinant
of IPO underpricing. I presented the application of the behavioral and
sentiment approach to clarify and to understand the IPO patterns by numerous
researchers to shed light on the importance of the sentiment investors in the
IPO market.
I continue in the same direction of the behavioral approach
and the investor sentiment explanation to the short run IPO puzzle, believing
in the relevance of this explanation to clarify and to understand the
underpricing phenomenon and in the importance of sentiment investors in the IPO
market to explain its anomalies. I presume that there are periods when capital
providers (individual and institutional investors) become irrationally
enthusiastic about new investment opportunities. In this thesis, we are in the
case of the new Initial Public Offerings. They become irrationally overly
optimistic about the IPO market. This over optimism is based on the favourable
recent history of the IPO market and the positive initial returns recently
observed for the new issues. These sentiment investors project this positive
tendency on the recent future, believing that the IPO market will continue in
the same direction in the recent future for sure. This period is known as
«Hot IPO market». The investors' exuberance translates into periods
of high demand for Initial Public Offerings, called «sentiment
demand» since it is based on sentiment and beliefs. It is far from a
perfectly rational demand based on fundamentals, and these sentiment investors
are willing to pay higher prices to have IPO shares. As I presented in a
previous paragraph, the IPO market is cyclical. There are periods of «hot
market», but there are also periods of «cold IPO market» and
sentiment investors become overly pessimistic about IPOs.
There are two types of investors: there are individual or
retail investors and institutional investors who are more informed and
important clients. A question may arise: what type of investors is driving
first day closing prices and the underpricing anomaly?
The empirical works and studies investigating in IPO issue
activity and particularly in the short run IPO anomaly, using the
«traditional explanations» based on the asymmetric or symmetric
theories, or using the behavioral approach and the sentiment explanation, draw
numerous and different conclusions.
The biggest limitation is that none conduct a comprehensive
analysis that evaluates all of the explanations in a systematic manner. None
try to present in the same model all the explanations: asymmetric, symmetric
and behavioral, to determine which is the most relevant and convincing to
explain the short run IPO puzzle, and none try to distinguish between the
sentiment of the two types of investors: individual and institutional, to
verify which type of investors exactly is driving the underpricing anomaly.
In this study, an effort to regroup the most important
explanations that have been advanced in the same model to determine which of
these explanations characterizes best the data in the context of a unified
framework and model. I introduce the three theories:
Ø Asymmetric information
Ø Symmetric information, and
Ø Behavioral approach.
And since there are two types of investors in the IPO market:
individual and institutional investors, one of the goals of this study, is to
identify which type is driving the first day closing prices and underpricing by
distinguishing between the individual investors' sentiment and the
institutional investors' sentiment.
To this end, I use direct measure of sentiment for the two
types of investors and this represents another contribution of this work.
The aim in this thesis is to show how sentiment investors and
their irrationally overly optimism can lead to a first day price run up and
therefore to underpricing, and can explain this short run anomaly with a
distinction between the two types of investors in the IPO market to clarify and
to understand which type is more conducting the short run IPO puzzle, and using
a direct measure of sentiment for each category of investors: the investor
sentiment index.
I- The model and explanatory variables:
I-1\ The model:
As I presented in the previous sections,
there are numerous explanations advanced to understand and to clarify the short
run IPO anomaly. These explanations can be classified in three main
categories:
Ø Explanations based on asymmetric information between
the key IPO parties and have been considered the most convincing explanations
for decades.
Ø Explanations asserting the informational transparency
and lucidity and asserting the IPO market efficiency.
Ø And explanations based on Behavioral Approach and on
investors' sentiments and beliefs.
I regroup the three theories advanced in the same model to
determine which of these explanations characterizes best the data in the
context of a unified model and presents the most relevant and reliable
explanation to underpricing phenomenon. I present every theory by one or more
indicators and determinants.
v For the informational asymmetry theory, I use the firm
quality as a determinant with many proxies: the Overhang Ratio, Venture Capital
backed, Underwriter reputation and R&D intensity.
v For the theory asserting the IPO market efficiency, I use
the risk determinant: age of the issuing firm, firm size (sales and assets),
firm profitability, ROA and the issue risk (if the firm operates in a
technological and risky sector). I use also the issue size (Ln (expected
proceeds)), and the issuer bargaining power.
v Finally, for the behavioral approach, I use direct measures
of investor sentiment, and I distinguish between the two types of investors:
the individual investor sentiment and the institutional investor sentiment. For
this, I use the individual investor sentiment index (AAII) and the
institutional investor sentiment index (II).
The regression model used in this study is as follows:
Underpricing = a0 + a1Underwriter
Reputation Dummy + a2Overhang + a3R&D Intensity +
a4VC Dummy + a5Ln (1+age) + a6Ln (assets) +
a7Ln (sales) + a8Firm Profitability + a9ROA +
a10Issue Risk Dummy + a11Ln (expected proceeds) +
a12Insiders Ownership + a13Institutional Ownership +
a14Blockholders Ownership + a15Individual Investor
Sentiment + a16Institutional Investor Sentiment+ a17Time
Dummy + åi
I-2\ The explanatory variables:
In this paragraph, I try to justify the use
of these determinants and explanatory variables in the model for each theory
and to present briefly the previous results reached by researchers that used
the same indicators and control variables in their models.
I-2-1\ Informational Asymmetry Theory:
* The theory of signalling: Firm quality
The issuer is the most and best informed party about the
issuing firm quality. There are many proxies of firm quality that can be
employed . I introduce the most important ones often used by researchers:
Ø The Overhang ratio = Pre-IPO shares retained by
insiders/Public Float
The percentage ownership retained by insiders serves as a
signal for firm quality, and two different relations are observed between firm
quality and underpricing with two different explanations. The first relation is
that, for high overhang ratio and so for high quality issues, the issue price
is lower a mean to demonstrate their quality and to distinguish themselves from
the pool of low quality issuers, then a higher level of underpricing is
observed. In the same direction, we can justify the use of overhang ratio and
its importance to underpricing phenomenon by the fact that only the shares sold
to the public in the IPO are undervalued. The shares retained by insiders are
valued at market. Thus, for a given degree of underpricing, the economic cost
per retained share (the dilution) declines as overhang rises. Because the cost
of underpricing to the issuer declines as overhang rises, it is natural to
conjecture that firms with greater overhang will have greater underpricing and
we find the same positive relation between overhang ratio and underpricing.
The second relation is completely different in that issuing
firm quality is negatively correlated with underpricing. Issuers with high
quality firms bargain for higher offer prices for their IPOs and then a lower
degree of underpricing is observed at the first day of trading.
Ø The R&D intensity = Pre-IPO R&D
expenditures/expected market value after IPO
R&D expenditures are the intangible investment most
extensively researched in economics, accounting and finance, they have to be
disclosed in the corporate financial reports. R&D contributes to
information asymmetry and Guo, Lev and Shi (2006) consider R&D activities
as the major source of asymmetry. Pre-IPO R&D intensity of the issuer is
strongly and positively related to the first day underpricing.
R&D-intensive firms are often undervalued by investors. That is why R&D
intensive issuers can not set a high offer price for their IPO. Besides, they
are more willing to forgo money on the IPO table than are no R&D issuers,
because they expect to recoup money left on the table by subsequent issues of
seasoned stocks when the market realizes over time the positive outcomes of
their R&D. So the relation between R&D intensity and underpricing is
positive but many studies find no relation between underpricing and SEO, which
refute the last point of recouping money left on the table by SEO in the
future.
Another relation can be found between R&D intensity and
underpricing, mainly since no relation between underpricing and SEO: R&D
intensive issuers believing in the high quality of their firms and in the
importance of their R&D and its positive outcomes in the recent future
require high offer prices for their IPOs which induces a negative relation
between R&D intensity and underpricing.
Ø Venture Capital backed: a dummy variable taking the
value of one if the issue firm is backed by a venture capital and zero
otherwise.
Since venture capitalists have expertise in particular
industries, they are expected to make superior investments relative to other
investors. In essence, VCs certify the quality of an IPO and their presence
signals that asymmetric information is relatively low for this issue and that
the issuing firm quality is high. So, issuers can bargain for a high offer
price which declines underpricing. Another explanation is found, that VC backed
firms face larger underpricing, since high quality issuers will continue
demonstrating the firm quality by throwing money on the IPO table and not
requiring high issue prices. However, in many studies using the venture capital
as a determinant of firm quality, this variable is found insignificant. A
question may arise: «Is Venture Capital backing really a signal of firm
quality and an explanatory variable to underpricing anomaly?». I introduce
this variable in the model to verify these results.
Ø Underwriter Reputation: a dummy variable taking the
value of one if the lead underwriter has a rank = 8 (zero otherwise).
Some issuers use it as a signal of high quality and want to
hire a prestigious underwriter, since by agreeing to be associated with an
offering, prestigious intermediaries «certify» the quality of the
issue. When an issuer chooses a prestigious underwriter for the book-building
mechanism, he sets a low offer price conducting a high underpricing on one
hand, as compensation to the underwriter and on the other hand, he is sure
about full subscription, he is concerned by quantity rather than price and a
lower offering price increases the probability of full subscription. Then,
there is a positive relation between underwriter reputation and
underpricing.
But, there is another explanation completely different: when
an issuer chooses a prestigious underwriter who certifies the high quality of
the issue, he can bargain for a higher offer price and then a lower level of
underpricing is observed: A negative relation between underwriter reputation
and underpricing.
I-2-2\ Theory asserting informational symmetry and IPO
market efficiency:
I use the main characteristic of Initial Public Offerings,
«risk» related to technological or valuation uncertainty and I use
many measures:
Ø The issuing firm size reflects the valuation
uncertainty risk: Ln (sales), Ln (assets).
Ø The issue risk, a dummy variable taking a value of
one if the firm operates in a risky industry and zero otherwise, a variable
reflecting technological risk which induces a valuation uncertainty.
Ø The age of the issuing firm: Ln (1+age) (age is
number of years since the firm's founding date to the date of going public and
the date of introduction in IPO market).
Ø I use also some financial data as proxies for
valuation uncertainty risk: firm profitability and ROA.
Almost the empirical studies introducing risk find a positive
relation between risk and underpricing: Riskier firms set a low offer price to
incite investors to participate in the IPO market and to buy the IPO risky
shares, and a high offer price will dissuade them. However, a study of Bartov,
Mohanram and Seethamraju (2003) reports that there is no correlation between
risk and underpricing. This finding refutes the prior researches and results
about the suitability of the risk as an explanation to the underpricing
anomaly. And I use this variable with many measures to verify if risk can be
considered as a relevant explanation to short run IPO anomaly.
I use another determinant of the symmetric information theory:
the issue size calculated as the natural logarithm of the net expected
proceeds. Previous researches report a negative and statistically significant
relation between size and offer price, so we can talk about a positive and
significant relation between issue size and underpricing (Cornelli, Goldreich
and Ljungqvist (2004)). Other researches find a negative relation between issue
size and underpricing, explaining this by the fact that sizable firms are
generally less risky than those making smaller issues, then issuers can bargain
a higher offer price conducting a lower level of underpricing.
I also introduce the issuer bargaining power as a variable in
the theory asserting the informational transparency and lucidity, with three
proxies to have an idea about the ownership structure: insiders' ownership,
institutional ownership and blockholders' ownership prior to the offering.
The main result found in the earlier studies, the greater is
the ownership concentration, the greater is the issuing firm's bargaining
power, the higher is the offer price and the lower is the first-day return and
vice-versa. But Loughran and Ritter (2004) argue that this argument
has little support as an explanation for underpricing.
I introduce another control variable «Time dummy»: a
dummy variable taking the value of 1 if the IPO date is after July 2007, and
zero otherwise. This variable is used to control the beginning of financial
crisis period and its impact on underpricing.
I-2-3\ Investor sentiment and Behavioral approach:
The list of proxies used by researchers to value investor
sentiment and to study its impact on underpricing anomaly is very long. The
most important proxies often used in researches and empirical studies are: grey
market prices, market conditions, demand submitted by individual investors,
discounts on closed-end funds and market-to-book ratio. Researches and
empirical works report that the higher is the investor sentiment and his
optimism, the higher is the level of underpricing.
In this study, I use the investors' sentiment index:
Ø The first measure is obtained from the survey data of
the American Association of Individual Investor (AAII): In July 1987,
AAII started conducting a weekly sentiment survey asking for the likely
direction of the stock market during the next six months (up, down or the
same). The participants are randomly chosen from approximately 100,000 AAII
members, only subscribers to AAII are eligible to vote and they can only vote
once during the survey period.
Each week, AAII mails the questionnaires, and members fill
them out and return them via US mail. Each week AAII collects responses from
Friday to the following Thursday, compiles the results based on survey answers
and labels them as bullish, bearish or neutral and reports the results on
Thursday or Friday. Since this survey is targeted towards individual investors,
it is primarily a measure of individual investors' sentiment.
Ø The second measure is obtained from the survey data
of Investors Intelligence (II), an investment service based in
Larchmont, New York. II compiles its sentiment data weekly by categorizing
approximately 150 market newsletters since 1964. Data is based on a survey of
investment advisory newsletters. To overcome the potential bias problem towards
buy recommendations, letters from brokerage houses are excluded. Newsletters
are read and marked starting on Friday each week. The results are reported as
percent bullish, bearish, or neutral on the following Wednesday. Since authors
of these newsletters are current or past market professionals, the II series is
interpreted as a measure for institutional investors' sentiment.
II- Data Description:
The sample consists of American Initial
Public Offerings underpriced in the first day of trading for 2006 and 2007. The
years 2008 and 2009 have not been included in the sample due to lack of
available information. The data base includes 348 offerings, after excluding
the issues having an underpricing less than 5%, the sample is reduced to 225
IPOs, and I require the firms to be available in the U.S Securities and
Exchange Commission website because I use the SEC database for the company
filings and prospectuses which further reduce the sample to 217 IPOs.
My primary data source for the IPOs is
http://www.iposcoop.com database. I have collected the missing
information from prospectuses available in the SEC's Electronic Data Gathering
and Retrieval (EDGAR) system for IPOs (final prospectuses are identified on
EDGAR as document 424B at
http://www.sec.gov), and from a number
of other sources.
Underwriter rankings are on a 0 to 9 scale.
Information comes from the Jay Ritter website, a file presenting the rankings
of all underwriters from 1980-2007. All the rankings in this file are integers
followed by a 0.1 (1.1 up to 9.1). Loughran and Ritter attach a 0.1 to all
rankings so that other researchers can easily distinguish between their
rankings and those from Carter and Manaster and Carter, Dark, and Singh, which
never end with a 0.1. Because Loughran and Ritter to make this underwriter
rankings' file start with the Carter and Manaster (1990) and Carter et al.
(1998) rankings, but with some changes, and they make their own methodology to
complete rankings for the other years.
To measure the Overhang Ratio, Pre-IPO shares
retained are calculated as the difference between shares post offer and shares
offered to the public. Information on shares post offer come from the
prospectuses and completed from:
http://biz.yahoo.com/ipo and
http://moneycentral.hoovers.com
.
Issuing firm age is calculated as Ln (1+age) and age
is the difference between the founding year and the issue year. Information on
founding year comes from Jay Ritter website, a file presenting founding years
for firms from 1975 to 2008.
Information on expected net proceeds to measure the issue
size, on ownership structure (insiders' ownership, institutional
ownership, blockholders ownership) and on financial data in the year prior to
going public (assets, sales, net income, EBITDA) to measure the different
proxies of risk and on R&D expenditures come from the final
prospectuses of issuing firms.
If a firm has zero sales, I assign a sales value of 1 thousand
$, since in my empirical work I use logarithms, and the logarithm of zero is
undefined.
R&D intensity is calculated as the ratio of
R&D expenditures (a year prior to offering) to the expected market value.
To calculate the expected market value of an IPO, I use the offer price
multiplied by the post-issue number of shares outstanding.
For sales and R&D expenditures, if I am not sure whether
they are zero or are missing, I treat the value as missing.
Unfortunately, missing values on R&D expenditures
(underwriter reputation for 6 firms and sales for 4 firms) reduce the sample to
117 observations. Trying to eliminate R&D intensity as an explanatory
variable to increase the number of observations has deteriorated the model, so
R&D intensity is a fundamental explanatory variable to underpricing
phenomenon.
Information on Venture Capital backed comes from
prospectuses.
Issue risk is a dummy variable taking the value of
one if the issue is operating in a technological risky sector and zero
otherwise. I use the same method of Loughran and Ritter (2004) to categorize
IPOs as a technology firm or not.
Tech stocks are defined as those with SIC codes:
3571, 3572, 3575, 3576, 3577, 3578 (computer
hardware)
3661, 3663, 3669 (communications equipment)
3671, 3672, 3674, 3675, 3677, 3678, 3679 (electronics)
3812 (navigation equipment)
3823, 3825, 3826, 3827, 3829 (measuring and controlling
devices)
3841, 3845 (medical instruments)
4812, 4813 (telephone equipment)
4899 (communications services)
7370, 7371, 7372, 7373, 7374, 7375, 7378, and 7379
(software).
The two sentiment indicators used in this model:
individual investor sentiment and institutional investor
sentiment are available on a weekly basis that are compiled from surveys
by the American Association of Individual Investors and Investors
Intelligence.
If I want to look at the true relationship between
underpricing and sentiment, for an IPO at the week t, I should work
with the sentiment indicator of the week t-1 because it more
accurately reflects the investor sentiment for the week t, but since
there is a time lag of 1 week between responses and reporting (as I presented
earlier the procedure of reporting these indicators), I should actually work
with the sentiment of the same week t to overcome this reporting
lag.
Time dummy: a dummy variable taking the value of 1 if
the IPO date is after July 2007, and zero otherwise. This variable is used to
control the beginning of financial crisis period and its impact on
underpricing.
Table 2 provides descriptive statistics of the full sample:
The overall mean underpricing of the sample (117 observations) 29.54%, the
overall mean for overhang ratio is 9.706, 0.022 for R&D intensity, the
overall mean firm age of the sample is approximately 11 years (10 years and 10
months). The overall means of firm profitability and ROA are negative and the
overall mean of insiders' ownership is 55.48%. The overall means of investors
bullish bearish ratios (individuals and institutionals) are higher than 1,
which indicates that individual and institutional investors in this period and
for this sample are rather optimistic than pessimistic.
Table 2. Descriptive Statistics of the Full
Sample
|
The sample size is 217, R&D expenditures is missing for 90
firms, Underwriter ranking is missing for 6 firms and sales is missing for 4
firms, reducing the number of observations to 117. The dependent variable
is the percentage first-day return from the offer price to the first-day
closing price. The underwriter reputation dummy takes a value of one if the
lead underwriter has an updated Carter and Manaster (1990) rank of 8 or more,
and zero otherwise. Share overhang is the ratio of retained shares to the
public float (the number of shares issued). R&D intensity is the ratio of
Pre-IPO R&D expenditures to the expected market value.
|
The VC dummy takes a value of one (zero otherwise) if the IPO
is backed by venture capital. Ln(1 + age) is the natural log of 1 plus the
years since the firm's founding date as of the IPO. The Ln(assets) is the
natural logarithm of the pre-issue book value of assets expressed in millions
$. Ln(sales) is the natural log of the firm sales a year prior the offering,
expressed in millions $. Firm profitability is the ratio of Pre-IPO EBITDA to
total assets value.
|
ROA is the ratio of Pre-IPO net income to total assets value.
The issue risk is a tech dummy takes a value of one (zero otherwise) if the
firm is in the technology business. Insiders' ownership and blockholders'
ownership are proxies to ownership structure and issuer bargaining power. AAII
and II bullish bearish Ratios are the % of bullish investors divided by the %
of bearish investors. Time dummy takes a value of one (zero otherwise) if the
IPO occurred after July 2007.
|
|
|
|
|
|
|
|
|
|
|
|
Mean
|
Median
|
Max
|
Min
|
Std Dev
|
Skewness
|
Kurtosis
|
Jarque-Bera
|
Probability
|
UNDERPRICING
|
0,295
|
0,219
|
1,254
|
0,055
|
0,235
|
1,408
|
4,831
|
55,027
|
0,000
|
UNDERWRITER REPUTATION
|
0,846
|
1,000
|
1,000
|
0,000
|
0,362
|
-1,919
|
4,682
|
85,584
|
0,000
|
OVERHANG RATIO
|
9,706
|
3,412
|
399,289
|
0,000
|
38,750
|
8,993
|
89,246
|
37839,240
|
0,000
|
R D INTENSITY
|
0,022
|
0,015
|
0,145
|
0,000
|
0,025
|
2,096
|
8,566
|
236,685
|
0,000
|
VC BACKED DUMMY
|
0,726
|
1,000
|
1,000
|
0,000
|
0,448
|
-1,016
|
2,033
|
24,699
|
0,000
|
FIRM AGE
|
2,475
|
2,303
|
4,905
|
0,000
|
0,871
|
0,612
|
3,988
|
12,057
|
0,002
|
FIRM SIZE LN ASSETS
|
4,300
|
3,985
|
8,640
|
0,272
|
1,506
|
0,900
|
3,788
|
18,828
|
0,000
|
FIRM SIZE LN SALES
|
3,473
|
3,859
|
9,225
|
-6,908
|
2,827
|
-2,051
|
8,830
|
247,683
|
0,000
|
FIRM PROFITABILITY
|
-0,064
|
0,053
|
2,062
|
-3,527
|
0,509
|
-2,448
|
22,255
|
1924,288
|
0,000
|
ROA
|
-0,068
|
-0,001
|
3,648
|
-1,279
|
0,497
|
3,222
|
28,728
|
3429,200
|
0,000
|
ISSUE RISK TECH DUMMY
|
0,556
|
1,000
|
1,000
|
0,000
|
0,499
|
-0,224
|
1,050
|
19,512
|
0,000
|
INSIDERS OWNERSHIP
|
0,555
|
0,599
|
1,000
|
0,000
|
0,269
|
-0,440
|
2,320
|
6,029
|
0,049
|
BLOCKHOLDERS OWNERSHIP
|
0,694
|
0,731
|
2,091
|
0,000
|
0,342
|
0,784
|
5,861
|
51,888
|
0,000
|
AAII BULL BEAR RATIO
|
1,263
|
1,219
|
2,148
|
0,491
|
0,416
|
0,325
|
2,401
|
3,812
|
0,149
|
INVI BULL BEAR RATIO
|
2,169
|
2,260
|
3,212
|
1,223
|
0,518
|
-0,171
|
1,865
|
6,852
|
0,033
|
TIME DUMMY
|
0,248
|
0,000
|
1,000
|
0,000
|
0,434
|
1,168
|
2,364
|
28,570
|
0,000
|
From the Jarque-Bera test, we can deduce that the dependant
variable and all the explanatory variables are not normally distributed except
for individual investors sentiment (p.value = 0.1486).
I classified the sample into two subsamples: firms with low
underpricing (=sample median 21.85% (59 obs)) and firms with high underpricing
(>sample median (58 obs)). (Descriptive statistics of the two subsamples are
in tables 3 and 4)
For firms with high underpricing, I notice that the means of
overhang ratio, R&D intensity and insiders' ownership are lower than those
of low underpricing, but the mean of AAII bullish bearish ratio is higher:
these remarks indicate that underpricing increases monotonically with higher
individual investors' sentiment and decreases with higher firm quality and
higher issuer bargaining power.
Table 5 indicates that firms with highest underpricing at the
1st day of trading are almost risky firms (young firms with small
assets and sales and operating in a technological sector). From the underwriter
prestige segmentation, I remark that almost firms look for hiring prestigious
underwriters and these firms have the highest underpricing degree. Higher
issuer bargaining power leads to lower underpricing.
Table 3. Descriptive Statistics of Firms with Low
Underpricing
|
Firms with low underpricing are firms with underpricing
less than the median of the full sample 21.85%.
|
|
|
|
|
|
|
|
|
|
|
|
Mean
|
Median
|
Max
|
Min
|
Std Dev
|
Skewness
|
Kurtosis
|
Jarque-Bera
|
Probability
|
UNDERPRICING
|
0,125
|
0,125
|
0,219
|
0,055
|
0,047
|
0,124
|
1,942
|
2,902
|
0,234
|
UNDERWRITER REPUTATION
|
0,814
|
1,000
|
1,000
|
0,000
|
0,393
|
-1,610
|
3,593
|
26,360
|
0,000
|
OVERHANG RATIO
|
14,228
|
2,895
|
399,289
|
0,160
|
54,189
|
6,352
|
44,887
|
4709,997
|
0,000
|
R D INTENSITY
|
0,028
|
0,022
|
0,145
|
0,000
|
0,029
|
1,743
|
6,773
|
64,893
|
0,000
|
VC BACKED DUMMY
|
0,712
|
1,000
|
1,000
|
0,000
|
0,457
|
-0,936
|
1,875
|
11,717
|
0,003
|
FIRM AGE
|
2,458
|
2,303
|
4,868
|
0,693
|
0,878
|
0,746
|
3,898
|
7,455
|
0,024
|
FIRM SIZE LN ASSETS
|
4,510
|
4,144
|
8,640
|
0,272
|
1,719
|
0,412
|
2,832
|
1,735
|
0,420
|
FIRM SIZE LN SALES
|
3,172
|
3,832
|
8,961
|
-6,908
|
3,436
|
-1,574
|
5,758
|
43,048
|
0,000
|
FIRM PROFITABILITY
|
-0,147
|
0,015
|
0,604
|
-3,527
|
0,589
|
-3,506
|
19,713
|
807,607
|
0,000
|
ROA
|
-0,076
|
-0,008
|
3,648
|
-1,279
|
0,623
|
3,309
|
23,149
|
1105,687
|
0,000
|
ISSUE RISK TECH DUMMY
|
0,576
|
1,000
|
1,000
|
0,000
|
0,498
|
-0,309
|
1,095
|
9,856
|
0,007
|
INSIDERS OWNERSHIP
|
0,603
|
0,649
|
1,000
|
0,000
|
0,268
|
-0,644
|
2,833
|
4,150
|
0,126
|
BLOCKHOLDERS OWNERSHIP
|
0,736
|
0,729
|
2,091
|
0,000
|
0,389
|
1,131
|
5,682
|
30,269
|
0,000
|
AAII BULL BEAR RATIO
|
1,229
|
1,216
|
2,087
|
0,537
|
0,403
|
0,394
|
2,446
|
2,277
|
0,320
|
INVI BULL BEAR RATIO
|
2,174
|
2,123
|
3,212
|
1,223
|
0,518
|
-0,271
|
2,022
|
3,074
|
0,215
|
TIME DUMMY
|
0,153
|
0,000
|
1,000
|
0,000
|
0,363
|
1,933
|
4,736
|
44,138
|
0,000
|
Table 4. Descriptive Statistics of Firms with High
Underpricing
|
Firms with high underpricing are firms with
underpricing more than the median of the full sample 21.85%.
|
|
|
|
|
|
|
|
|
|
|
|
Mean
|
Median
|
Max
|
Min
|
Std Dev
|
Skewness
|
Kurtosis
|
Jarque-Bera
|
Probability
|
UNDERPRICING
|
0,468
|
0,412
|
1,254
|
0,221
|
0,223
|
1,107
|
4,198
|
15,324
|
0,000
|
UNDERWRITER REPUTATION
|
0,879
|
1,000
|
1,000
|
0,000
|
0,329
|
-2,329
|
6,423
|
80,737
|
0,000
|
OVERHANG RATIO
|
5,105
|
3,843
|
30,441
|
0,000
|
5,007
|
3,356
|
15,321
|
475,732
|
0,000
|
R D INTENSITY
|
0,016
|
0,011
|
0,109
|
0,000
|
0,020
|
2,489
|
10,947
|
212,535
|
0,000
|
VC BACKED DUMMY
|
0,741
|
1,000
|
1,000
|
0,000
|
0,442
|
-1,102
|
2,216
|
13,237
|
0,001
|
FIRM AGE
|
2,492
|
2,303
|
4,905
|
0,000
|
0,871
|
0,474
|
4,106
|
5,126
|
0,077
|
FIRM SIZE LN ASSETS
|
4,086
|
3,812
|
8,553
|
2,323
|
1,231
|
1,727
|
6,334
|
55,706
|
0,000
|
FIRM SIZE LN SALES
|
3,778
|
3,874
|
9,225
|
-6,908
|
2,015
|
-2,756
|
17,031
|
549,203
|
0,000
|
FIRM PROFITABILITY
|
0,021
|
0,064
|
2,062
|
-1,026
|
0,400
|
1,819
|
13,611
|
304,105
|
0,000
|
ROA
|
-0,059
|
0,024
|
1,143
|
-1,095
|
0,328
|
0,016
|
6,215
|
24,986
|
0,000
|
ISSUE RISK TECH DUMMY
|
0,534
|
1,000
|
1,000
|
0,000
|
0,503
|
-0,138
|
1,019
|
9,668
|
0,008
|
INSIDERS OWNERSHIP
|
0,506
|
0,548
|
0,914
|
0,000
|
0,262
|
-0,290
|
1,953
|
3,463
|
0,177
|
BLOCKHOLDERS OWNERSHIP
|
0,651
|
0,746
|
1,095
|
0,000
|
0,282
|
-0,593
|
2,329
|
4,481
|
0,106
|
AAII BULL BEAR RATIO
|
1,297
|
1,265
|
2,148
|
0,491
|
0,430
|
0,244
|
2,359
|
1,567
|
0,457
|
INVI BULL BEAR RATIO
|
2,164
|
2,260
|
3,212
|
1,282
|
0,522
|
-0,072
|
1,717
|
4,027
|
0,133
|
TIME DUMMY
|
0,345
|
0,000
|
1,000
|
0,000
|
0,479
|
0,653
|
1,426
|
10,106
|
0,006
|
Table 5. Average First-day Returns Categorized by
Underwriter prestige, Share Overhang, R&D Intensity, VC Backing, Age,
Assets, Sales, Firm profitability, Industry, Bargaining Power, Individual
Investors' sentiment and Time
|
Data are from iposcoop, Securities and Exchange Commissions
data and other sources; the sample size is 217, R&D expenditures is missing
for 90 firms, Underwriter ranking is missing for 6 firms and sales is missing
for 4 firms. High prestige underwriters are those with a ranking of 8 or higher
on 0-9 scale. Low share overhang IPOs have an overhang ratio of 3.412 (median)
or lower. Firms with low R&D intensity are those with R&D intensity
lower than 1.5% (median). Firms with 0-7 years old are classified as young.
Firms with 12 months pre-IPO assets less than $53.8 million are classified as
small. Firms with 12 months pre-IPO sales less than $47.4 million are
classified as low sales firms. Firms with insiders' ownership less than 59.88%
(median) are classified as firms with low bargaining power.
|
Segmented by
|
Average 1st day return
|
N
|
|
Underwriter prestige
|
|
|
|
Low prestige
|
17.59%
|
39
|
|
High prestige
|
27.77%
|
164
|
|
Share Overhang
|
|
|
|
Low
|
20.53%
|
130
|
|
High
|
31.93%
|
87
|
|
R&D intensity
|
|
|
|
Low
|
35.02%
|
63
|
|
High
|
21.74%
|
64
|
|
Venture Capital backing
|
|
|
|
Non VC backed
|
20.70%
|
95
|
|
VC backed
|
28.53%
|
122
|
|
Age
|
|
|
|
Young ( 0-7 years old )
|
25.98%
|
68
|
|
Old ( 8 years and older )
|
24.7%
|
149
|
|
Assets
|
|
|
|
Small
|
31.18%
|
72
|
|
Large
|
22.08%
|
145
|
|
Sales
|
|
|
|
Small
|
28.21%
|
76
|
|
Large
|
23.97%
|
135
|
|
Firm Profitability
|
|
|
|
<0
|
24.88%
|
67
|
|
>=0
|
25.20%
|
150
|
|
Industry
|
|
|
|
Non Technology
|
23.50%
|
145
|
|
Technology
|
28.33%
|
72
|
|
Bargaining power
|
|
|
|
Low bargaining power
|
26.23%
|
107
|
|
High bargaining power
|
24%
|
110
|
|
Individual Investors' sentiment
|
|
|
|
Pessimistic sentiment
|
25.07%
|
162
|
|
Optimistic sentiment
|
25.21%
|
55
|
|
Time
|
|
|
|
Before crisis period
|
22.57%
|
168
|
|
After crisis period
|
33.80%
|
49
|
|
ALL
|
25.10%
|
217
|
|
III- Empirical implications and analysis:
Before presenting the results and empirical
implications of the model, I should describe the different steps and the
methodology I used to obtain the final specification:
Ø 1st Step: using the AAII and II weekly
sentiment indicators, I calculate three investors sentiment measures: bullish
proportion (% of bullish investors / % of bullish and bearish investors),
bullish-bearish Spread (% of bullish investors - % of bearish investors) and
the bullish bearish Ratio (% of bullish investors/ % of bearish investors).
From these 3 possible measures, I should find the best measure of sentiment and
the model that best explains the data. I try to construct 3 models, each one
contains all the variables with one of the 3 possible sentiment measures, so
every specification contains 17 explanatory variables with a constant:
Underwriter reputation, Overhang ratio, R&D intensity, VC backed, Firm age,
Firm size Ln(assets), Firm size Ln(sales), Issue size, Firm profitability, ROA,
Issue risk (tech dummy), Insiders' ownership, Institutional ownership,
Blockholders' ownership, AAII sentiment indicator, II sentiment indicator and
Time dummy.
The regression results and the models adjustment quality and
different measures of goodness of fit allow the choice of the model containing
the bullish bearish Ratio as the model that best explains underpricing within
the sample and using these control variables: the highest R-squared
and adjusted R-squared which measure the success of the regression in
predicting the values of the dependant variable within the sample, and the
lowest Akaike Information Criterion and Schwarz Criterion
which are measures of the goodness of fit of an estimated statistical
model and they measure the efficiency of the parameterized model in terms of
predicting the data. So in a first step, I continue working with the model
using the Bullish Bearish Ratio as measure of
investor sentiment with all the other explanatory variables.
The tables 6 and 7 present the regression results of the
models containing all the variables with respectively the bullish proportion
and the bullish-bearish spread as measures of investors' sentiment. The tables
also contain criterion used to decide which model explains best the dependant
variable within the sample.
Table 6. Ordinary Least Squares Regression Results
(with Bullish proportion as investors' sentiment measure)
|
Dependent Variable: UNDERPRICING
|
|
|
|
|
Method: Least Squares
|
|
|
|
|
Sample (adjusted): 1 214 Included observations: 117 after
adjustments
|
|
|
|
White Heteroskedasticity-Consistent Standard Errors &
Covariance
|
|
|
|
|
Variable
|
Coefficient
|
Std. Error
|
t-Statistic
|
Prob.
|
C
|
0.069774
|
0.309901
|
0.225149
|
0.8223
|
UNDREWRITER REPUTATION
|
0.095300
|
0.071413
|
1.334489
|
0.1851
|
OVERHANG RATIO
|
-0.000577
|
0.000260
|
-2.218402
|
0.0288
|
R D INTENSITY
|
-2.857168
|
0.928221
|
-3.078112
|
0.0027
|
VC BACKED DUMMY
|
0.014893
|
0.062503
|
0.238276
|
0.8122
|
FIRM AGE
|
0.014673
|
0.031730
|
0.462419
|
0.6448
|
FIRM SIZE LN ASSETS
|
-0.028986
|
0.026733
|
-1.084293
|
0.2809
|
FIRM SIZE LN SALES
|
-0.000771
|
0.009336
|
-0.082608
|
0.9343
|
ISSUE SIZE
|
0.007820
|
0.039760
|
0.196668
|
0.8445
|
FIRM PROFITABILITY
|
-0.067138
|
0.053643
|
-1.251562
|
0.2137
|
ROA
|
0.055279
|
0.059343
|
0.931524
|
0.3538
|
ISSUE RISK TEH DUMMY
|
0.000610
|
0.042783
|
0.014249
|
0.9887
|
INSIDER OWNERSHIP
|
-0.170075
|
0.086312
|
-1.970474
|
0.0516
|
INSTITUTIONAL OWNERSHIP
|
0.233858
|
0.231054
|
1.012134
|
0.3139
|
BLOCKHOLDERS OWNERSHIP
|
-0.368274
|
0.220834
|
-1.667651
|
0.0985
|
AAII BULL PROPORTION
|
0.477753
|
0.238433
|
2.003722
|
0.0478
|
INVI BULL PROPORTION
|
0.226409
|
0.369040
|
0.613508
|
0.5409
|
TIME DUMMY
|
0.146285
|
0.053135
|
2,742582
|
0.0070
|
R-squared
|
0.286636
|
Mean dependent var
|
0.295424
|
Adjusted R-squared
|
0.164139
|
S.D. dependent var
|
0.234851
|
S.E. of regression
|
0.214713
|
Akaike info criterion
|
-0.098386
|
Sum squared resid
|
4.564085
|
Schwarz criterion
|
0.326563
|
Log likelihood
|
23.75561
|
Hannan-Quinn criter.
|
0.074138
|
F-statistic
|
2.339949
|
Durbin-Watson stat
|
2.326671
|
Prob(F-statistic)
|
0.004784
|
|
|
|
Table 7. Ordinary Least Squares Regression Results
(with Bullish Bearish Spread as investors' sentiment measure)
|
Dependent Variable: UNDERPRICING
|
|
|
|
|
Method: Least Squares
|
|
|
|
|
Sample (adjusted): 1 214 Included observations: 117 after
adjustments
|
|
|
|
White Heteroskedasticity-Consistent Standard Errors &
Covariance
|
|
|
|
|
Variable
|
Coefficient
|
Std. Error
|
t-Statistic
|
Prob.
|
C
|
0.411271
|
0.171480
|
2.398364
|
0.0183
|
UNDREWRITER REPUTATION
|
0.095188
|
0.071482
|
1.331636
|
0.1860
|
OVERHANG RATIO
|
-0.000600
|
0.000259
|
-2.317958
|
0.0225
|
R D INTENSITY
|
-2.842995
|
0.930156
|
-3.056472
|
0.0029
|
VC BACKED DUMMY
|
0.015700
|
0.062839
|
0.249853
|
0.8032
|
FIRM AGE
|
0.014385
|
0.031341
|
0.458990
|
0.6472
|
FIRM SIZE LN ASSETS
|
-0.027984
|
0.026783
|
-1.044824
|
0.2986
|
FIRM SIZE LN SALES
|
-0.000854
|
0.009332
|
-0.091548
|
0.9272
|
ISSUE SIZE
|
0.006576
|
0.040015
|
0.164343
|
0.8698
|
FIRM PROFITABILITY
|
-0.067658
|
0.053506
|
-1.264489
|
0.2090
|
ROA
|
0.058442
|
0.059784
|
0.977542
|
0.3307
|
ISSUE RISK TECH DUMMY
|
0.001121
|
0.042737
|
0.026232
|
0.9791
|
INSIDER OWNERSHIP
|
-0.167241
|
0.085970
|
-1.945335
|
0.0546
|
INSTITUTIONAL OWNERSHIP
|
0.246116
|
0.228617
|
1.076544
|
0.2843
|
BLOCKHOLDERS OWNERSHIP
|
-0.381754
|
0.219424
|
-1.739803
|
0.0850
|
AAII BULL BEAR SPREAD
|
0.003062
|
0.001532
|
1.998317
|
0.0484
|
INVI BULL BEAR SPREAD
|
0.001949
|
0.002459
|
0.792373
|
0.4300
|
TIME DUMMY
|
0.144385
|
0.053118
|
2.718194
|
0.0078
|
R-squared
|
0.288315
|
Mean dependent var
|
0.295424
|
Adjusted R-squared
|
0.166106
|
S.D. dependent var
|
0.234851
|
S.E. of regression
|
0.214461
|
Akaike info criterion
|
-0.100743
|
Sum squared resid
|
4.553344
|
Schwarz criterion
|
0.324207
|
Log likelihood
|
23.89344
|
Hannan-Quinn criter.
|
0.071782
|
F-statistic
|
2.359205
|
Durbin-Watson stat
|
2.328713
|
Prob(F-statistic)
|
0.004430
|
|
|
|
Ø 2nd Step: I check the correlation between
the explanatory variables, I use Klein correlation detection criterion:
comparison between R-squared (R²) and the different
squared simple correlation coefficients (r²) with
r²=Cov²(Xi,Xj)/
Var(Xi)*Var(Xj)
r²Xi,Xj > R²
for i?j means the presence of correlation between Xi and
Xj.
For this, I should use the correlation matrix to determine the
different correlation coefficients between all the explanatory variables. For
R² = 0.2897, I find a correlation between issue size and firm
size Ln (assets) (r²= 0.4361) and a correlation between
institutional ownership and blockholders' ownership (r²=
0.8326). I construct all the specifications necessary to decide which control
variables I should eliminate and which explanatory variables I should keep in
the model to give the best explanation of underpricing phenomenon (the
dependant variable of the model). Founding my decision on measures of goodness
of fit and of adjustment quality for the model, I eliminate issue size and
institutional ownership, and I keep all the other control variables. The final
specification contains 15 explanatory variables: Underwriter Reputation,
Overhang Ratio, R&D Intensity, VC Backed, Firm Age, Firm Size Ln(assets),
Firm Size Ln(sales), Firm Profitability, ROA, Issue Risk (tech dummy),
Insiders' Ownership, Blockholders' Ownership, AAII Bullish Bearish Ratio, II
Bullish Bearish Ratio and Time Dummy.
With a new correlation matrix, I check the correlation between
these 15 control variables: r²Xi,Xj <
R² = 0.2833 for i?j
There is no correlation between the control variables after
eliminating issue size and institutional ownership.
The final specification is as follows:
Underpricing = a0 + a1Underwriter
Reputation Dummy + a2Overhang Ratio+ a3R&D Intensity
+ a4VC Dummy + a5Ln (1+age) + a6Ln (assets) +
a7Ln (sales) + a8Firm Profitability + a9ROA +
a10Issue Risk Dummy + a11Insiders' Ownership +
a12 Blockholders' Ownership + a13Individual Bullish
Bearish Ratio+ a14Institutional Bullish Bearish Ratio +
a15Time Dummy + åi
With underwriter reputation, overhang ratio, R&D intensity
and VC backing used to measure the informational asymmetry and exactly are
proxies for the firm quality. Age, firm size, firm profitability, ROA and issue
risk are measures of risk. Insiders' ownership and blockholders' ownership are
proxies for issuer bargaining power. Individual and Institutional bullish
bearish ratios are measures of investors' sentiment. Finally, time dummy is a
control variable to verify the impact of the beginning of the financial crisis
on IPO underpricing.
I present the Ordinary Least Squares regression results in
table 8. The first result is that the model is statistically significant
(p.value= 0.001935), which means the relevance of the control variables used in
this model to explain the underpricing phenomenon (the dependant variable). I
find acceptable values of Akaike Information Criterion and Schwarz Criterion
which measure the goodness of fit and the efficiency of the parameterized model
in terms of predicting the data.
Let's verify the individual significance of the explanatory
variables. 5 statistically significant variables: Overhang Ratio, R&D
Intensity, Insiders' Ownership, Individual Bullish Bearish Ratio and Time
Dummy.
§ The negative and significant coefficient of insiders'
ownership is consistent with the hypothesis that issue firms with high
bargaining power request higher offer prices conducting lower degree of
underpricing. This negative relation between issuer bargaining power and
underpricing is consistent with the findings of Ljungqvist, Nanda and Singh
(2003), Ljungqvist and Wilhelm (2003), Loughran and Ritter (2004) and many
other researchers who used this variable in their studies.
§ The positive and significant coefficient of Individual
Bullish Bearish Ratio is consistent with the hypothesis that investors with
high and optimistic sentiment are willing to pay higher prices to acquire the
IPO shares leading to higher underpricing. This result is consistent with the
findings of researchers who are interested in the behavioral explanation of IPO
first day price run up using different proxies for sentiment: Lee, Shleifer and
Thaler (1991) with discount on closed-end funds, Cornelli, Goldreich and
Ljungqvist (2004) with grey market prices and many other researchers using the
behavioral approach and the investor sentiment.
§ The positive and significant coefficient of Time dummy
presents the positive relation between underpricing and the beginning of the
financial crisis which has an impact on the IPO first day returns.
§ The negative and significant coefficients of overhang
ratio and R&D intensity (both are measures of firm quality) can be
explained by the fact that high quality issue firms request higher offer prices
for their IPOs conducting lower level of underpricing.
§ The lack of significance of the 6 measures of risk
(age, Ln(assets), Ln(sales), firm profitability, ROA and issue Risk (tech
dummy)) is consistent with the findings of Bartov, Mohanram and Seethamraju
(2003): using a dummy variable for risky IPOs, they find that there is no
correlation between risk and underpricing and the notion of risk can not
explain the setting of a lower offer price and then the underpricing
phenomenon.
§ The lack of significance of the VC backing coefficient
confirms the findings of many researchers that used VC dummy as a proxy and as
a signal for firm quality. A question can be asked about the explanatory power
of this variable and its introduction in explanatory models of underpricing
phenomenon.
By regrouping the three theories advanced earlier as
explanations for the underpricing phenomenon in the same model and by using
different proxies for each theory, I show that:
Ø The informational asymmetry theory and particularly
the issuing firm quality proxied by R&D intensity or by the overhang ratio
presents a relevant explanation to the short run IPO anomaly.
Ø The issuer bargaining power proxied by insiders'
ownership is also an important and a reliable determinant of underpricing.
Ø Finally, one of the main goals of this study is to
show the relevance and the importance of investors' sentiment and behaviour as
an explanation to the short run IPO puzzle, and to find the positive
correlation between the investors' optimism and underpricing phenomenon. This
hypothesis is confirmed in this study.
In this model, I distinguish between the two types of
investors: individual and institutional investors using a direct measure of
sentiment for each type calculated from the American Association of
Individual Investors and the Investors Intelligence
survey data, these are two other contributions in this study. The positive and
significant coefficient of individual investors' sentiment and the positive but
insignificant coefficient of institutional investors' sentiment lead to an
important finding: individual investors are those driving the first day closing
prices and then underpricing anomaly and are more conducting the short run IPO
puzzle than the institutional investors. The individual investors' sentiment
and their over optimism and enthusiasm is more important and relevant in
explaining the IPO underpricing anomaly than does the institutional investors'
sentiment. Individual investors are the type more conducting the IPO first day
returns and the short run IPO puzzle.
This finding can be explained by the fact that in some
researches and studies, institutional investors are defined as rational
investors. This can be a possible explanation for the irrelevance of
institutional investors' sentiment in explaining the underpricing anomaly.
Table 8. Ordinary Least Squares Regression
Results
|
The sample size is 217, R&D expenditures is missing for 90
firms, Underwriter ranking is missing for 6 firms and sales is missing for 4
firms, reducing the number of observations to 117. The dependent variable is
the percentage first-day return from the offer price to the first-day closing
price. The underwriter reputation dummy takes a value of one if the lead
underwriter has an updated Carter and Manaster (1990) rank of 8 or more, and
zero otherwise. Share overhang is the ratio of retained shares to the public
float (the number of shares issued). R&D intensity is the ratio of Pre-IPO
R&D expenditures to the expected market value.
|
The VC dummy takes a value of one (zero otherwise) if the IPO
is backed by venture capital. Ln(1 + age) is the natural log of 1 plus the
years since the firm's founding date as of the IPO. The Ln(assets) is the
natural logarithm of the pre-issue book value of assets expressed in millions
$. Ln(sales) is the natural log of the firm sales a year prior the offering,
expressed in millions $. Firm profitability is the ratio of Pre-IPO EBITDA to
total assets value.
|
ROA is the ratio of Pre-IPO net income to total assets value.
The issue risk is a tech dummy takes a value of one (zero otherwise) if the
firm is in the technology business. Insiders' ownership and blockholders
ownership are proxies to ownership structure and issuer bargaining power.AAII
and II bullish bearish Ratios are the % of bullish investors divided by the %
of bearish investors. Time dummy takes a value of one (zero otherwise) if the
IPO occurred after July 2007. The t-statistics are calculated using White's
(1980) heteroskedasticity-consistent method.
|
Dependent Variable: UNDERPRICING
|
|
|
|
|
Method: Least Squares
|
|
|
|
|
Sample (adjusted): 1 214 Included observations: 117 after
adjustments
|
|
|
|
White Heteroskedasticity-Consistent Standard Errors &
Covariance
|
|
|
|
|
|
|
|
|
|
Variable
|
Coefficient
|
Std. Error
|
t-Statistic
|
Prob.
|
C
|
0.292331
|
0.166898
|
1.75155
|
0.0829
|
UNDERWRITER REPUTATION
|
0.093909
|
0.069317
|
1.354779
|
0.1785
|
OVERHANG RATIO
|
-0.000488
|
0.000221
|
-2.205774
|
0.0297
|
R D INTENSITY
|
-2.946844
|
0.867721
|
-3.396074
|
0.001
|
VC BACKED DUMMY
|
0.029582
|
0.057948
|
0.510493
|
0.6108
|
FIRM AGE
|
0.010542
|
0.030908
|
0.341071
|
0.7338
|
FIRM SIZE LN ASSETS
|
-0.02194
|
0.02136
|
-1.027144
|
0.3068
|
FIRM SIZE LN SALES
|
-0.000269
|
0.009324
|
-0.028826
|
0.9771
|
FIRM PROFITABILITY
|
-0.034211
|
0.049397
|
-0.692579
|
0.4902
|
ROA
|
0.017825
|
0.051876
|
0.343617
|
0.7318
|
ISSUE RISK TECH DUMMY
|
-0.004296
|
0.0414
|
-0.103774
|
0.9176
|
INSIDERS OWNERSHIP
|
-0.177436
|
0.082075
|
-2.161876
|
0.033
|
BLOCKHOLDERS OWNERSHIP
|
-0.137413
|
0.09812
|
-1.400456
|
0.1644
|
AAII BULL BEAR RATIO
|
0.098838
|
0.04782
|
2.066853
|
0.0413
|
INVI BULL BEAR RATIO
|
0.034061
|
0.039904
|
0.853586
|
0.3954
|
TIME DUMMY
|
0.147677
|
0.053652
|
2.752493
|
0.007
|
R-squared
|
0.283352
|
Mean dependent var
|
0.295424
|
Adjusted R-squared
|
0.176919
|
S.D. dependent var
|
0.234851
|
S.E. of regression
|
0.213066
|
Akaike info criterion
|
-0.127981
|
Sum squared resid
|
4.585098
|
Schwarz criterion
|
0.249752
|
Log likelihood
|
23.48689
|
Hannan-Quinn criter.
|
0.025374
|
F-statistic
|
2.662259
|
Durbin-Watson stat
|
2.364719
|
Prob(F-statistic)
|
0.001935
|
|
|
|
CONCLUSION
T
he first and the most important observation in the IPO market
comes back to the early writers that have been interested in IPO market,
notably Stoll and Curley (1970), Logue (1973), Reilly (1973) and Ibbotson
(1975), who documented that when companies go public, the price of shares they
sell tends to jump substantially on the first day of trading and the first day
closing price is systematically higher than the issue price at which the public
offering was introduced in the market. This phenomenon is called
«underpricing» from the issuer's point of view, he thinks that he has
not correctly valued the IPO shares. He underpriced the real value of the
shares of his company, it is money left on the IPO table which could have been
raised if the offer price had been set at an appropriate and higher level.
IPOs exhibit positive first day returns on average with no
exception to the period and date of going public, to the country and to the
industry to which the IPO belongs. Underpricing is a persistent anomaly
characterizing the short run IPO market behaviour. It is a puzzle to
resolve.
Underpricing anomaly has intrigued academics and practitioners
over the past three decades and has generated considerable research which
provided numerous analytical advances and empirical insights aimed at
explaining this short run phenomenon.
The list of explanations that were advanced is very long, but
it can be classified in three main categories:
Ø Theories and explanations based on the informational
asymmetry between the key parties of an IPO.
Ø Theories asserting the informational transparency and
lucidity and the IPO market efficiency.
Ø Behavioral explanations based on the importance of
investors' sentiment as a primary driver to underpricing and to first day
returns.
Concerning the theories asserting the informational asymmetry,
we can begin by the fact that issuers are more informed than the other parties,
and then we find the theory of signalling based on the importance of the
issuing firm quality. Issuers are the most informed about the true value and
quality of their firms, and the high quality issuers may attempt to signal this
quality and value and to distinguish themselves from the pool of low quality
issuers. They may voluntarily sell their shares at a lower price than the
market beliefs to signal their high quality. They leave deliberately money on
the IPO table to deter lower quality issuers from imitating. However, another
conduct can be observed, high quality issuer may bargain harder for higher
offer price since he believes in the quality of his firm and its true value
conducting lower level of underpricing.
The most important proxies of firm quality used in almost
studies and researches to verify the relevance of the relation between firm
quality and underpricing are:
R&D Intensity, Overhang Ratio, Venture Capital Backing as
a dummy variable, Underwriter reputation,... The result found in almost studies
is a positive and significant relation between firm quality and underpricing:
Higher firm quality issuers do not bargain for higher offer prices to signal
the quality of their firms and to deter lower quality firms from imitating and
then a higher level of underpricing is observed at the first day of trading.
And the explanations for not requiring high offer prices vary from believing in
high returns on future SEO, to increasing the probability of a full
subscription of the first offering, this is dependant on issuers' beliefs and
future strategies.
As I said the relation between firm quality and underpricing
can be negative, high quality issuers bargain for higher offer prices and then
a low level of underpricing is observed at the end of the first day of trading.
However, some researchers also find this relation insignificant.
Other explanations were advanced going in the same direction
of informational asymmetry but asserting investors as the most informed party
of an IPO. We find the «Information Revelation Theory» in which
underpricing is compensation for revealing private information and interest
indications, the Winner's Curse explanation (Rock 1986) assuming an imbalance
of information between the potential investors themselves and the importance of
underpricing to encourage the best informed investors to participate in an
unattractive offering, and the agency conflicts between underwriter and issuing
firm.
The second category of explanations is assuming the
informational transparency and lucidity between the key parties and the IPO
market efficiency, and then underpricing phenomenon can be explained by the
characteristics of the offering: risk, issue size, or issuer bargaining
power.
Riskier issuing firms can not require high offer prices and
high underpricing is then observed. Risk can be proxied by issuing firm age,
issuing firm size (Ln(assets), Ln(sales)), or by the business and the activity
sector of the firm. Besides, Bartov, Mohanram and Seethamraju (2003) report
that a dummy variable for risky IPOs has no effect on the setting of the final
offer price and that is no correlation between risk and underpricing.
Issue size is also an important determinant: when the issue
size is large, the issue price should reflect the greater difficulty of selling
the shares in the aftermarket, and then the issue price should be lower leading
to higher level of underpricing. The relation can be seen of another side,
sizable issue is less risky and issuer can request higher offer price.
Issuer bargaining power can also be an explanation to this
short run anomaly. Issuing firms with concentrated ownership structure and so
with high bargaining power require high offer prices for their issues
conducting lower underpricing.
Some researches were advanced and based on other explanations
of underpricing by lawsuit avoidance, underpricing as a substitute of Marketing
expenditures, or by favourable market conditions.
The third category of explanations is the most important and
promising area of research, since all the «traditional» theories
advanced earlier are unlikely to clarify and to give a relevant, a reliable and
a convincing explanation to the underpricing anomaly, mainly after the
surprisingly and severe level of underpricing of the dot-com bubble. Turning to
behavioral approach and to investors' sentiment seems to be a necessity to
clarify the mystery of underpricing. Behavioral approach and investor sentiment
is not a new field, the investor sentiment was introduced earlier in the 1990's
by Welch who presented the Informational Cascade theory. However, this approach
has attracted more attention, has intrigued more and more researchers and has
taken all its impetus in this decade. Many researchers tried to introduce this
behavioral approach to explain the short run IPO anomaly and the research
effort is continuing.
Informational Cascade Theory (Welch 1992) assumes that issuers
should succeed the first sales and should underprice to induce the first few
potential buyers and later induce a cascade: bandwagon effects. All subsequent
investors want to buy irrespective of their own information, they will imitate
the first potential investors. Then we find, Loughran and Ritter (2002) who try
to apply the prospect theory of Kahneman and Tversky (1979) to IPO market to
argue that issuers are more tolerant of excessive underpricing if they
simultaneously learn about an aftermarket valuation that is higher than
expected.
But, we can say that the importance of investor sentiment was
introduced and analyzed in the context of the underpricing phenomenon for the
first time by Ljungqvist, Nanda and Singh (2004) in their article «Hot
markets, Investor sentiment and IPO pricing».
Many researchers try to value the investors' sentiment to
study its impact on underpricing and to verify the significance of the relation
between underpricing and investors' sentiment. The list of
proxies used by researchers to value investor sentiment is very long. I present
the most important: grey market prices, market conditions, demand submitted by
individual investors and discounts on closed-end funds. And the main result is
that high investors' sentiment induces high underpricing. The optimism and
enthusiasm of investors is positively related to first day returns and to
underpricing.
In the third section of this work, I regroup the most
important explanations that have been advanced in the same model to determine
which of these explanations characterizes best a sample of 217 U.S IPOs for
2006 and 2007. In the context of a unified framework and model, I present the
three theories: asymmetric, symmetric and behavioral approach. I use many
variables as proxies for the same theory and I even introduce some variables
found insignificant in earlier studies to verify the relevance of earlier
results for this sample. I also distinguish between the individual investors'
sentiment and the institutional investors' sentiment and I use a direct measure
of sentiment. In the model, I use 15 explanatory variables: Underwriter
Reputation, Overhang Ratio, R&D Intensity and VC Backing used to measure
the informational asymmetry and exactly are proxies for the firm quality. Age,
Firm Size, Firm Profitability, ROA and Issue Risk are measures of risk.
Insiders' Ownership and Blockholders' Ownership are proxies for issuer
bargaining power. Individual and Institutional Bullish Bearish Ratios are
measures of investors' sentiment. Finally, Time Dummy is a control variable to
verify the impact of the beginning of the financial crisis on IPO
underpricing.
The negative and significant coefficient of insiders'
ownership is consistent with the hypothesis that issue firms with high
bargaining power request higher offer prices conducting lower degree of
underpricing. The positive and significant coefficient of Individual bullish
bearish ratio is consistent with the hypothesis that investors with high and
optimistic sentiment are willing to pay higher prices to acquire the IPO shares
leading to higher underpricing. The positive and significant coefficient of
Time dummy presents the positive relation between underpricing and the
beginning of the financial crisis which has an impact on the IPO first day
returns. The negative and significant coefficients of overhang ratio and
R&D intensity (both are measures of firm quality) can be explained by the
fact that high quality issue firms request higher offer prices for their IPOs
conducting lower level of underpricing. And the lack of significance of the 6
measures of risk and of the VC backing is consistent with the findings of many
researchers.
Finally, the positive and significant coefficient of
individual investors' sentiment and the positive but insignificant coefficient
of institutional investors' sentiment lead to an important finding: Individual
investors are those driving the first day closing prices and then underpricing
anomaly and are more conducting the short run IPO puzzle than the institutional
investors.
Underpricing phenomenon can be explained by the informational
asymmetry theories based on issuer as the best informed party of an IPO about
its firm quality (a negative relation), by issuer bargaining power (a negative
relation) and by the importance of the individual investors' sentiment: the
higher the individual investors' optimism, the higher are the first day closing
prices and the higher are the first day returns and Underpricing anomaly.
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