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.
| 
