The role of underwriter and auditor reputation in the pricing of IPOs: evidence from London Stock Exchange, AIM Market

Askhat Azhikhanov

PhD student, Institute of Economics and Business,

Kazakh State Technical University Satpayev K.I. (Almaty, Kazakhstan),

e-mail: Askhat@ababank.com

Tel: + 855 23225333 (office), + 855 98890777 (mobile), +855 23216333 (fax)

Abstract

The primary objective of this research is to examine the role and impact of underwriter and auditor reputation on the IPO underpricing. The study finds that prestigious underwriters and auditors have significant negative impact on the underpricing of IPOs. In all three samples the results report that IPOs backed by prestigious underwriters and auditors are less underpriced than IPOs that taken to the market by non-prestigious underwriters and auditors. Overall, the findings of this paper provide strong support to the classical theories of IPO underpricing based on information asymmetry, specifically Rock’s (1986) winner’s curse model, which was taken as a basic model for this research.

Key words: underwriter and auditor reputation, stock market, initial offering, IPO, under pricing, foreign IPOs, asymmetric information.

Background

The underpricing of initial public offerings has been the subject of intensive theoretical and empirical research and yet still represents a puzzle. This puzzle of IPOs underpricing have been explained by a numerous theoretical studies over the last two decades that can be classified into four broad categories: asymmetric information model, institutional explanations, behavioral explanations, ownership and control approach. This paper based on the asymmetric information model, which suggests that IPOs with higher degree of information uncertainty are more underpriced. The various authors suggest that one way to reduce information uncertainty is to hire a prestigious underwriter or a reputable auditor. Booth and Smith (1986), Beatty and Ritter (1986), Carter and Manaster (1990), Titman and Trueman (1986), among others, argue that prestigious underwriters and auditors associated with lower risk. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters and auditors have a significant negative impact on the underpricing of IPOs.

However, the empirical findings on this theory are mixed. For example, Johnson and Miller (1988) find no relation between IPO underpricing and underwriter reputation. Moreover, Beatty and Welch (1996), using the sample of 823 firm-commitment offerings between 1992 and 1994, documented that the sign of the relation has even changed since the 1980s from negative to positive. Loughran and Ritter (2004) confirm the same result for the later period. For example, the average initial returns of IPOs done by “low prestige” underwriters was 9 % (1980-1989), 13% (1990-1998), and 35% (1999-2000), whereas the underpricing on IPOs done by “high prestige” underwriters was 5%, 16% and 72%, respectively. Loughran and Ritter explain this shift by the fact that underwriters have started to deliberately underprice the offers to their own advantage. As underwriters got bigger since the 1980s and gained market share, prestigious underwriters chose to not charge higher direct fees, but to charge higher indirect fees by leaving more money on the table. Another explanation is that prestigious underwriters relaxed their standards and took public an increasing number of very young, unprofitable companies. Thereby shift into riskier deals especially during the internet bubble period.

The brief review of the related literature leads me to conclude that empirical support of the asymmetric information theory and role of underwriter and auditor reputation are mixed and controversial. Thus detailed empirical analysis of the role of underwriter and auditor reputation in the pricing of IPOs is very important.

The main argument (hypothesis) of this paper is that IPOs with prestige underwriters and reputable auditors are less underpriced than ordinary IPOs due to the fact that prestigious underwriters and auditors associated with lower risk and reduce the level of information uncertainty.

Research design and implementation

Data and sample selection

To investigate the role and impact of underwriter and auditor reputation on the IPO underpricing I analyzed all companies that have been listed on the AIM market since its incorporation in June 1995 to 31 June 2006. The initial list of companies was obtained from the London Stock Exchange Official Statistics (AIM New Issues file) and consisted of 2 471 companies. In order to avoid survivorship bias delisted companies were also included in the sample. From the entire sample of the new issues, re-admissions and introductions from the Main Market were excluded. In addition, all financial companies were also eliminated from the sample, because their unique characteristics make them incomparable with other IPOs. The companies that already cross-listed on other markets before they started to list on the AIM market were also excluded from the sample, except companies that simultaneously went public in the AIM Market and other capital markets for the first time. Finally, in order to avoid discrepancy in the model I eliminated from the sample extreme observations with abnormally high initial returns relative to the average initial return of the sample (24 companies or 2.6% of the entire sample). The companies were eliminated from the sample had the abnormal initial return that at least three standard deviations above the average initial return of the sample and were mainly high-tech companies that went public during the internet bubble period (1999-2000). The final sample consisted of 906 IPOs, of which 774 domestic based IPOs and 132 foreign based IPOs.

Methodology

Both univariate and regression analysis were used to investigate the role of of underwriter and auditor reputation in the pricing of IPOs. For both models identical factors/variables were used that defined as follows:

RETURN – dependent variable, measured by IPO raw initial return, which was derived from the following formula: RETURN = , where P₀ is the initial offering price and P₁ is the first day closing price. The market adjusted initial return was also calculated in this research in order to analyze the impact of the general market fluctuation on the IPO initial return. However, taking into account that there was no significant difference between adjusted and raw initial return, the latter was used in this paper.

FOREIGN – dummy variable, measured by value 1 if the IPO is foreign based and value 0 indicating domestic based IPOs. The foreign companies were identified by the country of legal registration, according to the classification used by the London Stock Exchange.

UW_REP – dummy variable, measured by 1 if the IPO was underwritten by high prestige underwriter and 0 by low prestige underwriter. The high prestige underwriter was defined according to the ranking scale of underwriter reputation developed by Carter and Manaster (1990) and further updated by Loughran and Ritter (2004).

AUDIT_Q - dummy variable, measured by 1 if the IPO was audited by high quality auditor and 0 by low quality auditor. Since overwhelming empirical evidence suggest that Big 5 audit companies are more independent and provide audits of high quality (e.g. DeAngelo (1981), Colbert and Murray (1998), and others), high quality auditors in this research include only Big 5 audit companies. The IPOs that were audited by Arthur Andersen& Co. in the end of 2000 and 2001 were given value of 0.

Using dependent and independent variables identified above the following regression model was build to test some of the proxies of information asymmetry along with the FOREIGN variable:

RETURN = a + b₁ FOREIGN + b₂ UW_REP + b₃ AUDIT_Q + εi

To make the model statistically adequate the regression was tested for all diagnostic tests including heteroscedasticity (White test), autocorrelation (Durbin-Watson test), multicollinearity, and normality test. The model has passed all tests apart from the normality test. Therefore, extra dummy variable “ERROR” was include in the regression to remove extreme residuals and improve “normality” of the regression model.

Empirical results and analysis

Univariate Analysis

The results, contained in Table 1, show the difference between underpricing of foreign and domestic IPOs adjusted to the underwriter and auditor reputation factors. Although the empirical studies about the role of underwriter and auditor reputation is mixed, the results of this research consistent with studies by Booth and Smith (1986), Beatty and Ritter (1986), Carter and Manaster (1990), Titman and Trueman (1986), and others, who argues that prestigious underwriters and auditors have significant negative impact on the underpricing of IPOs. In all three samples the results report that IPOs backed by prestigious underwriters and auditors are less underpriced than IPOs that taken to the market by non-prestigious underwriters and auditors.

	Table 1: Comparative statistics adjusted to the underwriter and auditor reputation factors
		Foreign IPOs		Domestic IPOs		t-statistics ^b	Total Sample
		№	Return	№	Return		№	Return
	Panel A: UNDERWRITER PRESTIGE (Total sample)
	High	9	4.41%	12	1.41%	0.74	21	2.69%
	Low	123	11.74%	762	10.89%	0.52	885	11.01%
	t-statistics ^a		-2.06*		-3.84*			-4.1*
Panel A1: Matched by size sample
	High	9	4.41%	7	-2.78%	1.62
	Low	120	11.98%	122	7.10%	1.96**
	Panel B: AUDITOR QUALITY (Total sample)
	High	52	7.72%	233	9.84%	-0.96	286	9.44%
	Low	79	13.62%	526	11.41%	1.04	605	11.70%
	t-statistics ^a		-2,21*		-1.05			-1.71**
Panel B1: Matched by size sample
	High	51	7.85%	51	2.98%	1.49
	Low	78	13.81%	78	8.90%	1.51
	^a The null hypothesis is that the mean of returns between HIGH and LOW are not different from each other.
	^bThe null hypothesis is that the mean of returns between foreign and domestic IPOs are not different from each other.
	* Significant at 5% level, ** at 10% level.

In terms of comparative analysis of the foreign and domestic based IPOs grouped by prestige and non-prestige underwriters the evidence reveals that foreign IPOs with prestigious underwriters have the mean initial return (4,41%) compared to the (1,41%) return of domestic IPOs backed by similar reputable underwriters. Although this difference is not statistically significant, it presents economically significant results and consistent with the Hypothesis I of this paper. This argument also proved within the sample matched by size (Panel A1). Similar results were obtained with auditor quality factor (Panel B1).

Multivariate Analysis

The objective of multivariate analysis is to examine the relationship between the level of underpricing and underwriter / auditor reputation. The results of this regression model are reported in Table 2.

Consistent with the univariate analysis the dummy variable for the underwriter reputation are negatively and significantly associated with underpricing. These findings provide further evidence for results of univariate analysis, which states that IPOs with high-prestige underwriters are likely to be less underpriced than ordinary IPOs.

Table 2: Results of the Regression Model
	Regressions 1		Regressions 2
	Coefficient	t-statistic	Coefficient	t-statistic
Intercept	0.1943	6.51*	0.1938	6.41*
FOREIGN	0.0303	1.89***	0.0367	2.22**
UW_REP	-0.0507	-2.24**	-0.0590	-2.70*
AUDIT_Q	0.0052	0.40	0.0125	0.96
№ obs.	887		887
Adjusted R ^2	0.204		0.157
F-statistic	23.26*		28.10*
* Significant at 1% level, ** at 5% level, *** at 10% level.

To summarize, the regression coefficients are generally consistent with the univariate results reported in the table 1, support the main hypotheses of this paper, and statistically significant. Apart from the t-statistic, the F-statistic was also used to test the joint importance of all variables and shows statistical significance at the 1% level.

Finally, finds that IPOs with prestige underwriters and reputable auditors are less underpriced than ordinary IPOs due to the fact that prestigious underwriters and auditors associated with lower risk and reduce the level of information uncertainty.

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Official Reports, articles and sites:

· London Stock Exchange Official Statistics, June 2006.

· www.londonstockexchange.com

Databases: Datastream; Bloomberg; Perfect Filing