Review of theoretical and empirical studies of IPO underpricing

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)

Introduction

For the past several decades, there have been a large number of various theoretical and empirical studies on the IPOs motivated mainly by anomalies related to the IPOs, such as initial underpricing, “hot and cold” market phenomenon, and long run under performance. Since the pricing of IPOs has been the subject of intensive theoretical and empirical research, and still remains an unsolved puzzling phenomenon for the financial economists, the broad research area of this paper is underpricing of IPOs.

It is thoroughly documented in the financial literature that for IPOs, on average, shares start to trade below their market value, and earn abnormally high returns at the end of the first trading day. One of the first academic studies reporting this phenomenon is Ibbotson (1975). On a sample of 120 IPOs during 1965-69 he finds an average initial return of 11.4% from the date of issue to the end of the month. This result was also confirmed by additional studies documenting underpricing «anomaly» of IPOs, e.g. Ritter (1984) finds an initial return of 16.3% during the “cold issue” and 48.4% during the “hot issue” for a sample of 1 075 IPOs, Ibbotson, Sindelar and Ritter (1988) find an 16.4% average initial return for a sample of 8 670 IPOs during 1960-87. In addition, during the last two decades the evidence of IPOs underpricing has been found across almost all markets and time periods. For example, Aggarwall, Leal and Hernandez (1993) find that IPOs in Mexico, Brazil and Chile had initial average return about 33%, 78%, and 16%, respectively. Levis (1993), Rydqvist (1993) and Kunz and Aggarwall (1994) report the IPOs underpricing in European countries, such as United Kingdom, Sweden and Switzerland. Loughran and Ritter (2004), as well as Ljungvist and Wilhelm (2002) documented abnormal initial returns of IPOs across different time periods.

These empirical results 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. Since the best established and prominent of these theories is asymmetric information theory, for the most part of this research I mainly review the literature highlighting this theory, which suggests that IPOs with higher degree of information uncertainty are more underpriced.

The winner’s curse theory

Perhaps the most prominent theoretic work dealing with asymmetric information theory is the Rock’s (1986) winner’s curse model, which states that information asymmetry between investors is the cause for the IPOs underpricing. According to Rock, there are two groups of investors: informed who know the true value of the stock and uninformed who invest randomly without any knowledge of the company. Due to this asymmetry, informed investors based on their superior information bid only for “good” IPOs and avoid overpriced IPOs, whereas uninformed investors bid indiscriminately and based only on their expectations. Consequently, this leads to the situation, when uninformed investors end up holding disproportionally large amount of overvalued IPOs and leave the market. Rock claims that issuers intentionally underprice IPOs in order to induce uninformed investors to join the market and compensate for the risk of trading against informed investors. Thus, according to Rock’s analysis companies with greater level of uncertainty are more likely to be underpriced.

The Rock’s model was further tested and empirically supported by various studies that in general coincide with it.

One of the main implications of Rock’s model is that information asymmetry exists among investors and this is the cause of IPOs underpricing. Michaely and Shaw (1994) test this proposition and argue that underpricing should decrease as information becomes less heterogeneous across investors and disappear when all investors possess the same information about the company. They use the sample consists of master limited partnerships (MLPs) IPOs and the sample of “regular” IPOs. The idea behind this selection was that institutional investors, considered as informed investors, largely avoid MLPs and the market knows that. Thus, if retail investors considered as uninformed investors, prior knowledge of the absence of the informed investors would reduces the winner’s curse problem and consequently the need for underpricing. Consistent with this prediction, Michaely and Shaw find that average underpricing among 39 MLPs IPOs completed between 1984 and 1988 is –0.04%, whereas average underpricing among “regular” IPOs over the same time period is 8.5%. These results are consistent with Rock’s (1986) winner’s curse theory.

Another major implication of the Rock’s model is that the uninformed investor should earn the risk-free rate, conditional on the rationing process associated with various issues and ranges of application. This implication has been tested extensively in the context of countries with unbiased allocation market, e.g. markets where all investors applying for the same number of shares have an equal chance of success. Koh and Walter (1989) directly test this implication of Rock’s model analyzing new issues market in Singapore. Using data on 66 new issues made between 1973 and 1987, Koh and Walter documented that the likelihood of receiving an allocation was negatively related to the degree of underpricing, and that average initial returns fall substantially, from 27% to 1%, when adjusted for rationing. Similar studies also conducted by Levis (1990) in the UK, Keloharju (1993) in Finland, Amihud, Hauser, and Kirsh (2003) in Israel. All these studies provided similar evidence that consists with the winner’s curse model.

The final implication of the winner’s curse theory is that underpricing increase with measures of uncertainty associated with IPO valuation. Based on the Rock’s model Beatty and Ritter (1986) tested this proposition. Specifically, using two proxies for ex ante uncertainty they provided empirical evidence of direct and positive relation between the degree of (expected) underpricing and the ex ante uncertainty about the value of an issue. It is worth to mention that, this approach has received an excessive empirical support, and for the most part of my research I apply this hypothesis.

On the other hand, there is a number of studies that contradict to the winner’s curse theory. The problem with Rock’s model is that in the real world it is difficult to clearly separate uninformed investors from informed investors. Even so, the next question is how severe is the allocation bias in practice? (Ljungqvist, 2006). Several studies have considered institutional and retail investors to answer this question. For example, Hanley and Wilhelm (1995), using sample of 38 IPOs offered between 1983 and 1988, reported insignificant difference in the size of allocations received by institutional investors in underpriced and overpriced IPOs. Thereby, this result does not support implication of Rock’s model that informed investors not bid for the overvalued IPOs. On the other hand, Aggarwal, Prabhala, and Puri (2002), using larger sample (174 IPOs) drawn from a more recent period (1997-1998), documented that institutions dominate IPO allocations in the better performing IPOs and tend to earn greater profits on their IPO investments compared to retail investors. According to their study, average institutional allocation in stronger opening IPOs is 76.69% with average earning $27.3 million per issue, which is 2.83 times what retail investors take away from these issues.

Another issue contradicting Rock’s assumption of rational allocation is that IPOs are often over-subscribed and there is no true incentive for issuers and underwriters to price IPOs at a discount in order to attract uninformed investors. Benviste and Spindt (1989) reported that all of the IPOs by firm commitment offering during a five-year period were over-subscribed in the prelisting period. Koh and Walter (1989) also documented substantial level of oversubscription for the Stock Exchange in Singapore (90% of the 70 IPOs examined during the 1973-1987 period). Thus, this issue contradicts to the rationing process of allocation reported by Amihud, Hauser, and Kirsh (2003), Levis (1990), and Keloharju (1993).

Agency-conflict theory

Another theory of IPO underpricing based on the information asymmetry examines the relationship between the investment bank and the issuing company. Baron (1982) using principal-agent theory argues that investment bankers are more informed and have the superior knowledge about the issue than the issuing company. The model also implies that issue delegates the offer price decision to the underwriter. Thus, investment bankers deliberately underprice the issue due to the inability of issuing company to thoroughly monitor the underwriter’s distribution effort results. However, Muscarella and Vetsuypens (1989) find that contrary to the implications of Baron’s model investment banks underprice themselves as much as other IPOs when they go public, even though, there is no monitoring problem. Specifically, using sample of 38 investment banks went public in the period 1970 - 1987, they find that self-marketed offerings are characterized by underpricing about 7%, which is not statistically different from the initial return experienced by the typical IPOs of equivalent size.

Book building theory

The next asymmetric information theory is the book building theory. Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991) argue that pre-marketing and bookbuilding allow underwriters to obtain information from informed investors and set an offer price. During the road show, the underwriters closely monitor the demand for the stock from the potential investors. If there is strong demand, the underwriter will set a higher offer price. However, if potential investors know that showing a willingness to pay a high price will result in a higher offer price, they demand something in return. Thus, underwriters force to deliberately underprice the offer to induce investors to reveal information about their valuations of the new issue. Empirical findings that support this theory reported by Hanley (1993), Lee, Taylor and Walter (1996), Cornelly and Goldreich (2002). On the other hand, this hypothesis may not be always correct. As mentioned before in this paper in reality the IPOs often oversubscribed (Benviste and Spindt (1989), Koh and Walter (1989)), but underwriters still tend to underprice the IPOs. Moreover, this tendency is accelerating over the past decade (discussed in detail further in this paper).

Signaling theory

The final group of asymmetric information models is the signaling model. The basic foundation of this model is that there is an information asymmetry between the issuing companies and the investors. Allen and Faulhaber (1989), Grinblatt and Hwang (1989), and Welch (1989) argue that issuers have superior knowledge about the quality of the company going public than outside investors and deliberately underprice the offer to signal the company’s true value. According to Welch, the basic idea behind of this approach is that the cost of underpricing then recovered in the aftermarket, through seasoned equity offers and only the high quality companies can get the higher price after the true value of the company would be revealed. This is explained by the fact that bad companies cannot afford to underprice their IPOs because the cost of IPO may never be recouped if the true quality of the company would be revealed by investors. The shares would loose the value, making it impossible to issue additional offer. Similarly, Allen and Faulhaber’s model implies that the high quality company signal about the value of the company through its earnings and dividend policy. Thereby, companies with higher degree of underpricing are more likely to have higher dividends (earnings).

However the main problem of these models is the lack of empirical support. Michaely and Shaw (1994) test several empirical implications of the signaling-based models of IPOs underpricing and their results do not support these models. For example, contrary to Welch’s model they find that there is no relationship between initial underpricing and the success of the seasoned equity issue. Prior to the paper of Michaely and Shaw, Jegadeesh, Weinstein, and Welch (1993) also find the weak evidence that companies with higher level of underpricing are more likely to issue seasoned offerings. Similar results documented by Levis (1995) for the UK.

Another section of the literature, which studies the signaling model, focuses on the ownership concentration as one of the signals to the uninformed investors. However, implications and empirical support for this model is mixed. For example, Leland and Pyle (1977) argue that the initial owners have better knowledge about the quality of the company going public than outside investors. But, the outside investors can get the information about the company’s quality by observing the ratio of ownership concentration. A higher ratio would imply the higher quality of the company as owners are reluctant to share the future earnings of the company with outsiders. Based on the model of Leland and Pyle, formal signaling theory were developed by Grinblatt and Hwang (1989), who proposed that initial owners deliberately underprice their offerings to take advantage of selling the retained shares at higher price in the aftermarket. Thereby, their implication was that there is a positive relationship between the IPOs and the retained ratio of insider’s ownership.

On the other hand, Chen and Strange (2004) explain the relationship between underpricing and ownership structure applying corporate control model. Using the sample of 467 companies went public between 1995 and 1998 in China, they find significant negative relationship between the IPO market return and the single largest shareholding. In other words, the greater the proportion of shares held by the largest shareholder, the lower will be the IPO return. This finding contradicts the predictions Grinblatt and Hwang (1989), who maintained that a higher retained shareholding signaled about high quality of the company, and should be associated with greater IPO underpricing.

Studies using proxies for valuation uncertainty

Numerous empirical studies have also tested the information asymmetry theory using various proxies for valuation uncertainty such as age, size, leverage, industry, underwriter reputation, auditor quality, and corporate governance.

Ritter (1984) test the Rock’s model using size and age of the company as a proxy for risk. According to Ritter, these proxies should be as highly correlated with ex ante uncertainty as possible, and influence on the level of underpricing. For example, using the sample of 1 028 companies that went public during 1977-82, Ritter finds that small companies have substantially higher average initial returns (43,7%) than do the larger companies (7.7%). Similar results have been also reported by Megginson and Weiss (1991), Ljungqvist and Wilhelm (2003), and others.

Benveniste, Busaba, and Wilhelm (2002) and Benveniste, Ljungqvist, Wilhelm and Yu (2003) argue that the factor common to all firms within a particular industry is one of the sources of uncertainty. Specifically, they find that IPOs of companies from “nascent industries” (pharmaceuticals, computing, electronics, medical, etc.) have higher average initial return than IPOs of companies from “mature industries”.

James and Wier (1990) point out that the companies with high level of pre-IPO leverage are less underpriced based on the assumption that only high value firms apply for and are granted debt. However, Su (2004) finds the results indicating that underpricing is positively related to pre-IPO leverage ratios. He argues that companies with high leverage are more risky and associated with higher degree of uncertainty than companies with low leverage.

The various authors also suggest that another way to reduce the ex ante 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.

Summary

The review of the related literature leads me to conclude that empirical support of the asymmetric information theory is mixed and controversial, despite that this theory is the best established and most popular among financial economists. Moreover, Ritter in the latest studies has started to argue that nowadays theories based on asymmetric information are unlikely to explain the underpricing phenomenon. According to Ritter, future explanations will need to concentrate on agency conflicts and share allocation issues on one hand and behavioral explanations on the other hand. On the other hand, to present day models of underpricing based on the asymmetric information theory are the best established and almost all models imply that there is a positive relationship between underpricing and the degree of asymmetric information. Among these models, the winner’s curse theory that implies that underpricing increase with measures of ex ante uncertainty has received overwhelming empirical support.

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