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Underpricing of IPOs

Underpricing of IPOs. What is underpricing?. Underpricing: the first trading day closing price typically exceeds the price at which the shares were offered to the investors. Share price. Offer price. t=0. International evidence.

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Underpricing of IPOs

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  1. Underpricing of IPOs

  2. What is underpricing? • Underpricing: the first trading day closing price typically exceeds the price at which the shares were offered to the investors. Share price Offer price t=0

  3. International evidence • The first-day premium that investors experience is positive in virtually every country. • Underpricing averages more than 15% in industrialized countries • Underpricing is much higher in emerging economies. • The difference between industrialized and emerging countries is due to (i) valuation uncertainty and (ii) regulation (e.g. Taiwan, Malaysia)

  4. Consequence: Companies leave large amount of money on the table (sometimes more than $1bn) • In the US, only 15 of the 160 quarters between 1960 and 1999 saw the average company trade below its offer price • Underpricing was very high in 1999-2000 (around 50%) • Predictability of underpricing: • Underpricing varies over time • Underpricing is highly positively autocorrelated overtime

  5. What explains underpricing?

  6. Principal-agent theory • Underwriters are faced with a trade-off. On the one hand, underpricing lowers both the risk of failing to place equity, and their effort in marketing the issue. On the other hand, the fee is proportional to the price. • If the success of an IPO is important enough, the IB chooses underpricing • Issuers, because they delegate the pricing decision to the underwriter, cannot prevent opportunistic behavior

  7. Information revelation theories • Some investors are better informed about the issuing firm’s value. They also know better their demand of shares and the price they are willing to pay. • The key function of underwriters is to elicit information from better informed investors about the firm’s value, especially when the information is positive. Problem: Investors are unwilling to reveal positive information, because doing so would result in a higher offer price and a lower profit. Solution: Underpricing + allocation of more shares to the most aggressive bidders. This induces investors to reveal their information truthfully and bid aggressively.

  8. The winner’s curse problem Illustrative example: • Your firm is considering making a takeover offer for a start-up. The true value (V) of the shares are known with certainty only to the start-up management. • You know that the shares are worth somewhere between £0 and £1000 and each possible value has equal probability. • Synergy: shares would be worth 50% more than their current value to your firm if you successfully acquire the start-up. • The start-up sells to you if you bid more than V, and will turn you down if you bid less than V. • How much do you bid per share? On average the firm is worth 500. • However, if you bid 500, you will only win if V < 500. But, if the firm is worth at most 500, it is worth on average only 250, so you overpaid! Even with the synergies, 250x1.5 = 375 is less than your bid. This is the winner's curse!

  9. Same problem in IPOs for uninformed investors: If an investor overvalues the issue (bids H), he will end up will many shares and makes a loss. If an investor undervalues the issue (bids L), he will face strong competition and end up with only a few shares. • Underpricing implies that investors no longer make losses on average. bids distribution V H L

  10. Institutional explanations Legal liability • Investors can sue underwriters on the ground that material facts were mis-stated or omitted in the IPO prospectus. • Intentional underpricing may act as insurance against such litigation. • Evidence that underpricing reduces (i) the probability of a lawsuit, (ii) the probability of an adverse ruling conditional on a lawsuit, and (iii) the amount of damages awarded in the event of an adverse ruling.

  11. Price support • Underwriters can be required to stabilize trading prices at the offer price, thus minimizing the occurrence of overpricing. This leads to the censoring of the initial return distribution. Evidence: • Underwriters are aggressive buyers in the aftermarket • Initial returns are censored: they are non-normal and peak at zero. There is almost no negative tail. • Over time, underwriters remove price support. The effects of price support are temporary, leading prices to fall as support is withdrawn.

  12. Ownership and control Underpricing help to retain control of the issuing company. • Underpricing ensures that the offer is over-subscribed and that investors will be rationed. • Rationing allows the manager to discriminate between applicants of different sizes and so to reduce the block size of new shareholdings. • Greater ownership dispersion implies that the manager benefits from a reduced threat of being ousted in a hostile takeover. Evidence: Very large applicants are discriminated against in favor of smaller ones.

  13. Stock flipping When an IPO is underpriced, some investors who do not value the company high are allocated shares, while some valuing the company higher do not receive any shares. This demand of the latter causes the price to rise and the former sell their shares, hence trading activity will be high. The trading activity generates income for market making underwriters.

  14. If an issue is overpriced (price=PH), only the high bidders are allocated shares. When trading starts, only few shares are traded. Low trading activity If an issue is underpriced (price=PL), all bidders are allocated shares. When trading starts, those who value the issue high will buy shares from those valuing the issue low. High trading activity Underpricing More trading More income for the market making underwriters. V PH PL

  15. Long-run performance of IPOs Puzzle: The long-run performance of IPOs is negative! Share price t=0

  16. Explanations • Only the most optimistic investors buy the IPOs, and they pay too much for the shares • It seems that many firms go public near the peak of industry-specific fads. Issuers are then able to sell at high price • “Window dressing”: Firms manipulate their accounts before going public Lack of clear theoretical understanding or empirical evidence

  17. Evidence from Bath MSc students • Li-Wen Chen (2006): • 211 IPOs in Taiwan from 2001 to 2005 • Underpricing: 6% • 1-year performance: -9% • Finds that firms that have a lending relationship with their underwriters suffer from more underpricing. • Consistent with conflicts of interest.

  18. Huajing Wang (2007) • 296 IPOs on the Shanghai Stock Exchange from 1992 to 2007 • Underpricing of 127% • Controls for almost 20 explanatory variables • Evidence of the winner's curse • Underpricing higher for young, weakly profitable, and small companies. Consistent with information asymmetry.

  19. Kwanpongsa Dacharux (2006) • 122 IPOs in Thailand from 2001 to 2005 • Underpricing of 20%, decreasing • More underpricing for risky, small, young firms, with a high D/E ratio

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