Empirical Evidence on IPO-Underpricing E-Book

Marius Hamer

• Herausgeber: GRIN Verlag
• Sprache: Englisch

Veröffentlichungsjahr: 2007

Beschreibung

Diploma Thesis from the year 2007 in the subject Business economics - Investment and Finance, grade: 1,3, European Business School - International University Schloß Reichartshausen Oestrich-Winkel, language: English, abstract: This paper aims at establishing a link between the average level of initial return of IPO shares, existing underpricing explanations and the dot-com bubble. In years prior to the boom of the new economy, underpricing was explained by various theories, which have extensively been developed since decades. However, in the years 1998 to 2001 IPOs were overly underpriced, leading to assumptions about behavioural aspects and investor irrationality. Analysing a comprehensive dataset of 371 IPOs on the Frankfurter Börse between 1997 and 2007, this paper aims at providing evidence that the observed lower levels of initial returns in recent years can indeed be aligned with existing theories on the basis of rational behaviour of market participants. Firstly, the IPO process and its major participants will be presented followed by a review of relevant studies on the IPO phenomenon. In the next step, established underpricing theories are recapitulated. A descriptive analysis of the data sample points out the particularities concerning the company and transaction characteristics of the sample firms. In a last step, a regression analysis relates various proxies for information asymmetry to established underpricing theories. It gives reason to believe that the irrationality at the turn of the century has vanished and that underpricing can again be explained by established theories.

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Table of Contents

LISTOFTABLES

LISTOFABBREVIATIONS

1 INTRODUCTION

2 INITIALPUBLICOFFERINGS

2.1 The IPO Process

2.1.1 Institutions and Roles in IPOs

2.1.2 IPO Transactions

2.1.3 International Equity Issuing Conditions

2.2 Empirical Evidence on IPO-Underpricing

2.2.1 Definition of IPO-Underpricing

2.2.2 Evidence on Underpricing and Country Differences

2.2.3 Long-Term IPO Performance Studies

3 THEORIESEXPLAININGIPO-UNDERPRICING

3.1 Institutional Explanations

3.1.1 Reduction of Legal Liability

3.1.2 Analyst Compensation Theory

3.1.3 Banking Relationships

3.2 Models based on Ownership and Control

3.2.1 Reduced Monitoring Theory

3.2.2 Increased Monitoring Theory

3.3 Models based on Information Asymmetry

3.3.1 Information Asymmetry between Issuer and Investor

3.3.2 Information Asymmetry between Investor Groups

3.3.3 Information Asymmetry between Underwriter and Investor

3.4 Theories related to Individual Rent-Seeking Behaviour

3.4.1 Underpricing to the Benefit of the Management

3.4.2 Underpricing to the Benefit of the Underwriter

4 THEMODEL

4.1 Sample Description

4.1.1 Investigation of Data

4.1.2 Descriptive Characteristics of Sample Firms

4.2 The Regression Model

4.3 Results of the Regression Analysis

4.4 Interpretation of Regression Results

4.5 Alternative Interpretation

5 CONCLUSION

LISTOFAPPENDICES

LISTOFREFERENCES

ABSTRACT:

 

List of Tables

Table 1: Derivation of sample size

Table 2: Industry distribution of sample firms

Table 3: Company characteristics

Table 4: Transaction characteristics

Table 5: Underpricing for different time periods

Table 6: Weekly breakdown of underpricing, closing spread and turnover values

Table 7: Explanatory variables and assumed relation to underpricing

Table 8: Regression results

 

List of Abbreviations

1 Introduction

Objective of the paper

The decision to go public marks a milestone in the life of a company. Its implications for the firm are manifold, as it provides access to public equity capital, enables existing shareholders to diversify their investments and raises the level of public attention. However, the company also becomes obligated to conform to certain transparency standards and disclosure requirements, which impose a challenge on the management.{1} Most companies entering the equity market do so via an initial public offering (IPO), wherein the valuation of the newly issued shares has been subject to academic debate for decades.{2} Researchers empirically discovered that offer prices tend to be undervalued, resulting in a price jump on the first day of trading.{3} This phenomenon, termed IPO-underpricing, is consistently observable across countries and time periods, but with varying magnitudes.{4} Underpricing reached a peak during the years 1998 to 2001, commonly known as the dot-com period.{5} Seemingly, underpricing comes as a cost to existing shareholders, because it fundamentally dilutes the value of the pre-IPO shares. Based on the supposition that this is not a favourable outcome for these shareholders, the search for a satisfactory answer to this apparent incongruity has led to a broad array of theories explaining its occurrence.

This paper has the objective to relate the most well-established theories to an empirical analysis performed on the German IPO market with the intention to obtain a greater understanding for the motives of underpricing in Germany. In doing this, it outlines empirical findings on underpricing and performs a thorough literature review on the different approaches explaining these observations. With those findings, it builds a regression model based on a comprehensive dataset of IPOs in Germany and tests theoretical models based on two forms of information asymmetry. In addition, this paper provides an alternative explanation based on behavioural patterns of market participants during the turn of the century, which seems to be applicable for this period.

Organisation of the paper

The paper starts with outlining the essential steps in an IPO process and describes the functions and motives of its participants. A comparison of international equity issuing regulations and practices helps the reader to determine in how far underpricing observations can be compared across countries. Next, the term underpricing is defined, and evidence on underpricing across countries and time periods is compiled. In order to distinguish between the concepts of underpricing and overvaluation, the results of various long-term IPO performance studies are investigated and placed into the context.

In the following step, different theories explaining IPO-underpricing are presented to the reader. The theories are clustered into four groups which differ in their underlying fundamental assumptions. All of them strictly refer to rational behaviour of the IPO participants. Note that it is not attempted to take account of all underpricing theories, as this would exceed the scope of this paper.

Subsequent to this academic section, a data sample of 371 IPOs on the Frankfurter Börse is analysed with reference to its company and transaction characteristics, especially to the level of underpricing. This data is then used in a regression analysis, relating information asymmetry-based underpricing explanations to the findings in the sample transactions. The regression is tested for consistency by various statistical measures and the results are described.

In its last section, the paper links the findings of the regression analysis to the previously described underpricing theories and interprets the results. Because initial returns of IPOs at the turn of the century exhibit rather peculiar patterns, alternative explanations referring to the area of behavioural finance are given.

 

2 Initial Public Offerings

In going public, an issuing firm undergoes a rather complex process which must meet the requirements and expectancies of the capital markets, and at the same time maximise the desired benefits for the issuer. However, the listing process is associated with several risk factors, which must be evaluated before the IPO initialisation. In the following, the IPO process is be presented with respect to its major participants and country particularities. Then, the underpricing phenomenon is described and put into a temporal and cross-country context.

2.1 The IPO Process

2.1.1 Institutions and Roles in IPOs

Issuing company

An initial public offering, also named primary offering, describes the first issuance of stock for public sale of a private company. {6} Prior to an IPO, the issuing firm has to comply with explicit listing regulations such as legal and formal requirements set by the respective stock exchange authority. In addition, market participants expect non-explicit qualities like the comprehensibility of the equity story as well as a clear organizational and ownership structure.{7}

An IPO has certain implications for the issuing firm, which can be grouped into financial and non-financial aspects. Empirical studies have shown that the main financial reason to go public is to strengthen the equity base with the purpose of financing company growth. In many cases, this is a prerequisite for higher future leverage. A second financial benefit in going public is in enabling the company to make use of capital market instruments like corporate bonds and to potentiate restructuring measures like Spin-Offs or Equity Carve-Outs. Noteworthy with reference to non-financial benefits is the increased public exposure, which yields positive effects on the company’s attractiveness to its employees, customers and suppliers.{8}

 Besides mentioned benefits, going public bears disadvantages and sources of risk: augmented disclosure requirements, one-time costs (provisions and marketing costs) as well as recurring costs (preparation of shareholder documents and organization of meetings) are the most relevant drawbacks. These costs can make up to 10% of the whole issue volume.{9}

Investment bank

The main task of an investment bank in an IPO transaction is the development and execution of the issuing strategy.{10} In its intermediary role, the bank communicates between the investor community and the issuer, merging both parties’ interests. Besides the generation of information about investor demand, it consults the company management in aspects about the preparation of the IPO, elects consortium banks and actively manages the entire offering process.{11} Concerning the internal bank structure, the Equity Capital Market Division (ECM) is responsible for the fundamental pricing and placement of the shares as it is in close contact to institutional and large private investors. The Research Division closely monitors the market and must therefore also be integrated into the IPO process.{12}

Investors

For the investment bank, the selection and analysis of potential investor groups is essential, as investor demand ultimately determines the success or failure of the offering. The specific risk-return relationship of the respective share needs to be evaluated and matched to the proper investor segment.