Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
Many empirical researches examining IPO allocations focus on the distinction between types of investors: institutional investors and individual or retail investors.
Institutional investors are different from retail investors, in that institutions are better informed and more important clients. The evidence to date suggests that where bookbuilding is used, institutional investors receive preferential allocations. They are favoured by underwriters in the IPO allocations compared to retail investors who are uninformed and not very important clients since they do not buy many shares. Using U.S. data, Hanley and Wilhelm (1995) and Aggarwal, Prabhala, and Puri (2002) find that institutions are favoured, as do Cornelli and Goldreich (2001) using U.K. data. Cornelli and Goldreich (2001) also find that more information-rich requests are favourably rewarded.
Ljungqvist, Nanda and Singh (2003) 14 present a model in which they distinguish between the two types of investors, and they present these definitions:
The retail investors are small, unsophisticated investors who are prone to episodes of optimistic or pessimistic «sentiment» about the stock market, especially IPOs, where sentiment denotes incorrect beliefs about the fundamental value of an asset arising from treating noise as relevant information (Black (1986)).
The second type of investor holds beliefs that correspond to an unbiased estimate of the issuing firm's future prospects. Ljungqvist, Nanda and Singh (2003) regard institutional investors as belonging to this category.
Ritter and Welch (2002) advance that institutions are naturally blockholders, potentially capable of displacing poorly performing management. That is why, this type of investors is favoured in IPO allocations, and they are able to change and to improve the management and the performance of the IPOs in which they invest.
Booth and Chua (1996), Brennan and Franks (1997), Mello and Parsons (1998), and Stoughton and Zechner (1998) all point out that underpricing creates excess demand and thus allows issuers and underwriters to decide to whom to allocate shares. Surely, they will favour the institutional investors for the advantages advanced from which they can take profit. These institutional investors will monitor the IPO firm's management, creating a positive externality.
Supporting the argument of favoured institutional investors in IPO allocations, Ljungqvist, Nanda and Singh (2004), advance another explanation. They show that value to an issuer is maximized by underwriters allocating IPO shares to their regular (institutional) investors for gradual sale to sentiment investors as they arrive in the market over time. Regulars maintain stock prices by holding IPO stocks in inventory and restricting the availability of shares.
Underpricing emerges as fair compensation to the regulars for expected inventory losses arising from the possibility that sentiment demand may cease.
But these advantages such improving the firm's performance and management may not be of primary importance for some companies for corporate control considerations.
14 in their article «Hot markets, Investor sentiment and IPO pricing»
Retaining control for some managers is the primary and the most important objective. When they are obliged to go public, they try to protect their private benefits by favouring the individual investors rather than institutions, since retail investors are not able to buy large volume of IPO shares and they end up holding small parts. The managers seek to avoid allocating large volume of shares for few important investors (institutions), in order to protect the control of the management. Greater ownership dispersion implies that the incumbent managers benefit from a reduced threat of being ousted, because the most important part of the IPO firm still retained by its managers and the other part is dispersed between many retail investors.
Going further in this point of view (control retain), Brennan and Franks (1997) argue that managers deliberately underprice the IPO shares, since underpricing generates excess demand. This gives the managers the opportunity to protect their private benefits by allocating shares strategically when taking their company public, favouring the retail investors and then a greater ownership dispersion. So retaining control can be an explanation for underpricing anomaly for some companies for which managers consider their private benefits in the first place.