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Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing

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par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010

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I-2\ The explanatory variables:

In this paragraph, I try to justify the use of these determinants and explanatory variables in the model for each theory and to present briefly the previous results reached by researchers that used the same indicators and control variables in their models.

I-2-1\ Informational Asymmetry Theory:

* The theory of signalling: Firm quality

The issuer is the most and best informed party about the issuing firm quality. There are many proxies of firm quality that can be employed . I introduce the most important ones often used by researchers:

Ø The Overhang ratio = Pre-IPO shares retained by insiders/Public Float

The percentage ownership retained by insiders serves as a signal for firm quality, and two different relations are observed between firm quality and underpricing with two different explanations. The first relation is that, for high overhang ratio and so for high quality issues, the issue price is lower a mean to demonstrate their quality and to distinguish themselves from the pool of low quality issuers, then a higher level of underpricing is observed. In the same direction, we can justify the use of overhang ratio and its importance to underpricing phenomenon by the fact that only the shares sold to the public in the IPO are undervalued. The shares retained by insiders are valued at market. Thus, for a given degree of underpricing, the economic cost per retained share (the dilution) declines as overhang rises. Because the cost of underpricing to the issuer declines as overhang rises, it is natural to conjecture that firms with greater overhang will have greater underpricing and we find the same positive relation between overhang ratio and underpricing.

The second relation is completely different in that issuing firm quality is negatively correlated with underpricing. Issuers with high quality firms bargain for higher offer prices for their IPOs and then a lower degree of underpricing is observed at the first day of trading.

Ø The R&D intensity = Pre-IPO R&D expenditures/expected market value after IPO

R&D expenditures are the intangible investment most extensively researched in economics, accounting and finance, they have to be disclosed in the corporate financial reports. R&D contributes to information asymmetry and Guo, Lev and Shi (2006) consider R&D activities as the major source of asymmetry. Pre-IPO R&D intensity of the issuer is strongly and positively related to the first day underpricing. R&D-intensive firms are often undervalued by investors. That is why R&D intensive issuers can not set a high offer price for their IPO. Besides, they are more willing to forgo money on the IPO table than are no R&D issuers, because they expect to recoup money left on the table by subsequent issues of seasoned stocks when the market realizes over time the positive outcomes of their R&D. So the relation between R&D intensity and underpricing is positive but many studies find no relation between underpricing and SEO, which refute the last point of recouping money left on the table by SEO in the future.

Another relation can be found between R&D intensity and underpricing, mainly since no relation between underpricing and SEO: R&D intensive issuers believing in the high quality of their firms and in the importance of their R&D and its positive outcomes in the recent future require high offer prices for their IPOs which induces a negative relation between R&D intensity and underpricing.

Ø Venture Capital backed: a dummy variable taking the value of one if the issue firm is backed by a venture capital and zero otherwise.

Since venture capitalists have expertise in particular industries, they are expected to make superior investments relative to other investors. In essence, VCs certify the quality of an IPO and their presence signals that asymmetric information is relatively low for this issue and that the issuing firm quality is high. So, issuers can bargain for a high offer price which declines underpricing. Another explanation is found, that VC backed firms face larger underpricing, since high quality issuers will continue demonstrating the firm quality by throwing money on the IPO table and not requiring high issue prices. However, in many studies using the venture capital as a determinant of firm quality, this variable is found insignificant. A question may arise: «Is Venture Capital backing really a signal of firm quality and an explanatory variable to underpricing anomaly?». I introduce this variable in the model to verify these results.

Ø Underwriter Reputation: a dummy variable taking the value of one if the lead underwriter has a rank = 8 (zero otherwise).

Some issuers use it as a signal of high quality and want to hire a prestigious underwriter, since by agreeing to be associated with an offering, prestigious intermediaries «certify» the quality of the issue. When an issuer chooses a prestigious underwriter for the book-building mechanism, he sets a low offer price conducting a high underpricing on one hand, as compensation to the underwriter and on the other hand, he is sure about full subscription, he is concerned by quantity rather than price and a lower offering price increases the probability of full subscription. Then, there is a positive relation between underwriter reputation and underpricing.

But, there is another explanation completely different: when an issuer chooses a prestigious underwriter who certifies the high quality of the issue, he can bargain for a higher offer price and then a lower level of underpricing is observed: A negative relation between underwriter reputation and underpricing.

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