Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
he first and the most important observation in the IPO market comes back to the early writers that have been interested in IPO market, notably Stoll and Curley (1970), Logue (1973), Reilly (1973) and Ibbotson (1975), who documented that when companies go public, the price of shares they sell tends to jump substantially on the first day of trading and the first day closing price is systematically higher than the issue price at which the public offering was introduced in the market. This phenomenon is called «underpricing» from the issuer's point of view, he thinks that he has not correctly valued the IPO shares. He underpriced the real value of the shares of his company, it is money left on the IPO table which could have been raised if the offer price had been set at an appropriate and higher level.
IPOs exhibit positive first day returns on average with no exception to the period and date of going public, to the country and to the industry to which the IPO belongs. Underpricing is a persistent anomaly characterizing the short run IPO market behaviour. It is a puzzle to resolve.
Underpricing anomaly has intrigued academics and practitioners over the past three decades and has generated considerable research which provided numerous analytical advances and empirical insights aimed at explaining this short run phenomenon.
The list of explanations that were advanced is very long, but it can be classified in three main categories:
Ø Theories and explanations based on the informational asymmetry between the key parties of an IPO.
Ø Theories asserting the informational transparency and lucidity and the IPO market efficiency.
Ø Behavioral explanations based on the importance of investors' sentiment as a primary driver to underpricing and to first day returns.
Concerning the theories asserting the informational asymmetry, we can begin by the fact that issuers are more informed than the other parties, and then we find the theory of signalling based on the importance of the issuing firm quality. Issuers are the most informed about the true value and quality of their firms, and the high quality issuers may attempt to signal this quality and value and to distinguish themselves from the pool of low quality issuers. They may voluntarily sell their shares at a lower price than the market beliefs to signal their high quality. They leave deliberately money on the IPO table to deter lower quality issuers from imitating. However, another conduct can be observed, high quality issuer may bargain harder for higher offer price since he believes in the quality of his firm and its true value conducting lower level of underpricing.
The most important proxies of firm quality used in almost studies and researches to verify the relevance of the relation between firm quality and underpricing are:
R&D Intensity, Overhang Ratio, Venture Capital Backing as a dummy variable, Underwriter reputation,... The result found in almost studies is a positive and significant relation between firm quality and underpricing: Higher firm quality issuers do not bargain for higher offer prices to signal the quality of their firms and to deter lower quality firms from imitating and then a higher level of underpricing is observed at the first day of trading. And the explanations for not requiring high offer prices vary from believing in high returns on future SEO, to increasing the probability of a full subscription of the first offering, this is dependant on issuers' beliefs and future strategies.
As I said the relation between firm quality and underpricing can be negative, high quality issuers bargain for higher offer prices and then a low level of underpricing is observed at the end of the first day of trading. However, some researchers also find this relation insignificant.
Other explanations were advanced going in the same direction of informational asymmetry but asserting investors as the most informed party of an IPO. We find the «Information Revelation Theory» in which underpricing is compensation for revealing private information and interest indications, the Winner's Curse explanation (Rock 1986) assuming an imbalance of information between the potential investors themselves and the importance of underpricing to encourage the best informed investors to participate in an unattractive offering, and the agency conflicts between underwriter and issuing firm.
The second category of explanations is assuming the informational transparency and lucidity between the key parties and the IPO market efficiency, and then underpricing phenomenon can be explained by the characteristics of the offering: risk, issue size, or issuer bargaining power.
Riskier issuing firms can not require high offer prices and high underpricing is then observed. Risk can be proxied by issuing firm age, issuing firm size (Ln(assets), Ln(sales)), or by the business and the activity sector of the firm. Besides, Bartov, Mohanram and Seethamraju (2003) report that a dummy variable for risky IPOs has no effect on the setting of the final offer price and that is no correlation between risk and underpricing.
Issue size is also an important determinant: when the issue size is large, the issue price should reflect the greater difficulty of selling the shares in the aftermarket, and then the issue price should be lower leading to higher level of underpricing. The relation can be seen of another side, sizable issue is less risky and issuer can request higher offer price.
Issuer bargaining power can also be an explanation to this short run anomaly. Issuing firms with concentrated ownership structure and so with high bargaining power require high offer prices for their issues conducting lower underpricing.
Some researches were advanced and based on other explanations of underpricing by lawsuit avoidance, underpricing as a substitute of Marketing expenditures, or by favourable market conditions.
The third category of explanations is the most important and promising area of research, since all the «traditional» theories advanced earlier are unlikely to clarify and to give a relevant, a reliable and a convincing explanation to the underpricing anomaly, mainly after the surprisingly and severe level of underpricing of the dot-com bubble. Turning to behavioral approach and to investors' sentiment seems to be a necessity to clarify the mystery of underpricing. Behavioral approach and investor sentiment is not a new field, the investor sentiment was introduced earlier in the 1990's by Welch who presented the Informational Cascade theory. However, this approach has attracted more attention, has intrigued more and more researchers and has taken all its impetus in this decade. Many researchers tried to introduce this behavioral approach to explain the short run IPO anomaly and the research effort is continuing.
Informational Cascade Theory (Welch 1992) assumes that issuers should succeed the first sales and should underprice to induce the first few potential buyers and later induce a cascade: bandwagon effects. All subsequent investors want to buy irrespective of their own information, they will imitate the first potential investors. Then we find, Loughran and Ritter (2002) who try to apply the prospect theory of Kahneman and Tversky (1979) to IPO market to argue that issuers are more tolerant of excessive underpricing if they simultaneously learn about an aftermarket valuation that is higher than expected.
But, we can say that the importance of investor sentiment was introduced and analyzed in the context of the underpricing phenomenon for the first time by Ljungqvist, Nanda and Singh (2004) in their article «Hot markets, Investor sentiment and IPO pricing».
Many researchers try to value the investors' sentiment to study its impact on underpricing and to verify the significance of the relation between underpricing and investors' sentiment. The list of proxies used by researchers to value investor sentiment is very long. I present the most important: grey market prices, market conditions, demand submitted by individual investors and discounts on closed-end funds. And the main result is that high investors' sentiment induces high underpricing. The optimism and enthusiasm of investors is positively related to first day returns and to underpricing.
In the third section of this work, I regroup the most important explanations that have been advanced in the same model to determine which of these explanations characterizes best a sample of 217 U.S IPOs for 2006 and 2007. In the context of a unified framework and model, I present the three theories: asymmetric, symmetric and behavioral approach. I use many variables as proxies for the same theory and I even introduce some variables found insignificant in earlier studies to verify the relevance of earlier results for this sample. I also distinguish between the individual investors' sentiment and the institutional investors' sentiment and I use a direct measure of sentiment. In the model, I use 15 explanatory variables: Underwriter Reputation, Overhang Ratio, R&D Intensity and VC Backing used to measure the informational asymmetry and exactly are proxies for the firm quality. Age, Firm Size, Firm Profitability, ROA and Issue Risk are measures of risk. Insiders' Ownership and Blockholders' Ownership are proxies for issuer bargaining power. Individual and Institutional Bullish Bearish Ratios are measures of investors' sentiment. Finally, Time Dummy is a control variable to verify the impact of the beginning of the financial crisis on IPO underpricing.
The negative and significant coefficient of insiders' ownership is consistent with the hypothesis that issue firms with high bargaining power request higher offer prices conducting lower degree of underpricing. The positive and significant coefficient of Individual bullish bearish ratio is consistent with the hypothesis that investors with high and optimistic sentiment are willing to pay higher prices to acquire the IPO shares leading to higher underpricing. The positive and significant coefficient of Time dummy presents the positive relation between underpricing and the beginning of the financial crisis which has an impact on the IPO first day returns. The negative and significant coefficients of overhang ratio and R&D intensity (both are measures of firm quality) can be explained by the fact that high quality issue firms request higher offer prices for their IPOs conducting lower level of underpricing. And the lack of significance of the 6 measures of risk and of the VC backing is consistent with the findings of many researchers.
Finally, the positive and significant coefficient of individual investors' sentiment and the positive but insignificant coefficient of institutional investors' sentiment lead to an important finding: Individual investors are those driving the first day closing prices and then underpricing anomaly and are more conducting the short run IPO puzzle than the institutional investors.
Underpricing phenomenon can be explained by the informational asymmetry theories based on issuer as the best informed party of an IPO about its firm quality (a negative relation), by issuer bargaining power (a negative relation) and by the importance of the individual investors' sentiment: the higher the individual investors' optimism, the higher are the first day closing prices and the higher are the first day returns and Underpricing anomaly.