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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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II- Theoretical explanations of short run underpricing: A literature review

The research effort aimed at explaining the short run anomaly of the IPO market has provided numerous analytical advances and empirical insights, and a large list of explanations has been offered.

Ibbotson (1975) is the first who offered a list of possible explanations for underpricing, many of which were formally explored by other authors in later work.

The list of explanations that were advanced to clarify and to understand the underpricing anomaly and to resolve this short run puzzle of the IPO market is long. The considerable research effort in the field of Initial Public Offerings market has resulted in many explanations and the list can not be exhaustive. In this paragraph, I summarize the most important researches and findings and I classify the different theories and explanations advanced in two main categories:

Ø Explanations related to the asymmetric information theory that have been popular among academics and have been considered the most convincing explanations for decades by a great number of researchers, and

Ø Explanations asserting the symmetric information.

II-1\ Asymmetric information:

The key parties to an IPO transaction are the issuing firm, the bank underwriting and marketing the deal, and investors. Asymmetric information models assume that one of these parties knows more than the others.

II-1-1\ The issuer is more informed than the investors:

Welch (1989) and others assume that the issuer is better informed about its true value.

* The theory of signalling; Firm quality:

The high quality issuers may attempt to signal their quality and their true value, and to distinguish themselves from the pool of low quality issuers, they voluntarily sell their shares at a lower price than the market beliefs. They leave deliberately money on the IPO table to deter lower quality issuers from imitating, and to demonstrate that they are high quality by throwing money. Investors who are less informed about the issue quality and about its true value will be incited to buy the shares since the price is low and because they begin to believe on the high quality of the issuer. And the issuers with some patience can recoup the amount of money left on the table by future issuing activity. There are some issuers who have the intention to conduct future equity issues at a later date on better terms (Seasoned Equity Offerings SEO) (Welch 1989) or they look for favourable market responses to future dividend announcements (Allen and Faulhaber 1989).

Michaely and Shaw (1994) argue that some issuers voluntarily desire to leave money on the table in order to create, in the words of Ibbotson 1975 «a good taste in investors' mouths» as a signal of high quality, allowing issuers to have more successful Seasoned Equity Offerings in the future. But, surprisingly, they find that the hypothesized relation between initial returns and subsequent seasoned new issues is not present. There is no relation between underpricing and Seasoned Equity Offerings. So, we can say that the explanation of underpricing based on creating a good taste in investors' mouths in order to have the investors' confidence in the future and to conduct future equity issues on better terms and then recouping the amount of money left on the IPO table, is not relevant and it is not convincing.

Jegadeesh, Weinstein, and Welch (1993), using data on IPOs completed between 1980 and 1986, find that the likelihood of issuing seasoned equity and the size of seasoned equity issues increase in IPO underpricing, as expected. However, they note that these statistically significant relations are relatively weak economically. But, Michaely and Shaw (1994) refute completely the existence of this relation between underpricing and SEO.

Guo, Lev and Shi (2006) 4, using a sample of 6010 US IPOs from 1980 to 1995, find that R&D expenditures (using the ratio of R&D expenditures to sales or to expected market value for the last fiscal year before IPO as a measure) are the best proxy to informational asymmetry about the issuer quality and find a positive and statistically significant relation between the firm quality and underpricing. 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 informational asymmetry such as 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 IPOs. Besides, they are more willing to forgo money on the table at IPO 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 (in the words of the authors), because as I presented earlier some studies find no relation between underpricing and SEO.

Guo, Lev and Shi (2006) introduce another measure of firm quality in their model, the Share Overhang Ratio (the ratio of retained shares by insiders to the number of shares issued). They find a positive and statistically significant relation between firm quality and underpricing: the percentage ownership retained by insiders serves as a signal for firm quality. Also, Grinblatt and Hwang (1989) report a positive association between the degree of underpricing and the level of insiders' ownership. For high overhang ratio and so for high quality issues, the issue price is lower a mean to demonstrate their quality and a higher level of underpricing is observed: higher quality firms underprice more than do those of lower quality.

In their article «Why Has IPO Underpricing Changed Over Time?», Loughran and Ritter (2004) use many proxies for the firm quality:

4 Guo, R., B. Lev, and C. Shi (2006): «Explaining the Short- and Long-Term IPO Anomalies in the US by R&D».

Share overhang which is the ratio of retained shares to the public float (the number of shares issued) and the Venture Capital a dummy variable which takes a value of one (zero otherwise) if the IPO is backed by venture capital. They find a positive and statistically significant relation between the firm quality and underpricing using the share overhang ratio, but a statistically insignificant relation using the venture capital as a proxy to firm quality. The presence of venture capitalists in the IPO firm is expected to signal issue quality, since their presence reduces the perceived uncertainty over firm value. Venture capitalists have expertise in particular industries and they are expected to make superior investments relative to other investors. In essence, venture capitalists certify the quality of an IPO and their presence signals that asymmetric information is relatively low for the issue and that the issuing firm quality is high and hence leads to a higher issue pricing and to a lower degree of underpricing (Megginson and Weiss, 1991). But in this article, this variable is found insignificant. The same result of insignificance using the venture capital backing as a signal of firm quality is found by Guo, Lev and Shi (2006). A question is then can be asked: Is Venture Capital backing really a signal of firm quality and an explanatory variable that can be introduced in the models?

Ben Dov (2003) looks at the level of institutional ownership shortly after the IPO and finds that high institutional ownership (a signal of firm quality and a proxy for information asymmetry) forecasts higher returns in hot markets.

In the same way of informational asymmetry and firm quality, we can talk about the underwriter reputation (Booth and Smith (1986), Carter and Manaster (1990), Michaely and Shaw (1994)). Some issuers use the underwriter reputation 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. It also increases the positive news coverage and the investors' interest in future equity offerings, if issuers have the intention to conduct Seasoned Equity Offerings in later date to recoup the money left on the table. 5

5 All are explanations advanced by researchers to the underpricing anomaly when issuers choose to hire prestigious underwriters. Because, logically, hiring a prestigious underwriter is a signal of high quality and issuers should require high offer prices for their high quality issues.

This intention of Seasoned Equity Offerings can explain the mystery that issuers seem to be happy and not upset when leaving money on the table, they are certain to recoup this money in later date. 6

This explanation of underwriter reputation can take many senses and will be discussed later in other theories.

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