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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-1-2\ The investors are the most informed:

We are in the case of investors that are more informed than the other parties about the demand, the price they are willing to pay to acquire the IPO stocks, ...

* Information Revelation Theories:

To reduce this informational asymmetry, issuers tend to hire underwriters and to use a «Bookbuilding mechanism». This common practice of Bookbuilding consists on setting a preliminary offer price range by the issuing firm, then the underwriter will take the role of trying to collect private information from investors about the offering which is called «indications of interest» such as their demand, the price they are willing to pay to acquire the IPO shares... The bookbuilding mechanism allows underwriters to extract this private information. During pre-selling period, the underwriter tries to gauge demand and to have an idea about the price that potential investors are willing to pay, these indications are then used in setting the final offer price. If there is strong demand and the investors are willing to pay a higher price to obtain the IPO stocks, the underwriter will set a higher offer price and vice-versa.

But, Ritter and Welch (2002) add that if potential investors know that showing a willingness to pay a high price will result in a higher offer price, these investors must be offered something in return. They have to be rewarded for communicating favourable information. Otherwise, if these investors are offered nothing in return and the issuing firm will go public with a higher offer price, investors are dissuaded and they will not reveal their intentions and may even try to reveal wrong information to bias the underwriter's decision.

6 There is a debate concerning the correlation between underpricing and SEO, many researchers use the SEO as an explanation for not requiring high issue prices for their offerings and others refute this explanation and the relation between SEO and underpricing.

So, to induce investors to truthfully reveal that they want to purchase shares at a high price, underwriters must offer them some combination of more IPO allocations and underpricing when they indicate a willingness to purchase shares at a high price : Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991).

Lee, Taylor, and Walter (1999) and Cornelli and Goldreich (2001) show that informed investors request more, and preferentially receive more allocations.

For the issuer, underpricing is on one hand compensation to the underwriter: Baron (1982) has the same theory which is based on the fact that issuers are less informed than underwriters, they delegate the pricing decision to underwriters who possess superior information regarding the demand for the IPOs, and to induce the underwriter to requisite effort to market shares, it is optimal that issuer lets some underpricing because he can not monitor the underwriter without cost. However, we should point out the findings of Muscarella and Vetsuypens (1989) that when underwriters themselves go public and then there is no monitoring cost, their offerings are also underpriced. So underpricing is a necessary cost of going public and not a monitoring cost as advanced by Baron.

On the other hand, underpricing is compensation to investors to truthfully reveal their willingness to purchase the IPO shares and with a higher price.

But we should also mention the fact that underwriters should not underprice too much to not lose business from issuers. Nanda and Yun (1997) find that high levels of underpricing lead to a decrease in the lead underwriter's own stock market value, whereas moderate levels of underpricing are associated with an increase in stock market value.

In a similar sense, Dunbar (2000) finds that banks subsequently lose IPO market share if they either underprice or overprice too much.

As a conclusion for the information revelation theory, we can say that underpricing can be reduced by reducing the informational asymmetry between the IPO parties.

And as Ritter and Welch (2002) note, if underwriters used their discretion to bundle IPOs, problems caused by asymmetric information could be nearly eliminated.

Underwriters, are intermediaries between issuer and investors, they advise the issuer on pricing the issue, both at the time of issuing a preliminary prospectus that includes a file price range, and at the pricing meeting when the final offer price is set. In the bookbuilding period, they try to collect the investors' private information which can help in setting the price and even the volume of IPO shares. Their role is very important in reducing the information asymmetry by transmitting the investors' private information to issuers. So, the revelation information theory is based on the work of underwriters.

I presented in the previous paragraph that underpricing is positively associated with underwriter reputation. For example, consistent with evidence from the 1990s (Beatty and Welch (1996)), Ljungqvist, Nanda and Singh (2004) predict that underpricing increases in underwriter prestige, but that this relation depends on the state of the IPO market.

Also, Benveniste, Ljungqvist, Wilhelm and Yu (2003) find a positive relation between underpricing and underwriter prestige in the 1999-2000 hot market.

First, we should present the measures used of underwriter reputation: Carter and Manaster (1990) provide a ranking of underwriters based on their position in the `tombstone' advertisements in the financial press that follow the completion of an IPO. This ranking, since updated by Jay Ritter, is much used in the empirical IPO literature, it is a discrete underwriter reputation measure ranging from 0 to 9, where a 9 (0) represents the most (least) prestigious underwriter.

Megginson and Weiss (1991) measure underwriters' reputation instead by their market share, and this approach too is widely used.

The fact of using a prestigious underwriter in the bookbuilding process has an impact on signalling the high quality of the issuing company as I said earlier, but it has also a great impact on the information revelation, since prestigious underwriter is a source of confidence to investors. The prestigious underwriter has a great ability and power to make investors reveal their private information.

Many explanations were presented to the positive relation: when an issuer decides to hire a prestigious underwriter, he is sure about a full subscription, he is concerned by quantity rather than price, and by setting a low offer price, he tries to increase the probability of full subscription. There are some other issuers who are concerned by their firm quality and by hiring a prestigious underwriter, they tend to demonstrate their high quality and they set a low offer price as a signal of quality and of the real value of the company. From the point of informational revelation theory, underpricing and underwriter reputation are positively related because underpricing is used as compensation to the underwriter (Baron 1982).

In Loughran and Ritter (2004) model, top-tier underwriters are associated with more underpricing in the 1990s, and especially in the bubble period.

Loughran and Ritter (2003) argue that prestigious banks have begun to underprice IPOs strategically, in an effort to enrich themselves or their investment clients. Another explanation is that top banks have lowered their criteria for selecting IPOs to underwrite, resulting in a higher average risk profile (and so higher underpricing) for their IPOs.

But the relation between underwriter reputation and underpricing is not systematically positive and it is empirically mixed, there are some researchers who find that the correlation between underpricing and underwriter reputation is negative: when an issuer hires a prestigious underwriter, he can set a higher offer price and then lower underpricing will be observed. For example, Carter and Manaster (1990), and Carter Dark and Singh (1998) find that more prestigious underwriters are associated with lower underpricing.

There are also some researchers who have introduced the underwriter reputation variable in their models and find that it is statistically insignificant as in Guo, Lev and Shi article (2006). These authors have introduced the underwriter reputation as an explanatory variable to explain underpricing and find that it is statistically insignificant.

In practice, results are not very sensitive to the choice of underwriter reputation measure, but they are highly sensitive to the period studied.

* Winner's Curse:

Rock (1986) assumes that some investors are more informed than are other investors in general, the issue firm, and its underwriter. There is an imbalance of information between the potential investors themselves. These better informed investors bid only for attractively priced IPOs. In the case of unattractive offering, the better informed investors will not purchase the shares and the uninformed investors will have all shares they have bid for because they bid indiscriminately. But, these uninformed investors are unable to absorb all the shares offered, that is why underpricing is necessary to incite informed investors to bid for this offering's shares even if they think it is unattractive. The lower offer price will incite them to try to have the offering's shares. This underpricing is necessary also to not result in a negative return for this offering for the uninformed investors, whose capital is needed even for an attractive offering. They must be protected in IPO market to not lose their capital and their participation because in the case of attractive offerings, informed investors are also unwilling to absorb all the shares offered and their demand is insufficient. The uninformed investors should not fear the IPO market, positive returns are required to protect them and to ensure a continued participation in IPO market.

In the spirit of Rock (1986), Chowdry and Nanda (1996) develop a model in which price support is used as a complement to underpricing to reduce the losses supported by uninformed investors and induce them to participate in the IPO.

In conclusion for the theory of winner's curse of Rock 1986, which is an application of Akerlof's (1970) lemons problem, underpricing is necessary to not lose the capital of uninformed investors and to incite informed investors to take part of an offering allocation even if it is unattractive. Pricing too high might induce investors and issuers to fear a winner's curse.

In the same sense of inciting informed investors to participate in an unattractive offering, Ljungqvist, Nanda and Singh (2001) find and explain underpricing by the fact that noise traders cannot absorb the entire IPO because they are wealth constrained. To induce rational investors to participate in the offering, issuers must set the IPO price below the price noise traders are ready to pay, to induce underpricing and to make the offering attractive for the rational investors. These better informed investors can sell the shares to the irrational investors in the aftermarket and make a profit.

Rock's (1986) winner's curse model turns on information heterogeneity among investors. Michaely and Shaw (1994) argue that as this heterogeneity goes to zero, the winner's curse disappears and with it the reason to underprice.

Tore Leite (2007) in his article «Adverse selection, public information and underpricing in IPOs» finds that favourable public information (such as high market returns) reduce the winner's curse problem. And this induces the issuer to price the issue more conservatively in order to increase its success probability. The author finds a positive relation between public information and underpricing.

* Agency conflicts: The agency problems between the underwriter and the issuing firm.

Underpricing represents a wealth transfer from the IPO company to investors. These investors compete for allocations of underpriced stock, they can even try to collude with the underwriter by offering side-payments if they have underpriced stocks. Such side-payments could take the form of excessive trading commissions paid on unrelated transactions, or investment bankers might allocate underpriced stock to executives at companies in the hope of winning their future investment banking business, a practice known as «spinning». So the underwriters, seeking for their own interests have an incentive to underprice IPOs if they receive commission business in return for leaving money on the table, they will try to underprice the issuer's stock by not revealing the truthfully information obtained from potential investors ...

The underwriter will use a sub-optimal effort. He will use his informational advantage over issuing companies to increase his benefit and he will not do his mission perfectly. The underwriters are given discretion in share allocation. This discretion will not automatically be used in the best interests of the issuing firm, and they can also underprice more than necessary and then allocate these shares to favoured buy-side clients.

In the post-bubble period, increased regulatory scrutiny reduced spinning dramatically. This is one of several explanations why underpricing dropped back to an average of 12%.

As a conclusion, we can say that issuing firms who seek out prestigious underwriters to advice, to look after the IPO process, to bear for the risk of hot market crashing... can suffer from enormous problems if conflict of interest problems are not controlled.

Baron and Holmström (1980) and Baron (1982) construct screening models which focus on the underwriter's benefit from underpricing. In a screening model, the uninformed party (issuer) offers a menu or schedule of contracts, from which the informed party (underwriter) selects the one that is optimal. The contract schedule is designed to optimize the uninformed party's objective, which, given its informational disadvantage, will not be first-best optimal. To induce optimal use of the underwriter's superior information about investor demand, the issuer in Baron's model delegates the pricing decision to the bank (the underwriter). Given its information, the underwriter self-selects a contract from a menu of combinations of IPO prices and underwriting spreads. If likely demand is low, he selects a high spread and a low price, and vice versa if demand is high. But as we said earlier, underwriter can use this delegation to increase his own benefit and to think about his individual interest only. He can collude with the potential investors to the potential detriment of the issuer.

This agency conflict can be mitigated in two ways:

Ø Issuers can monitor the investment bank's selling effort and bargain hard over the price,

Ø or they can use contract design to realign the bank's incentives by making its compensation an increasing function of the offer price.

Ljungqvist and Wilhelm (2003) provide evidence consistent with monitoring and bargaining in the U.S. in the second half of the 1990s. They show that first-day returns are lower, the greater are the monitoring incentives of the issuing firms' decision-makers.

Ljungqvist (2003) studies the role of underwriter compensation in mitigating conflicts of interest between companies going public and their investment bankers (their underwriters). Making the bank's compensation more sensitive to the issuer's valuation should reduce agency conflicts and thus underpricing. Consistent with this prediction, Ljungqvist shows that contracting on higher commissions in a large sample of U.K. IPOs completed between 1991 and 2002 leads to significantly lower initial returns, after controlling for other influences on underpricing and a variety of endogeneity concerns.

So, we can say that by making underwriter's compensation an increasing function of the offer price or of the issuer's valuation, the agency conflicts between underwriter and the issuing company could be mitigated. Underpricing could even disappear if we consider the agency conflicts as the primary driver and source of underpricing.

As a conclusion for the asymmetric information theories, we can say that almost informational asymmetry theories share the prediction that underpricing is positively related to the degree of asymmetric information, and when asymmetric information uncertainty approaches zero, underpricing disappears entirely.

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