II-2\ Symmetric information:
There are some theories and explanations
advanced by a great number of researchers that do not rely on asymmetric
information, this theory that has been very popular among academics and
practitioners for decades and that has been considered as the most relevant and
convincing explanation to the short run IPO anomaly. There are some researchers
that advanced other theories and they explain underpricing by other reasons,
asserting symmetric information between key IPO parties. As hypothesis, all the
key parties of an Initial Public Offering share the same information. We talk
about informational transparency and lucidity and about IPO market
efficiency.
II-2-1\ Risk premium:
Let's begin by the risk premium explanation. Because the hot
market can end prematurely, the sentiment demand may cease and then we face a
market crashing, carrying IPO stocks in inventory is risky.
Ljungqvist, Nanda and Singh (2003) in their article: «Hot
market, investor sentiment and IPO pricing» argue that underpricing
emerges as fair compensation to the regulars for expected inventory losses
arising from the possibility that the hot market ends prematurely. If the
demand is small (in comparison to the issue offer), the issuer needs the
regular investor to hold inventory. So long as the hot market persists, the
regular investor sells this inventory to newly arriving sentiment investors,
but the problem arises if the hot market ceases and the regular investor is
then left with shares priced at the fundamental value (which is less than the
offer price).
The issuer underprices the stock to compensate the regular
investor for bearing the risk of an uncertain sentiment demand. It is a fair
payment for the regular's expected loss. It is a way of compensating the
regular investor for taking on the risk of hot market crashing.
However, Ritter and Welch (2002)7 refute this
explanation since they argue that if the underpricing is simply a compensation
for bearing a systematic or liquidity risk, why do second-day investors not
seem to require this premium, after all fundamental risk and liquidity
constraints are unlikely to be resolved within one day.
As a conclusion for the risk premium explanation based on
Ritter and Welch (2002) point of view, we can say that this explanation is
refuted and can not be considered as a relevant and a convincing explanation
for the underpricing anomaly.
II-2-2\ Characteristics of the Initial Public offering:
* Risk: Risk can reflect either technological or
valuation uncertainty.
Loughran and Ritter (2004) use many measures of risk: the
natural logarithm of the assets and the natural logarithm of the sales which
reflect the issuing firm size and then a risk related to valuation uncertainty,
internet and tech dummy variables which reflect technological uncertainty which
also induces a valuation uncertainty, and the natural logarithm of one plus the
age (years since the firm's founding date to the date of going public and the
date of introduction in IPO market) which reflect the age of the issuing firm.
For a sample including 5,990 US operating firm IPOs over 1980-2003, they find a
positive relation between risk and underpricing.
If the issuing firm is risky from the investors' point of
view, it can not be introduced in the market at a higher price because it will
not be accepted by these investors who are dissuaded about the risky IPO
shares. The offer price is set at a lower level to incite investors
7 Ritter and Welch (2002): «A review of IPO
activity, pricing, and allocations».
to purchase the IPO stocks even if they think it to be
risky.
The risk composition hypothesis, introduced by Ritter (1984),
assumes that riskier IPOs will be underpriced by more than less-risky IPOs.
Riskier firms set a low offer price to incite investors to participate in the
IPO market and to buy the IPO risky shares, and then the underpricing will be
higher. For example, young firms are riskier and the internet bubble period saw
a high proportion of young firms going public and a high percent of
underpricing, which can confirm the explanation of risk.
In the same direction of the risk, we can also talk about the
uncertainty level introduced by Beatty and Ritter (1986). They relate the level
of ex-ante uncertainty surrounding the intrinsic value of an IPO to the level
of underpricing. The higher the uncertainty level about the intrinsic value of
the IPO, the higher is the level of underpricing. It reflects the valuation
uncertainty.
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, providing evidence for the argument that risk might not be that
important for the pricing of IPOs. So there is no correlation between risk and
underpricing. The notion of risk can not explain the setting of a lower offer
price and then the underpricing phenomenon. This important finding refutes the
prior researches and results about the suitability of the risk as an
explanation to the underpricing anomaly. Risk can not be considered as a
convincing explanation to the short run IPO anomaly since it has no effect on
the setting of a lower offer price, and then underpricing is not induced by
risk.
* Issue size: The issue size or offer size is the
number of shares introduced in IPO market and offered by the issuing company
for sale.
Cornelli, Goldreich and Ljungqvist (2004) argue that 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. They find a negative relation between the size and the offer price of
IPOs: a discount in the offer price by ëS with S the size of IPOs. When
the offer size is large, the offer price will be lower and so underpricing will
be higher. They find that the issue price should be negatively correlated with
the issue size, and it is a negative and statistically significant relation
between size and offer price, so we can talk about a positive and significant
relation between issue size and underpricing.
This relation between issue size and underpricing was studied
briefly in Ljungqvist, Nanda and Singh (2003) article. Supposing VR
the market price of the IPO shares and VS the value sentiment
investors place on the IPO shares and so is the price these investors are
willing to pay for the IPO shares, the authors set VS as a function
of VR and Q which represents the total number of IPO shares (the
offer size), and the relation between VS and Q is negative. The
greater is the number of shares issued, the lower is the price that sentiment
investors are willing to pay, and the greater is underpricing: positive
relation between issue size and underpricing.
Besides, some researchers find a negative relation between the
issue size and underpricing. Guo, Lev and Shi (2006) introduce a different
issue size variable in their model (the natural logarithm of issue proceeds)
and find a negative relation between issue size and underpricing. They explain
this finding by the fact that sizable firms are generally less risky than those
making smaller issues, and they can bargain for a higher offer price conducting
a lower level of underpricing.
* Bargaining power:
Ljungqvist, Nanda and Singh (2003) study the impact of
bargaining power on the first day return and so on underpricing. They use as a
proxy for bargaining power «the ownership structure». A firm with a
highly concentrated ownership, is reflecting a high incentive to bargain hard,
while an increased ownership fragmentation, and an increased frequency and size
of «friends and family» share allocations, make the issuing firm
decision-makers less motivated to bargain for a higher offer price .
Ljungqvist, Nanda and Singh assume that the issuing firm's
ownership structure is such that â of the extracted surplus from the
investor sentiment is captured by the issuing firm and 1-â is
captured by a combination of the regular investor and the investment bank. For
a firm with highly concentrated ownership, they believe â will
be close to 1 reflecting the high incentive to bargain hard over the surplus,
while for a firm with dispersed ownership or other agency problems â will
be significantly smaller than 1.
An issue firm with a concentrated ownership and high
bargaining power requests a higher offer price and faces a lower underpricing.
Ljungqvist and Wilhelm (2003) show that companies with more concentrated
ownership at the time of the IPO suffer lower underpricing, consistent with the
findings of Ljungqvist, Nanda and Singh (2003).
And an issue firm characterized by ownership fragmentation and
so by lower bargaining power, can not bargain hard for a higher offer price.
The issue price will be set at a lower level and underpricing will be higher in
the first day of trading. Tim Loughran and Jay Ritter (2004) 8 also
use the ownership structure as a proxy for bargaining power and find that an
increased ownership fragmentation induces a decrease in the bargaining power of
the issuing firm, a lower offer price is presented inducing a higher level of
underpricing.
The greater the issuing firm's bargaining power relative to
the underwriter, the higher is the offer price and the lower is the first-day
return and vice-versa.
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