Investor sentiment and short run IPO anomaly: a behavioral explanation of underpricing
par Ines Mahjoub
Institut des Hautes Etudes Commerciales - Mastère de Recherche 2010
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.
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.
* 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.