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The extraordinary expected return from the first day of the initial public offering (IPO) trading brings the great attention of the issue of the IPO underpricing. The object of this paper is to produce a through and in-depth literature review in the field of the underlying reasoning of the underpricing. The relationship between the underpricing and the asymmetric information has been the major topic being studied. Three basis theories are focused: 1) the Rock's ‘the winner's curse' regarding to the adverse selection model; 2) the ex ante uncertainty and the asymmetric information; 3) the signalling theory with the moral hazard model. The vast empirical evidence is provided on the basis of the positive relationship between the underpricing and the asymmetric information. The final conclusion indicates a further research direction.
Keywords: Underpricing; Asymmetric Information; Adverse Selection; Moral Hazard; Ex ante Uncertainty
This paper aims to provide a review of the contemporary literature in relation to the phenomenon of the underpricing of the IPOs. The underlying theories of the asymmetric information are the major topic to be investigated due to the word limit.
The theoretical rationale has provided a great underlying reasoning on the underpricing of the initial public offering. The adverse selection, ex ante uncertainty and the signalling theory based on the moral hazard are the major concerns in this literature review. The involuntary underpricing and the voluntary underpricing have brought the light into the analyses. The critical discussions of these underlying theories of the underlying of the IPOs have also been exploited.
The empirical findings across different countries are brought into the paper with varies data and methods. The empirical findings which supports or do not support the theories are exploited. The reasoning behind the inconsistency of the findings is discussed. However the data used in the empirical studies are old and the contemporary data may need to be exploited in the future studies. The future trend for the studies on the issue may lead to the more defined geographical regime which may give a better support of the underlying theoretical rationale.
The underpricing of an initial public offering (IPO) has become a universal phenomenon. This underpricing occurs when the price jumps on the first day of the trading. Bodie et al. (2009) has given a dramatic example of this phenomenon. VA Linux's share was sold in an IPO at $30 per share; however it turned to $239.25, which gives a 698% return in that day (Bodie et al. 2009, p.56).
Economists have been trying to explain this so called “IPO underpricing puzzle” (Lorenzo and Fabrizio (2001). Several literature theories are developed. The underpricing is associated with the booking-keeping scheme. At the book-keeping stage, the investment bankers will ask the large institutional and other investors to share their valuations about the firm, and then the underwriters will adjust their initial value of the offering price and the numbers of the shares which are going to be offered. (Bodie et al. 2009)
Benveniste and Spindt (1989) argued that the underpricing is used to reward institutional investors for revealing more accurate information at book-keeping. Hughes and Thakor (1992) thought that the underpricing is used to remove the potential legal damages in order to induce the issuers to participate.
Asymmetric information is one of the major theories for the reasoning of the underpricing which includes the adverse selection, the signaling theory and the agency model. This paper focuses on the first two theories by studying the adverse selection and the signaling theories. The theory of the ex-ante uncertainty has also been studied. The theories above are based on the inverse relationship between the pricing and the first day gain. The supporting empirical studies have been provided as well as the inconsistent findings. However those findings are broad in an international context without necessary studies within a defined geographical regime. The regional defined studies may give more consistent results according to the theories.
2. Adverse Selection Models
2.1. The Rock's model and Empirical Evidence
The issue of the adverse selection can be the starting point while considering the IPO underpricing. Rock (1986) formed a model called ‘the winner's curse'. He separated investors in two types: perfectly informed with superior information and uninformed with less information and also the issuing firms and their underwriters as uninformed about the value of the firm. Under Rock's model, the underpricing is necessarily used to compensate uninformed investors to ensure that they will participate in the IPO market. As the informed investors can obtained all the shares on demand, however the uninformed investors cannot take such an advantage. Thus uninformed investors who are disadvantaged from having less information are likely to exit from the IPO market. In order to fulfil the offering of the shares in the IPO market, there is a need to keep the uninformed investors in. Rock's model is conceptually different from the initial adverse selection model in Akerlof's (1970)'s paper (Jenkinson and Ljungqvist 2001, p.64), where Akerlof (1970) suggested that the uninformed buyers exit from the used car market if the uninformed investors are disadvantaged from the quality distribution of the used car.
The question arises on how to empirically test the Rock's adverse selection model. Jenkinson and Ljungqvist (2001) have shown the way that after adjusting the rationing properly, uninformed investors' abnormal returns should be zero on average and also said this is potentially testable. The Rock's model has been given positive supports in Singapore, UK and Finland from Koh and Walter (1989), Levis (1990) and Keloharju (1993b)'s empirical tests, which found that the underpricing returns go towards riskless rate while adjusting the rationing properly. However it was also found the disagreement in Hongkong from McGuiness (1993a). These papers have shown that the evidence mostly supports the Rock's model from the countries used fixed-price rather than the book-building (Jenkinson and Ljungqvist 2001, p.65). However the book- building mechanism has been widely used nowadays, for example, Japan disused the auction mechanism and started to use the book-building mechanism in 1997 (Jenkinson and Ljungqvist 2001, p.40). The scepticism may arise whether the Rock's adverse selection model still holds nowadays according to the widely used book-building mechanism. The further research on this issue should be more addressed through empirical test in more countries where book-building schemes are used.
2.2. Criticisms of Rock's model
Jenkinson and Ljungqvist (2001) brought three points of the criticisms about the Rock's model. Firstly, they has criticized that the Rock's model is ‘a deceptively simple and rather intuitive observation' while making ‘a mockery of simple measures of underpricing which are based on an equally weighted average.' (Jenkinson and Ljungqvist 2001, p.73)) Secondly, as Rock assumed that the issuers must pay to compensate the uninformed investors to participate in the initial offering market, there is a contrary view arising. That is while the numbers of informed investors in the market are limited; the uninformed investors could simply invest through the informed investors by paying a commission. Therefore there is no need to worry about the insufficiency of the numbers of investors who can take up the shares on offering if the uninformed investors withdraw from the market. (Jenkinson and Ljungqvist 2001, p.73) Thirdly, the question is how the allocation bias really is in reality. Jenkinson and Ljungqvist have argued this answer relies on the distinction between uninformed and informed investors. They have found that informed and uninformed investors are difficult to be distinguished at empirical test. Past studies have distinguished them through the institutional and retail investors. (Jenkinson and Ljungqvist 2001, p.73) Further, Hanley and Wilhelm (1995) showed that the institutional investors do benefit from the underpricing, however no difference was found at the allocation size that institutional investors generally obtain. Jenkinson and Ljungqvist (2001) also argued that the doubt should be casted according to the Rock's theory as many theorists have found there are unobserved information being distributed within investors, the distinction between uninformed and informed may be absurd. Lastly, as Rock assumed the interests of the issuing firm and the investment bankers are in line, an agency issue can occur as they do have a conflict of the interest in reality (Jenkinson and Ljungqvist 2001).
2.3. Reduction of the adverse selection cost
As the underpricing brings an involuntary cost to the issuer, how to mitigate the risk of adverse selection is another important issue to be addressed. (Jenkinson and Ljungqvist 2001, p.68) Florin and Simsek (2007) first distinguished the definition of the adverse selection from the moral hazard. The adverse selection was found when there is ‘hidden information' in comparison with the moral hazard where there is a ‘hidden action'. In an example of a technology firm, the investors do not have accurate information in general about the firm, for example, its R&D capabilities. Managers may hide the firm's unpleasant internal information from the outsiders in order to void them not to purchase the initial shares. In order to mitigate the risk of adverse selection, investors likely look at the market indicators that is associated with high performing IPOs. Florin and Simsek (2007) have found that the hotness of the industry sector's IPO market and the size of the offering are two indicators, which positively link with the IPO performance on the first day, where they used a sample of 270 firms from public offerings in 1996. (Florin and Simsek 2007, pp.132-140)
Lastly, Rock's theory falls into the involuntary theory of the underpricing. That is to say that the underpricing in the IPOs is an involuntary action to response to some necessary problem. Jenkinson and Ljungqvist (2001) have argued that when taking into the valuation of the initial price, it is necessary to take into account the private information disseminated among all the investors. Therefore, the tenders and the auctions may be a great solution. However the tender offer was unpopular in reality except in France. (Jenkinson and Ljungqvist 2001, p.74)
3. The Ex ante Uncertainty and Asymmetric Information
3.1. The Theoretical Rationale and Empirical Evidence
An ‘ex ante uncertainty' is an uncertainty about the value per share where an investor cannot be certain about an offering's value once the public trading starts. This is studied in a great detail in Beatty and Ritter (1986)'s paper. Betty and Ritter have demonstrated that the greater the ex ante uncertainty is, the greater the number of investors who turns into the informed investors is. This is why there is a positive relationship between the ex ante uncertainty and the degree of the underpricing. Beatty and Ritter has also found that “due to the Rock's winner's curse problem facing uninformed investors, all of the profits accruing to investors due to underpricing will be received by informed investors. Investors seeking these profits, however, will incur sufficient costs so that the aggregate costs of becoming informed equal the amount of money ‘left on the table'” (Betty and Ritter 1986, p.229). At the empirical testing stage, Betty and Ritter used the age of the company, the sales revenue in the last year before the IPO issuing and the volume of the offering as the proxies for the ex ante uncertainty (Betty and Ritter 1986).
Corwin (2003) has also found seasoned equity offers with higher levels of uncertainty and asymmetric information is more underpriced. Their empirical results have also suggested that the price uncertainty has an important effect in the seasoned equity offers but the role of the asymmetric information effect is weak. (Corwin 2003, p.2276)
3.2. Reduction of the ex ante Uncertainty
Betty and Ritter (1986) further argued that the resulting underpricing equilibrium is enforced by investment bankers. They found that ‘an investment banker who ‘cheats' on, this underpricing equilibrium will lose either potential investors if it doesn't underpriced enough or issuers if it underpriced too much, and thus forfeit the value of its reputation capital.' (Betty and Ritter 1986, p.213) This implies that one way to reduce the asymmetric information is to hire a high reputable underwriter. As the underwriters frequently engage in the IPO market, they have strong incentive to maintain their reputations for their work, so arguably they likely convey the accurate information to the market in comparison with the less reputable underwriters (Beatty and Ritter 1986; Carter and Manaster 1990; Yung and Zender 2008; Jenkinson and Ljungqvist 2001).
4. The Signalling Theory and the Moral Hazard
4.1. The Theoretical Rationale
The behavioural finance literature assumes that the investors are not fully irrational therefore they are likely to react to rumours about the IPOs and also considers IPOs as short-term gambles (Shleifer 2000). Therefore, some theorists argued that certain public signals may lead investors to second-guess the pricing process, and to make decision based on what they think what other investors would do other than the judgment on the true value of the firms (Ritter and Welch 2002; Welch 1992).
The question leads to what can be considered as a public signal. Allen and Faulhaber (1989), Grinblatt and Hwang (1989) and Welch (1989) have modelled the IPO underpricing as a way to signal firm's quality. They assumed that the companies know that their true values better than the investors and there are two-stage selling steps at the IPOs. The high quality firm can recover the cost of the underpricing through the subsequent placement at more favourable prices; therefore there is a great probability that the high quality firm will be estimated as a potential good investment by the investors. The underpricing is a mean to convince the potential investors that the firm has a great value. (Allen and Faulhaber 1989; Grinblatt and Hwang 1989; Welch 1989)
This is similar from the case of moral hazard in Akerlof (1970)'s paper (Jenkinson and Ljungqvist 2001). Akerlof (1970) claimed that sellers will need to underprice the high quality car at the earlier stage before they can establish a good reputation for selling a good quality car. This is saying that the sellers are taking actions to signal that they have a good quality car (Akerlof 1970).
There are more quality signals which have been considered. For example, the quality of the venture capital firm (Dolvin 2005), the percentage of the ownership of the top management team (Florin et al. 2003), and the reputation of the investment banker (Carter et al. 1998, Florin and Simsek 2007).
4.2. Empirical Evidence of the Signalling theory
Allen and Faulhaber (1989) and Welch (1989)'s models have argued the underpricing is used to assist the returning to the after IPO market. Their empirical tests have been done and also relevant only according to the placement occur in the year immediately after the initial public offering (Lorenzo and Fabrizio 2001, p.5).Therefore the scepticism exists merely to do with the empirical question on the whether the firms do have the two stage selling strategies (Jenkinson and Ljungqvist 2001). There are two specific issues considered in testing the signalling theory: 1) the subsequent equity offering and 2) the insider selling at the aftermarket.
4.2.1. Subsequent Equity Offering
Earlier studies showed that a positive relationship exists between the underpricing and the probability and size of subsequent equity offering in Jegadeesh et al. (1993). Jegadeesh et al. (1993) showed that the market feedback hypothesis is consistent with the signaling theory. However, Jegadeesh et al. (1993) argued that the market feedback hypothesis in the early post-IPO time has the equal or greater explanatory power for the probability of reissue regarding to the underpricing. The market feedback hypothesis states that the issuers have undervalued the marginal return as the market is better informed than the firm itself. Therefore the issuers do not need to rely on the costly underpricing to signal to the market about the quality of the firm and the evidence in supporting the signaling theory as the main determinant for the underpricing is weak. (Jegadeesh et al. 1993)
Garfinkel (1993) argued that Jegadeesh et al.'s work has ignored the control of the effect of the partial adjustment process on underpricing The partial adjustment process is a process where the investment bankers partially adjust the share price and number of share issued according to the demand at the pre-selling period of IPO (Garfinkel 1993). Garfinkel (1993) has found that the signaling effect has little impact on the probability of the reissue of the seasoned offering after controlling the ex-ante uncertainty, the firm's post-stock price performance and the partial adjustment process.
4.2.2. Insider Selling
Filatotchev and Bishop (2002) says that the ‘underpricing represents a direct wealth transfer from the founders and initial shareholders to new investors, but its extent can be reduced by a number of governance-related ‘signals' that may potentially enhance firm value, such as retained share ownership by IPO insider'. (Filatotchev and Bishop 2002, p.941)
The test for the signaling theory is done in Garfinkel (1993)'s paper by studying the relationship between the underpricing and the subsequent insider sales. Garfinkel (1993) argued if the underpricing works as signal, the insiders of the firms with more underpricing should sell shares more often than those insiders in the firms with less underpricing. Insiders can recover the cost of the underpricing through the subsequent sales at a higher price. However the empirical results do not support the theory (Garfinkel 1993).
The ‘lock-in' period is the time which restrains the pre-IPO shareholders from trading in the after-market. Jenkinson and Ljungqvist (2001) has argued that the longer the ‘lock-in' period is, the exogenous events will affect the beneficial effects of the underpricing. The ‘lock-in period' in the USA is generally 180 days; however it can be 2 years length (Jenkinson and Ljungqvist 2001, p.79). Garfinkel (1993)'s data follows the two -year -interval of the trading in CRSP daily NASDAQ and NYSE/AMEX after the issue. One may argue that the inconsistent result from Garfinkel (1993) may be caused by the ‘lock-in' period, even though he contended that it should not be affected by the ‘lock-in' period as the period is generally less than 2 years.
The study of the underpricing has been enormous interests among the past theorists in both theoretical and empirical way. The field in relation to the relationship between the asymmetric information and the underpricing has been studied in numerous models and foundations.
This paper focuses on three models: the adverse selection model, the ex ante uncertainty and the moral hazard in the signalling model. The behaviour finance in relation to the investor s behaviour and the agency model in relation to the underlying reasoning of the IPO underpricing have not been studied here due to the time efficiency. Firstly, Rock (1986) initiated the so called ‘the winner's curse' model in relation to the adverse selection theory in order to explain the underlying reasoning of the underpricing. This has been considered as the involuntary action necessary to solve the problem of likelihood of the uninformed investors who will leave the market. Several criticisms of the Rock's model have been developed and also been explained in depth. Secondly, the relationship between the ex ante uncertainty and the underpricing is considered. Thirdly, the signalling theory based on the moral hazard is explained in detail. This is a deliberate action considered by the issuer to signal the firms' quality. The empirical test regarding to the specific issue as the subsequent equity offering and the insider trading has not supported the signalling theory.
Overall the tendency to reduce the asymmetric information has been found. Firstly, the hotness of the industry sector's IPO market and the size of the offering are the two indicators for investors to check for the reduction of the adverse selection cost. Secondly, Jenkinson and Ljungqvist (2001) have considered the auction and tenders instead of the fixing price may be a solution. Thirdly, hiring a reputable underwriter can reduce the asymmetric information. Finally, the empirical evidence provided in this paper is in the broad international context. The more defined geographical studies and analysis of the underpricing and the asymmetric information should be considered in the future as the laws of the IPOs are totally different in different countries. The geographical defined studies may give us more accurate and consistent results regarding to the theories.