Under-pricing of IPO and investors interest on UK, Germany, Austria, Poland and Czech Republic capital markets during 2009-2011 Author: Duca Elena Elisabeta Coordinator:Prof. Univ. Dr. Anamaria Ciobanu Introduction In a capitalist economy a company becomes important if its stocks and bonds are quoted to the stock exchange. Initial public offering is defined by Loughran, Ritter si Rydqvist in 1994 as: publicly initial selling of a company s stocks for the first time on primary capital market and it gives access to public equity capital. Raising public equity capital allows risk distribution among investors so may lower the company s operating and investment expenses. This will provide a higher financial autonomy to the company and the shareholders will obtain, besides dividends, capital gains and they will know permanently the real value of their stocks attributed by the market. The companies will beneficiate of publicity, conducting to high levels of investor s interest and high trading volumes of the stock. The act of going public attracts new obligations too; there will be new transparency and disclosure requirements imposed by regulatory commissions. Also there is the risk that unwilling investors take over the control of the company, or that the new investors be more focused on capital gains than in sustaining the development of the firm. There are a lot of studies regarding initial public offerings and most of them reflect high initial returns for investors than for the issuer as IPO are underpriced initially. The related literature shows that under-pricing is an assumed cost, when going public and it is seen as an efficient answer to a complex question regarding valuation of new issuing companies (Rock 1986, Beatty and Ritter 1986, Welch 1986, Benveniste and Spindt 1989, Loughran, Ritter and Rydqvist in 1994 and so on).
This paper analyzes the relationship between initial under-pricing and pre- and post- initial public offering level of investor interest. The IPO influences the offering price of the IPO and creates divergence among investor s opinions conducting to high/low subsequent trading volume on the capital market. Even if there are other studies related to this subject (Reese 1998, Sohail and Raheman 2006, Ritter ) most of them are based on a single market and are quite old. This analysis is based on five European capital markets: Austria, UK, Germany, Poland and Czech Republic during 2009-2011. It is well known that this period follows the financial crisis from 2008, which affected most of capital markets and stock prices lost minimum 20% and maximum 70% of the their value from 2006 and 2007. 2009 was a critical year, the economic activity contracted significantly: Czech Republic with 4.2%, UK with 5%, Germany with 5% and Austria with 4.3%. Poland was the only country that had economic growth (+1.7%). During 2010 and 2011 the economic activity continued to recover, the monetary conditions from euro zone improved until August 2011 when in Europe triggered the sovereign crisis. This influenced negatively the recovery of the European economy, and uncertainty returned on financial markets. During 2009 IPO market declined massively in Europe, in value and volume too, with 57% to 126IPOs comparing to 295 in 2008, while the value dropped with 49% from 13953 millions of euro in 2008 to 7112 millions of euro in 2009. Although London Stock Exchange was on the second place both in volume and value, the number of IPO was lower by 75% as in 2008. Warsaw Stock Exchange had the biggest transaction in value through privatization of the energy company PGE: 1407 millions of euro. Compared to 2009, in 2010 there were 380 new listings, their value raised from 7112 millions of euro to 26282 millions of euro. 2011 had a fresh start, but until the end the uncertainty returned. During 2011 there were 430 new IPOs, more with 13% than in 2010, and 6 important listings of which 3 of them on London Stock Exchange: Glencore, Vallares and Justice Holdings. London Stock Exchange was leader through European capital markets reasserting itself as key financial center. Warsaw Stock Exchange was on third place as value of new listings with 2067 million euro raised and 31 new IPOs. As of these conditions, I consider that the results of the study are interesting to analyze, because most of the IPOs in the research sample are under-priced, and are consistent with the working hypothesis: under-pricing and investor s interest are correlated and influences one another.
Before presenting literature review, below you will find a short description of each IPO mechanism of fixing the offer price and allotting the shares between the investors: fixed priced offerings, auctions and book-building procedures. In fixed-priced offerings, shares are offered to all categories of investors, private and institutional, at a single and unchangeable price set in advance by the underwriter and filed in the introduction of the prospectus. A pro rata is used to allocate shares. Auctions or tender offering are IPO mechanisms in which the issuer sets the minimum price at which is willing to sell its shares. All investors, individual or institutional, are invited to place subscription orders at prices above or equal to minimum price. Orders are served in the order of descending order of price limits until clearing the number of shares offered. The lowest price is the equilibrium price. Also pro rata can be used. In book-building procedure, also called placing in UK, shares are offered exclusively to institutions but not to individual investors. The underwriter sets a price range for the shares to be placed, and investors are invited to place purchase commitments in an order book at prices inside the price range. At the end of subscription period, the issue price is determined by monitoring the subscription orders received, and in case of over subscription, the underwriter has complete discretion to allocate the shares. 2. Literature and empirical review Theories based on asymmetric information assume that there is difference of information between investors, issuers and the underwriter. Winner s curse model of Rock (1986) assumes that there are some investors which are better informed about the true value of the shares of an offer than others, the issuing firm, or its underwriting bank. Informed investors will bid only for attractively priced IPOs, whereas the uninformed will bid indiscriminately. This leads to a winner s curse on uninformed investors: they will receive all the shares they have bid and pay more in unattractive offers, while their demand is partly crowded out by the informed investors in attractive offerings. Also Rock assumes that the primary market is dependent on the continued participation of uninformed investors as informed investors are insufficient to bid all the offerings even if there were only
attractive ones. Finally the conclusion is that issuers obtain benefits from going public, even if it is costly, they raise the money they need and attract the equity capital of uninformed investors. Starting from this model Koh and Walter (1989) in Singapore, Levis (1990) in UK, Keloharju (1993) in Finland, tested the empirical implication of hypothesis that uninformed investors earn zero initial returns and informed investors conditional returns just cover their costs of becoming informed. Their results were un concluding because of the lack of information about of the cost of being informed. Another empirical implication of this model tested by Michaely and Shaw (1994) was that under-pricing is lower if the information is distributed more homogeneously across investor groups. He demonstrates that winner curse disappear if heterogeneity of information incline to zero. Ritter (1984) and Beatty and Ritter (1986) find out that there is a strong positive relationship between initial returns and ex-ante uncertainty. Information revelation theories (Benveniste and Spindt (1989), Benveniste sand Wilhelm (1990), and Spatt and Srivastava (1991)) have as a starting point the allocation of the shares issue in book-building procedure, which gives discretion over allocations to the underwriter. Therefore the book-building can be a mechanism used by underwriter to stimulate investors to reveal their information truthfully, by making in their own interest doing so. Investors who bid aggressively and so reveal favorable information, on the other hand, are rewarded with disproportionately large allocations of shares. But the more aggressive are investors bids, the more the offer price is raised, and the underwriter has to be very careful to leave money on the table as truth reporting would be incentive compatible. Other empirical tests regarding this procedure were made by Cornelli and Goldreich (2001, 2003) and Jenkinson and Jones (2004) using information about IPOs traded by some leading European investment banks. While Cornelli and Goldreich (2001) sustain Benveniste and Spindt theory, Jenkinson and Jones study is not in favor of book-building procedure. Principal-agent models reveal the dark side of the institutional arrangements, by highlighting the potential agency problems between the investment banks and the issuing firm (Loughran and Ritter (2003)). As under-pricing represents a wealth transfer from the IPO company to investors, a rent-seeking behavior can appear, because investors compete for allocations of the underpriced stock and may offer to the underwriter side-payments. Such side-payments can take the form of excessive trading commissions paid on unrelated transactions. Underwriting fees are typically proportional to IPO proceeds, and thus inversely related to under-pricing. Although this would
be an incentive for the underwriter to keep the under-pricing low, investment banks can gain more by making the offers more attractive to investors. Ljungqvist and Wilhelm (2003) made several empirical studies on US capital market which certified the existence of the principalagent problems described above. They show that the lower first-day returns are, the greater monitoring incentives of the issuing firms decision-makers (CEOs) are. Monitoring incentives are given to decision-makers in the form of equity ownership level and the higher equity ownership the decision-maker has he is getting a greater stake in the outcome of the pricing negotiations. Under-pricing as a signal of firm quality model (Ibbotson (1975)) sustain the idea if companies have better information about the present value or risk of their future cash flows than do investors, under-pricing may be used to signal the company s true high value. This cost may signal the quality of the company, and may allow the issuer to return to the market to sell equity on better terms at a later date. Allen and Faulhaber (1989), Grinblatt and Hwang (1989), and Welch (1989) sustained this theory adding some arguments in its favor. Starting from the premise of existing two types of firms (low-quality and high-quality), high-quality firms have incentive to credibly signal their higher quality, in order to raise capital on more advantageous terms. The proposed signal in the IPO signaling models is the issue price. Institutional theories have three approaches to explain IPO under-pricing. First is inspired from the insurance business as it works as a legal insurance seeking lawsuit avoidance. Logue (1973) and Ibbotson (1975), is that companies deliberately sell their stock at a discount to reduce the likelihood of future lawsuits from shareholders disappointed with the post- IPO performance of their shares. Empirical studies were made by Drake and Vetsuypens (1993) showing that firms sued were as much as under-priced as the other firms but Lowry and Shu (2002) consider that the study examined only ex-post events. Empirical analysis regarding the under-pricing and litigation probability relationship should take into account also the risk of being sued (the ex-ante probability). The second institutional approach is based on the practice of price support. One of the services that underwriters provide in connection with an IPO is price stabilization, intended to reduce price drops in the after-market for a few days or weeks. Ruud (1993) sustain the idea that IPO are not under-valuated deliberately, but the offer prices are fixed at the level expected by the market, and their evolution represent price stabilization imposed by the market itself. Benveniste,
Busaba, and Wilhelm (1996) consider this practice as a mechanism to consolidate the relationship between the underwriters and investors. As a result of book-building procedure there is evidence that institutional investors benefit from price stabilization, but Chowdhry and Nanda (1996) demonstrates that private investors too. Third institutional explanation may be that issuers could benefit from tax deductions from IPO under-pricing, but it still remains a challenge to create equilibrium between the cost of underpricing and the fiscal benefits. There is some evidence that under-pricing could be advantageous: Rydqvist (1997) showed that some companies from Sweden preferred to pay their employees through assets allocation in order avoid tax on salaries. Another study was made by Taranto (2003) which noticed that in US equity options were taxed differently in two stages: once at the option exercise and then later at the selling of the stock. While the tax on capital gain being deferred, and lower than on salaries, there is an explanation why management of companies preferred distribution of under-priced stocks towards employees. Going public is in many cases a step forward to the eventual separation of ownership and control. There are two models that seek to explain the under-pricing phenomenon in the context of agency cost approach regarding ownership and control. The results are diametrically opposed: while Brennan and Franks (1997) view under-pricing as a means to strengthen managerial control and the attendant agency costs by avoiding monitoring by a large outside shareholder, Stoughton and Zechner s (1998) analysis instead suggests that under-pricing may be used to minimize agency costs by encouraging monitoring by a large outside shareholder. Behavioral explanations for IPO under-pricing assume either the presence of irrational investors who bid up the price of IPO shares beyond true value, or that issuers are subject to behavioral biases and therefore fail to put pressure on the underwriting banks to have underpricing reduced. Welch (1992) shows that informational cascades can develop in some forms of IPOs if investors make their investment decisions sequentially: later investors can be influenced by the bids of earlier investors, rationally disregarding their own information. Successful initial sales are interpreted by subsequent investors as evidence that earlier investors held favorable information, encouraging later investors to invest whatever their own information. Conversely, disappointing initial sales can discourage later investors from despite of their private signals.
Investor sentiment model of Ljungqvist, Nanda, and Singh (2004) assume that investors hold optimistic beliefs about the future evolution of the IPO company. The issuer s objective is to obtain as much as possible from the investors surplus on the downward-sloping demand curve, and that is to maximize the excess valuation over the fundamental value of the stock. A large quantity of stock in the market will depress the price, so the optimal strategy involves holding back the stock in inventory in order to avoid price falling and naturally the market will adjust the price up to its real value. This explains the under-performance on the long run demonstrated by Ritter (1991). Loughran and Ritter (2002) propose an explanation for IPO under-pricing that combines prospect theory of Kahneman and Tversky (1979) with mental accounting concept of Thaler s (1980). They assume that the decision-makers initial valuation beliefs are reflected in the mean of the indicative price range reported in the issuing firm s IPO prospectus. This serves as a starting point in assessing the result of the IPO process. The offer price for an IPO differs from this reference point, because of the underwriter who can influence the decision maker s beliefs or maybe he has information revealed by institutional investors, both conducting to lowering the price range. The decision-maker finds a positive revision from the reference point as a wealth gain, while a positive initial return is perceived as a wealth loss under the assumption that shares could have been sold at the higher first-day trading price. 3. Methodology and data The objective of the study is to assess the relationship between initial under-pricing and investors interest pre-and after IPO procedure using a research sample of 214 IPOs from UK, Germany, Austria, Poland and Czech Republic during 2009-2011. The data are collected from each country stock exchange (London Stock Exchage, Deutsche Boerse, Vienna Stock Exchange, Warsaw Stock Exchange si Prague Stock Exchage) and from Bloomberg database. First I will analyze the daily return of the IPO and daily trading volume during one month after going public, and I have divided the sample into two groups: under-priced IPOs (which have positive initial returns) and over-priced IPOs (which have negative initial returns). Then using Eviews 5.1 I have made a multiple regression to analyze the influence of all variables on the initial return having the model below:
Initial return = a x Log (Initial trading volume) + b x Subscription rate + c x Log (Offer Size) + d x Market volatility + e x Log (Firm size ) + f 4. Results Comparing roughly the mean of the daily return with the mean of the daily trading volume there can be noticed that there is a positive relationship between the these two variables; from the two graphics below the initial return is much higher that the rest of the days (around 12% compared to 2%) and the initial trading volume is decreasing too from around 10% of the shares issued to 1% of the shares issued during the rest of the days. Figure 1. Daily evolution of the mean return / trading volume of IPOs After running the regression I have observed that the model is verified (both overall (F test) and individual for each estimated parameter (t test) are under the significance level of 5%) and the conclusion is that the daily return and the size of the company explains in a large proportion the evolution of the daily trading volume (adjusted R 2 = 25%) (see table below). Table 1. Regression result daily trading volume daily return firm size Dependent Variable: LOG(VTZ) Method: Panel Least Squares Date: 06/02/12 Time: 10:38 Sample: 1 4237 Cross-sections included: 20 Total panel (unbalanced) observations: 3475 White cross-section standard errors & covariance (no d.f. correction) Variable Coefficient Std. Error t-statistic Prob. RCP 0.238646 0.072107 3.309625 0.0009 LOG(MF) 0.437590 0.050640 8.641155 0.0000 C -5.972300 0.369373-16.16873 0.0000
R-squared 0.253514 Mean dependent var -3.064443 Adjusted R-squared 0.248974 S.D. dependent var 2.746992 S.E. of regression 2.380591 Akaike info criterion 4.578886 Sum squared resid 19568.89 Schwarz criterion 4.617842 Log likelihood -7933.814 F-statistic 55.84164 Durbin-Watson stat 1.725359 Prob(F-statistic) 0.000000 In the end I have tested the relationship between initial return (as dependant variable) and the initial trading volume, subscription rate, size offer, size of the company and volatility of the market (as independent variable). The result was that all these factors explain in proportion of 66% the variability of initial return; a raise of 1% of the subscription rate as measure of the pre- IPO investors interest contribute with a raise of 0.03% of the initial return (more than initial trading volume). Table 2. Regression result initial return initial trading volume subscription rate Dependent Variable: RI Method: Least Squares Date: 05/28/12 Time: 13:13 Sample: 1 214 Included observations: 214 Variable Coefficient Std. Error t-statistic Prob. LOG(VTI) 0.005780 0.002689 2.149032 0.0328 LOG(MO) -0.490809 0.026936-18.22112 0.0000 LOG(MF) 0.484758 0.026714 18.14614 0.0000 RS 0.032229 0.009526 3.383193 0.0009 VP 0.795302 2.190735 0.363030 0.7170 C 0.047188 0.035244 1.338878 0.1821 R-squared 0.667217 Mean dependent var 0.073415 Adjusted R-squared 0.659217 S.D. dependent var 0.174544 S.E. of regression 0.101893 Akaike info criterion -1.702151 Sum squared resid 2.159492 Schwarz criterion -1.607778 Log likelihood 188.1302 F-statistic 83.40633 Durbin-Watson stat 2.051587 Prob(F-statistic) 0.000000 After testing the behavior of the residual variable of the multifactor regression model, it results the validation of the three assumptions of the model: the normal distribution, homoskedasticity and nonauto-correlated errors. The validation of these assumptions shows that the model s parameters obtained through the least squares method are efficiently estimated.
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