Effects of Institutional Investors’ Bidding Information on Offer Prices and Initial Returns of IPOs

• Date: 01 February 2017
• Published date: 01 February 2017
• Author: Yoo‐Hwan Kim,Sung Wook Joh
• DOI: http://doi.org/10.1111/ajfs.12161

Effects of Institutional Investors’ Bidding

Information on Offer Prices and Initial

Returns of IPOs*

Sung Wook Joh**

College of Business Administration, Seoul National University, Republic of Korea

Yoo-Hwan Kim

Meritz Securities Co., Ltd, Republic of Korea

Received 31 January 2016; Accepted 8 November 2016

Abstract

Using hand-collected data on all IPOs in Korea from 2001 to 2007 before the global financial

crisis, we find that institutional investors’ favorable valuation increases the offer price and

initial returns. In particular, when institutional investors’ weighted average bidding price

(WAP) increases by 1%, the offer price increases by 0.81%. A higher WAP predicts higher

initial returns. While oversubscription ratios yield positive effects on offer prices and predict

higher initial returns, their effects are weaker when IPO market conditions or WAP are

included in the regression equations. These results suggest that institutional investors’ bidding

prices reflect their private valuations of firms more than their oversubscription ratios. In

addition, for predicting initial returns, institutional investors’ bidding information outper-

forms the revised offer price.

Keywords Institutional investors; Bidding price; Bidding ratio; Offer price revision; IPO

underpricing; Price support requirement

JEL Classification: G24, G28, G32

*We are grateful for comments and suggestions by Jay Ritter, Vidhan Goyal, Joong Hyuk

Kim, Lawrence Khoo, the Associate Editor, and anonymous referees and participants of semi-

nars at Seoul National University, Korea University, Korea Finance Association Conference,

and the Korea Economics Association Conference. We are also thankful to Sungho Shin and

Inseok Shin for sharing their insights and information on bookbuilding activities with us. We

are grateful to Hong Kee Sul and Jihun Oak for their help in data collection. The paper was

awarded the best paper at the Korea Economics Association Conference. Joh appreciates

financial support from the SNU Institute for Research in Finance and Economics, the Insti-

tute of Finance and Banking, and the Institute of Management Research at Seoul National

University.

**Corresponding author: Sung Wook Joh, Department of Finance, College of Business

Administration, Seoul National University, 1 Gwanak-Ro, Gwanak-gu, Seoul, 151-742, Korea.

Tel: +82-2-880-9384, Fax: +82-2-873-4821, email: swjoh@snu.ac.kr, sungwook.joh@gmail.com.

Asia-Pacific Journal of Financial Studies (2017) 46, 116–154 doi:10.1111/ajfs.12161

116 ©2017 Korean Securities Association

1. Introduction

When IPO stocks are publicly traded for the first time, their stock prices often

exceed their offer prices (Ibbotson, 1975; Ibbotson and Jaffe, 1975; Ritter, 1984;

Loughran et al., 1994). Past studies argue that, along with other factors,

1

informa-

tion asymmetry between IPO firms (or underwriters) and investors contributes to

underpricing and high initial returns. As institutional investors often have more

information on IPO firms and evaluate them more accurately compared to individ-

ual investors (Rock, 1986), underwriters often gather this information and partially

reflect it when revising their offer prices (Benveniste and Spindt, 1989; Benveniste

and Wilhelm, 1990).

As informed investors, institutional investors’ valuation for an IPO firm can

provide information to underwriters. As bidding price represents investors’ willing-

ness to pay, informed investors’ high bidding price indicates that the firm has a

high value. In an IPO auction setting (Sherman, 2005; Chiang et al., 2010), institu-

tional investors’ higher bidding prices can signal a positive valuation for IPO firms

based on their private information.

Underwriters can reflect institutional investors’ information extracted during

bookbuilding when they revise their offer price. As underwriters can compensate

institutional investors for revealing positive valuation information (Benveniste and

Spindt, 1989; Benveniste and Wilhelm, 1990), they do not fully reflect it; they par-

tially reflect the truth-telling institutional investors’ valuation information into the

offer price. So, underwriters raise their offer price less than institutional investors’

valuation for positive valuation information. As information is partially reflected,

initial returns would be higher when institutional investors’ valuation is high.

The ex-ante effects of institutional investors’ oversubscription during bookbuild-

ing are unclear. On the one hand, like informed investors entering an IPO auction

(Sherman, 2005; Chiang et al., 2010), institutional investors’ oversubscription can

signal a positive valuation for IPO firms based on their private information.

2

Insti-

tutional investors place bids only when they expect to receive returns from their

subscription, given their expectation of the finalized offer price. Chowdhry and

Sherman (1996) theoretically show that oversubscription and underpricing are cor-

related. In this case, high subscription can indicate that institutional investors

expect high returns from subscribing shares for IPO firms. Therefore, upon receiv-

ing high subscriptions from institutional investors, underwriters can raise the offer

price and still observe high initial returns.

1

See Ibbotson (1975) and Ritter and Welch (2002) for this discussion.

2

When institutional investors make higher bids, their returns are generally higher. Chiang

et al. (2010) argue that this finding suggests that institutional investors bid less than their

valuation of the firm (shave bids) in an IPO auction. However, unlike the Taiwanese auctions

where the mean oversubscription ratio among institutional investors is only 0.76 (Chiang

et al., 2010), the average oversubscription ratio in Korea is over 106 times larger than the

allocated shares in the data in this study.

Investor Bidding, Offer Prices, and Returns

©2017 Korean Securities Association 117

On the other hand, high subscription does not necessarily indicate institutional

investors’ positive valuation of an IPO firm based on their private information for

two reasons. First, institutional investors may also subscribe shares to enhance their

long-term relationship with underwriters, not only based on their true valuation of

the IPO firm. US and UK underwriters exercise their discretion and allocate more

shares to frequent, regular subscribers (Cornelli and Goldreich, 2001; Jenkinson and

Jones, 2004). To maintain their relationship with underwriters, institutional inves-

tors might subscribe shares for IPO firms they do not value highly.

Second, institutional investors might also heavily subscribe to an IPO even for a

small profit (Amihud et al., 2003). When there is a high likelihood of a positive

return for institutional investors, they can subscribe for many shares even for small

returns. The subscription behavior of institutional investors in Hong Kong supports

this argument. Although underwriters in Hong Kong do not have discretion in allo-

cating shares, institutional investors’ oversubscription ratio is high (91 times on

average). As their subscription does not necessarily reflect their valuation, heavy

oversubscription shows inconsistent effects on stock returns, yielding large positive

initial returns but negative long-run excess returns (Agarwal et al., 2008). In short,

heavy oversubscription by institutional investors does not necessarily indicate that

their valuation of a firm is high. Hence, institutional investors’ high subscription

ratios might not always yield high initial returns.

In this study, we empirically examine how bidding price and oversubscription

ratios affect offer price revisions and initial returns. Although Cornelli and Goldre-

ich (2003) show that institutional investors’ bidding price affects price revision but

not initial returns, and that their subscription rate affects initial returns, their sam-

ple only includes 37 IPOs and does not control for IPO-related market conditions

and market run-ups. Thus, past studies have not examined the effects of institu-

tional investors’ bidding price on offer prices and initial returns for a large number

of IPOs.

Using hand-collected institutional investors’ bidding information for 489 IPOs

from Korea during 2001–2007 (before the 2008 global financial crisis), we examine

their effects on offer price revisions and stock returns. In particular, we examine

how investors’ weighted average bidding price (WAP) and oversubscription rate

affect offer prices and stock returns. Owing to regulatory changes, firms have not

been required to report WAP since 2007. So, the information on WAP is not pub-

licly available after 2007. Instead, firms and underwriters disclose a simple distribu-

tion of bidding price in relation to filing bands or offer price, which is not

sufficient to construct a WAP. Hence, we use data that were available before the

2008 crisis.

The South Korean market is especially suitable for our analysis because it (i)

has substantial underpricing of IPO stocks, (ii) requires institutional investors to

make binding bids of both quantities and maximum purchase prices, (iii) allocates

shares on a pro rata basis (no underwriter discretion), and (iv) required underwrit-

ers to support IPO prices strongly during 2001–2003 but only weakly afterwards. As

S. W. Joh and Y.-H. Kim

118 ©2017 Korean Securities Association