UNDERPRICING AND LONG-TERM PERFORMANCE OF IPOS: EVIDENCE FROM EUROPEAN INTERMEDIARY-ORIENTED MARKETS.

• Author: Gandolfi, Gino
• Position: Initial Public Offerings - Report

1. Introduction

   Europe is increasingly becoming a single market, but there are still some significant differences between countries, especially in the financial sector. The differences are clear between the Eurozone economies themselves, as well as between Eurozone and non-Eurozone countries.

   This study therefore examines one of the most important phenomena of financial markets, Initial Public Offerings (IPOs), focusing on the European market. The paper aims to analyze two main anomalies related to IPOs: underpricing and long run underperformance.

   Previous studies mainly investigated such anomalies comparing very different European markets (Berk et al., 2015). This paper, on the other hand, considers a homogeneous Eurozone context consisting of three markets: Italy, France and Germany. These countries have many features in common. They have a common currency, the Euro, and a centralized banking system supervised by the European Central Bank (ECB). Italy, France and Germany are the most populated countries in Europe and represent over 40% of the European Union (EU 28) and over 60% of the Euro Area (EA 19) in terms of population (Eurostat data). They are important developed economies, considering that their GDP jointly represents almost 50% of the European Union (EU 28) and over 65% of the Euro Area (EA 19) (Eurostat data), and their financial system is highly significant in the Eurozone (ECB, 2015). They are intermediary-oriented countries (Cobham et al., 1999; Demirguc-Kunt, 1999; Levine, 2002; WSBI-ESBG, 2015; Aggarwal and Goodell, 2016) and have over 53% of the 5,469 Euro area credit institutions (ECB data) and over 45% of the assets in EU countries (EBA data).

   The study aims to answer the following research questions: What is the trend in short and long run anomalies for Italy, France and Germany? Do differences exist between these countries? Is industry a determinant of underpricing and long run performance?

   Our analysis is based on the following hypotheses: Hypothesis 1: IPOs in the three main European countries are characterized by underpricing and long run underperformance.

   Hypothesis 2: Geographical context impacts on differences in short term and long term anomaly.

   Hypothesis 3: Industry is a determinant of underpricing and long run performance.

   Our findings will make an interesting contribution of the paper to the existing literature in several ways. Unlike previous literature, the paper aims to study underpricing and long run performance over the period 1997-2011, including the recent financial crisis. Moreover, the analysis focuses on homogeneous Eurozone countries, thus providing results comparing with other international markets, such as the US. The study also aims to verify whether emerging trends show different dynamics across industries or whether they are generalized.

   The paper is structured as follows. There is a review of the main literature in Section 2, followed by a description of the sample and methodology in Section 3. Section 4 shows the empirical results: in 4.1 the short term analysis of underpricing and in 4.2 long run performance by industry. Section 5 presents conclusions.

2. Literature Review

   Initial Public Offerings (IPOs) have been shown to be characterized by two anomalies: underpricing in the short-term horizon and underperformance in the long-term horizon (Rhee, 2002; Khan et al., 2014).

   Underpricing, the phenomenon of the market share price being higher than the offer price in the first listing days, occurs widely in many countries, and many explanations have been put forward over time. In order to determine the cause, in other words to determine whether the IPO issuer offers too low a price, or whether investors offer too high a price, market trends are usually observed immediately after the listing. It has been shown that the market does not usually lower the price after the first listing day, so the market price during the first few days can be considered "right." The difference between the offer price and the market price on the first listing day, i.e. underpricing, can thus be considered "money left on the table" (Ibbotson, 1975). In a study of 8,668 US IPOs over the period 1960-1987, Ibbotson et al. (1988) find that underpricing runs at 16.4% on average. Moreover, it tends to occur particularly on "hot issue" markets, rather than being steady over time (Ritter, 1984; Loughran and Ritter, 2002).

   Previous studies have attempted to identify the precise time when the reduction in share price is made. They show that underpricing is identifiable on the first listing day (Miller and Really, 1987) and that it is already measurable at the beginning of the listing day as the difference between the opening price and the IPO price (Barry and Jennings, 1993).

   Underpricing has been studied in many other countries as well as the US (Ritter, 2003). Hopp and Dreher (2007) examine 29 markets in four continents (America, Europe, Asia and Oceania) over the period 1988-2005, and find underpricing to be widespread all over the world, with very variable average values ranging between 2.45% (Austria) and 66.06% (India).

   Engelen and Van Essen (2010) investigate differences between countries in their study of 2,920 IPOs in 21 countries, and find that "country-specific characteristics explain about 10% of the variation in the level of underpricing" (2010: 1967) and in countries with an effective legal system and law enforcement, i.e. a high level of investor protection, the level of underpricing in firms going public is significantly lower. On the other hand, Boulton et al. (2010) study 4,462 IPOs in 29 countries between 2000 and 2004 and show that "underpricing results suggest that IPO initial returns are greater in countries offering stronger protections to investors" (2010: 219).

   No single convincing explanation for underpricing has so far been put forward, although various attempts have been made, and certain factors and variables have been identified (Katti et al., 2016; Khan et al., 2016).

   One of the main causes of underpricing appears to be informational asymmetry.

   Rock (1986) identifies informational asymmetry between investors, who can be either informed or uninformed about IPO shares and cannot "participate in the new issue market until the price falls enough to compensate for the 'bias' in allocation" (1986: 188).

   Baron (1982) provides another explanation for underpricing, identifying information asymmetry between issuer and underwriters as a cause. He states that underwriters tend to minimize the offer price compared to the "real" price, in order to promote underwriting and minimise their commitment. Muscarella and Vetsuypens (1989), studying IPO underpricing on a large US sample, including investment banks, find no evidence of this. Regalli and Soana (2013) study IPOs on the Italian market and their results appear to support Baron's theory.

   Informational asymmetry also underpins the signaling models developed to explain the underpricing phenomenon. In these models, underpricing is considered to be caused by the need of "good" firms to signal their quality (Allen and Faulhaber, 1989; Welch, 1989; Grinblatt and Hwang, 1989).

   Other explanations for underpricing concern the desire to avoid the risk of not selling by issuers and banks responsible for underwriting. Tinic (1988) also points out that underpricing could be the "price to pay" to avoid litigation from investors underwriting shares in IPOs. This is confirmed by Banerjee et al. (2011) and by Lin et al. (2013), who examine 13,759 IPOs in 40 countries over the period 1991-2011.

   Moreover, Chang (2011) examines 1,558 IPOs on the Taiwan market in the period 1962-2009, showing that "when issuing firm insiders cannot accurately evaluate an IPO's intrinsic value, they use the information of other IPOs in the same industry that went public earlier to determine an IPO offer price" (2011: 369).

   As factors impacting on the level of underpricing, Engelen and Van Essen (2010) cite the following variables from the literature: nature of the offer (primary vs. secondary offering), company age, venture vs. non-venture backed IPO, technology industry, introduction method, year, price earning ratio, offer size and underwriter reputation.

   Long run underperformance is the second anomaly characterizing IPOs. It is different from underpricing, a short-term phenomenon, as it implies an underperformance of stocks after the IPO in the long term. Underpricing reveals that markets are basically efficient, and can adjust the stock price to its "correct" level almost immediately after the IPO, whereas long run negative performance shows that financial markets find it difficult to price stock correctly, thus making periodical adjustments necessary in the long term.

   Aggarwal and Rivoli (1990) make one of the first studies of long run performance. They examine 1,598 IPOs on the US market over the time horizon 1977-1987 for a period of almost a year (250 days) after each IPO, and find that stocks show a negative performance (-13.73%) compared to market performance. This can be explained by an excessive optimism, or investors' initial overestimation of stock price in what are termed "fads." These results are confirmed by Ritter (1991), who observes a negative long run performance analyzing 1,526 IPOs over 36 months in the period 1975-1984. He finds a negative long run performance compared not only to some market indexes, but also to other comparable firms. For this reason, Ritter (1991) demonstrates that "the quantitative measurement of the long-run performance of initial public offerings is very sensitive to the benchmark employed" (1991: 12).

   Further explanations for long run underperformance in IPOs can be found in firm characteristics. They include the acquisition of other firms (Brau et al., 2013), the presence of independent directors (Liao et al., 2011) and the presence of venture capitalists (Brav and Gompers, 1997; Michel, 2013). On this...