Self-underwritten IPOS: an analysis of underpricing and market liquidity.

Author:Varshney, Sanjay
Position:Initial public offerings - Report
 
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  1. INTRODUCTION

    The conventional underwriting of initial public offerings typically involves investment bankers. Past research has indicated that investment bankers play an important role in the going-public process such as facilitating private information disclosure among insiders (Booth and Smith, 1986, Benveniste and Spindt, 1989). Yet some firms choose to go public by themselves in the form of self-underwriting their new issues. In this paper we study a unique set of firms that choose self-underwriting IPOs (SUI) instead of employing the service of investment bankers (IUI). We focus on our analysis on three issues. First, do self- underwriting IPOs suffer from larger underpricing? Second, how do the self-underwritten stocks perform during the first three months of trading? And third, what is the market liquidity for self-underwriting firms in the aftermarket? We study these issues by comparing IPOs that are self-underwritten with those underwritten by investment bankers.

    Why do firms choose to self-underwrite their shares? One possible reason is because of the costs associated with an IPO. Firms typically pay 7% underwriting fees to an investment banker. In addition, empirical evidences suggest a large amount of money left on the table for companies going public, which is the excess of the first day closing market price over the offer price multiplied by the number of shares offered. Loughran and Ritter (2002) estimate that the sum of money on the table and gross investment banker fees is on average about 21% of the proceeds. This phenomenon of offer prices being lower than the first day closing price, called IPO initial underpricing, has drawn much academic attention. The theories of underpricing include asymmetric information, institutional, control and behavior while the empirical evidence supports the view that information frictions have a first-order effect (Ljungqvist, 2007). More specifically, asymmetric information models assume that one of the three key parties to an IPO, the issuing firm, the investment bank, and the new investors, knows more than the others, resulting in informational frictions that give rise to underpricing in equilibrium. For example, Booth and Smith (1986) argue that investment bankers stake their reputation to certify that insiders fully disclose their private information regarding the value of the new issues to the market. The initial underpricing therefore is justified as a fair compensation for such a service. We find self-underwritten IPOs are underpriced significantly less than the investment banker-underwritten IPOs, in both the NYSE and Nasdaq markets. The average underpricing for self-underwritten IPOs is 7.76%, compared to 56.7% for investment banker underwritten IPOs over our sample period. This suggests that firms save a significant amount of money by self-underwriting their new issues.

    The second issue is related to the performance of newly issued stocks. Investment bankers can affect the secondary market trading in new issues for several reasons. First, Carter and Manaster (1990) argue that prestigious underwriters screen new issues and select the less risky firms using non-public information. The low risk of these new issues may attract fewer informed traders in the secondary market. Second, the new issues brought out by prestigious investment bankers tend to be larger in firm size, and may be characterized by more analyst following. The larger rate of flow of public information that accompanies a wider group of analysts lowers the marginal return on information gathering. Third, if prestigious investment bankers succeed in attracting more uninformed investors in the secondary market, the cost of informed trading would be spread over a larger number of liquidity traders (Easely, O'Hara, and Paperman, 1995). Finally, if, as in Benveniste and Spindt (1989) model, underwriters have induced their regular clients to reveal their positive private information in the premarket, the investment bankers begin market making in the secondary market with less information disadvantage. These arguments suggest that uninformed investors in the primary and secondary markets expect less adverse selection risk the higher the reputation of the underwriter of the IPO. We find that over the following 59 days of trading there is little difference in the mean and median stock returns between the self-underwritten and conventional IPOs. This finding is surprising given seemingly many disadvantages for self-underwritten IPOs: they probably attract fewer analyst followings and uninformed investors. Our result broadens our understanding of the benefits of investment bankers in the secondary market trading.

    Evidence on the microstructure characteristics following an IPO is sparse. The lead underwriter and other syndicate members continue to serve as major market-makers in their new issues in the over-the-counter (OTC) market. For IPOs on the NYSE, the underwriters facilitate market making by placing limit orders and acting as floor brokers. Using daily data, Hegde and Miller (1989) study IPOs during 1983-84 and report that quoted percentage spreads for IPOs are on average three-fourths as large as those for seasoned stocks. They find significant differences in both the determinants of spreads (e.g. price level and trading volume) and in elasticity across samples. Hanley (1993) and Rudd (1993) study the effects of price stabilization by underwriters. Hanley finds that the daily closing bid-ask spreads are smaller for issues hypothesized to be most affected by underwriter price support during the first ten days of trading. We find that, without the help from investment bankers, self-underwritten IPOs are significantly less liquid in the immediate aftermarket trading. They suffer from significantly higher bid-ask spreads, lower trading frequency, lower trading volumes and higher adverse selection components of the spread. After controlling for traditional determinants, the liquidity differences are significant in the immediate aftermarket, but not over longer trading horizons. Our result suggests that investment bankers help to reduce the liquidity costs for firms in the short term but not in a longer term.

    Overall our results suggest that there are benefits for firms to choose self-underwriting their new issues. Comparing to investment banker underwritten IPOs, self-underwritten IPOs have less underpricing, comparable stock returns over the next 3 months, and although suffer from higher liquidity costs on the first day, these higher costs diminish in a longer term. Our sample period coincides with the hot IPO market in the late 90s. The high demand for new issues at that time may result in good performance in the overall IPO market. However we believe the main driver for firms to choose self-underwriting comes from the advancement in information technology, information dissemination and trading, which lowers the information cost significantly in the marketplace. When the dot com bubble burst, the self-underwriting activity by IPOs came to a halt as firms were no longer able to risk bypassing the traditional investment bankers and their distribution and marketing channels. However, with future restoration of capital markets to normalcy, and further advancements in technology, it is likely that once again some firms will choose to self-underwrite their IPOs, a trend comparable to consumers bypassing realtors to...

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