Master thesis. IPO underpricing in China

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1 Master thesis IPO underpricing in China Supervisor: dr. J.K. Martin Name: Ying Xiong Studentnr.: Business Economics Faculty of Economics and Business Universiteit van Amsterdam

2 To my dearest family and Peter 2

3 Table of Contents 1 Introduction Main developments of China s IPO market Issuing system Allocation system Pricing mechanism Literature review Information asymmetry theory Behavioral theory CLAS controversies Methodology Measurement of underpricing Ex-ante model I Ex-ante model II Data and descriptive summaries Descriptive summaries Validity of the models Results Ex-ante model I Ex-ante model II Discussion and conclusion Future studies References Appendix

4 1 Introduction When firms go public to raise capital, the offer price of the issued equity is usually lower than the first day trading price. The abnormal return between the offer price and the first trading day closing price of the IPO is called underpricing or initial return. Underpricing has become a hot topic among academics since Logue (1973) and Reilly (1973) have reported this phenomenon. Its reasons have been extensively studied, especially in the U.S. stock markets (Gao, 2010). In recent years, China s IPO underpricing has drawn much attention as it is experiencing the highest underpricing in the world (Guo & Brooks, 2008). While American IPO s only gain 24.21% initial return between 1990 and 2001 (Ritter & Welch, 2002), China s average IPO underpricing has witnessed 238% between 1991 and 2005 (Zhou & Zhou, 2010). Moreover, virtually all IPO s were underpriced in China, creating the IPO never loses myth (China Economics, 2010). This only happened in China, making China s IPO market specifically interesting for researchers. Various researchers have touched on China s IPO underpricing and tried to explain the reasons of such severe underpricing. As China s IPO market was highly regulated and controlled by the government in the beginning, early studies regularly relate underpricing with government. Chen et al. (2004) investigated the relationship between government shareholdings, legal shareholdings and underpricing. Su and Fleisher (1999) tested the bribery hypothesis on underpricing. More recent studies have changed this direction toward more internationally recognized theories as the Chinese IPO market has become more market-oriented. Gao (2010) examined the rational and behavior theories on the Chinese IPO s. He and Lü (2010) studied public information, the bookbuilding method and underpricing. Zhou and Zhou (2010) looked at the hot issues market in China and underpricing. Lin (2011) investigated the effect of BBS discussions regarding the IPO shares on IPO underpricing. Despite the comprehensiveness of all research, none of the studies has explored the influence of analyst coverage on IPO underpricing in China despite the vividness of analyst coverage about the IPO price. In particular, the relation between the analyst coverage and underpricing is not investigated by any other researchers in any other countries to my knowledge. Incorporating analyst coverage to explain the IPO underpricing is necessary. Firstly, the valuations are done by different professional analysts that have more knowledge and insights about the value of the IPO than individual investors. Since individual investors 4

5 know that professionals have more knowledge than themselves, it is reasonable to assume that individual investors will be influenced by those professionals opinions. Moreover, several studies have been examined the impact of analyst coverage on the share price in general and found evidence of the importance of analyst coverage by underwriters. E.g. Michaely and Womack (1999) reported that recommendations from unaffiliated brokers have more predictive effect on the share price than the underwriter analysts; Bradley et al. (2003) reported that initiated firms experience a five-day abnormal return of 4.1% versus 0.1% for firms with no coverage. Examining the impacts of analyst coverage on underpricing not only covers a new research area, but could also unravel some new insights about the reasons of underpricing. My study thus adds value in the existing literature. China s IPO market is a great market to study the influence of analyst coverage on underpricing since various non-lead underwriters will estimate the value of the IPO which will be spread through newspapers and the internet. Before the listing date of each IPO, non-lead underwriters will analyze the value of the IPO and publish an estimated price range. The valuation will be firstly submitted to a large database before the beginning of the bookbuilding and will be published through various newspapers and websites after the offer price is announced. Not all IPO s draw equal attention from other underwriters. Some popular IPO s have gained more than 10 analyst reports and some only a few. My thesis is related to the work of Gao (2010). He examined the effectiveness of rational (information asymmetry) and behavior theory in explaining the Chinese IPO underpricing. While his sample took place at the beginning of the bookbuilding system in which the system was not well developed yet, my sample took place after a regulation reform on the bookbuilding system which has become much more market oriented. Gao (2010) has obtained quite contradictory results to the mainstream literature. It is interesting to compare the findings in the new IPO cycle with the mainstream literature. In this thesis I will generate two ex-ante models to examine the possible factors that contribute to IPO underpricing. Both information asymmetry theory and behavior theories will be tested. In particular, variables reflecting the Chinese features and variables concerning analyst coverage will be included in the models. The sample period started in June 2009 which is the start of a very interesting period for the Chinese IPO market. It is the beginning of a new round of IPO s. In September 2008, 5

6 the IPO market was shut down by the regulators due to the bad performance of the stock market 1. Besides, it is also the beginning of the implementation of the new IPO regulations (this will be extensively discussed in the next section). Furthermore, it is the beginning of a real market-oriented system. Firms which meet the listing requirement will be approved for listing and the price is also set by the market without any restriction. In the previous round IPO cycle between 2006 and 2008, only 269 IPO s have been listed within 28 months, while this amount of IPO s is reached within 12 months in the new round IPO cycle (News, 2010). The remainder of the thesis proceeds as follows. Section 2 depicts the main developments of the Chinese IPO market. Section 3 presents the explanations of IPO underpricing. Section 4 describes the methodology. Section 5 gives an overview about the data and the descriptive summaries. Section 5 presents the results. Finally, section 6 discusses the findings and concludes. 1 On 16 th October 2007, the Shanghai composite index has reached Since then, the stock market has shown a decreasing trend. On 28 th October 2008, the Shanghai composite index was dropped to 1664 (Caixun, 2011). 6

7 2 Main developments of China s IPO market China's stock exchange market is very young. It has existed for only 20 years, which is relatively short compared to the U.S. which has 200 years of history. However, China has undergone many heavy and consistently changing government regulations (Gao, 2010). In particular, there have been many reforms of the regulatory framework of the Chinese IPO market, transforming it from a highly centrally regulated system to a more market-oriented institution. Various researchers (Guo & Brooks, 2008; Chiou, J. et al., 2010) found that the degree of underpricing is significantly affected by the issuing regulations and mechanisms. Graph 1 shows the number of offerings and average underpricing on Chinese IPO s between 1990 and Graph 1: Number of offerings and average underpricing on Chinese IPO s between 1990 and 2010 The number of Chinese A-share IPO s (bars) and average underpricing (connected dots) Source: Ritter (2011). Before going into the possible variables contributing to IPO underpricing, I will first describe the main changes of China s stock market. Knowing the main developments of the Chinese IPO market enables the reader to understand its features and the source of China s extremely high underpricing. The main reforms of the Chinese IPO market focused on the issuing system, share allocation system and pricing mechanism. The following sections give an illustration of reforms in these three respective fields. 7

8 2.1 Issuing system China s IPO market has experienced two IPO issuing systems, the Administrative Authorizing System and the Approval System. The Approval System is much more market-oriented and the Administrative Authorizing System on the contrary was heavily regulated. In the early stage of the stock markets, the Chinese authority played a dominant role in issuing IPO s (Cheung et al., 2009). The Administrative Authorizing System was applied until Under this system, the quota of IPO s that could be issued in each year was controlled by the China Security Regulatory Commission (CSRC) and was part of the national investment and credit plan. IPO s were a tool to save the loss-making state-owned enterprises (SOE s). Therefore the majority of the listed companies were SOE s (Gao, 2010). The number of IPO s is allocated to provinces and municipalities. The criteria of granting an IPO to a company are based on the regional needs, quality in managements, finance and operations etc. (Guo & Brooks, 2009). According to CSRC (2009), the government intervention was necessary due to the limited economic, social and legal system. This Administrative Authorizing System had to be implemented to protect investors and to establish the stability of the stock market (Guo & Brooks, 2009). However, this system has also its drawbacks, namely it creates very high demand and low supply. Chinese investors have few profitable investment opportunities as the capital controls restrict them from investing in the foreign capital market (Chan et al., 2004) and the savings interest rate was very low. An IPO is one of the few profitable investment opportunities. Therefore, there is huge speculation in IPO s and public investors invariably rush to submit applications whenever there are new issues (Chan et al., 2004). In March 2001, China amended the IPO issuing system by adopting the Approval system. Under this system, underwriters started playing a role in issuing IPO s they are charged to take over part of the responsibilites of the CSRC, e.g. evaluating issuer s credit and risk (Guo & Brooks, 2009). Moreover, instead of having no authority about the kind of companies that get listed, underwriters are also in charge of recommending qualified companies to the CSRC under the new system (Guo & Brooks, 2008). Since this reform, China s IPO market has started linking up to the international standard and has become more efficient. Guo and Brooks (2009) found that the average time to get a company listed is reduced from 36 days to 17 days after adopting the new system. In particular, 8

9 they found that the time range under the Approval System varies between 10 and 39 days, which is much smaller than between 7 and 382 days under the Administrative Authorizing System. Table 1 illustrates the evolvement of the issuing system in the past two decades. Table 1: The development of the issuing system from 1990 to 2010 Time Regulatory System Description Administrative Authorizing System Approval System It is a centralized system. The CSRC determined quota of IPO s in each year and granted permission of IPO s to certain companies. Approval System is more market oriented. Underwriters took over part of the responsibility of the CSRC, e.g. evaluating issuer s credit and risk, recommending qualified companies to the CSRC etc. 2.2 Allocation system The second major government intervention was in the allocation system. Before 2002, a lottery system was applied to allocate shares. Investors could apply for IPO shares by submitting application forms. Each application form has a unique number and consists of a fixed amount of shares. The owner of the winning numbers would be granted IPO shares. Until 2002, the lottery system had been changed in several ways. First of all, the restriction of a limited amount of IPO application forms per investor was abolished so that investors could submit as many forms as they want. Secondly, investors had to start depositing a certain amount of money in a special saving account. The amount depends on the amount of shares that investors apply and it will be frozen during the lottery process (Chan et al, 2004). Lastly, the CSRC changed the analogue system to the electronic online system in June 1995 (Chiou, J. et al., 2010). In general, investors could gain a lot from purchasing IPO s due to high underpricing, so they are eager to invest in IPO s. Therefore, a tremendous amount of money was frozen for the new shares, leading to few investments and activities in the secondary market. To stimulate participation in the secondary market, the IPO allocation system was changed to the secondary market proportional offering in May 2002 (Guo & Brooks, 2009). This new system only allowed investors holding shares in the secondary market to submit IPO application forms. In particular, the amount of IPO shares they could subscribe to 9

10 depends on the market value of the shares they have in the secondary market (Guo & Brooks, 2009). Despite the good intention, the secondary market proportion offering did not work out due to the distorted supply-demand equilibrium. Thus the system was abandoned and the market-oriented bookbuilding system was adopted in August Under this system, usually around 20% of the IPO shares are allocated to the institutional investors 2 and the remaining 80% to the individual investors through the lottery system (Gao, 2010). The institutional investors which have submitted valid prices 3 during the bookbuilding process will receive amounts of IPO shares equal to the proportion of their valid demand relative to the total valid demand 4 of institutional investors (CSRC, 2010). After implementing the bookbuilding system, underpricing has been reduced significantly. Between July 2006 and April 2008, IPO underpricing was lowered to 157% (Gao, 2010), almost 50% less than in the 1990s. Table 2 summarizes the main developments of allocation system between 1990 and Table 2: Main developments of allocation system between 1990 and 2010 Time Regulatory System Lottery System Secondary Market Proportional Offering System Bookbuilding System Description The shares are allocated by a lottery system. In 1995, the electronic online system is introduced. Shares are allocated to subscribers that have shares in the secondary market. The amount of the allocated shares is proportional to the amount of shares that investors obtain in the secondary market. 20% of the shares are allocated to the institutional investors. The amount of allocated shares is equal to the proportion of the valid demand relative to the total valid demand of institutional investors. The remaining 80% is allocated to individual investors through the lottery system. 2 Institutional investors refer to the securities investment funds management companies, securities companies, trust and investment companies, financial companies, insurance institutional companies, and qualified foreign institutional investors that meet the conditions prescribed in the present Measures, and other institutional investors authorized and approved by the CSRC (Invest in China, 2006). 3 Valid price is the price submitted by institutional investors that is higher than or equal to the offer price. 4 Valid demand is the demand which is related to the valid price. 10

11 2.3 Pricing mechanism The third major government intervention is related to the pricing mechanism of IPO s. Contrary to the American stock market, where the IPO price is set by market forces, the Chinese IPO price has been controlled by the CSRC for a long time. From 1990 to 1998, the price was artificially set around 15 times of the earning per share in the range of 13 to 16 (Chan et al, 2004). The offer price is much lower than the face value in the secondary market, creating huge abnormal returns (Chiou, J. et al., 2010). Chen et al. (2004) estimated that the average underpricing between 1992 and 1997 was 298%. From July 1999 to the first half of 2002, Chinese regulators tried the auction system in which the price is set mainly by individual investors through online bidding (Gao, 2010). The auction system was meant to reduce the huge underpricing. However, it did not reach the expected target. Instead, the price of the IPO was pushed to a historically high level. As a result, many stocks experienced a loss in the secondary market (Gao, 2010). Having perceived this situation, China s IPO market abandoned the auction system and returned to the controlled price-earning (P/E) mechanism in July Under this pricing mechanism, the IPO price is set with the cap of 20 times P/E ratio (Gao, 2010). In 2004, the Company and Securities Laws were amended to suit the more developed stock market condition (Chiou, J. et al., 2010). One of the important amendments was that the offering price no longer needs to be approved by the CSRC (Chiou, J. et al., 2010). As mentioned in the previous section, the internationally popular bookbuilding method was finally reinforced. Under this system, the price is firstly determined by institutional investors through a price inquiry process. Individual investors could apply the new shares at the determined price (Gao, 2010). Because China has very little experience with this method, the CSRC implicitly put a price cap of 30 times P/E ratio (Gao, 2010) in order to prevent an overheated stock price (CSRC, 2009). The new adopted method has effectively pushed China s IPO issuing system toward more market orientationh. However, the system is still not well-developed. Since the institutional investors have the same right as an individual investor in applying new shares online, they have little incentive to convey the true price. It widely happened that institutional investors do not buy the shares after having submitted a high demand during the price inquiry, or buy many shares after having submitted low demand (CSRC, 2009). 11

12 To eliminate this phenomenon and induce the true value, the CSRC further amended the IPO regulations in June 2009 which is the beginning of the sample period. Firstly, the institutional investors who have participated in the price inquiry are prohibited from applying shares online as individual investors. Secondly, the quota of the applied shares by individual investors is limited to 1/1000 of the total issued shares. Thirdly, the issuer is required to set a minimum quantity that the participated institutional investors have to apply. So the only way for the institutional investors to obtain IPO shares is applying shares offline during the bookbuilding process. As a result, the institutional investors are more motivated to submit the true value of the IPO. Finally, to further liberalize the IPO process, the implicit cap of 30 times P/E ratio is removed. Table 3 described the main developments of the pricing mechanism of IPO s. Table 3: The main developments of the pricing mechanism of IPO s Time Regulatory System Description Fixed P/E ratio The price is set around 15 times P/E ratio in the range of 13 to Auction System The price is set mainly by individual investors through online bidding Controlled P/E ratio The price is set with the cap of 20 times P/E ratio Bookbuilding method with the price cap Bookbuilding method The price is set after the price inquiry. However, there is an implicit cap of 30 times P/E ratio. The price ceiling is abolished. It is determined completely by the market force. In my sample, the Chinese stock exchanges used the offline electronic system for the price inquiry process and purchasing process, enabling institutional investors submitting applications through the internet (SSE, 2009; SZSE, 2008). During the price inquiry for the IPO s that will be listed in the Shenzhen Stock Exchange (SZSE), the issuer will give a price range as a reference that is only shown to the participated institutional investors and not revealed to the public. Figure 1 shows a window of the price inquiry on the electronic system of SZSE. In this window the institutional investors can read quickly through the main information about the IPO, including the initial price range set by the lead underwriter. Figure 2 shows the window of the possible IPO demand during the price inquiry. In this window, the institutional investors can submit three different prices and the 12

13 related quantities they are willing to buy. Figure 1: Electronic system for price inquiry I of SZSE: information about the IPO 1. Initial price inquiry 2. Low price of the price range given by the lead underwriter, only meant for references 3. High value of the price range given by the lead underwriter, only meant for references Source: (SZSE, 2010). 13

14 Figure 2: Electronic system for price inquiry II of SZSE 1. Minimum purchasing quantity 2. The maximum purchasing quantity 3. The smallest unit to add when purchasing more than the minimum quantity 4. The ratio of the highest price divided by the lowest price during the price inquiry 5. The possible demand data Possible price 1 7. Possible quantity 1 (x10,000 RMB) Source: (SZSE, 2010). Having been through the main developments of the IPO regulations in the last two decades, we can see that the IPO issuing system has become more market oriented. In the early stage, the quota, the region and the kind of company of the issued IPO s were determined by the Chinese government. Moreover, the offer price and the share allocation were strongly controlled by the CSRC, creating huge underpricing. Fortunately, the degree of the government intervention has been gradually reduced and China s IPO market is evolving to meet the international standard. Figure 3 illustrates the main 5 Institutional investors are allowed to submit three different prices and the related quantities. The possible demand 1 indicates the first price and the quantity. Under number 6, investors can submit the possible demand 2 and 3. 14

15 developments of the IPO markets on the fields of the issuing system, the allocation system and the pricing mechanism through years. Figure 3: Time line of the main developments of China s IPO market on the fields of the issuing system, the allocation system and the pricing mechanism 1990 Shanghai Stock Exchange and Shenzhen Stock Exchange are established Administrative Authorizing System is adopted Shares are allocated through the lottery system Fixed P/E ratio is adopted 1999 Auction System is adopted 2001 Approval System is implemented 2002 Secondary Market Proportional Iffering System is reinforced Controlled P/E ratio system started in use 2004 Bookbuilding system is introduced with the price cap 2009 Bookbuilding system is still in use, the price cap is removed 15

16 3 Literature review Systematic increase of the offer price compared to the first day closing price is called underpricing (Ritter & Welch, 2002). It is a common phenomenon which happens widely in every nation s stock market (Guo and Brooks, 2008). There is a large amount of literature on IPO s regarding the explanations of IPO underpricing (Gao, 2010), forming two main streams: information asymmetry and behavioral theory (Xie, 2010). These two theories will be reviewed below. Furthermore, the CLAS controversies which are termed by Ritter (2011) will be discussed. Graph 2 and Graph 3 show IPO underpricing in different countries in Europe, Asia Pacific and Latin America. In general, underpricing remains under 40% in all countries, except for Poland and Malaysia which have underpricing exceeding 60% and 90% respectively. The figures show underpricing of different countries, indicating the severity of China s IPO underpricing which is 238% between 1991 and 2005 (Zhou & Zhou, 2010). Graph 2: IPO underpricing in Europe between 1990 and 2003 IPO underpricing is measured by the return of the first trading day closing price over the offer price for all countries, except for France and Greece where they are measured on the fifth day of trading due to daily volatility limits. Between 1990 and 2003, 4,079 IPO s were completed in the 19 countries shown in the figure. This breaks down as follows: Austria (83), Belgium (102), Denmark (69), Finland (70), France (679), Germany (583), Greece (301), Hungary (54), Ireland (22), Italy (158), Luxembourg (5), Netherlands (77), Norway (167), Poland (214), Portugal (33), Spain (47), Sweden (180), Switzerland (68), and the United Kingdom (1,167). Source: Ljungqviste (2007). 16

17 Graph 3: IPO underpricing in Asia Pacific and Latin America between 1990 and 2001 IPO underpricing is measured by the return of the first trading day closing price over the offer price for all countries. Between 1990 and 2001, 2,716 IPO s were completed in the 16 countries shown in the figure. This breaks down as follows: Australia (633), Hong Kong (523), Indonesia (213), Malaysia (506), New Zealand (51), Philippines (91), Singapore (313), Thailand (251), Argentina (25), Barbados (1), Brazil (13), Chile (7), Colombia (3), Mexico (79), Uruguay (1), and Venezuela (6). Source: Ljungqviste (2007). 3.1 Information asymmetry theory Information asymmetry theory argues that different relevant parties hold different degrees of information about IPO s. In this section, information asymmetry among investors (Winner s curse hypothesis) and information asymmetry between investors and issuers (Market feedback hypothesis and Signaling theory) will be described. Winner s curse hypothesis One of the most well-known information asymmetry theories is the Winner s curse hypothesis which is proposed by Rock (1986). He divided investors into informed and uninformed investors. Informed investors know the true value of the IPO and will only apply for it if it is underpriced so they can gain profit. Uninformed investors have little idea about the true price of the IPO and will bid indifferently for both profitable and unprofitable 17

18 IPO s. As a result, less-informed investors will receive all unprofitable shares they bid and will be rationed in profitable shares. In the extreme case, uninformed investors will be rationed completely in profitable IPO s, leading to negative return (Ljungqviste, 2007). In the long run, uninformed investors will develop adverse selection behavior, abstaining from the IPO market and leaving only informed investors behind. However, Rock (1986) assumed that the IPO market also needs uninformed investors as informed investors do not have enough capital to absorb all IPO s. Therefore, IPO s need to be underpriced to compensate uninformed investors and keep them active in the IPO market. Koh and Walter (1989) examined Rock s hypothesis by examining IPO s in Singapore where the chance of receiving shares are equal to the same subscription amount. They define small shareholders which only subscribe 1000 shares as uninformed investors and large investors which apply for to more than 250,000 shares as informed investors and found that small, uninformed investors are indeed less responsive to severe underpricing and hence will not necessary gain profit in average. So IPO s need to be underpriced to keep these uninformed investors in the IPO market. One of the core ideas of the winner s curse is that uninformed investors will receive zero average initial return after rationing, just enough to retain uninformed investors (Ljungqviste, 2007). Koh and Walter (1989) found evidence that the initial return of uninformed investors is not significantly different from the risk-free rate. In particular, the initial return drops to 1% after the rationing. However, Amihud et al. (2003) found that uninformed investors who have participated in all IPO s earned a negative allocation-weighted return in Israel in early 1990s. This finding is inconsistent to Rock s theory as this phenomenon suggests that IPO s are overpriced for uninformed investors (Amihud et al, 2003). Yu and Tse (2006) studied winner s curse in the Chinese market and found that the average allocation rate for overpriced IPO s is 34%, which is much higher than 1.51% by the underpriced IPO s. This evidence suggests that uninformed investors have a higher probability of obtaining overpriced IPO s 6. Furthermore, the authors found that uninformed investors in the Chinese market indeed break even after adjusting the rationing. Su (2004) uses the proxy percentage shares held by insiders and institutional investors to measure the severity of the winner s curse problem. He found significant 6 Winner s curse hypothesis is only weakly validated by Yu and Tse (2006) as they only have 7 overpriced IPOs in their sample, out of 343 IPOs. 18

19 positive relation between underpricing and this proxy, referring that informed investors select underpriced IPO s. Michaely and Shaw (1994) have also proved Rock s theory, supporting adverse selection behavior. They further argued that if investors become more homogenous, e.g. if there are only uninformed investors in the IPO market, underpricing will not exist. Therefore, issuers have the incentive to reduce the information asymmetry among all investors as underpricing is costly to issuers (Ljungqviste, 2007). Habib and Ljungqvist (2001) reported that issuer will take actions to reduce information asymmetry. However, issuers will firstly trade off underpricing and actions to maximize their wealth, and will incur direct costs for actions only to the point where the marginal cost of the taken action equals the marginal benefit. One of the good methods for reducing asymmetry information among all investors is hiring a reputable underwriter. Carter and Manaster (1990) argued that reputable underwriters are associated with lower risks. As the underwriter can be easily perceived by all investors, the degree of information asymmetry among informed and uninformed investors is therefore reduced. Various researchers have found a significant negative relation between the reputable underwriters and underpricing (Carter & Manaster, 1990; Michaely & Shaw, 1994). Gao (2010) on the contrary found that the reputable underwriter does not play an significant role in China s IPO market. Lastly, public information such as firm size, ratio of the issued share relative to retained shares (overhang ratio) and waiting time between the issue date and the listing date will also reduce the information asymmetry among investors. Here I will explain the relation between the waiting time, information asymmetry and underpricing in detail since it is a Chinese feature. In the U.S. the IPO can be traded in the secondary market one day after the issue (Pilgrim, 2010). Conversely, it is unknown in China how long the waiting time will be. Chen et al. (2004) reported that it was common for IPO s issued after the 1990s to wait for half a year before getting listed. The duration is created by meeting various required regulations (Chen et al, 2004). Guo and Brooks (2009) argued that the waiting time is an indication of the quality of firms. They reported that IPO s with good quality tend to be subscribed and listed faster. Underpricing is required in case the duration is long because the investors have the risk that the IPO will not be listed and their investment are locked for a long time (Chen et al, 2004). Chan et al. (2004) reported that the average waiting time between 1993 and 1998 is days and that it is significantly positively related with the underpricing. Chen et al. (2004) found that the underpricing of IPO s with 19

20 less than 2 months duration is much smaller than those with longer than 2 months. In their sample, the average underpricing for the former IPO s is 110% and 631% for the latter. Market feedback hypothesis In the previous paragraph, information asymmetry among investors is described. I will now review the second information asymmetry in which investors have more information than issuers. In this case, issuers do not know about the acceptable market price and the demand of investors (Ritter & Welch, 2002). Benveniste and Spindt (1989) and Spatt and Srivastava (1991) argued that bookbuilding system can reduce this kind of information asymmetry, allowing issuers to obtain information from investors. Under the bookbuilding method, a preliminary offer price range is firstly set by issuers, then issuers will go on road show to promote the IPO, targeting potential investors. During the road show, issuers could estimate the demand based on the interests shown by the potential investors. If investors are very enthusiastic about the IPO, indicating high demand, the issuer will then set a high offer price and vice versa. Knowing that the consequence of revealing the true demand is getting higher price and thus obtaining a lower initial return, investors are reluctant to reveal the true feeling about the IPO. In order to induce investors to reveal the true information, issuers have to compensate investors by setting a lower price than the true value (Ritter & Welch, 2002). Therefore issuers only partially adjust the price information. Hanley (1993) has firstly examined this partial adjustment in her study. She tested the implication of the price revision after gathering information from investors and found that issuers do not fully adjust the information into the offer price, still leaving a large amount of money on table. Her study shows that if the offer price of an IPO is positively revised from the preliminary price range based on the obtained information, the IPO will be significantly more underpriced than other IPO s. Ritter (1998) reported that IPO s with upward price revision in the U.S. have an average initial return of 30.22% between 1990 and However, IPO s with a downward revision only show 3.54% initial return on average. In general, empirical results support the theory of Beneviste and Spindt (Ljungqviste, 2007). Bradley and Jordan (2002) even found evidence that the revision on the original file range (not on the offer price) in advance of the offer date also play a significant role in influencing the underpricing. Gao (2010) on the contrary reported a 20

21 different result in China. By examining 217 Chinese IPO s between 2006 and 2008, he found that the price adjustment is negatively correlated with underpricing. In other words, his study shows that with every 1% price upward revision, underpricing will be reduced by 3.6%. The reason for this result is that the bookbuilding method in China is not fully an information extraction process. The bid price offered by institutional investors during the bookbuilding process has nothing to do with the shares that can be allocated (Gao, 2010). Signaling hypothesis The third information asymmetry is about issuers have more insights regarding the value of the IPO than investors. Consider that investors have little idea about the true value of the IPO, rational investors will fear the lemons problem: only companies with worse than average quality are willing to go public (Ritter & Welch, 2002). To show their value, high quality issuers will use underpricing to signal their superiority in case the investors are less informed than the issuers (Welch, 1989). Welch (1989) argued that only high quality issuers can afford underpricing the IPO, because they have lower marginal cost of underpricing the IPO than the low quality issuers. Moreover, the cost of underpricing of the high quality issuers will be compensated when they issue seasoned equity offerings (SEOs) at a higher price. By that time, the investors have learned from their initial purchase and are able to observe the true value of the firm. Therefore they are more willing to pay a higher price for the SEO. Low quality issuers on the other hand will not gain from SEO s and will even incur extra imitation costs if they tried to imitate the high quality issuers. They are better off to reveal themselves as low quality issuers. Thus, high quality issuers are more likely to raise SEO s since they can distinguish them from low quality issuers by underpricing the IPO. In line with Welch, Chen et al. (2004) assumed that issuers use an IPO as a pilot experiment allowing investors to learn the true value of the shares. The real financing will be raised via SEO if the IPO is a success. Therefore, issuers underprice IPO s to attract investors, leaving a good taste to investors. However, they did not find significant evidence in the Chinese A-share IPO market in the period of 1992 through Also, Yu and Tse (2006) conclude that the signaling model does not hold in the Chinese market based on their study of 343 Chinese IPO s during 1996 and Su (2004) on the contrary have found a positive relationship between the degree of IPO underpricing and 21

22 the probability for a firm to issue SEO s. Besides, he has also found evidence that the higher the IPO underpricing, the larger is the size of the SEO. 3.2 Behavioral theory Behavioral theory is interesting to examine since Gao (2010) reported that the behavior theory is more significant in explaining underpricing than the rational theory (information asymmetry theory) in China in the early period of the bookbuilding system. While information asymmetry theories suggest that investors make their decisions based on rational arguments, behavioral theories argue that investors are (partially) sentiment-driven, disregarding rational information. Ljungqviste (2007) argues that irrational investors may be overoptimistic about a certain IPO, driving up IPO price. Gao (2010) finds evidence that underpricing is overvalued by sentiment investors, indicating the first day price does not reflect the true price. By studying the grey market in Europe, Cornelli et al. (2006) have even calculated that the investor s overoptimism causes aftermarket prices 40.5% higher than in the absence of those investors. In this section, informational cascades and investor sentiments will be explained. Informational cascades Welch argued (1992) that IPO shares are sold sequentially. Later investors tend to ignore their own information and imitate the purchasing decision of earlier investors. So if the issue does not attract many investors despite favorable information, the probability of an IPO failure will then be very likely as investors will not purchase the shares because other investors do not buy. Conversely, if the initial sale was a big success, later investors will believe that the issue is hot and will therefore request the shares, generating a snowball effect. In realizing their importance of inducing a positive purchasing sentiment among investors, early investors will demand more underpricing in return for committing to the IPO (Ljungqviste, 2007). Ritter (1998) calls the cascade effect a bandwagon effect and has found an interesting relation between the information cascade hypothesis and the market feedback hypothesis. In market feedback theory, the offer price will be upward adjusted if the expected demand is high. Therefore, upward adjustments are perceived as an indication 22

23 of hot issues, causing positive information cascades. Of cause, downward price adjustments will induce negative information cascades. China is an interesting market to test the cascade effect since Chinese people are very group-oriented. They will make a share purchase decision based on the purchase behavior of other investors (Chi & Padgett, 2005). Besides, China s IPO market is a suitable place to study the individual behavior since it applies a lottery system to allocate around 80% of IPO shares to the individual investors. The winning lottery ratio is a good variable to measure the cascade effect. It is the ratio of successful subscribers on total valid subscribers, which reflects the popularity of a particular IPO (Guo & Brooks, 2008). In other words, a low lottery ratio refers to a high demand that will bid up the offer price, resulting in high underpricing. Gu (2000), Chi and Padgett (2005) reported that there are bandwagon effects in China s IPO market. Many other researchers have found a significant negative relation between the winning lottery ratio and underpricing (Lin, 2011; Xie, 2010; Francis et al, 2009; Chiou, J. et al., 2010; Gao, 2010; Guo & Brooks, 2008). Although the winning lottery ratio plays a significant role on underpricing, its contribution is very small. In general, for each percentage increase in the winning lottery ratio, the underpricing will be reduced by less than 1%. However, Xie (2010) found in his sample (between 2005 and 2006) that each percentage point increase in winning lottery ratio decreases the underpricing by 56.76%. Investor sentiment The investor sentiment hypothesis suggests that some investors are overoptimistic about the value of IPO s, paying insufficient attention on profitability in valuing IPO s (Purnanandam & Swaminathan, 2004), leading to high underpricing on the first day. Hence, the first day price does not necessary reflect the true value of the IPO. Loughran and Ritter found that IPO s in the U.S. underperform significantly compare to comparative non-issuing companies in five years after the listing (1995). Various studies found the same result across other countries (Chan et al, 2004). Gao (2010) reported that the difference between the first day closing price and the offer price contains two elements, namely the underpricing and the overpricing component. He argued that the overpricing component, rather than the underpricing component of the IPO initial return predicts IPO long-term underperformance. 23

24 Ljungqvist et al. (2004) argue that the impact of investor sentiment is regarded as particularly acute in periods in the hot issues markets. Ibbotsen and Jaffe (1975) originally examined the existence and implication of these markets. They define hot issues markets as periods in which the average first-month performance (or aftermarket performance) of new issues is abnormally high. In other words, there are high autocorrelations of monthly average initial return. Ljungqvist et al. (2004) assumes that there may be an additional inflow of optimistic investors if the hot market continues. Ritter (1984) reported that there have been three or four periods during 1960 and 1982 in which the monthly average underpricing on IPO s has been extremely high for prolonged periods. He further showed that each of these hot issues periods was followed by a large and prolonged increase in the volume of initial public offerings. Zhou and Zhou (2010) examined this market cycle by studying 1380 Chinese IPO s between 1991 and 2005 and conclude that the monthly IPO volume and the average initial return are highly correlated. They found that high IPO underpricing tends to lead to more IPO s in the consequent months. Graph 4 shows the monthly average return and the IPO volume in China between 1991 and Bradley and Jordan (2002) tested the effect of hot issues markets on underpricing by using average daily initial return for all IPO s in the last 30 days before the issue date. Consistent with Ibbotsen and Jaffe (1975), they found a significantly positive relation between hot issues markets and underpricing in the U.S. between 1990 and Graph 4: Monthly average return and the IPO volume in China between 1991 and Source: Zhou and Zhou (2010). 24

25 Another measure for investor sentiment is media coverage. Tetlock (2007) argued that media coverage is linked to the behavior of individual investors, e.g. high values of media pessimism induce downward pressure on market prices. Bradley et al. (2003) reported that IPO firms which have almost positive analyst coverage will experience a five-day abnormal return of 4.1% relative to 0.1% for firms without coverage around the end of the quite period. Moreover, the authors reported that the more media reports by multiple analysts, the higher the increase of the share price. This is because that large media coverage brings the stock to the attention of more investors, shifting out the demand curve for the stock (Aggarwal et al, 2002). Michaely and Womack (1999) have studied the impacts of recommendations about IPO stocks by the lead underwriter analyst and other underwriter analysts on the stock price. They reported that the performance of the firms recommended by the lead underwriter analyst is significantly worse than those from other underwriters. Interestingly, the authors found evidence that the same underwriter makes better recommendations when it is not the lead underwriter. Hence, it is not the ability of underwriters, but a bias which is directly related to whether the recommender is the lead underwriter. Lin (2011) has studied the relation between IPO underpricing, investor sentiment and online discussions. The author collected discussion messages between October 2009 and May 2010 from the online forum guba.eastmoney.com, which is the most popular online forum for discussing stocks in China. Lin (2011) measures the investor sentiment and found the number of the messages regarding a particular IPO play a significant role. This finding is consistent with Aggarwal et al. (2002). Furthermore, the author did not find evidence of investor optimism and disagreement between investors influencing the IPO underpricing. Lastly, market momentum can also be used as a proxy of investor sentiment (Gao, 2010). Market momentum is originally explained by Loughran and Ritter (2002) and is an indicator of market movements. The authors argued that underpricing will be higher following market rises. Gao (2010) and Chiou et al. (2010) have tested this proxy on the Chinese IPO market and found that the market momentum is significant relative to underpricing. Moreover, Gao (2010) reported that the market momentum also contributed to the overpricing component of IPO s, indicating overoptimism of investors. 25

26 3.3 CLAS controversies Ritter (Ritter, 2011) criticized the recognized importance of information asymmetry theory among many researchers. He estimated that information asymmetry theory only explained 2% to 5% underpricing. The author argued that excessive underpricing which took place e.g. during the internet bubble years is mainly caused by the CLAS effect. CLAS stands for Commissions, Laddering, Analyst conflicts of Interest and Spinning. The terms will be explained below. Except conflicts of interest among analysts, the other three terms are related to the share allocation. According to Ritter (2011), underwriters have discretion in allocating shares to investors and they also use this discretion to reach certain purposes. The first purpose mentioned by Ritter (2011) is to gain more commissions. Underwriters will allocate popular underpriced IPO shares to rent-seeking investors if they receive payments from the investors as a reward. Secondly, underwriter will also allocate popular underpriced IPO shares to certain investors only if the investors promised to buy additional shares in the immediate aftermarket. The purpose of buying extra shares is artificially pushing up the share price. This practice is called laddering. Thirdly, in order to gain the mandate of underwriting, underwriters will promise to allocate shares to the private accounts of corporate executives. This is called spinning. Another way to win the mandate of the underwriting is promising favorable media coverage written by influential security analysts. This practice is the conflicts of interest among analysts mentioned by Ritter. Despite the interesting insights of reasons about high underpricing in the U.S., the CLAS effect is not really applicable in China during the bookbuilding period. This is because that the underwriters do not have the discretion of allocating shares (Wu & Shao, 2009). As described in the section The Allocation System, shares for individual investors are allocated through the lottery system and shares for institutional investors are distributed proportionally to their demand relative to the total valid demand. Conflicts of interest among analysts is the only practice that might be present in China as it is not related with share allocation. 26

27 4 Methodology and Hypothesis The objective of the thesis is finding explanatory variables of underpricing before the IPO gets listed, making IPO underpricing more predictable. Therefore I have constructed two ex-ante models. The first model is meant to unravel possible factors that influence the underpricing before setting the offer price but after the price inquiry process. The second model explains variables that contribute to the underpricing before shares get listed, after completing the issuance. In the models, both information asymmetry theory and behavioral theory will be tested combining Chinese features. In particular, the influence of the price analysis written by non-lead underwriters on IPO underpricing will be examined. In China, non-lead underwriters will analyze IPO s and give advice of the reasonable price range. This report with the price range will be submitted first to the large database such as the Wind database before the price inquiry. Institutional investors and other clients of the database are able to view the price ranges in the early stage. Usually the price ranges reported by non-lead underwriters will be published during the period after the price inquiry but before the listing date on different newspapers and websites such as finance.sina.com, finance.ifeng.com, stock.sohu.com etc. Since the price ranges are set by unaffiliated professionals, it is interesting to test their influence on underpricing. The models will be presented below. Firstly, the term initial return or underpricing will be defined. 4.1 Measurement of underpricing As described in the introduction, the return of the first-day closing price and the offer price of an IPO is called initial return or underpricing. It is calculated as follows: 1 100% RET represents the initial return or underpricing. P 1 is the stock market price at the end of the first trading day, P 0 is the offer price of the IPO. 27

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