Does IPO mispricing impact underwriter market value in China?

Transcription

1 FACULTEIT ECONOMIE EN BEDRIJFSWETENSCHAPPEN Does IPO mispricing impact underwriter market value in China? Quinten Arnouts in samenwerking met Christophe Houben S Masterproef aangeboden tot het behalen van de graad MASTER IN DE TOEGEPASTE ECONOMISCHE WETENSCHAPPEN: HANDELSINGENIEUR Major Accountancy en financiering Promotor: Prof. Dr. Nancy Huyghebaert Werkleider. Weidong Xu Academiejaar

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3 ABSTRACT China s financial markets and its regulatory system are different from most other nations. The IPO system has changed drastically in the last decade, notably in June of 2009, when the CSRC decided to no longer intervene in the pricing of IPOs. The purpose of this study is to detect the impact of IPO mispricing on the underwriter s market value in the People s Republic of China. Because of the CSRC reform, we only consider IPOs after June of By using a sample of 142 IPOs over the period from June of 2009 to 2010, we find that mispriced IPOs do indeed negatively impact underwriter market value. The impact of IPOs that are insufficiently underpriced is considerably weaker than that of IPOs that are excessively underpriced. We can therefore also conclude that investment bank shareholders believe IPO issuers have a larger influence on the future market value of the bank than investors do. 3

4 1 Introduction When a firm goes public in an initial public offering (IPO), it uses an investment bank as intermediary between the issuing company and the investors who are interested in buying the firm s stock. The IPO process is usually led by a syndicate of investment banks, one of which is the so-called lead underwriter. This investment bank syndicate has several tasks and obligations. A first one is to assist the IPO firm in selling the shares on the stock exchange to investors. It is also the task of the underwriter to set a fair offering price, based on a due diligence investigation of the issuer. Moreover, the syndicate will perform marketing actions for the stock, such as conducting a road show, as explained by Ritter (1998). Once the IPO goes public, it will, if necessary, support the price in the aftermarket. Finally, it will also provide a monitoring of the company after the IPO has taken place, which it does to protect its own reputation. The Chinese stock market has a number of interesting characteristics. As with the entire Chinese economy, the financial system in China has experienced a steep growth in the last decades. The Chinese stock market boomed since its opening in 1991 and at the end of 2012 the Chinese securities market (both Shenzhen and Shanghai combined) listed 2494 companies (A-shares and B-shares combined) with a total value of 3,7 trillion US dollars. IPO data of 2011 shows that Greater China 1 accounts for more than 31% of the world s IPOs with 388 deals, worth over 72 billion US dollars, while the United States had 108 deals worth 36 billion US dollars. This growth did not come without complications. The strict 1 Greater China includes Mainland China, Hong Kong and Taiwan. 4

5 government control and regulations gave rise to some problems at the beginning of the 21st century. The regulators intervened heavily in new public offerings, which distorted the market s ability to accurately value these companies. A first important reform was implemented in 2005, gradually giving more freedom to the market. A second reform took place in June of 2009, when the CSRC decided to no longer intervene in the pricing of IPOs. This did not, however, mean that IPO prices and their underpricing were identical to Western customs. Loughran et al. (1994, update in 2012) show, with regard to this matter, that Chinese stocks have some of the biggest average first-day returns out of almost 50 countries with an average first-day return of 137,5% from 1990 to 2010 compared to a total average of 30,33%. Our paper tries to obtain a better understanding of the market s perception on the pricing of IPOs by underwriters in China. We look at the impact of IPO mispricing on the underwriter s market value in China in the period between June of 2009 and It seems, for instance, that mispricing will lead to a negative image for the investment bank, which is likely to be reflected in the underwriter s reputation. We hope to find evidence of this reputational effect and to quantify it. In order to comprehend the impact of IPO mispricing on underwriter market value, we first estimate the correct level of underpricing. To do so, we develop a regression model including IPO firm characteristics to estimate the expected level of IPO mispricing. In a next step, we deduct the expected from the actual first-day 5

6 abnormal 2 returns and we then look at what impact this difference has on the market value of the underwriters. Using a sample of 142 IPOs over a period from June 2009 to 2010, we study the impact of IPO mispricing on underwriter market value in China. Given that the more an IPO is underpriced, the more profits the issuer loses, the issuer should react negatively to excessive underpricing. We hypothesize that they do so by damaging the reputation of the underwriters and refusing to do future business with them. Investment bank owners should take this information into account when valuing the bank s share value and we thus expect excessive underpricing to negatively impact underwriter market value. We observe that banks that underwrite an excessively underpriced IPO do indeed experience a significant loss in their market value. The mean first-week abnormal return of these banks after the IPO date is -2,05% and the mean first-month abnormal return is -7,71%. On the other hand, insufficiently underpriced IPOs should displease investors, as they receive too little profits. We expect investors to have less influence on the Chinese IPO market than issuers do. They have limited alternative investment possibilities, are eager to participate in the highly profitable Chinese IPOs and are relatively inexperienced in reacting to IPO pricing set by the underwriter. They should therefore react less strongly to unfavourable IPO pricing. We observe that the mean first-week abnormal return of the market value of underwriters of insufficiently underpriced IPO is -1,24% and the mean first-month abnormal return is -4,57%. This is, indeed, a significant but smaller impact. This means that investment bank owners believe that the loss in underwriter market value of the 2 Abnormal return indicates that the return is adjusted for the same-period market return. 6

7 bank due to displeased investors will be smaller than the loss due to displeased issuers. From these results, we can conclude that mispricing does indeed impact underwriter market value and that the issuers dominate the IPO market in China. The results of this paper are useful for multiple reasons. First and foremost, our research indicates that IPO mispricing (either excessive or insufficient underpricing) negatively impacts underwriter market value in China. This has important implications for investment banks that want to underwrite a Chinese IPO. Our study implies that these investment banks should make sure that they dedicate the necessary resources to determining the expected IPO price in order to avoid the negative value implications for their market value. Secondly, it provides interesting insights into the Chinese stock market, allowing Western investors to obtain a better understanding of Chinese financial markets. After the 2009 reform, the market had to adapt to the new system and freedom. With our research, we analyse the underwriter s valuation skills and obtain a better understanding of mispricing in China. A final major use is the possibility for comparison. If similar research were performed in different markets (European stock markets, American stock markets ), we could analyse differences in mispricing levels in these markets and how they impact underwriter market value. Nanda and Yun (1997) have already performed related research on IPO mispricing in the American stock market. Because our paper uses a different way of estimating the level of mispricing, a precise comparison is not feasible. However, their results lead us to believe that insufficient and excessive underpricing in the American stock market 7

8 impacts underwriter market value in a similar manner as it does in the Chinese stock market. The remainder of this paper is organised in the following way. In section 2, we talk about the Chinese financial system and its application to our analysis. Section 3 gives an overview of relevant literature about the Chinese stock market and underpricing. This literature study is then used in combination with China s unique characteristics to form our hypothesis. In section 4, we describe the data and the methodology used to obtain our results. Section 5 presents the results from our model and discusses its meaning. And finally, section 6 concludes this paper. 2 Chinese Stock Market Having been established in 1991, the Chinese stock market is roughly 200 years younger than the NYSE and the LSE. The Chinese financial system has followed an evolution similar to the Chinese economy in general: a late start in comparison to Western economies and an impressive growth in an attempt to catch up. However, it has not quite succeeded in doing so and this is especially true for the stock markets. Naughton (2006) gives a good overview of the Chinese stock market. Despite impressive efforts to develop these markets and the implementation of several reforms, China s shortcomings became apparent after 2000 and translated 8

9 into a decline of stock market capitalization as a fraction of GDP. Two pivotal years for Chinese stock markets were the year 2005 and the year In the years before 2005, the Chinese stock market had a number of characteristics that obstructed the full development of the market. A first was the segmentation of the stock market. On the one hand, the market was divided into A-shares (the primary type of shares, denominated in Chinese currency and available only to Chinese citizens), B-shares (denominated in foreign currency and originally reserved for foreign investors) and H-shares (listed by Chinese companies on the Hong Kong stock exchange or on other markets outside of China) and on the other hand between tradable and nontradable shares. This division lead to low contestability of control, reduced liquidity of the market and a solidification of state control. A second characteristic of the stock markets before 2005 was the state and regulator interference and control. The listing opportunities were rationed because listing was so lucrative, distorting the market s ability to accurately value the companies. Disclosure and regulation standards were also very poor, allowing state-owned enterprises to manipulate their earnings, although concerted efforts had been made to improve disclosure since Throughout the years, the clear majority of shares on the Chinese stock market have been non-tradable ones, which are usually controlled either directly or indirectly by the state. Due to the rigid nature of these shares, they are not attractive to investors and impend the liquidity of the market and thus its 9

10 development. Not until 2005 did policy makers succeed in abolishing this distinction. In 2005, they devised a way to reduce the number of non-tradable shares. They allowed each company to decide on itself how to reduce that number. Often times, this involved some sort of compensation for holders of tradable shares. This was an important step towards putting an end to the decline of the Chinese stock markets and improving its functioning. The characteristic of the Chinese stock market that is most relevant to our research is the pricing of IPOs. With regard to this, there have been two noteworthy reforms in recent years (Huyghebaert and Xu, 2012). A first was the abolishment of the IPO pricing cap. Prior to 2005, the CSRC 3 fixed a P/E ratio cap on IPO prices, thereby seriously limiting IPO pricing possibilities. However, this pricing cap was no longer enforced after December 31 of 2004, although the CSRC continued to play a part in setting the IPO price. The second and most important reform took place in June of As stated before, after 2005 the CSRC continued to interfere in the pricing of Chinese IPOs. In June of 2009, however, it published The guiding advice on further reform of the IPO pricing method. In this publication, the CSRC announced that it would no longer intervene in the pricing of IPOs in Chinese stock markets. This reform is of great importance to our research. First of all, it means that we can only use IPO samples as of June of The underwriter has priced these IPOs and 3 CSRC (=China Securities Regulatory Commission) is the Chinese equivalent of the American SEC (=Securities and Exchange Commission). Until recent reforms, the CSRC played a major role in the Chinese IPO market by, among others, determining IPO prices, the amount of IPOs allowed in a year and what companies were allowed to become publicly listed. 10

11 mispricing of the IPO can thus be attributed to the underwriter only and not to the CSRC. A second implication of this reform is that Chinese investors and issuers have little experience with reacting to mispriced IPOs by influencing the underwriters market value. This is especially true for our sample, which spans a period of June of 2009 to Literature and Hypotheses 3.1 Why should IPOs be underpriced? IPOs in Chinese stock markets are notoriously heavily underpriced. Loughran, et al. (1994 and update in May 2012) show that China has one of the biggest average first-day IPO returns (with 137,40% from 1990 to 2010) out of almost 50 countries (with a total average of 30,33%). The same conclusions are made by Tian (2007) and Su and Bangassa (2011), while the latter also observe that Chinese IPOs generally underperform in the long run. They add that underwriter reputation does not have a significant impact, except for mitigating this long-run underperformance. Gao (2010) confirms the long-run underperformance. However, he adds that this is generally the result of overpricing rather than underpricing. According to Chen et al. (2004), the underpricing of A-shares is extremely high and far above what is observed in other emerging and transitional economies with a sample of 701 Chinese IPOs having an average market-adjusted first-day return of 298% from 1992 to

12 The academic literature offers a wide range of explanations for IPO underpricing. Chen et al. (2004) state three major reasons for the underpricing of A-shares in Chinese stock markets. A first is that underpricing increases when there is a long delay between the issue or sale of shares and the listing of those shares on the stock exchange. A second reason is that IPO firms might plan future equity offerings. When firms can sell more shares to investors in a later offering, there will be more underpricing in the initial one. A third is that ownership structures affect the amount of underpricing. When government and legal entities own a lot of shares, underpricing is greater. Guo et al. (2011) provide an overview of literature on IPO underpricing. They point out that an information discrepancy exists between underwriters and issuers, between issuers and potential investors, and between informed and uninformed investors. This leads to an information asymmetry, for which parties want to be compensated and that is one of the most important factors in IPO underpricing. When there are such asymmetries between the issuer and investors, the latter will fear the lemon s problem in which only issuers with worse-than-average quality want to sell their shares at an average price (Ritter and Welch, 2002). Furthermore, the information gap between informed and uninformed investors leads to what is known as a winner s curse problem, in which uninformed investors receive a greater proportion of overpriced shares. Yu and Tse (2006) argue that this information-asymmetry hypothesis is the main reason for underpricing in Chinese IPOs. Another issue related to imperfect information is the ex-ante uncertainty. The less information revealed by the issuer, the higher the cost for obtaining that 12

13 information. The investor wants to be compensated for this extra cost by an underpriced IPO. Beatty & Ritter (1986) argue that ex-ante uncertainty about the offering s value and the amount of underpricing are positively related. To achieve and maintain an underpricing equilibrium, which is enforced by the investment banking industry, they state three necessary conditions. First of all, underwriters cannot perfectly forecast the aftermarket price. Secondly, every underwriter is required to have non-salvageable reputation capital at stake for which it is getting a return. And finally, an underwriter who tries to cheat by pricing off the line has to lose clients. Yu and Tse (2006) and Mok and Hui (1998) find support for this hypothesis in their Chinese IPO research. It should be noted, however, that not all theories follow the idea of asymmetric information. Ritter and Welch (2002) believe that irrationality and agency conflicts are more adequate at explaining IPO pricing. Loughran and Ritter (2004) for instance, argue that underwriters might underprice IPOs to leave some money on the table for their favoured investor clients by offering a lower price. Research about the effects of underpricing by Chen et al. (2004), Gannon and Zhou (2008) and Guo and Brooks (2008) further examines the agency effect on IPOs in China. Ownership dispersion can be another motive for IPO underpricing. By generating excess demand through underpricing, a firm will have many small shareholders with relatively little power (Naughton, 2006). This creates liquidity and gives management more control. According to Wang (2005), ownership concentration has a substantial influence on IPO performance. In general, underpricing can also be the result of signalling effects. Ritter and Welch (2002) propose that issuers want to retain a positive image with investors 13

14 for a future SEO. Some research, however, such as Yu and Tse (2006), does not find any evidence of signalling effects. This may point out that the signalling effect is not always present. Additionally, underpricing induces investors to reveal information that can be used by underwriters when pricing the IPO firm. The offering is therefore underpriced in order to encourage regular investors to come forward with meaningful information and to compensate them for doing so, as stated by Ibbotson et al. (1994) and Ritter (1998). 3.2 Why should underpricing influence investment bank market value? The above-mentioned literature indicates a heavy underpricing standard in China. Therefore, we believe the proper level of underpricing and thus the IPO pricing equilibrium in Chinese stock markets will be considerably lower than in Western economies. Our predictions on how the underwriter s market value will be influenced by IPO mispricing in Chinese stock markets are in line with the findings of Nanda and Yun (1997), taking into account the characteristics of Chinese stock markets and firms Indirect Wealth Effects: Reputation The general idea of a reputation effect is supported by extensive research, including Su and Bangassa (2011) and Carter and Manaster (1990), but was first established by Beatty and Ritter (1986). They say that underwriters put reputational capital at stake by supporting an offering and valuing the firm. These underwriters are caught between two parties that they want to please: the issuing 14

15 company and the investors. On the one hand, excessive underpricing implies the loss of potential profits for the issuing firm. An underwriter that heavily underprices IPOs on a regular basis will therefore attract fewer future issuers. On the other hand, a certain amount of underpricing is needed in order to attract investors and compensate them for their investment and information costs. Thus, insufficient underpricing might scare off future investors. Incorrectly pricing an IPO can therefore harm the reputation of an underwriter and, consequently, his market value because a bad reputation may bring less future business, which the investors in the investment bank might take into account. This concept of reputational effects has consequences for all parties, since it gives investors and issuers an idea of the quality of an underwriter and at the same time also gives the investment bank the opportunity to show its quality to future clients by delivering good work at present. Based on these previous studies, we derive our own predictions as to the effect of IPO mispricing on the market value of underwriters in China as a result of the indirect reputational capital effect. An optimal underpricing equilibrium can be achieved by adequately pricing the IPO (Ibbotson et al., 1994) and should result in a better underwriter reputation. This, in turn, is believed to be rewarded by an improvement in market value (as a result of correct pricing and the good results from the IPO). Consequently, in the event of severe mispricing (either extreme or insufficient underpricing), we expect to see a decline in underwriter market value as negative results on an offering result in a negative reputation. 15

16 3.2.2 Direct Wealth Effects The research about the topic in the United States by Nanda and Yun (1997) predicts that the direct wealth effects are asymmetric, depending on whether the offering is priced too high or too low. Insufficiently underpriced IPOs are expected to show a decrease on the underwriter s market value because of two major reasons. First of all, there could possibly be a cost associated with price stabilization when underwriters have to spend resources in an effort to support the public offering. Secondly, there is also the anticipated cost related to possible legal actions by investors in case of insufficient underpricing. The magnitude of both direct wealth effects is difficult to predict but expected to be in correlation with the extent of price stabilization and legal costs incurred by the underwriter. The direct wealth effects in case of excessive underpricing, on the other hand, are expected to increase the market value of underwriters. 3.3 Hypotheses A first hypothesis is built by dividing underpricing into insufficient and excessive underpricing and predicting the outcome on underwriter market value for both sections. The second hypothesis is formed by analysing the market dominance in the Chinese IPO market. By combining the predicted indirect reputational and direct wealth effects, we obtain the following predictions with regard to our first hypothesis: (a) Impact of insufficiently underpriced IPOs on underwriter s market value: In case of insufficient underpricing, we expect the negative reputational and direct costs associated with it to have a negative effect on the stock market value of 16

17 underwriters. It is also expected that the reputational effect will account for a bigger effect on the market value than the direct wealth effects. (b) Impact of excessively underpriced IPOs on underwriter s market value: The effects of excessive underpricing on the investment bank market value are expected to be negative as well. A certain amount of underpricing is necessary for the underwriter s market value to be positively influenced, mainly by means of the reputational effect. Excessive underpricing, however, is expected to result in a decline of the market value of the underwriter because of negative reputational effects. Thus, our main hypothesis is as follows. Insufficient underpricing should have a negative impact on the underwriter s market value because of reputational costs and the direct costs necessary to stabilize the price. We expect to find that this negative impact will be more pronounced than in the research of Nanda and Yun (1997) because of the standard in China being such heavy underpricing (Loughran et al., 1994 and update in May 2012). The underwriter will therefore need to set a lower issue price. In other words, the amount of underpricing necessary for the underwriter market value to be positively affected by the IPO pricing should be higher than in Western markets. When the underpricing level exceeds this equilibrium and the offer is thus excessively underpriced, however, the underwriter market value is once again negatively affected because of negative reputational effects. 17

18 Hypothesis I: We expect that both insufficient and excessive IPO underpricing will have a negative impact on underwriter market value. Additionally, we formulate a hypothesis about whether Chinese IPO markets are dominated by the issuers or by the investors. In order to do so, we need to take the following into consideration. When an IPO is underpriced, the issuer loses potential profits. The reason is that the issuer is giving up part of his profit, in the form of the first-day abnormal return of the IPO shares, to the investors who bought the shares. The investors, consequently, will gain when an IPO is underpriced. Therefore, an investor will want the IPO to be as underpriced as possible, whereas the issuer desires as little underpricing as possible. In this regard, the best scenario for an issuer occurs when the IPO first-day abnormal returns are negative. But as indicated in our literature study, IPOs are traditionally underpriced in order to attract investors and assure the sale of shares. With this information, we can determine what party dominates the IPO market by looking at the significance and value of our results. If we assume that the abnormal return of the market value of underwriters of insufficiently underpriced IPOs is significant and negative, we can conclude that the investors have a strong say in the IPO market. Having received too little profits because of insufficient underpricing, these investors will damage the underwriter s reputation and perhaps undertake legal action. Investment bank owners will incorporate this negative information in their valuing of the investment bank. In this way, the investors will negatively impact the underwriters market value. 18

19 When underwriters of excessively underpriced IPOs experience a significantly negative abnormal return of their market value, the issuers, discontent because of the loss of potential profits, also have an important influence on underwriter market value. They exercise this influence by damaging the underwriter s reputation and by not doing future business with them. Investment bank shareholders will, again, incorporate this information and the abnormal return of the underwriter s market value will be negative. We predict that the impact of excessive underpricing will be most significant and negative on the underwriter s market value. The reason for this prediction is threefold. First of all, Chinese investors are inexperienced in reacting to IPO mispricing. The reason for this is that the underwriter has solely determined IPO pricing for only a short while (since June of 2009). Secondly, Chinese investors have few investment alternatives. And thirdly, they are attracted by the high IPO returns. As a result, they are unlikely to react strongly to insufficiently underpriced IPOs. Investment bank owners know this and therefore do not drive down the underwriter market value as heavily as when the issuers are discontent. Hypothesis II: Investment bank owners incorporate information about the reaction of issuers and investors to IPO mispricing in the stock price. We expect the owners to attach more importance to the reaction of the issuers than to that of the investors. 19

20 4 Methodology In order to empirically test our hypotheses, we will make use of two models. A first (regression) model will serve to determine the expected level of IPO underpricing in Chinese stock markets. It will do so, taking into account several characteristics of the firm and its industry, such as firm size. The second model will allow us to conclude what the effect of IPO mispricing is on the underwriter s market value. The model achieves this by comparing the actual level of underpricing to the expected level found in the first model. The first section of the chapter discusses the data and the sample description; section 2 will talk about model specifics. 4.1 Data We started with a dataset of 461 firms that conducted an initial public offering with A-shares in 2009 and 2010 on the Shanghai or Shenzhen stock exchange. These offerings and their characteristics were obtained from the GTA China listed firm s IPO research database. Our research required information on the IPO underwriter, the IPO listing date, the first-day return of the IPO share, the IPO firm s assets, the days between listing and issuing of the stock, whether the IPO firm was in a regulated market, whether the it was listed in Shanghai or Shenzhen, whether the firm was state-owned and information on the location of the firm s head office. The regression model uses data from both years, but 35 events had to be removed because of missing data. This led to a total sample size of 426 offerings (containing listed as well as unlisted underwriters at the time of the IPO) 20

21 between July 10, 2009 and December 31, 2010 to estimate the coefficients with which we determine the expected amount of first-day abnormal return for the IPO shares. To estimate the impact of this return on the IPO underwriter s market value, information about the underwriter and market indices were obtained through the Datastream online database. We collected data on the investment bank s unadjusted stock price for the required period of our research. The coefficients obtained in the regression model could only be applied to IPOs with a publicly listed underwriter in the event study model. Therefore, an additional 3 underwriters and their corresponding 31 IPOs had to be removed since they were not listed when the IPOs they advised, took place. Events with missing values for the amount of underpricing on day 1 were also removed and omitted values of other variables were replaced by those variables median in the sample. This led to a total of 142 initial public offerings for which we could calculate a good estimation of their expected level of mispricing. We additionally used a nonoverlapping sample in which IPOs underwritten by the same bank were left out if the separation between their respective offering dates was less than a day, week or month. The daily non-overlapping sample contains 131 IPOs, the weekly sample contains 112 IPOs and the monthly non-overlapping sample consists of 77 IPOs. The daily, weekly and monthly non-overlapping samples will be used when calculating the impact of mispricing on the abnormal return of the market value of the IPO underwriter after the first day, week and month of the IPO offering date, respectively. 21

22 4.2 Sample Description <Insert Table I> Table I provides data on the 426 initial public offerings that are used in the regression model to estimate the correct level of underpricing, which is later used to draw conclusions regarding the impact of underpricing on underwriter market value. The majority of the IPOs (77%) took place in 2010, with a mean abnormal first-day return of 40,5% and a standard deviation of almost 0,40. Offerings in 2009 experienced much higher first-day abnormal returns at almost 73%, with a standard deviation of 0,39. The overall mean first-day abnormal return is 47,81%. It is also noteworthy that only 16 or 3,7% of the IPOs have a negative first-day abnormal return. As the literature indicates a heavy underpricing standard in China, this is not surprising. Finally, 398 or 93% of the offerings took place on the Shenzhen stock exchange. <Insert Table II> Table II provides an overview of the data used in the event study model to estimate the impact of IPO mispricing on underwriter market value. In 2009, 18 IPOs had an average 15,66% difference between the expected and the observed first-day abnormal return of the underwriter s market value. The clear difference between mean and median values is probably attributable to the small sample size. For the 2010 period, 124 observations were used with a mean mispricing of -6,43%. Considering the entire period, consisting of 142 observations, IPOs 22

23 have an average of -3,63% difference between expected and observed first-day underwriter market value abnormal return. 4.3 Regression Model As explained earlier, we will first try to determine the expected level of IPO firstday abnormal returns. This is equivalent to finding the expected amount of underpricing. It requires a model with variables that represent characteristics of the IPO firm and event. The following regression model is used for this first part of our analysis: IPORET = α0 + α1assets+ α2lag + α3mar + α4priv + α5reg + α6sse + α7beijing + α8shanghai+ α9shenzhen With: IPORET: first-day IPO return adjusted for market return ASSETS: Log of IPO firm s assets at the date of the offering LAG: Listing lag indicates the number of days between the share offering and the actual listing of the shares MAR: Market return for period starting 1 year prior to the IPO date PRIV: Dummy variable equals 1 if the IPO firm is private and 0 if state-owned when listed REG: Dummy variable equals 1 if the IPO firm s industry is regulated SSE: Dummy variable equals 1 if the IPO firm is listed on the Shanghai Stock Exchange and 0 if it is listed on the Shenzhen Stock Exchange 23

24 BEIJING: Dummy variable equals 1 if the IPO firm has its headquarters in Beijing SHANGHAI: Dummy variable equals 1 if the IPO firm has its headquarters in Shanghai SHENZHEN: Dummy variable equals 1 if the IPO firm has its headquarters in Shenzhen <Insert Table III> This regression of the expected IPO first-day abnormal return allows us to calculate the difference between the expected and observed first-day abnormal return in the event study model. A variety of independent variables are used to model this first-day abnormal return. ASSETS is the logarithm of the IPO s assets at the time of the offering. It is used to get the firm size into the equation. We expect IPOs of large firms to be less underpriced as these firms have a smaller need to attract the attention of investors by offering a considerable amount of underpricing. MAR is the cumulative return of the market over a one-year period prior to the firm s public listing and is used to take economic conditions into account. LAG measures the time lag between the share offering and the actual listing of those shares. We expect this variable to have a negative impact since the lag increases uncertainty for investors, who will want more underpricing to compensate for this uncertainty. Finally, we add dummy variables to increase the preciseness of the model by categorizing the IPOs into groups of certain characteristics. REG is a variable to indicate whether the IPO firm is active in a 24

25 regulated industry. PRIV indicates whether the issuer was private or state-owned prior to the IPO offering date. SSE shows on what stock exchange the IPO firm is listed. The last three dummy variables indicate whether the IPO firm has its headquarters in Beijing, Shanghai, Shenzhen or another town (if all headquarter location dummies equal 0). 4.4 Event Study Model In line with Nanda and Yun (1997), we examine the relation between first-day IPO mispricing and one-day, one-week and one-month abnormal returns 4 of the underwriter s market value. First, however, we will determine the terminology in order to avoid any confusion. An IPO is mispriced whenever the IPO first-day abnormal return is either higher or lower than expected, as calculated in the regression model. Assuming that an IPO price is considered correct and well priced if there is no such mispricing, our hypothesis states that a correctly priced IPO should not negatively impact the underwriter s market value. Our method consists of subtracting the expected from the observed IPO first-day abnormal return. If the result of this subtraction is positive, the observed IPO price was set below the expected price and the IPO has been excessively underpriced. If it is negative, the observed price was set above the expected price and the IPO has been insufficiently underpriced. In order to reach more precise conclusions with regard to our hypotheses, we created mispricing categories. Every IPO is placed into one of two categories, 4 Abnormal indicates that the return is adjusted for the same-period market return. 25

26 depending on whether the difference between the observed and expected IPO first-day abnormal returns is positive or negative. Using a market model, the underwriter market value abnormal return is measured by subtracting the market-adjusted return from the realized daily return on the investment bank stock or more precisely: UMV it = r it (a i + b i r mt ) In this equation, rit is the underwriter s daily raw return over the period t (which always starts one day after the IPO event in order to evaluate the impact of the IPO on the underwriter s market value) and rmt is the return on the market index (Shanghai SE A-share index or Shenzhen SE A-share index, depending on where the bank is listed) over the period t. Both ai and bi are OLS estimates of the regression equation for offering i or r it = α i + β i r mt + ε it over the estimation period, -150 to -10 trading days prior to the offering. The length of this estimation period should level out the effects of other prior events, such as other IPOs advised by the investment bank. In order to define the deviation from expected pricing, we will compare the observed amount of underpricing to the expected amount, which is derived from the regression model. This will allow us to look at how the magnitude of mispricing impacts the underwriter s market value. As explained earlier, we will look at the underwriter market value abnormal return over three different periods. The daily return is the return of the underwriter 26

27 market value on the day after the IPO offering date. Since we want to study the impact of IPO mispricing on the underwriter s market value, the analysis does not start on the event day itself because it takes one day for the IPO first-day abnormal return to be found. Day 1, rather than day 0, is the event day for the underwriter. Weekly and monthly underwriter market value abnormal returns are calculated similarly by adding up the daily returns for respectively 5 and 21 days after the IPO, similarly starting on day 1. The results thus obtained are displayed in Tables IV, V and VI and will be discussed in the following section. 5 Results <Insert Table IV> Table IV contains the results of the regression model that we use to determine the expected IPO first-day abnormal return. The table shows the independent variables, their coefficients and the significance of each of these independent variables. It also reports the adjusted R² of the regression model and the total number of observations. The average expected IPO first-day abnormal return is 45,55%, the maximum is 84,58% and the minimum is 11,21%. When we deduct this expected from the observed IPO first-day abnormal return, we obtain an average value of -3,63%, a maximum value of 136,94% and a minimum value of -52,84%. 27

28 This regression model allows us to determine the expected or correct level of underpricing for each IPO in our sample. By comparing this expected to the observed IPO first-day abnormal return, we can study the effect of the difference between both on the market value of the IPO underwriter. Table V divides the sample of IPOs into two distinct categories. The first category contains all IPOs for which the observed first-day abnormal returns were higher than expected (meaning that the IPO was excessively underpriced). The second contains those IPOs for which the observed first-day abnormal returns were lower than expected. This means the IPO price was set too high and the IPO was insufficiently underpriced. The underwriter market value abnormal returns are then grouped in these categories accordingly. Panels A, B and C, indicate the one-day, one-week and one-month abnormal returns for the underwriter s market value, respectively. <Insert Table V> Daily underwriter market value abnormal returns are never significant. The daily mean abnormal return of the market value of banks that underwrote excessively underpriced IPOs is -0,16%, with a t-statistic of -0,61. For underwriters of insufficiently underpriced IPOs, these daily abnormal returns have a mean of -0,24%, with a t-statistic of -0,89. The insignificance of these daily returns is presumably because of the fact that the considered time period is too short for investment bank owners to fully and correctly react to the IPO pricing. For instance, the process of price stabilization or perhaps the actual selling of shares 28

29 might still be taking place. Therefore, we expect weekly and monthly abnormal returns to provide more accurate and representative results. The stock price abnormal returns for underwriters of insufficiently underpriced IPOs are significantly negative. Weekly market value abnormal returns for these underwriters have a mean of -1,24%, with a t-statistic of -1,86, as displayed in panel B. Panel C indicates that the monthly stock price abnormal return of these underwriters have a mean of -4,57% and a t-statistic of -2,24. This result corresponds to our hypothesis that insufficiently underpricing the IPO will negatively impact underwriter market value due to price stabilization efforts, possible legal actions by investors and reputational effects. Weekly and monthly market value abnormal returns of underwriters of IPOs with larger first-day abnormal returns than expected (meaning that the IPO price was set below the expected IPO price, as determined by model 1) are significantly negative as well. For these underwriters stock price, panel B indicates that the weekly abnormal return mean is -2,05% with a t-statistic of -2,37 and panel C shows that the monthly abnormal return mean is -7,71% with a t-statistic of -3,12. These results, too, correspond to our hypothesis. We predicted that excessively underpriced IPOs would have a negative effect on underwriters market value because of reputational effects inflicted by the IPO issuers. <Insert Figure I> <Insert Figure II> The results are further illustrated in Figures I and II. Both graphs represent the cumulative average abnormal return (CAAR) of the underwriters market value 29

30 for a period up to one month after the IPO. The AAR per day is found by taking the daily market value abnormal return of the underwriter per IPO and then calculating the average for these 142 events. This is repeated for the 21 days following the IPO and these 21 averages are cumulated to get the cumulative average abnormal return. The graph shows the same results as Table V with only three periods (day, week and month) does, but provides evidence on the consistency between these measuring periods. Figure I displays the CAAR for all excessively underpriced IPOs, while Figure II shows the CAAR for all insufficiently underpriced ones. Although both figures seem identical, Figure I has a steeper slope, revealing that the negative impact of excessively underpriced IPOs on the IPO underwriter s market value is greater than that of IPOs with a lower-than-expected first-day abnormal return. Because both graphs continuously decline, they show that the negative effect of mispricing perseveres throughout the 21-day period. We additionally conduct a secondary analysis, taking into account the possibility of overlapping samples. If an investment bank underwrites two IPOs on the same day, the impact of the pricing of one of the IPOs on the first-day market value abnormal return of that underwriter might distort the impact of the pricing of the other IPO. The same logic holds for a bank that underwrites multiple IPOs in the same week (thereby possibly distorting the impact of one of those IPOs mispricing on the first-week market value abnormal return of the underwriter) or in the same month. We therefore left out IPOs that took place in the same day, week or month, when looking at the impact of the mispricing of the IPO on the 30

31 daily, weekly or monthly abnormal return of the market value of the underwriter of that IPO, respectively. These results are displayed in Table VI. <Insert Table VI> This table shows that the results are essentially the same as those in Table V, which does contain overlapping samples. The weekly and monthly mean market value abnormal return of underwriters of insufficiently underpriced IPOs is significantly negative. For underwriters of excessively underpriced IPOs, only the weekly mean market value abnormal return is significantly negative. This might be because of the reduction in sample size. We thus observe that the mean abnormal return of the market value of underwriters of excessively underpriced IPOs is more negative than that of underwriters of insufficiently underpriced IPOs. These results indicate that the IPO market in China is dominated by the issuer, rather than by the investor. The more an IPO is underpriced, the larger the profit an investor will receive when participating in the IPO but, consequently, the smaller the profit of the issuer will be. Given that the market value abnormal returns of banks that underwrite underpriced IPOs are significantly negative, we have reason to believe that the issuers will punish these underwriters for having failed to maximize their profits. As underwriters of overpriced IPOs have considerably less negative market value abnormal returns, it seems as though investors are less able or willing to punish the underwriter for failing to maximize their profits. Investment bank owners are 31

32 aware of this and incorporate this information in the stock price, which is why the underwriter market value abnormal returns are more negative for excessively underpriced IPOs. This observation might be attributed to three factors. A first is that Chinese investors do not have a lot of alternative investment opportunities. Secondly, due to the high first-day IPO share abnormal returns, investors in China are very eager to participate in an IPO, regardless of the quality of the IPO firm. Chinese IPOs have therefore often been heavily over-subscribed. And a third factor is the inexperience of Chinese investors with regard to IPO pricing. As noted in section 2, underwriters have only been pricing IPOs independently from the CSRC since June of Given that our sample only consists of IPOs up till the end of 2010, Chinese investors have indeed not had a lot of time to gain experience with the correct pricing of IPOs. 6 Conclusions Using a sample of 142 IPOs over the period , we have studied the impact of IPO mispricing on underwriter market value in China. Taking into account the heavy underpricing that is customary to the Chinese IPO market and the research of Nanda and Yun (1997), we derived our hypothesis for this impact. This hypothesis states that any deviation of the expected IPO return should have a negative impact on the IPO underwriter s market value. Too little underpricing is expected to have a limited impact, whereas heavy underpricing is expected to have a bigger influence on the underwriter s market value. 32

33 Our research shows that IPOs that have larger abnormal returns than expected significantly and negatively impact the market value of the corresponding underwriters. Issuers, who lose potential profits when an IPO is underpriced, will presumably be more hesitant to involve an underwriter that they know underprices too heavily, which translates into a damaged underwriter reputation. When an IPO is insufficiently underpriced, on the other hand, it will also have a significant but smaller impact on the underwriter s market value. From that observation, we derive that investment bank owners know that Chinese investors, who make less profits the less an IPO is underpriced, have a less meaningful reaction to IPO mispricing (by means of undertaking legal action or damaging underwriter reputation) than issuers do. Our results thus indicate that the issuers dominate the IPO market in China. This finding is not surprising for a country in which investors have relatively few alternative investing possibilities, little IPO pricing experience and are keen on participating in the profitable Chinese IPOs. There are a number of limitations to our study, most notably our limited sample size. As a result, we see a number of possibilities for further research. A first would be to use a larger sample size and verify whether the results correspond to ours. Related to this, future research could also include other variables to which we had no access (such as issuer operating income growth, the debt level of the issuer or the underwriter fee). Moreover, it might be interesting to include data from more recent years and to see how the IPO mispricing impacts underwriter market value after the 2009 reform, which allows underwriters to set their own 33

34 IPO price. More general lessons might also be drawn from this as regards the evolution of market sentiment and investor knowledge as a result of reforms. Finally, it might also be interesting to study geographically different IPO markets or carry out a comparative study of these different stock markets. 34

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37 Underwriter CAAR Attachments Figure I Cumulative average abnormal return of market value of underwriters of insufficiently underpriced IPOs The data in the figure is calculated by taking the average of the abnormal returns of the underwriter market value per day and then adding them together for 21 days to make it cumulative. The horizontal axis shows the number of days and the vertical axis shows the cumulative average abnormal return of the underwriters market value. CAAR INSUFFICIENT UNDERPRICING,000% -,500% -1,000% -1,500% -2,000% -2,500% -3,000% -3,500% -4,000% -4,500% -5,000% Number of days

38 Undewriter CAAR Figure II Cumulative average abnormal return of market value of underwriters of excessively underpriced IPOs The data in the figure is calculated by taking the average of the abnormal returns of the underwriters market value per day and then adding them together for 21 days to make it cumulative. The horizontal axis shows the number of days and the vertical axis shows the cumulative average abnormal return of the underwriters market value.,000% -1,000% -2,000% -3,000% -4,000% -5,000% -6,000% -7,000% -8,000% -9,000% CAAR EXCESSIVE UNDERPRICING Number of days