Pre-Market and IPO Pricing: Evidence from Taiwan

Transcription

1 Pre-Market and IPO Pricing: Evidence from Taiwan Chun Chang Shanghai Advanced Institute of Finance Shanghai Jiaotong University Yao-Min Chiang Department of Finance, National Taiwan University Yiming Qian Department of Finance University of Iowa Jay R. Ritter Department of Finance, Insurance, and Real Estate University of Florida January 9, 2014

2 Abstract We study the only mandatory pre-ipo market in the world Taiwan s Emerging Stock Market (ESM). We document that pre-market prices are very informative about post-market prices and that the pre-market price efficiency increases with trading liquidity. Pre-market prices are utilized in IPO pricing. The ESM price shortly before the IPO explains about 90% of the variation in the offer price. Moreover, the more informative the pre-market price is, the higher the offer price (i.e., the lower the underpricing). However, the average IPO underpricing level remains high despite the pre-market. We provide evidence that this is due to underwriters rentseeking behavior. Our results suggest that agency problems can lead to high levels of underpricing even when there is little information asymmetry or valuation uncertainty about the stock.

3 1. Introduction The most important issue as well as the biggest challenge in an initial public offering (IPO) is the pricing of the stock. It has been well documented that IPOs tend to be underpriced (relative to aftermarket prices), and that the underpricing phenomenon is persistent over time and across countries. Such money left on the table constitutes a substantial opportunity cost of going public for issuing firms. Ritter (2011) argues that theories based on asymmetric information are consistent with a relatively low level of average underpricing, and that the observed average underpricing in recent decades in the US and in many other countries is so high that it is mainly driven by underwriters rent-seeking behavior. 1 For example, Liu and Ritter (2011) document an average first-day return of 24% in the U.S. for , and we report an average first-day return of 55% for Taiwanese IPOs from Underwriters are paid large amounts of fees for pricing and allocating the IPO shares. So how do they come up with an IPO price? Under the US bookbuilding method, underwriters first come up with a suggested price range partly using benchmark pricing, which is based on the firm s accounting measures and comparable firms price multiples. The method often leads to wide possible price ranges (e.g., depending on what firms are picked as the comparables) and may not adequately account for the uniqueness of the issuing firm. Kim and Ritter (1999) show that IPO prices based on this method are far from being accurate, in terms of setting the offer price as well as predicting the after-market price. Underwriters then collect investors indicators of interest from the bookbuilding process and determine a final offer price. Bookbuilding mechanism design theory argues that value-relevant information is collected during the process and underwrites allocate underpriced shares to induce investors to reveal information 1 In some cases, high underpricing is partly driven by constraints imposed by regulators. For example, Chinese regulators imposed a maximum market-to-book ratio or P/E ratio on the offer price during (see Ritter 2011). 1

4 (Benveniste and Spindt, 1989). The information obtained this way, therefore, is costly to the issuer. In addition, self-interested underwriters have strong incentives to bias the price down so that they can allocate underpriced shares to their favored clients in exchange for side payments (Loughran and Ritter 2002, Reuter, 2006; Nimalendran, Ritter and Zhang, 2007; Liu and Ritter, 2010, Goldstein, Irvine and Puckett 2011). In recent years, a new phenomenon has emerged that may potentially provide a solution to the IPO pricing problem trading platforms or markets for pre-ipo firms (hereafter pre-ipo market or simply pre-market). These pre-markets are in various forms. For example, in the US, online sites such as SecondMarket and Sharespost started around 2009, partly due to strong demand for private company stocks such as Facebook. These sites hold auctions for private company stocks from time to time. In the UK, firms can choose to get listed and trade on the Alternative Stock Market before an IPO (Derrien and Kecskés, 2007). In Taiwan, firms are actually required to be listed on a so-called emerging market and trade there for at least 6 months before applying for an IPO. It is reasonable to think that a pre-market would help mitigate the uncertainty about a firm s valuation, achieving the goal of price discovery, and therefore leads to high pricing efficiency during an IPO. However, because of the lack of data, we are not sure whether and to what degree such benefits exist. Meanwhile, there are concerns about such markets. Private firms worry about disclosure costs, potentially losing control to some random investors, as well as a decreased ability to retain talent. Investors are leery about the low liquidity of the market and associated potential fraud. Questions therefore arise in the U.S. regarding whether premarkets should be allowed, encouraged, and regulated. The US Securities and Exchange Commission (SEC) showed concerns about related issues (see Stone (2011) and Smith and 2

5 Eaglesham (2012)), although the Jumpstart Our Business Startups (JOBS) Act of 2012 relaxed a number of regulatory constraints. This study contributes to the debate by investigating the only mandatory pre-ipo market in the world so far Taiwan s Emerging Stock Market (ESM). Since 2005, private firms in Taiwan have been required to trade on the ESM for at least six months before they can apply for an IPO. The mandatory feature of the market frees our study from self-selection issues and the relatively long trading period enables us to observe the dynamic changes of trading characteristics. We focus on two big research questions in this study. The first question is how useful the pre-ipo market is in terms of price discovery. In other words, how accurate is the pre-market price as a predictor of the after-market price? What factors determine the accuracy of the premarket price? The second question is whether and to what degree the pre-market price is utilized to set the offer price. If the pre-market price is informative about the after-market price, then the asymmetric information theory of IPO underpricing predicts that the IPO offer price should exhibit the following features: (1) the offer price should largely depend on the pre-market price but not peers pricing; (2) the more informative the pre-market price is, the higher the offer price will be relative to the pre-market price; and (3) there should be little underpricing. In contrast, the agency theory of IPO underpricing predicts (1) incomplete incorporation of information into the offer price and (2) high underpricing. We start by examining the dynamic changes in prices, liquidity and volatility once a stock is listed on the ESM. We find that in event time, prices and liquidity increase and volatility decreases. This process largely speeds up once the firm applies for an IPO. As the time approaches to the IPO, the prices become more and more informative, 3

6 measured against the after-ipo market price. We measure price (in)accuracy as the absolute value of the percentage difference between the pre-market and after-market prices (the larger the measure, the lower the price accuracy). By the day before IPO pricing, the average price inaccuracy is 15% with a standard deviation of 11%. Moreover, the pre-market price tends to be higher than the after-market price (for 66% of firms in our sample, the pre-market closing price on the day before IPO pricing is higher than the closing price on the first trading day after the IPO). The average price error (defined as pre-market price minus after-market price, relative to after-market price) is 6% on the day before IPO pricing, with a standard deviation of 18%. We hypothesize that the pre-market price should be more informative if the trading is more liquid. We find supporting evidence for the hypothesis using three measures of (il)liquidity. A one-standard-deviation increase in each of the illiquidity measures increases price inaccuracy by 2-3 percentage points, which is 15-20% of the mean of the price inaccuracy. Given the informativeness of the pre-market price, it is only natural that the price should be utilized in the IPO pricing. We find that this is the case: the pre-market price alone explains more than 80-90% of the variation in the offer price. After taking into account the issuer s premarket price, peer firms pricing ratios have little explanatory power for the offer price. We then examine the cross-sectional differences in the offer price relative to the premarket price. Consistent with the asymmetric information theory, the price discount (one minus the offer price relative to the pre-market price) increases with price inaccuracy and volatility, and decreases with firm size. The results suggest that underwriters not only understand the usefulness of the pre-market price, but also understand when the pre-market price is more informative. Despite the pre-market, however, the IPO underpricing level remains quite high. The 4

7 average offer price is set at 67% of the pre-market price and the average initial return is 55%. Such a high level of underpricing is hard to explain with the asymmetric information theory. We provide evidence that it is driven by underwriters rent-seeking behavior. Specifically, underwriter incomes increase with the underpricing level, and hence they have strong incentives to deliberately keep the price low. This study contributes to the IPO literature in several ways. First, our study shows that the pre-market price is very informative, and therefore it can and should facilitate IPO pricing. We also offer insight on when the pre-market price is more informative and more useful in IPO pricing. Second, we document evidence that underpricing can remain at high levels even when there is little asymmetric information or valuation uncertainty about the IPO stock. Although the explicit fee structure in Taiwan is different from that in the US, the two regimes are similar in that underwriters have strong monetary incentives to underprice the stock, and the bookbuilding IPO method gives them a lot of power to do so. The results from the unique setting of our test provide new insights to the important debate on causes for underpricing and the choice of the IPO method. Existing studies have examined two alternative types of pre-ipo markets. Not only are these markets different from Taiwan s Emerging Stock Market (the differences will be detailed in Section 2), but the focus of these studies also differ from ours. Loffler, Panther and Theissen (2005), Cornelli, Goldreich and Ljungqvist (2006), Aussenegg, Pichler and Stomper (2006) and Dorn (2009) investigate when-issued markets that trade during days before European IPOs. These markets are over-the-counter markets and are dominated by retail investors. Cornelli, Goldreich and Ljungqvist (2006) and Dorn (2009) find evidence of investor sentiment on these markets specifically, they find high pre-market prices are associated with high first-day returns 5

8 but poor long-run returns. In contrast, Loffler, Panther and Theissen (2005) report Pre-IPO prices appear to be largely unbiased estimates of the subsequent exchange prices (p467). Dorn (2009) argues that the price LPT uses the midpoint of the last when-issued quote is a poor proxy for actual trading prices. Our study also finds that pre-market prices immediately before the IPO tend to be higher than the after-market price, consistent with bullish investor sentiment affecting the pre-market. Despite this, we emphasize that the pre-market price is still very informative. Derrien and Kesckés (2007) compare firms that choose to do a normal IPO and firms that choose to do an introduction (i.e., get listed without an IPO) on London s Alternative Investment Market (AIM). In their sample, only a small fraction of firms (11%) chose to do an introduction. When these firms conducted IPOs eventually, they suffer less underpricing. They conclude that the pre-ipo trading helps to reduce valuation uncertainty, which is consistent with our finding. Compared to existing studies, our sample does not suffer from self-selection issues due to the mandatory feature of the market. Moreover, we provide cross-sectional evidence on what determines the informativeness of the pre-market prices and what factors lead to less underpricing. Finally, our study sheds new light on the causes of underpricing. The remainder of the paper is organized as follows. Section 2 describes the institutional features of the Emerging Stock Market and the IPO process in Taiwan. Section 3 describes the sample and the data we use. Section 4 examines the pre-market price accuracy as the time approaches to the IPO. Section 5 studies how pre-market prices are used in IPO pricing. Section 6 explores the reason behind the high level of underpricing despite the pre-market. Section 7 concludes. 6

9 2. Institutional Features of Taiwan s Emerging Stock Market Taiwan has one of the most active stock markets in the world, with two major stock exchanges: the Taiwan Stock Exchange (TWSE) and the Gre Tai Securities Market (GTSM). 2 The Emerging Stock Market (ESM) was established in January 2002 and is operated by GTSM (although this market is separate from the trading of the GTSM listed firm). By providing a trading platform for unlisted stocks, the ESM is intended to prepare firms for getting listed in terms of improving information transparency and increasing firm visibility. It is also expected to achieve price discovery for the security. Since 2005, it is mandatory for unlisted firms to trade on the ESM for at least 6 months before they can apply for an IPO and get listed on either the TWSE or GTSM. To register its stock for ESM trading, a firm mainly needs to satisfy two conditions. First, it needs to make public disclosure of its financials and important corporate events. In particular, it has to disclose audited annual and semi-annual financial statements. In contrast, a public firm traded on TWSE or GTSM is required to publish quarterly financial statements. Second, the firm needs written recommendations by two or more securities firms, one of which is designated as the lead advisory/recommending securities firm, which typically will also act as the lead underwriter in its later IPO. 3 In contrast, both TWSE and GTSM markets have listing requirements on firm age, size, profitability, and the number of shareholders, with TWSE generally having more rigorous listing requirements than GTSM. When registering on the ESM, a firm needs to prepare a prospectus that makes 2 At the end of 2010, there were 758 companies listed on the TWSE with a total market capitalization of US$784 billion, ranked number 21 in the world according to the World Federation of Exchanges web site. The total trading volume of TWSE in 2010 was US$ 895 billion, ranked number 14 in the world. In addition, GTSM listed 564 companies with a total market capitalization of US$66.15 billion and had a total trading volume of US$ billion in Firms traded on ESM are also subject to additional regulations: (1) they have an additional regulator Financial Supervisory Commission (FSC). Otherwise a private firm only needs to register with Economics Department Business Bureau; and (2) they are subject to additional laws such as Securities Trading Law. Otherwise a private firm just needs to comply with Company Law. 7

10 disclosures about the firm s background and history, top management and board of directors, stock ownership, and firm financials. When applying for an IPO later, the firm has to file a new prospectus that makes similar disclosures, and in addition includes underwriters opinions of the firm and the IPO including the valuation of the stock. The ESM is a dealers market. The recommending securities firms act as dealers or market-makers for the recommended stock. They assume the responsibility to continuously offer bid and ask quotes during normal trading hours through the Emerging Stock Computerized Price Negotiation and Click System (the Click System). The quoted spread cannot exceed five percent of the ask price. The recommending securities firms are obligated to trade at the quoted prices as long as the order does not exceed 2,000 shares. Investors can submit orders to the Click System through their brokers. For orders of 10,000 shares and more, the investor can directly negotiate with a dealer via other methods (e.g. by letter, telephone or face-to-face talk). All trades are recorded in the Click System. In contrast, both TWSE and GTSM operate through fully automated electronic trading systems where only limit orders are accepted and orders are executed in strict price and time priorities. Shorting is prohibited on the ESM. Both individual and institutional investors can trade on the ESM, although mutual funds were prohibited from participating during our sample period. However, based on interviews with staff members of the ESM and practitioners in various institutions, we learned that institutional investors (such as insurance companies, pension funds, and foreign institutional investors) tend to refrain from investing in ESM stocks because they are highly risky investments. So ESM trading is typically dominated by retail investors. The following group of insiders is restricted from selling once the company applies for an IPO: directors, supervisors 4, and 4 According to Article 216 of Company Law of Taiwan, a firm subject to public disclosure requirements should have at least two supervisors, who are elected at shareholder meetings. A supervisor shall not concurrently be a director, 8

11 shareholders who hold at least 10% of the firm. Differences from other pre-ipo markets in the world There are a few other pre-ipo markets in the world. One is the Alternative Investment Market (AIM) on the London Stock Exchange (LSE). AIM allows firms, when getting listed, to choose to do an IPO or an introduction (i.e., without raising capital). For those who choose to do an introduction, AIM serves as a pre-ipo market for their stocks. The main difference between AIM and Taiwan s ESM is that pre-ipo trading is not mandatory on AIM. Derrien and Kesckes (2007) document that only a small fraction (11% for the period of ) of firms that got listed on AIM chose to do an introduction. Compared to regular IPO firms on AIM, the two-stage firms (with an IPO within 5 years following the introduction) tend to be smaller when they are first traded. There is also no minimum requirement for the length between an introduction and a subsequent IPO. In contrast, in Taiwan, all firms have to be traded on ESM for at least 6 months before they apply for an IPO. Another type of pre-ipo market is the when-issued markets (aka grey markets ) in European countries. Not only are these markets not mandatory, but they are not one unified market (not even within the same country) because trading is organized by independent brokers who make forward markets in IPO shares on a when-issued basis. In addition, the extent to which IPO shares are traded in grey markets varies widely from country to country (Cornelli, Goldreich and Ljungqvist (2006, p1198). Another important difference is that the grey-market trading for a firm typically lasts for only a week or so before the stock s post-ipo first trading manager, or employee of the company. Supervisors in Taiwan are responsible for monitoring directors and management. Supervisors function similarly as the audit committee of firms in the United States, fulfilling their duties by providing an independent and objective review of the financial reporting process, internal controls, and the audit function. 9

12 day. In summary, Taiwan s ESM has two distinctive features: (1) it is mandatory for pre-ipo firms, and hence there is no concern for selection bias. (2) The pre-ipo market for each stock lasts for a relatively long period (by regulation, at least 6 months), which enables us to make observations about the dynamic development of pre-ipo trading and helps us understand what factors might affect the usefulness of such trading and the related pre-ipo prices. IPO process in Taiwan Taiwan had experimented with various IPO methods in the past including fixed-price offering (FPO hereafter), auction, bookbuilding, hybrid auction (auction plus FPO), and hybrid bookbuilding (bookbuilding plus FPO). Since 2005, the hybrid bookbuilding method has become the dominant method. In our sample, most IPOs use hybrid bookbuilding except that 14 firms use pure bookbuilding. During our sample period of October 25, 2005 through March 1, 2011, only two IPOs use non-bookbuilding methods (one uses hybrid auction and the other uses fixedprice offering). Both are excluded from the sample. As a normal practice worldwide, the bookbuilding tranche is open to institutional and large individual investors. The FPO tranche, on the other hand, is open to the general public. Bookbuilding investors give indications of interest (nonbinding bids with price-quantity combinations). Allocation to bookbuilding investors is at the discretion of underwriters. In the FPO, each investor can only submit an order of one lot (i.e., one thousand shares) and allocation is determined by a lottery if there is oversubscription. FPO investors do not submit price suggestions, with the understanding that they will receive the same offer price as bookbuilding 10

13 investors. Institutional investors are prohibited from participating in the FPO. 5 Except for the overallotment, only primary shares are sold in the IPOs during our sample period. That is, all of the shares offered are from the issuing firm rather than selling shareholders. Typically 70-90% of total shares offered in the IPO are sold through the bookbuilding tranche. For hybrid bookbuilding IPOs in our sample, the bookbuilding and FPO tranches run simultaneously. The bookbuilding period typically lasts for four business days over which investors submit nonbinding orders. The FPO process often starts one day later than the bookbuilding but ends at the same time. An announcement is made the day before bookbuilding starts that, among other things, gives a suggested price range. On the business day after bookbuilding ends, the offer price is determined (we call this day the pricing day and t he last bookbuilding day the pre-pricing day). In the next few days, allocation is determined and proceeds are collected. In most cases, the stock starts trading on TWSE or GTSM on the 5 th business day after the pricing day ( the 4 th trading day being the last trading day on ESM). Figure 1 shows the time line of the IPO process. 3. The Sample and Data Our sample includes 218 firms that went IPO between October 25, 2005 and March 1, All sample firms are subject to a regulation effective in January 2005 that firms must be traded on the Emerging Stock Market for at least 6 months before they apply for an IPO. Three types of firms are exempt from this requirement: firms spun off from listed parents, privatization of 5 As argued in Chiang, Qian and Sherman (2010), although a hybrid IPO consists of two stages, they are essentially independent sales from the investors point of view. They state, Due to the one-lot size constraint and frequent oversubscription in the fixed-price tranche, any investor who wishes to make a large investment will not rely on the second-stage sale. More important, there is little room for strategic interaction between the two stages. (p1210). Their comments are for hybrid auctions during , during which the fixed-price offer is run after the auction tranche, hence referred as second-stage sale. The same argument, however, applies to the hybrid bookbuilding method in our sample. 11

14 public enterprises, and foreign companies. Although some of these exempted firms chose to trade on the ESM before an IPO, we exclude all of them from our sample. 6 We obtain daily trading data for ESM stocks including price, return, trading volume and shares outstanding from the Taiwan Economic Journal (TEJ). TEJ also provides daily trading data for listed firms after the IPO. Firm information such as firm age, assets, whether it is backed by venture capital, and accounting information is collected from the ESM or IPO prospectus. IPO characteristics such as fees, offer price, and the number of shares issued in each tranche are collected from three sources: the IPO prospectus, the bookbuilding and FPO announcement, and the underwriting announcement that is made after the bookbuilding and FPO processes are completed. Table 1 presents the summary statistics of firm characteristics at two points of time: when firms start to trade on the ESM (Panel A) and when they apply for an IPO (Panel B). When firms first trade on the ESM, their average firm age is 12 years old, with an average asset value of NT$ 2.1 billion and an average annual revenue of NT$ 1.6 billion. 7, 8 The average debt ratio is 41.3%. The average return on assets (ROA) is 9.2%. Forty-five percent of firms are backed by venture capital. At the time of the IPO application, on average firms are 1.7 years older, with increased assets, revenues, and ROA, and a decreased debt ratio than when ESM trading started. Panel C compares the differences in means and medians of these variables between the two time points 6 During our sample period, there are 8 IPOs that are spin-off firms and 32 that are foreign companies (including those that issue Taiwan Depository Receipts). Two IPOs are privatization of public enterprises. One of them uses the hybrid auction IPO method and the other uses pure fixed-price offering. There is also one firm that went IPO during our sample period (in November 2005) but its IPO application was before 2005 and hence was not subject to the new regulation. These firms are excluded from our sample. 7 At the end of 2011, the exchange rate is US$1 =NT$ All NT$ values are deflated to constant year 2011 NT$ based on Taiwan s CPI index. 12

15 and all differences are significant at the 1% level. In addition, more firms (56.4%) are backed by venture capital at the time of the IPO application. Table 2 shows the IPO characteristics. In the average IPO, the number of shares issued is 10.4% of shares outstanding before the IPO. The average proceeds raised is $NT million. Both of these numbers are considerably lower than the corresponding numbers for U.S. IPOs, where the average IPO during included close to 50% of the pre-ipo shares outstanding and raised approximately 15 times as much money, according to numbers listed on Jay Ritter s website. Thirty percent of the firms are listed on the TWSE as opposed to the GTSM. The average P/E ratio (i.e., offer price relative to the annual earnings per share before the IPO) is After excluding three outliers as described in footnote 8, the average P/E ratio is We calculate the price discount as one minus the ratio of the offer price over the closing price on the pre-pricing day on the ESM. The average price discount is 33.0%. Alternatively, the ratio of the closing price on the pre-pricing day on the ESM over the offer price minus one, has an average of 58.4%. In comparison, the initial return of IPO investors (i.e., the closing price on the first-trading day on TWSE/GTSM relative to the offer price minus one) has an average of 55.3%. Although the average first-day return is high, the small issue size on average lowers the opportunity cost associated with leaving money on the table. With an average discount of 33% and an issue size of 10% of the pre-ipo shares outstanding, the foregone proceeds of approximately 3% of firm value is smaller than that in the United States, where the comparable numbers are 50% (for discount) and 10% (for issue size), resulting in foregone proceeds of 5% of pre-ipo firm value. 9 When applying for IPO, firms in general are required to have positive earnings. However, a firm can be exempted from the requirement if it is deemed as advancing important innovations or participates in major national public construction projects. In our sample, two firms have negative earnings when applying for an IPO. Another firm has a tiny EPS and hence a P/E ratio larger than We exclude these 3 firms when the P/E ratio is used in our analysis. 13

16 We note that not all ESM firms have IPOs. There are 299 firms that have traded on the ESM during our sample period but haven t had an IPO by the day of analysis (January 2014). Among them, 166 firms stopped trading on ESM, mostly due to poor performance and sometimes because of mergers and acquisitions. We compare the 299 no-ipo firms with our sample firms in the appendix. These firms tend to be less profitable than our sample firms, and they suffer lower liquidity and lower returns during the first 6 months of ESM trading. So there is survivorship bias for our sample, i.e., those that perform well on the ESM tend to have an IPO. However, this bias does not affect the validity of our main study, which is the informativeness of ESM prices for those that do go public and to what extent such prices are incorporated in the offer price. Table 3 shows the summary statistics of two key hiatuses: days between the first trading day on the ESM to IPO application, and days between IPO application to the first trading day on the TWSE or GTSM. The first period has a median of calendar days and a mean of days. The second period has a median of days and a mean of days. 4. The Trading and Prices on the Emerging Stock Market 4.1 Trading on the emerging stock market We first examine how trading and prices evolve for an ESM stock. Specifically, we examine its liquidity, returns and volatility for three event periods: the period immediately after its ESM trading starts (for 6 months, or 126 trading days), the period around IPO application (6 months before to 3 months after), and the period around IPO pricing (6 months before and 4 trading days after). 10 If the hiatus between IPO application and pricing is less than 6 months, we let this 10 Most firms start to trade on TWSE or GTSM on the 5 th trading day (and their ESM trading ends on the 4 th trading day) after the IPO pricing. 14

17 period start from the IPO application date. For comparison, we also investigate the 6-month period of trading on the TWSE or GTSM after the IPO. For stock liquidity, we start with intuitive indicators such as daily turnover and dollar trading volume. We then use three measures of illiquidity: percentage of zero trading days during a certain period (Rabinovitch, Silva and Susmel, 2003), percentage of zero return days (Bekaert, Harvey and Lundblad, 2007; Chen, Lesmond and Wei, 2007), and the Amihud ratio (Amihud 2002), which measures the price impact of certain trading volume. We present the time series of trading volume and return for the four periods in Figures 2-5. We also report the summary statistics of volume, volatility, and illiquidity measures in Table 4. Figure 2 displays the mean and median daily turnover ratio (Figure 2.1), daily dollar trading volume (Figure 2.2), and cumulative buy-and-hold return (Figure 2.3) for the 6-month period after ESM trading starts. We notice an abnormally high trading volume on the first trading day, probably due to the newly opened opportunity to trade. Other than that, the ESM trading in the first 6 months is inactive. The average daily dollar volume fluctuates around NT$ 4.1 million and the average daily turnover is around 0.07%, an annualized rate of about 17%, although on an annualized basis trading as a fraction of the public float is over 100%, since the average public float is so small. The median values are even lower. Other than one or two temporary jumps in the average dollar volume, there is no increasing trend of volume and turnover during the first 6 months. In comparison, the mean daily dollar volume for stocks listed on the TWSE and GTSM is NT$93.9 million and the mean daily turnover is 0.86% during Figure 2.3 shows the mean and median cumulative returns. The mean cumulative return reaches 11% six months after trading starts. Most of the increases occur in the second half of the 6 months. The median cumulative return curve is pretty flat around zero for the first 3 months 15

18 and gradually increases to around 4% in the second half of the period. Calculating abnormal returns against the TWSE index return does not change the time-series trends much (not graphed). To see whether the increase in cumulative returns during the second half of the period is driven by stocks that get ready to do an IPO, we exclude firms that apply for an IPO within 8 months of ESM trading (there are 58 such firms). For the rest of the sample, the mean (median) cumulative return increases to 10% (0.7%) and most of the increases occur in the 2 nd half of the period. Therefore returns are generally positive for ESM firms during the period, but more so for firms getting ready for IPO. It should be noted that, because we restrict our sample to ESMtraded firms that subsequently conduct an IPO, the resulting survivorship bias probably results in a higher average return than if we included firms that never did go public. Figure 3 displays the mean and median daily turnover, volume, and cumulative return for the period around the IPO application. In this period, all 3 statistics have clear increasing trends. For example, the average daily turnover increases from 0.07% for the first 10 days of the period, to 0.14% in the last 10 days before the IPO application (with an average of 0.09% for the 6 months before IPO application), jumps to 0.20% on the IPO application day, and maintains a mean of 0.13% for the 3 months after the application. The increase in cumulative return is substantial: the mean and median cumulative returns are more than 40% and 30%, respectively, by the IPO application day, and they continue to increase in the next three months. Figure 4 displays the mean and median daily turnover, volume and cumulative return for the period around IPO pricing. Trading volume and prices continue to increase in this period. The mean and median cumulative returns are 38% and 20%, respectively. The mean daily turnover ratio is 0.17% and the mean dollar volume is NT$9.8 million. Notice that the tradable shares are reduced for this period because insiders are restricted from selling once the firm 16

19 applies for an IPO. The average insider holding (including directors, supervisors, and shareholders who hold at least 10% of the firm) at the time of the IPO application is 34.0%. Compared to the rest of the period, trading volumes are particularly large during the last month before IPO pricing and in the few days after the pricing. In the one month prior to pricing, the mean turnover ratio is 0.26%, and the mean dollar volume is NT$16.0 million. For comparison, Figure 5 displays the mean and median daily turnover, volume, and cumulative return for the 6-month period after the IPO. We exclude the first trading day on TWSE or GTSM from the graphs since the trading volume and returns on that day are of different magnitudes compared to the rest of the period. Specifically, on the first trading day, the average dollar volume is NT$361.5 million, the average turnover is 4.59% of shares outstanding (about 45% of the shares issued) and the average initial return is 55.3%. In the next one and onehalf months or so, trading volume gradually declines and then levels off. During the 6 months after the IPO (excluding the first trading day), the mean daily turnover is 0.96% and the mean dollar volume is NT$76.0 million. The mean and median cumulative buy-and-hold returns during this period are 2.0% and -5.7%. Neither is statistically significant. The buy-and-hold abnormal return against the market index has an insignificant mean of -1.6% and a median of %, significant at the 1% level (not reported in graphs or tables). Table 4 reports the summary statistics of turnover, dollar volume, and cumulative returns during four periods similar to but slightly different from those described above: the 6-month period after ESM trading, the 6-month prior to the IPO application, the 3-month period prior to IPO pricing and the 6-month period after the IPO. In addition, it also reports the summary statistics of volatility and three illiquidity measures. Daily volatility decreases over time: the mean decreases from 4.4% in the first 6 months on the ESM, to 3.6% during the 3 months before 17

20 IPO pricing, to 3.2% in the 6 months after the IPO. In comparison, the mean volatility for TWSE and GTSM firms during is 3.0%. Illiquidity also decreases as a firm moves closer toward its IPO. In the first 6 months on the ESM, the average firm has no trading on 44.7% of the days and has a zero return (including no trading) on 62.9% of the days. During the 3 months prior to IPO pricing, the average firm has no trading on 10.1% of the days and has a zero return on 26.3% of the days. During the 6 months after the IPO, the two numbers decrease to 0.04% and 6.1%. The Amihud ratio for firm i is defined as A i 1 T T r i, t dvol t 1 i, t, where r i,t is the daily stock return (in percentage points) and dvol i,t is daily dollar volume (in millions of NT$). It measures the price impact (i.e., the absolute value of the return) of certain dollar volume. The larger the price impact, the less liquid the market for the stock is. Consistent with other measures, the Amihud ratio also decreases over time: its mean decreases from 34.8 in the first 6 months on the ESM to 5.9 in the 3 months prior to IPO pricing to 0.6 after the IPO. In comparison, the mean Amihud ratio for TWSE and GTSM stocks during is In summary, when a firm moves toward its IPO, its stock trading on the ESM becomes more liquid and less volatile; and it tends to have a large price run-up prior to the IPO. 4.2 Price accuracy on ESM We examine the informativeness of the pre-market prices in reflecting the fundamental value of a stock. To do that, we assume the after-ipo market price is efficient and use it as the benchmark. Specifically, we define price error for stock i on day t as: 11 If the dollar trading volume was calculated using US dollars, the Amihud ratio would be approximately 30 times larger. 18

21 Price Error, i t P i, t P P i, FTD i, FTD, where P i,t is the closing price on day t (t belongs to the pre-ipo period), and P i,ftd is the closing price on the first trading day on TWSE or GTSM. We define the absolute value of price error as price inaccuracy, i.e., Pi, t P Price Inaccuracy i, t P i, FTD i, FTD. Considering that the fundamental value of a firm and its stock may change over time, we examine price inaccuracy only for the period around IPO pricing, i.e., from 6 months before IPO pricing or the IPO application date, whichever is later, to 4 business days after the IPO pricing. Figure 6.1 displays the time series of the mean and median price inaccuracy for this period. Both curves show a clear decreasing trend. That is, price inaccuracy significantly decreases as the time approaches to the IPO. At the beginning of the period, the mean (median) price inaccuracy is 50.8% (35.1%). On the pre-pricing date, the mean (median) price inaccuracy is 14.8% (13.0%). Table 4 also reports these statistics on several additional days: the days 3 months, 2 months and 1 month prior to the pricing. Price inaccuracy steadily declines. The standard deviation of price inaccuracy also decreases over the pre-pricing period: from 50.4% six months before pricing to 11.4% on the pre-pricing day. The decreasing trend of price inaccuracy can be either due to the convergence of the premarket price towards the fundamental value or to changes in the fundamental value, or both. We are unable to disentangle the two alternative explanations. Nonetheless, it is clear that the premarket prices shortly before the IPO are close to and hence very informative about the aftermarket price. Several reasons may contribute to the disparity between the ESM price on the pre-pricing day 19

22 and the after-market price: (1) there might be information resolution over the 5-day period. This applies to firms on TWSE and GTSM as well, except that our sample firms have an important type of information resolution in common the culmination of the IPO; (2) the trading environment changes. Now officially listed on TWSE or GTSM, these stocks may gain more attention and attract more investors; their trading becomes more liquid, and hence prices more efficient; and (3) last but not least, there might be clientele changes of investors. As discussed before, institutional investors are either restricted or self-restricted from participating in the ESM market. Hence there may be more institutional investors investing or trading on the stock once it is listed on the TWSE or GTSM. Figure 6.2 reports the time series of the mean and median price error. Both curves tend to stay close to zero. The mean curve has a slight downward trend and the median moves upward over time. The two curves get very close around 1 month before the IPO pricing, after which both exhibit an upward trend. Table 5 also shows that mean and median price errors are mostly insignificantly from zero at the following points of the time: at the beginning of the period, 3 months before pricing and 1 month before pricing. However, on the day before IPO pricing, the average pricing error is 6.0% and the median is 6.5%, both significantly different from zero. This indicates the existence of positive sentiment (i.e., over-optimism) shortly before the IPO. In summary, by the day before IPO pricing, the ESM price is on average close to the after-market price. However, there is still dispersion in price accuracy across firms. Next, we examine what factors affect price accuracy on the pre-pricing day. We hypothesize that the informativeness of pre-market prices should depend on the liquidity of the stock. The more liquid the stock trading, the more information may be incorporated into the stock price and hence the more efficient the price. As discussed before, we 20

23 use three measures of (il)liquidity: % of zero-trading day, % of zero-return day, and the Amihud ratio. In regressions presented in the tables, we measure the three illiquidity variables during the three months prior to the pricing day. Using a 6-month measuring period yields similar results. We include a set of other firm and stock characteristics as control variables. Specifically, we include firm size measured by log(assets), return on assets, a VC dummy that equals one if the firm is backed by venture capital, and return volatility. We also include year and industry dummies. Table 6 reports results of both univariate and multiple regressions of pre-pricing day price inaccuracy on illiquidity. Consistent with our hypothesis, price inaccuracy increases with all measures of illiquidity (i.e., price accuracy increases with liquidity). In terms of economic significance, a one-standard-deviation increase in % of zero-trading day (16.76%) increases price inaccuracy by 2.48 percentage points (using the multiple-regression regression result); a onestandard-deviation increase in %of zero-return day (21.10%) increases price inaccuracy by 2.58 percentage points; and a one-standard-deviation increase in the Amihud ratio (10.66%) increases price inaccuracy by 2.46 percentage points. In comparison, the mean price inaccuracy is percentage points. The coefficients on the control variables are insignificant, although their signs are consistent with the notion that larger firms, less profitable firms, and less volatile firms tend to have higher price accuracy (i.e., lower price inaccuracy). In unreported robustness checks, we run the same regressions using the turnover ratio or log(dollar volume) as a measure for liquidity. The coefficients on turnover and log(dollar volume) are all negative, and those on log(dollar volume) are significant at the 10% level. So the evidence is weaker but still consistent with the notion that price accuracy is positively related to liquidity. We also use the closing price 5 trading days after the first after-market trading day as 21

24 the benchmark to compute price accuracy. We reach the same conclusion that liquidity increases price accuracy. We also examine how price error depends on firm characteristics including liquidity (results not tabulated). Interestingly, we find that price error increases with illiquidity. In other words, the more illiquid the pre-market is, the more positively biased the pre-pricing day price is. There is weak evidence that price error decreases with volatility. The coefficients on the other variables as those in Table 6 are insignificant. 5. IPO Offer Price and Pre-Market Price The previous section shows that as time approaches to the IPO, the pre-market price gets very informative about the fundamental value of the stock, measured by the after-market price. The pre-market price therefore should be useful in setting the IPO offer price. More specifically, the theories based on asymmetric information such as the Benveniste and Spindt (1989) bookbuilding theory predict that the IPO offer price should exhibit the following features: (1) the offer price should largely depend on the pre-market price but not peers pricing; (2) the more informative the pre-market price is, the closer and higher the offer price will be relative to the pre-market price; and (3) there should be little underpricing. We test the first two predictions in this section and explore the third in the next section. To test the first prediction, we run a horse-race between the stock s own pre-market price and its peer companies prices in determining the IPO offer price. Specifically, we regress the (standardized) offer price on the stock s own pre-market price and its peer firms market price. We are interested to see which variable explains more of the variation in the offer price. We standardize prices using two variables earnings per share (EPS) and book value of equity per 22

25 share, i.e., we use two price ratios: P/E ratio and M/B (market-to-book) ratio. For each sample firm, peer companies are identified in two alternative ways: (1) we include all firms in the same industry that are listed on either the TWSE or GTSM, and use the median price ratio; (2) we identify a matching firm in the same industry that is traded on the TWSE or GTSM and has the closest asset value as the IPO firm. Table 7 Panel A reports the summary statistics of the price ratios. Table 7 Panel B (using P/E ratio) and Panel C (using M/B ratio) report the regression results. The results suggest that pre-market price explains most variation in the offer price, and its explanatory power overwhelmingly dominates that of the peer companies prices. Take Panel B, for example, where the dependent variable is the offer-price P/E ratio. In the first column, the only explanatory variable is the pre-market price P/E. The regression coefficient is positive and highly significant and the R-squared is 91.4%. In Column 2, the only explanatory variable is industry median P/E. The regression coefficient is also positive and significant but the R-squared is only 1.9%. When we include both variables in the regression in Column (3), both the value and the t-statistic of the coefficient on pre-market P/E remain similar as those in Column (1), but the coefficient on industry median P/E becomes significantly negative. In addition, the R-squared is close to that in Column (1) (91.7% vs. 91.4%), suggesting that adding industry median P/E in the regression does little to improve the fit of the model. Surprisingly, given the high R 2, the slope coefficient for the pre-market P/E is approximately 0.6, rather than the 1.0 that might be expected. Column (4) uses the matching firm s P/E ratio as the only explanatory variable and Column (5) includes both the matching firm s and the issuing firm s pre-market P/E ratios. In both regressions, the coefficient on the matching firm s P/E is insignificant. Results are qualitatively the same in Panel C when the M/B ratio is used instead of the P/E ratio. 23

26 The results in Table 7 support the notion that pre-market price is highly relevant in setting the IPO price. The information contained in the pre-market price is not captured by peer firms price information. Instead, once taking into account the issuer s own pre-market price, peer companies prices are not important in determining the offer price. We then examine what determines the cross-sectional difference in the offer price set relative to the pre-market price, i.e., the price discount. We hypothesize that the less risky the stock is and the more informative the pre-market price is, the less discount should be taken when setting the IPO offer price. Specifically, we estimate a regression of price discount on the stock and firm characteristics. We predict that price discount increases with pre-market price inaccuracy and pre-market stock volatility. To the extent that large firms, profitable firms and firms backed by VC are less risky, we predict price discount decreases with log(asset), ROA and VC dummy. Table 8 reports the regression results. Columns (1)-(5) present univariate regressions of price discount on each of the firm characteristic variables we describe above, and Column (6) presents a multiple regression including all of the variables as well as year and industry dummies. Consistent with the hypothesis, the coefficients on price inaccuracy and volatility are both significantly positive, and the coefficient on log(asset) is significantly negative. The coefficients on VC dummy and ROA are negative, as predicted by the hypothesis as well, although neither is statistically significant. In terms of economic significance, a one-standarddeviation increase in price inaccuracy (11.4 percentage point) increases price discount by 2.0 percentage points; a one-standard-deviation increase in volatility (1.5 percentage point) increase price discount by 3.6 percentage point; and a one-standard-deviation increase in log(asset) (0.9) decreases price discount by 3.4 percentage point. 24