Why IPOs are traded, on average, with initial high returns?

Over the past 25 years several empirical studies have proven that the Initial Public Offerings (IPOs) achieve exceptionally good average returns over very short periods. Many analysts suggested that this has been attributable to the fact that those IPOs might be under-priced from the very beginning. More specifically, researchers have identified three anomalies associated with IPOs contradicting at the same time the theory of Market efficiency. These are:

1) Initial high returns of IPOs ranging in average from 10% to 15% during the first day of trading.

2) Hot issue periods with not only extraordinary first day returns but also big trading volumes

3) Long run under-performance. Shares of Companies in the US, Germany and Latin America lost from 10% to 40% by the third anniversary of their floatation.

High returns always attract special attention that is why many theories have been developed to provide an explanation for IPOS’ high initial returns. All the related explanations stem from the relations among Issuers, Financial Institutions (acting as underwriters) and Investors.

Before making reference to the main reasons that cause those anomalies in IPOs it would be helpful to provide some information on the role of Underwriters:

The underwriters are usually investment banks, brokers or security dealers that mainly provide the following services:

· Consulting; upon the calculation of proper share prices
· Buy new shares; at a lower price than the introductory one
· Resell; sell the securities to their customers at the proposed price
· Take supportive action; in order to keep the initial price at the appropriate level.

The main source of fees of underwriters comes from the difference between the buying and the selling price of the security.

On the other hand a public issue has the following costs for companies seeking floatation:

· Underwriting costs i.e. the cost of the spread.
· Administrative costs mainly registration, legal, printing, promotion and mailing costs.
· Under-pricing costs; lower valuation of the share and therefore of the company. These are considered to be the highest though “hidden” costs of the issue.

Now concerning the reasons why IPOs are appeared with high initial returns, the following theories can explain this phenomenon.

Asymmetric Information – Companies and Underwriters.

This theory is based on the assumption that asymmetric information exists between the underwriters and the issuers, in that the formers have better information about the probable market demand. Therefore, it is the underwriter that will have more chances to have the last say on the IPO price.

Consequently, the underwriter may have an incentive to under-price intentionally the IPO share, as its main purpose is to create and facilitate appropriate marketing conditions ensuring the successful disposal of the related shares to the public. This kind of intention from the underwriters’ point of view is natural as in no way they would like to face the possibility of ending up with an unsuccessful issue resulting to financial losses.

Many underwriters have limited information or knowledge about the nature of business companies carry out or they may even lack the expertise and know-how to evaluate and quantify the firm’s future prospects. As a result of this, they only rely on historical financial and management accounts to evaluate the overall financial position of the company and sometimes they disregard important information about the level and quality of management and favorable changes during the post public offering period.

Nonetheless, underwriters are always considered by Investors to be more specialized in evaluating companies therefore they gain good reputation and recognition in the market. This of course comes gradually and there is usually a positive correlation between their success to be established in the market and the accuracy of their predictions. (Longer experience and competence are the reasons why big investment bankers are more credible than their minor competitors).

In addition to the above, under-pricing serves as an efficient form of insurance against potential legal liabilities of underwriters and issuers.

If the IPO is overpriced there are more possibilities that the value of the shares will fall soon after the issue and investors will lose money immediately. In this case it is probable that those investors that suffered damages may proceed with legal action against everyone who has signed the registration statement, prospectus etc. This can be dangerous for the underwriter that can influence negatively its reputation. Bearing this in mind as well as the fact that more or less the evaluation of company’s shares is based on subjective judgement, it is obvious that underwriters will try to protect themselves in advance by under-pricing the IPO.

It is quite remarkable to mention here that extensive studies in different stock exchanges came up with the following evidence:

· Risky, small and not very well known companies leave more money on the table by being under-priced to a greater extent.
· Underwriters with no expertise in evaluation of specific companies belonging to specific industries tend to under-price more IPOs to be on the safe side
· Major underwriters with more expertise go for large new issues. They usually refuse to underwrite small offerings from newly established firms for reputation reasons.

In general, the smaller the firm the greater is the bargaining power that can be exercised over the issuer. What happens most of the times is that the under-priced by the underwriters stocks will be allocated to favored for them customers. These are frequent customers who do business with the underwriters paying of course the related commissions and fees.

However, some other analysts have challenged the presumption that positive average returns results from deliberate under-pricing and attributed the phenomenon of high initial returns to the underwriter’s intervention to support IPO prices. Usually those intervention actions from the side of underwriters can formally or informally be a part of the overall IPO agreement reached between the issuer and the underwriter.

Price supporting involves transactions that prevent or hold back a decline in the market price of a stock with main effect to reduce the number of negative initial returns from what would otherwise be observed in free market trading. The price support cannot be considered as manipulative as long as the possibility of such an action is disclosed in the offering prospectus.

Asymmetric information – Informed and uninformed investors.

Another explanation for IPOS’ high initial returns is given by the view that in the market there are two groups of investors who possess asymmetric information.

a) The informed investors.

In this group we have the investors that know something more about the particular IPO because usually they purchase useful information at a cost. This information will be used to improve estimates of securities’ expected returns and is usually provided by specialists with analytical and forecasting skills.

Investors belonging in this category will of course proceed with investments only if they expect the value of the share to exceed the offer price soon. In this case the post IPO price should definitely be enough to cover their costs of acquiring and processing their information as well as securing an acceptable capital gain.

b) The Uninformed Investors.

In this group we have the investors that are not getting into the effort to acquire and process information in order to make their own estimates for the value of IPOs. Instead they have available funds for investments (coming from deposits or loans) and are willing to subscribe to every IPO indiscriminately.

Consequently those investors will face a winner’s curse in that they will not now which IPOs will be under or over-priced and unavoidably they will end up purchasing a disproportionately large percentage of the least desirable in terms of prospects new shares.

In other words, informed investors possess valuable information not known to uninformed investors and consequently asymmetry of information will prevail.

Nevertheless, uninformed investors more or less are suspicious and know that the other category of investors (informed) possesses valuable information and they will not participate in the new issues until the share has been priced downwards enough to compensate for the bias in allocation.

Bearing this in mind, as well as the fact that uninformed investors outnumber by far informed investors, the issuing firms must price the share at a discount so as to guarantee that uninformed investors will participate in the IPO. (Most of the times, over-subscription occurs because uninformed investors have been attracted, thus, doing the maximum to attract this category of investors is vital).

Conclusion.

Companies want their floatation to be successful and they know that it is better for them to do it through professional financial institutions (underwriters) that are specialized in this kind of business. From its point of view, the issuing firm cannot risk a fall in price because the target for panned market capitalization of the company will not be reached and on the on the other hand the underwriter cannot jeopardize its reputation and also lose money from a fall in price. Within this frame, various aspects and forces among investors issuers and underwriters interact which eventually lead to the under-pricing of IPOs.