Why Has IPO Underpricing Changed Over Time?
Tim Loughran and Jay Ritter*
lu the l9SOs. the average first-day rcliirn on inilial public offerings (IPOs) was 7%, The average firsl-day return doubled to almost I5'''i during 1990-1998. before jumping to 65% during Ihe internet bubble years of 1999-2000 and then reverting la / i % during 2001-2003. We attribute much of the higher underpricing during the bubble period to a changing issuer objective function. We argue that in the later periods there wav less focus on maximizing IPO proceeds due to an increased emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage accounts oj issuing firm executives created an incentive to seek rather than avoid underwriters with a reputation for severe underpricing.
What explains the severe underpricing of initial public ofrerings in 1999-2000, when the average rirsl-day return of"65% exceeded any level previously seen before? In this article, we address this and the related question of why IPO underpricing doubled from 7% during 1980-1989 to almost 15% during 1990-1998 before reverting to 12% during the post-bubble period of 20012003. Our goal is to explain low-frequency moveinents in underpricing (or first-day returns) that oeeur less often than hot and cold issue markets. We examine three hypotheses for the change in underpricing: I) the changing risk composition hypothesis, 2) the realignment of incentives hypothesis, and 3) a new hypothesis, the changing issuer objective funetion hypothesis. The changing issuer objective funetion hypothesis has two components, the spinning hypothesis and the analyst lust hypothesis. The changing risk composition hypothesis, introduced by Ritter (1984), assumes that riskier IPOs will be underpriced by more than less-risky IPOs. This predietion follows from models where underprieing arises as an equilibrium eondition to induee investors to participate in the IPO market. If the proportion of IPOs that represent risky stoeks inereases, there should be greater average underprieing. Risk can refleet either teehnologieal or valuation uncertainty. Although there have been some ehanges in the eharaeteristics of firms going public, these changes are found to be too minor to explain much of the variation in underpricing over time if there is a stationary risk-return relation. The realignment of incentives and the changing issuer objective function hypotheses both fi'e liuiiik JI.Mniii-Chi Chen. Hurry DeAu^elo. Cniig Diinhar. Tochi Uniige. .Josh Lamer. Lemma Senhct and Jame.s Seward t'hf Ediiors). Toshio Seri/a, Iva Welch. Ayako Yasuda. and Dongluing Zhang: seminar pariUipciiils al the 2002 Chicago NBER behavioral finance meelings. the 2002 Tokyo PACAP/APF.4/FMA meetings, the 20113 AFA meetings. Boston College. Cornell. Gothenburg. Indiana. Michigan Stale. Penn State. Stanford, ihe Stockholm School of Economics. Vandorhilt. NYU. SMU. TCU, and the Universities of Alabama. California (Berkeley). Colorado, Houston. Illinois, fowa. Notre Dame, ami Pennsylvania, and several anonymous referees; and especially Alexander LjiingqvisI for useful eommenis. Chris Barry: Laura Field. Paul Gompers. .losh Lerner. Alexander Ljungqvist. Scott Smart. Li-Anne Woo. and Chad Zutier generously provided IPO data. Bruce Foerster assisted us in ranking underwriters. Underwriter ranks are available online at http://bear.cha.ufl.edii/ritter/rank.him. Donghang Zhang supplied useful research assislance. 'Tim Loughran is a Professor oj Finance at the University of .Moire Dame. Jay Ritier is the Cordell Profes.sor of Finance til ilw University of Florida. Financial Management • Autumn 2004 • pages 5 - 37
Financial Management • Autumn 2004
posit changes over time in the willingness of issuing firms to accept underpricing. Both hypotheses assume that underwriters benefit from rent-seeking behavior that occurs when there is excessive underpricing. The realignment of incentives hypothesis, introduced by...
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