IPO Puzzles

According to J. R. Ritter (1991) we have documented three anomalies in the pricing of initial public offerings (IPOs) of common stocks: the short-run underpricing phenomenon, the ‘‘hot issue’’ market phenomenon and the third anomaly is the long-run Underperformance of IPOs.


1. The short-run underpricing phenomenon

The short run underpricing refers to the price run up of the IPO on the first day trading. It is also known as the initial return of first-day return of the IPO.

Underpricing=(First day closing price-Offer price)÷Offer price×100%

Most IPOs are underpriced; the level of underpricing varies across IPOs with different issue characteristics, allocation mechanisms, underwriter reputation, and general financial market conditions. For example, the level of underpricing is reduced for larger IPOs, those underwritten by prestigious investment banks, firms with a longer operating history or more experienced insiders on the board, and those which intend to use the proceeds to repay debt. On the other hand, technology firms, firms backed by venture capital, firms with negative earnings prior to the IPO, or firms that went public during a bull market experience greater underpricing.

The Short run underpricing of IPOs is one of the puzzles on IPOs. Hence, lot of academics and researchers try to explain this puzzle but the solution may lie in the offer price where the “normal interplay” of Supply and Demand is suppressed by the underwriter. Ritter and Welch in a review on allocation of shares at 2002, suggest that the information symmetry-asymmetry between the parties (issuers, underwriters, entrepreneurs, investors) and simultaneously the allocation of shares. They may be the theatrical key theories causing that phenomenon on an IPO.

The theories that can explain short run underpricing according to Ritter & Welch (Pricing and Allocation 2002) are:

• Theories Based on Asymmetric Information

Information Asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. In contrast to neo-classical economics which assumes perfect information, this is about "What We Don't Know". In situations where the issuer is more informed than the investors, issuers trying sell or buy firms shares to achieve better positions. If investors are more informed than an issuer, for example, about the general demand for shares, then the issuer faces a placement problem because he/she doesn’t know where the market is willing to bear.

Ritter & Welch (2002) assumed that all theories of underpricing are positively related to the degree of asymmetric information. When the asymmetric information uncertainty approaches zero in these models, underpricing disappears entirely. 

Thereafter, because the underwriters have discretion regarding whom shares are allocated to, they could insist on selling IPOs only to investors who agree to buy both hot and cold IPOs.

• Theories based on Symmetric Information

Even in that condition, where all parties have relevant information, we observe underpricing that do not rely on asymmetric information. Tinic (1988) and Hughes & Thakor (1992) argue that issuers underpriced to reduce their legal liability. If there was an IPO which starts trading at 40$ and it’s priced at 30$ it is less likely to be sued if it had been priced at 40$, if only because it is more likely that at some point on the aftermarket share price will drop below 40$ than below 30$.

• Theories focusing on the Allocation of shares

This theory negotiates how IPOs are allocated and how a firm’s shares trade. IPO allocation is the process by which an issuing company allocates securities to the investors. There are many ways through which this allocation is done, some of them are the followings methods:

Method of Fixed-Price issue

Process of Book Building

Dutch auction Method

2. “Hot issue” Market Phenomenon

 “Hot issue” or “hot IPO”, is an issue that sells at a premium over the public offering price on the first day of trading in which the stock of the newly offered company is in great demand, causing the initial trading price to surge above the IPO price. An example of a hot IPO period is the hot market of 1980, where the hot issue market extending from January 1980 to March 1981 is characterized by an average initial return of 48.4% on unseasoned new issues of common stock, as compared to the 16.3% average initial return of the cold issue period for the remainder of 1977-1982. A second example of hot issue market is the internet bubble of 1999-2000 when the average initial return of 64.4%.

In regard to Shipping IPOs, there wasn’t, according to the evidence we have, a period with so high initial return at first day that we can name it hot IPO period. Although, if we have to name a hot period for the shipping IPOs we suggest that the years 2002 until 2005 was for the shipping IPOs the best period including the maritime market as well.

3. Long run underperformance

Long run underperformance was the reason why many academics researched and investigated this IPO phenomenon. The majority of the evidence for this phenomenon is being provided by J. Ritter and his research on long run underperformance (1991).

According to Ritter (1991), there are several reasons why long –run performance of IPOs is of interest in the US market. First of all, looking from the investors’ perspectives, the existence of price patters may present opportunities for active trading strategies to produce returns. Secondly, equity markets in general and the IPO market in particular are subject to fads that affect market prices. Thirdly, the volume of IPOs displays large variations over time. If the high volume periods are associated with poor long-run performance, this would indicate that issuers are successfully timing new issues to take advantage of “window of opportunity”. Fourthly, the cost of external equity capital for companies going public depends not only upon the transaction costs incurred in going public but also upon the returns that investors receive in the aftermarket. To the degree that low returns are earned in the aftermarket, the cost of external equity capital is lowered for these firms.

Possible explanation for this underperformance may be risk miss-measurement, bad luck or fads and over optimism. Also, one more explanation for long-run underperformance is prospect theory. If we be, although, more realistic it is very difficult for an IPO to keep over performed for a long-run period and that’s why everything flows as Heraclitus said. 

CG