1. Initial Public Offering Market.
L o nd o n S t o c k E x c h a nge
IP O M a r k e t 2 0 0 9 - 2 0 1 1
What is the implication of IPO under-pricing for the long run
performance of IPO stocks?
Module Code: DB311
Author: Kishor Pun
Student Number: 11813812
Date: 12th May 2014
Supervisor: Mr Paul Grant
Word Count: 6100
Proposal: The under-pricing phenomena within UK financial market
I declare that this report is my own original work and that no part of it has been submitted
to any other institute of learning in support of an application for another award. The
opinions expressed in the report are put forward in a personal capacity and do not
represent those of the University of Brighton Business School or any other organisation
with which the author may be associated.
Signature…………..…Kishor_Pun………………………………
Date……………….12/05/2014……………………………………………
2. Contents
Executive Summary ..............................................................................................................4
Preface.....................................................................................................................................5
Chapter 1.................................................................................................................................6
Introduction of IPO...................................................................................................................................................6
Motives of the IPO......................................................................................................................................................6
Two different points of views about IPO: ....................................................................................................7
Table 1: Benefits andCosts of IPO to the issuers....................................................................................7
Aim and Objectives ...............................................................................................................9
Scope of Dissertation............................................................................................................9
Chapter 2...............................................................................................................................11
Background into the IPO Market within UK..................................................................11
The Process of IPO..................................................................................................................................................11
Figure 1 – Global Proceeds................................................................................................................................11
Table 2, Under-pricing implication for financial community.......................................................12
Chapter 3...............................................................................................................................13
Introduction.........................................................................................................................13
Under-pricing anomaly......................................................................................................13
Table 3 - Regarding the empirical studies on under-pricing........................................................13
The winner’s curse hypothesis.......................................................................................................................14
The underwriter reputation hypothesis...................................................................................................15
The signalling hypothesis..................................................................................................................................15
Behavioural finance..............................................................................................................................................16
The long run underperformance anomaly ....................................................................17
Table 4- long run under-performance study..........................................................................................17
Fad hypothesis.........................................................................................................................................................17
Signalling hypothesis...........................................................................................................................................18
Hot and cold market period..............................................................................................18
Conclusion about the IPO research .................................................................................19
Research.......................................................................................................................................................................20
Hypothesis..................................................................................................................................................................20
Chapter 4...............................................................................................................................21
Research Methodology.......................................................................................................21
Initial Return Calculation..................................................................................................................................21
Long run under-performance of the IPO...................................................................................................22
Chapter 5...............................................................................................................................24
Data Analysis and Evaluation ...........................................................................................24
Results for IPOs from 2009 to 2011: “Under-pricing” .................................................24
Table 5- First day return for IPO stocks....................................................................................................24
Figure 1- IPO performance over two-year period...............................................................................26
3. Figure 2 -Existence of under-pricing..........................................................................................................27
Long run underperformance Analysis............................................................................28
Table 6: Results for IPOs from 2009 to 2011.........................................................................................28
Figure 3:CAAR for first year and second year performance using theCAPM.....................28
The relationship between under-pricing and long run performance using the
regression model.................................................................................................................30
Figure 4:The relationship between under-pricing and 3 month performance................30
Figure 5:The relationship between under-pricing and 1 year performance.....................30
Figure 6:The relationship between under-pricing and 2 year performance.....................31
Chapter 6...............................................................................................................................32
Conclusion and Recommendations.................................................................................32
Appendices 1........................................................................................................................34
Figure 7- First day return for IPO relative to the market return (%)......................................34
Table 7– The IPO first day return in each market in 2001.............................................................35
T-Test tables for: 2009 IPOs, 2010 IPOs, 2011 IPOs, 2009-2011 IPOs....................................35
Table 8: Cold period - T test on2009 IPO stocks..................................................................................35
Table 9: Hot/Cold period -T test on 2010 IPO stocks.......................................................................36
Table 10: Hot period - T test on 2011 IPO stocks.................................................................................36
Table 11: Hot/Cold period- T-test for 2009-2011 IPO stocks...........................................................37
Appendix 2............................................................................................................................37
Short term performance analysis.................................................................................................................37
Figure 8 – IPO performancein one month MAAR (%)......................................................................37
Figure 9 – IPO performancein three months MAAR (%)................................................................38
Appendix 3............................................................................................................................38
Long term performance analysis...................................................................................................................38
Figure 10 – IPO performance in one yearCAR (%).............................................................................38
Figure 11 – IPO performance in two year CAR (%)............................................................................39
Appendix 4............................................................................................................................40
T Test statistics for IPOs from 2009-2011...............................................................................................40
Table 12: Long run under-performance of IPO stocks in 1 year.................................................40
Table 13: Long run under-performance of IPO stocks in 2 year.................................................40
Appendix 5............................................................................................................................41
Regressionanalysisto identifyrelationshipbetweenunder-pricingandlongrun
performance..............................................................................................................................................................41
Figure 12: The relationship between 1-day return to 1-month return..................................41
Figure 13: The relationship between 1-day return to 3-month return..................................41
Figure 14: The relationship between 1-day return to 1-year return.......................................42
Figure 15: The relationship between 1-day return to 2-year return.......................................42
Appendix 6............................................................................................................................43
The Initial publicoffering process...............................................................................................................43
Methods ofissue & Price setting....................................................................................................................44
Further study recommendation....................................................................................................................44
Bibliography.........................................................................................................................45
4. Executive Summary
IPO is the first sale of equity securities to outside investors for cash. Benefits to be
listed in London stock exchange includes diversification for primary shareholders
wealth and liquidity benefit derived by the secondary financial market, which allows
companies to expand further through acquisition of other company. Costs associated
with IPO includes legal requirement of regular accounting updates, excessive costs for
underwriters’ participation in IPO process and excessive dilution of the primary
shareholders. Thus, for IPOs to be useful benefits must outweigh costs.
The theoretical frameworks have observed that IPOs are faced with three anomalies,
under-pricing of IPO stocks, long run under-performance and hot & cold IPO market.
Thus, focus of the study is on whether there is any distinct relationship between under-
pricing and long run performance through observation on 2009 to 2011 IPO stocks. In
addition, this study will focus on factors that cause IPOs to be under-priced and the
existence of long-run underperformance supported by the existing literature.
Under pricing of IPOs is historically documented with previous studies by Ibbotson
(1975). Theoretical explanation for under-pricing is explained by Rock’s (1986)
argument of information asymmetric amongst the financial agents. Ritter (1981)
explains long run under-performance is affected by the valuation of optimistic investor
in the short run; thereby over-time IPOs fads towards its fair value. Whist IPO under-
pricing and long run under-performance does exist in the UK IPO market, the degree of
under-pricing and long run performance is determined by the timing of the IPO in the
market. During cold issue period there is less under-pricing and better long run
performance, whereas during hot issue period there is greater under-pricing followed
by long run under-performance.
Furthermore, due to the weak positive correlation coefficient derived from the analysis
on under-pricing and long run performance the research question has not been
answered clearly. Further study on the relationship between IPO under-pricing and
level of SEO & acquisition can be used to analyse if under-pricing leads to increase long
run performance and firm value.
5. Preface
IPO market is of great interest to the financial community due to the high initial return
that can be gained by the financial community and to UK economy as it helps to
maintain a healthy financial system in the UK economy. IPOs are faced with three main
anomalies; therefore it is of interest to identify if these anomalies exist in the UK IPO
market and what is the implication of these anomalies.
Quantitative research methodology was used whereby data for the study were accessed
from various sources, yahoo finance, FT, Bloomberg, BBC, Reuters and others. In
recognition of the use of CAPM as benchmark, it was difficult to obtain beta value of
each stock. Because this is a study on IPO portfolio of all IPOs that were listed in the LSE
during 2009 to 2011, use of all IPO stock price movement and the market price
movement for each time period were used to calculate the beta value for the IPO
portfolio. This beta value was used to calculate the required rate of return; thereby
long-term performance analysis of the IPOs could be conducted. To calculate market
return data on FTSE 100 was used due to the difficulty in obtaining FTSE AIM historical
data. Thus long run performance of IPOs can be negatively expressed.
I would like to express great appreciation to Mr Paul Grant, my supervisor, for the
support and guidance in finalising this particular study on the 2-year performance
analysis on 2009-2011 IPO stocks.
6. Chapter 1
Introduction of IPO
Initial public offering is the first sale of equity shares by private company to outside
investors for cash. When private companies are unable to expand further through internal
funding and debt financing, according to Arnold (2005a) stock market launch can facilitate
this financing gap supported by the pecking order theory. 1According to Arnold (2005b)
substantial amount of money raised can lead to a new, accelerated phase of business growth.
Motives of the IPO
There are many motives to be listed from issuer’s perspective, these motives revolves around
the notion that companies are able to raise the required capital (Breakey & Myers, 2003) and
the liquidity benefit provided by the secondary markets (Brau & Fawcett , 2006)2. Taking
liquidity into consideration Habib & Ljungqvist (2001) argues appointment of reputable
underwriters is essential for preventing greater wealth dilution and improvement on liquidity
of their equity holdings in secondary markets (Corwin, Harris , & Lipson , 2004). Since
financial risk is reduced due to improvement in capital structure in relation to debt to equity
ratio reduction. As such, value of the stock held by firm is increased along with benefits of
the liquidity within secondary market; this increase in stock value can be used as currency
for acquisition (Amihud & Mendelson, 1986), (Becker-Blease & Donna , 2006)). Donald &
Chew (1999a) finds providing an exit route for certain primary shareholders to diversify their
wealth is another motive. Whilst IPO can seem attractive, benefits and costs of the IPO
strategy must be considered.
1 Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their
sources of financing, first preferring internal financing, and then debt, lastly raising equity as a “last
resort”.
2 Liquidity benefit refers to the ability of the stocks to be traded amongst the investment community freely.
7. Two different points of views about IPO:
Table 1: Benefits and Costs of IPO to the issuers
Source Adapted from Arnold (2005c) - “Benefits and Costs of IPO”
8. Focus of the Study
Table 1 above explains IPO involves both risk and rewards for the issuers. This study
focuses on the risk whereby IPOs are sold at a discount through empirical data by Ibbotson
& Jaffe (1975a)3 showing IPOs are generally under-priced.
Success in terms of liquidity benefit & sufficient amount of capital raised without excessive
dilution of control depends on the pricing method used. Edelen & Kadlec (2005) suggests
adoption of conservative offer 4 would help to reduce probability of the IPO failure and
create liquidity for IPO stocks. Ritter (1991) documented performance of 1,526 IPOs that
went public in the US during 1975-84 with 34.37% over set of comparable firms matched by
industry and size with 61.38% over 3 years of going public. Thus additional to under-pricing
anomaly, IPO are associated with long run under-performance anomaly.
This study is based on relationship between pricing strategy adopted by IPO and its long-
term performance to analyse whether IPO’s firm value is increased through adopting of
under-pricing strategy. Whilst IPO is beneficial for private firms, the extent of the benefit
according to Donald & Chew (1999b) depends upon the overall market conditions, the
specifics of the firm, and the policies of investment bankers. As such, study will be formatted
on the analysis of 2009, 2010 and 2011 IPO stocks separately to identify difference in IPO
performance related to different market condition5. This study focuses specifically only at
placing and public offer by IPO within the financial markets.
3 Ibbotson & Jaffe (1975a) reported an average initial return an average initial return of 16.8%.
4 Conservative offer whereby some amount of money are left in the table for outside investors to induce
demand from financial community.
5 IPO market condition involves hot and cold issue period. Hot issue period is associated with greater
level of IPO proceeds, whereas cold issue period is associated with lower level of IPO proceeds.
9. Aim and Objectives
Efficient market hypothesis indicates all relevant information is fully reflected in the
share price (Kendall, 1953), thus one should not be able to predict the share price
movement of the IPO stocks6. The aim of the dissertation is to identify whetherthere is
positive relationship between the under-pricing pricing strategy of IPO and the
performance of the IPO stocks over time through observation of 2009-2011 IPO stocks
over 2 years period performance analysis. Relationship analysed will be used to evaluate
whether IPO’s firm value is increased through adoption of conservative pricing strategy.
Objectives of IPO study is to analyse the significance of IPO market in the UK financial
market, the growth of the IPO market over the previous years from 2009 to 2011,
existence of under-pricing & long-run under-performance anomaly in UK IPO
market through statistical measurement and whether IPO performance over 2 years
period are determined by the different market condition7.
Scope of Dissertation
The scope of dissertation is to look at the motives of the issuers and its relationship with the
IPO methods used, factors that causes IPO stocks to be under-priced through looking at
information asymmetric between financial agents and factors that causes long run
underperformance of IPO as studied by previous literature. Analytical research upon 2009-
2011 IPOs performance over 2 year period will be conducted.
What is the implication of IPO under-pricing for the long run performance of IPO stocks?
6 Since IPO stocks are valued using similar fundamentals and accounting measures to that of normal stocks,
thus share price movement on its first day of trading should originates around the offer price according to
efficient market hypothesis.
7 Market condition in 2009 assumed to be cold period whereby there was lower level of IPO proceeds
whereas IPO market in 2011 was associated with higher level of proceeds, thus regarded as hot issue
period.
11. Chapter 2
Background intothe IPO Market within UK
The Process of IPO
The process of IPO in UK typically involves a number of experts who can help the company
in raising funds. The agents involved in the IPO process includes issuer, sponsor either the
merchant banks or stockbroker and the investors. There are 2 stage admission processes
within IPO according to (London stock exchange, 2014). 8 The UKLA (United Kingdom
Legislation Authority) has set a number of basic requirements that must be met before listing
can be granted and the exchange can admit the shares to trade9.
Figure 1 – Global Proceeds
According to Figure 1, it can be assumed IPO market is cyclical to the economic
development. As the performance of the economy develops, the need for companies to seek
investors’ cash to finance growth enhances. IMF has forecasted UK economy to grow by
2.7% during 2015 (BBC, 2014), thus IPO proceeds are likely to increase over the next few
8 The first stage companies need to apply to the UKLA for their security to be approved by being admitted to
the UK Authority’s official list (UKLA’s list of approved companies). Thereafter, IPO need to apply to the
exchange to be admitted for trading.
9 These requirements include the sponsor,trading records, minimum shares in public hands,the controlling
shareholders,the prospectus and the continuing obligations.
Source: Financial Time, 2013
12. years. The current IPO market in UK represents great opportunity for investors of IPO stocks
whereby 71 companies debuted the London stock exchange market in 2013, which
represents an increase of 54% in the level of IPO activity from previous years (FT, 2013a).
Theoretical framework of discounted sale of IPO stocks implies a sum of money is left in the
table to induce demand from the financial community. The 2009 -2011 IPO data10, shown
below in Table 1, illustrates IPO do leave some money in the table with maximum money
left in the table at £20.27m in 2011.
Important to recognise that mispricing of IPO stocks is evident during hot issue periods when
there are greater levels of uncertainty within the market. Table 1, shows maximum money
left in table for 2010 & 2011 at 14.67 & 20.47 respectively, whilst during 2009 the
maximum average of money was at 3.08m. This supports FT (2013b) argument whereby
investment in IPOs stocks during cold period leads to cheaper financing for issuers due to
greater certainty in the financial market. To finalise, these data do show that mispricing of
IPO stock are to be expected. Therefore study upon its performance over time presents an
interesting outlook.
Table 2, Under-pricing implication for financial community
Money left in the table
Cold
Period
Hot/Cold
Period Hot Period
2009 2010 2011
Total during
2009-2011
Overall
Total Money raised 601.45 3632.94 7825.37 12059.75
Market Valuation at day 1 601.99 3606.63 7059.47
Total money left in table 0.54 -26.31 -765.90
Minimum money left in
the table -4.24 -15.47 -798.73
Maximum money left in
the table 3.08 14.67 20.27
Average 0.05 -0.57 -17.41
Median 0.00 0.00 0.35
Range 7.31 30.13 819.00
Total Number of Issues 11 46 44
Source adapted from (London stock exchange, 2014)
102009 – 2011 IPO data are derived from the London Stock Exchange New Issues (2014). Data includes IPO
stocks that have been processed via placing and public offer during those 2009-2011 periods.
13. Chapter 3
Introduction
According to Adams , Thornton and Hall (2008a) as the issuer does not generally receive the
market value of the share issued does this indicate informational inefficiency or is the initial
return of 11.4% on sample of 120 IPOs during 1965-1969 by Ibbotson (1975b) an indication
of the risk premium for investment in IPO stocks. As explained earlier, motives of going
public relates to liquidity and diversification of wealth11 . To provide liquidity benefit,
optimal price of IPOs that satisfies the three agents must be offered to the market initially.
Under-pricing anomaly
Empirical evidence by Ibbotson , Jody and Ritter (1988) identifies initial return of 18.8% for
sample of 5162 IPOs. Additional studies from Aggarwal , leal , & Hernandez (1993) have
confirmed the positive average initial returns of 78.5%, 16.3%, and 33.0% in Brazil, Chile,
and Mexico respectively. Rydqvist (1993), Kunz & Aggarwal (1994) and Levis (1993)
identifies European countries’ initial returns ranging from 12% to 39%, of which were found
in Sweden, Switzerland and United Kingdom.
Table 3 - Regarding the empirical studies on under-pricing
11 (Brau & Fawcett , 2006) Argument developed for liquidity and diversification of wealth of primary investors
in IPO process.
14. Under pricing of IPOs appears to be constant in the general financial market. As such,
theoretical explanation on the reasoning behind ‘why issuers leave an amount of money in
the table’ is critical for the observation into the long run performance of the IPO stocks.
Loughran & Ritter (1995 ), Matecon & Poon (2009) identifies that firm who benefit from
going public hire more reputable underwriters and adopt more conservative pricing policies.
Under-pricing lead to liquidity benefit, thus increased firm value and increased perceived
wealth for the issuers. The following research will focus upon the theoretical explanation of
the under-pricing phenomenon.
The winner’s curse hypothesis
Under-pricing of IPO stocks can be explained by the investor psychology and normative
financial theory (Adams , Thornton , & Hall , 2008b). A fundamental explanation of the IPO
under-pricing is the adverse selection model developed by (Rock, 1986) where there is
information asymmetric between market participants. Rock illustrates that investors can be
divided into two groups, informed (II) and uniformed investors (UI)12. Thus due to this
asymmetry, II only compete with UI for under-priced issues, UI will ‘win’ the entire issue of
over-priced issues causing winner curse problem. Ljungqvist (1996) explains with under-
pricing UI will have a chance to earn positive returns. To encourage participation of the
uninformed investors and benefit from liquidity of the secondary market, IPO must be under-
priced by the issuer and under-writer.
The implication of Rock’s adverse selection theory is that riskier IPO should be under-priced
to greater limit. Rock’s theory is supported by Beatty & Ritter (1986 ), the greater the ex-
ante uncertainty of the issue the greater the under-pricing. However, it must be argued
whether under-pricing can encourage UI participation since II would demand greater portion
of the under-priced offering and why participation of UI is critical for issuers (Anderson et
al, 1995). In other hand, Keasey and Short (1992) advise that under-pricing is a reflection of
the issuers’ perspective into uncertainty of the demand for IPOs.
12 Informed investors (II) are those who have more information than uninformed investors (UI).
15. The underwriter reputation hypothesis
The underwriter’s reputation effect on the under-pricing policy follows the asymmetric
information notion amongst the market participants.13 Baron & Holmstrom (1980) contends
the sponsor have superior knowledge over the issuing companies. As such, sponsor under-
price IPOs favouring their buying clients due to aversion to loss 14and inability to short sell
the risk of issuer’ stocks (Adams , Thornton , & Hall , 2008c).
Beatty & Ritter (1986) developed studies that the more prestigious the underwriters, the less
degree of under-pricing. Donald & Chew (1999c) supports due to underwriters’ desire to
protect its reputation and continue its relationship with issuers in future, this would limit
their ability to take advantage of an issuer.
However, Muscarella & Vetsuypens (1989) casts doubt in exploitation of the underwriter
and the asymmetric information associated with the sponsor through empirical findings
regarding investment bankers themselves underwrite its own IPO at lower prices15. Thus,
imply under-pricing of IPOs is recurring theme.
Benveniste & Spindt (1989) offer a dynamic information acquisition explanation for under-
pricing of IPO stocks whereby for institutional investor to express their true interest and
valuation of the IPO they must be rewarded with more under-pricing. Empirical evidence by
Hanley (1993) supports this theory of information acquisition through under-pricing of IPOs,
whereby under-pricing is positively related to the percentage revision in offer price from the
original filling price and concluded offer price revision as control variable.
The signalling hypothesis
Model developed by Grinblatt & Hwang (1989 ) focuses on use of superior information that
issuer has over other agents to market their IPO. Thus, under-pricing policy is used as a form
of signalling information about the firm value.
13 Baron (1982) develops empirical findings whereby due to positive demand for investment bank advising and
distribution service, IPO are generally under-priced.
14 Loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains.
15 Muscarella & Vetsuypens (1989) findings shows 38 investment banks that went public during1970-87
average initial return of 7.1%
16. IPO under-pricing increases liquidity benefit, thus firm value. Signalling model developed
by Allen & Faulhaber (1989) suggests good firms may employ under-pricing as signal about
the firm value. Empirical study by Keasey and Guiness (1992) 16 found positive relationship
between the market value and the under-pricing, which supports the signalling model.
Welch (1989) identifies significant positive relation between under-pricing and SEOs 17. This
indicates that reduction in IPO proceeds for the benefit of enhanced firm value can be
recovered in SEOs because higher prices can be fetched at the second stage sale (SEO), if the
firm value is enhanced.
Welch (1992) argues IPO market is liable for information ‘cascades’, due to the uncertainty
in IPO stocks. Information refers to when an investor demand are not only determined by
their valuation, but the demand of other investors. Thereby to provide positive ‘cascade’
effect and widening of the investor base through subsequent investor demand for the IPO
stocks, IPO must be under-priced. This can be referred to as herd behaviour18.
Behavioural finance
The use of under-pricing strategy by IPO issuer can be justified because of high volatility of
IPO stocks that can lead to excessive losses (Barberis , Huang , & Santos, 2001), thus
investors require a high premium to hold stocks. Studies based upon behavioural finance in
terms of investors’ sentiment due to over confidence (Daniel , Hirshleifer , &
Subrahmanyam , 1998), extrapolation of random sequence (Barberis, Shleifer, & Vishny,
1998) and limited attention spans can lead to discarding of critical information about IPO
stocks (Hirshlefier & Teoh , 2003 ). This can cause over-reaction, thus mispricing can occur
in IPO initial first day return.
16 Keasey and Guiness (1992) directly investigates the under-pricing and the firm market value using UK
USM data.
17 Welch (1989) documented one-third of the companies that went public in the late 1970s and early 1980s
have issued seasoned equity at least once since then.
18 Herd behaviour describes how individuals in a group can act together without planned direction
17. The long run underperformance anomaly
The second major anomaly of IPO literature concerns the long-run under-performance of the
IPO firms. (Ritter, 1991) first documented the long run underperformance of the IPO
stocks.19 Thereafter, Loughran & Ritter (1995) using larger sample of IPOs (4,753 issues
between 1970 and 1990) reported long run abnormal return of negative 17.1%. Further study
on global scale by Aggarwal , Leal , & Hernandez (1993) provides evidence of long run
under-performance of IPOs globally. Thereby empirical evidence suggests that followed by
initial rise in return is followed by long run under-performance. As such, study regarding the
cause of this anomaly is important.
Table 4- long run under-performance study
Fad hypothesis
Ritter J (1991) provides empirical evidence that is constant with the notion that many firms
go public near the peak of industry specific fads, whereby younger firms and firms that went
public in high volume years of early 1980s had the most serious under-performance.
Therefore, investors over-paid initially. Carter , Dark , & Singh (1998) find
underperformance of IPO stocks relative to the market (NASDAQ index) over 3 year
holding period is less severe for IPOs handled by more prestigious under-writers.
19 Ritter (1991) using sample of 1,526 IPOs that went public in the US during 1975-84 identified after 3 years
of going public, these firms considerably underperformed the market indices and set of comparable firms
matched by industry and size. Using the buy and hold strategy during this 3 year period and excluding the
initial rise of 14.32%, it produced average returns of 34.37% whereas comparable firms produced 61.86%
during the same 3 year period.
18. Due to the varying range of valuation upon IPO stocks from both optimistic and pessimistic
investors, Miller (1977) conducts offering prices will be higher than fair-value since prices
will be based on optimistic investors’ valuation. Hong & Stein (1999) studies the gradual
diffusion of news causes momentum, thus with time and greater information coverage on the
IPOs these stock price will approach to its fair values.
Signalling hypothesis
Signalling mechanism demonstrates that in order to reveal true values about the stock, firms
need to employ some signal after the flotation as well as before the flotation. Jegadeesh ,
Weinstein and Welch (1989 ) argue that firms that raise equity after IPO via SEOs are high
value and hence outperform the un-issuing firms in the long term. However, empirical results
show mixed results whereby Welch (1996) support the positive relation between under-
pricing and long run performance, whereas Yi (2003 ) argue that firms that under-price do
not implicitly imply that those firm will outperform as withdrawal of underwriters’ support
upon these new issues will cause share prices to fall.
In addition, Brav & Gompers (1997) identifies that venture capital backed IPOs outperform
non-venture capital backed IPOs when returns are computed on equal weighted basis. In
sum, agents can have an impact in the valuation process for investors. Studies have shown
prestigious investment bankers and venture capital backing of IPOs can create positive firm
value effect in the long term.
Hot and cold market period
The third anomaly of IPO is related to the initial short-term performance of the IPO during
different time frames. It regards the positive relationship between the number of IPO offers
and the initial return performance. Ibbotson & Jaffe (1975 ), Ritter (1984) identifies
unexpected high average initial return of 48.4% during the hot issue period in 1980-1981
whilst reporting low figure of 16.3% during cold issue period in the period 1977-80.
19. Using the assumption that riskier IPO should be under-priced to greater extent, Ritter (1984)
provides can empirical evidence to explain the change in initial return whereby ‘hot issue’
market are influenced by riskier offerings20.
Conclusion about the IPO research
The success of IPO strategy is reflected in the price the owners can gain from their shares
(Jensen & Meckling, 1976). 21The asymmetric information amongst the financial agents can
consequently lead to under-pricing phenomena. Since IPO stock involves uncertainty, risk
must be compensated by return, thus initial offer prices are historically set low.
Literature review in regards to information signalling theory, initial offer prices are
deliberately set low. 22 Whilst under-pricing can results in greater liquidity and firm value, if
the price set is too low the issuer may not be able to raise the full capital required or the
issuers would suffer from excessive dilution of ownership. In addition, issuer can recoup the
perceived lost wealth by seasoned equity offering.
To conclude the success of IPO depends on the accurate valuation from the investment
community. Due to differing motives of the investment community, accurate valuation is
diminished thereby under-pricing exists in the market. Long-run under-performance can be
explained by risk involved since firms go public during the industry peaks whereby it is
difficult to grow further without taking greater risk as justified by Ritter (1991). In reflection
of the long-term under-performance of the IPOs, factors in terms of venture capital backed
firm and support of prestigious investment bankers can be used to explain the fad hypothesis.
20 During hot issue period discounted sale of IPO stocks tends to be evident.
21 In regards to the motives of going public by private companies. It can be assumed issuers have an intention to
offer their securities at lower price, thereby under-pricing phenomena is created.
22 The under-pricing strategy can represent a positive outlook for the liquidity issue and future value of the
company (Edelen & Kadlec, 2005).
20. Research
Empirical evidence documents that IPO stocks are underpriced and the long-term under-
performance of the IPO stocks is evident. Focus on the initial returns data and the long-term
performance benchmarked by CAPM will be used to identify whether these anomalies
associated with IPOs are consistent in the UK IPO market. IPO sample consists of IPO that
floated in the London stock exchange market during 2009-2011 periods. Furthermore,
observation on the IPO stock price movement over one month, 3 month, one year and 2-year
period will be used to whether underpricing can be justifiable.
To exploit such study, selection of IPOs that had adopted placing or open offer pricing
methods from the London stock exchange IPO new issue data (2014) 23 within the specified
period of 2009-2011 will be used as sample study. The reasoning for concentration on such
IPO methods is so to relate to the liquidity benefit that can be derived from secondary market
and dilution of primary shareholders motives.
Hypothesis
Null Hypothesis (H0) = There is a positive relationship between under-pricing and the long
run positive abnormal return.
Alternative Hypothesis (H1) = Relationship differs for different IPO stocks due to varying
macroeconomics and microeconomics factors.
23 In regards to IPO motives from issuer’s perspective, placing offer leads to lower dilution of ownership at
higher costs (Arnold, 2005) whereas public offer leads to greater liquidity through widening of the investors
bases,but risk of offer withdrawal remains (Donald & Chew , 1999).
21. Chapter 4
Research Methodology
Initial Return Calculation
To analyse the initial returns of the IPO stocks, methods used by Aggarwal , Leal &
Hernandez (1993)24 will be adopted whereby total return for stock “I” at the end of the first
trading day is calculated as:
(%) Return on I = ((P1– P0)/P0) x 100% (Formula 1)
Key: Offer price = P0, Adjusted close price in day 1 = P1, Return on I = RI
To identify the initial return on IPOs, IPOs are be adjusted for market return. This will help
to identify the abnormal return, which would reflect the over-reaction of the investors. FTSE
100 would be used as first day’s comparable market return; data for the market return will be
gained from the Yahoo Finance (2014).
(%) Return on M = ((Closing market value on the trading day - Opening market value on the
trading day) /opening market value on the trading day) x 100% (Formula 2)25
Using these two returns, the market adjusted abnormal return (MAAR) for each IPO upon
the first trading day would be computed whereby:
MAAR (%) = RM % -RI % (Formula 3) 26
24 Aggarwal, Leal and Hernandez (1993) conducted their study on initial return by calculation first day
return in excess of the market return.
25 KEY: Opening market value on the trading day= P0, Closing market value on the trading day= P1, Return
on M = RM
26 KEY: MAAR = Market adjusted abnormal return
22. To calculate the initial return on the whole IPOs during 2009 to 2011 years, mean of the
MAAR would be calculated as shown in formula 4 below, mean MAAR is the sample mean
abnormal return that reflects the risk of the market.
Mean of MAAR (%) = Sum of all MAAR (%) /N (Formula 4) 27
To test the hypothesis that 1 MAAR equals zero we compute the associated t statistics:
(Formula 5)
Whereby S is the standard deviation of MAAR across companies
Long run under-performance of the IPO
To study the long run performance analysis, standard event study methodology was used
whereby IPO returns were calculated for 2 years period following the first trading day.
Study on the IPO stocks for year 1 and year 2 performances are benchmarked against capital
asset pricing model (CAPM) to calculate the cumulative abnormal return of year 1 and year
2 performances.
(%) Abnormal return (AR) = Return on the IPO stocks from the offer price – CAPM
(Formula 6)
27 KEY: N = Number of sample
23. CAPM = Rf + Average Beta of all IPO stocks (Rm – Rf) (Formula 7) 28
Cumulative AR (%) = Sum of abnormal return / number of sample (Formula 8)
Once cumulative abnormal returns (CAR) are calculated to provide a generalised long run
performance, cumulative average abnormal return (CAAR) on stock will be calculated. The
CAAR formula is given below:
(Formula 9)
The test for the significance of long run under-performance is based on the t-test conducted
by (Brown & Warner , 1980) crude dependence adjustment test in order to correct for cross-
sectional dependence.
(Formula 10)
Thereafter, regression model will be used to identify any relationship between the under-
pricing and long run performance can be identified.
28 Key: Rf= risk free rate (2 years UK gilts), Rm= Return on the market from the open market value of the
FTSE 100 in the first trading day
24. Chapter 5
Data Analysis and Evaluation
The study sample consists of all 101 IPOs listed in the London Stock Exchange via placing
or public offer during the period from 2009 to 2011. 29 IPO initial return will be calculated
looking at the closed priced in relation to offer price, this will follow systematically for all
IPOs chosen within sample size of IPOs listed during 2009 and 2011. The short-term
performance of IPO stocks were analyzed using the returns of FTSE 100, to calculate the
existence of underpricing in IPO stocks over 1 day to 3 month period for further data
analysis.
The long run returns in the study are adjusted for dividend and stock splits. Similarly the
returns on the FTSE 100 were measured as total returns including dividends. The cumulative
abnormal return on stocks measured through using sum of abnormal return divided by the
number of time periods, returns rate measured through day 1 price to y year’s close price.30
Results for IPOs from 2009 to 2011: “Under-pricing”
Table 5- First day return for IPO stocks
First day
market
adjusted
return for
IPOs in UK
Cold
issue
period
Hot/col
d issue
period
Hot
issue
period
Mixture
of all IPO
issues
First day
market
unadjust
ed return
for IPOs
in UK
Data from
2009 to 2011
2009
IPO
portfo
lio
2010
IPO
portfoli
o
2011
IPO
portfo
lio
2009-11
IPO
portfolio
2009 IPO
portfolio
2010
IPO
portf
olio
201
1
IPO
port
folio
2009-
11
IPO
portf
olio
Mean (%) -2.57 -0.86 8.79 3.16 -2.68 -0.77 8.67 3.13
29 Reported IPO data by London stock exchange on new issues statistics were used (London stock exchange,
2014).
30 The data regarding the return in the market and IPO stocks during the period considered were generated from
Yahoo Finance, Financial Times and Bloomberg (2014).
25. Standard
Deviation (%) 7.14 18.36 17.84 17.96 6.99
18.2
6
17.6
3 17.79
T-statistics
-
0.035 -2.483 3.255 1.769
Critical value -2.085 -1.987 2.015 1.983
P value
0.972
4
0.01492
2324
0.002
17885
0.079776
6648
Statistical
significance
of under-
pricing of IPO No Yes Yes No
Median (%) 0.52 -0.52 6.70 1.05 0.00 0.00 6.99 0
Minimum (%) -17.77 -90.94 -39.79 -90.94 -17.59
-
89.8
0
-
37.4
0
-
90.00
Maximum (%) 3.57 63.27 60.14 63.27 3.85
64.2
9
58.7
0 64.00
Total number
of issues 11 46 44 101 11 46 44 101
Source adapted from: LSE, Yahoo Finance (2014)
For the 2009-2011 IPO portfolios, the mean MAAR is found to be 3.16% with an associated
t-statistics of 1.769 and 0.0797% probability figure, which is less than the alpha figure of
0.05% (See appendix 1). Since t statistic is less than the critical value, null hypothesis cannot
be rejected whereby market adjusted abnormal return is zero. Interestingly, mean MAAR of
3.16% is significantly worse than the reported IPO first day return by Levis (2001). 31
Adams, Thorthon and Hall (2008) suggest ‘the book building approach, a process used for
placing offer, has reduced information asymmetry and thus the under-pricing over time’. As
the IPOs studied are mostly processed via placing offer, this would explain such small under-
pricing of IPOs32.
During 2011 IPO market, greater level of under-pricing was evident33. This is supported by
the t statistics for 2011 IPO stocks of 3.25 and probability figure of 0.00217% which are
greater than critical value of 2.015 and less than alpha figure of 0.05%. This concludes IPOs
during hot issues period are associated with under-pricing. (See appendix 1)
31 Levis (2001) reported 60.1% in first trading day return on all IPO that were listed in 2001.
32 Of the 101 sample for the data analysis, 76 were processed viaplacing method.
33 2011 associated to be regarded as hot issue period.
26. Figure 1- IPO performance over two-year period
Source: adapted from London Stock Exchange (2014)
Following the assumption of gradual diffusion of news by Hong and Stein (1986) and Rock’s
(1996) argument of asymmetric information between different types of investors, it can be
recognised that under-pricing of IPO stocks is clearer to see after 1 month of trading. Thus,
the mean MAAR for one-month performance of the 2009-11 IPO stocks is found to be
10.89%, with t statistics of 2.34 which is greater than critical value of 1.984 thereby we can
now reject the null hypothesis that MAAR equals zero for 1 month performance.
Furthermore, rejection of H0 is supported by the probability value of 0.021% that is less then
alpha figure of 5%. As seen in figure 1 after 1 month there appears to be incremental stock
return until 3 months, thereafter long run under-performance of IPO stocks becomes evident.
-15
-10
-5
0
5
10
15
Before IPO
offer day.
Average
share
price. T 1 -
1
First
trading
day.
Average
share
price. T 0
1 month.
Average
share
price. T 1
+1
3 Month.
Average
share
price. T 1
+2
1 year.
Average
share
price. T 1
+3
2 years.
Average
share
price. T 1
+4
Abnormalreturn(%)
MAAR (%)
MAAR (%)
27. Figure 2 - Existence of under-pricing
Source: adapted from London Stock Exchange (2014)
It is clear now that under-pricing is evident in UK IPO market, which is consistent with the
previous empirical study by Ibbotson (1975). However the degree of under-pricing of IPOs
depends on hot and cold issue period as argued by Ritter (1986). Figure 2 shows 2011 IPOs
were under-priced to a greater extent than the IPOs during 2010 and 2009, this could be
explained by Welch (1986) assumption of greater uncertainty in the financial market during
hot issue period, thereby to compensate for risk IPOs are under-priced more than IPOs
during 2009.
-5
0
5
10
15
20
25
Day 0 Day 1 1 Month 3 Month
AbnormalReturnlevel(%)
Short term average
IPO performance analysis
2009
2010
2011
2009-11
28. Long run underperformance Analysis
Table 6: Results for IPOs from 2009 to 2011
Event studies
performance
Average
abnormal
return Data
from 2009 to
2011
2009 2010 2011 2009-11
Day 0 0 0 0 0
Day 1 -2.57 -0.86 8.79 3.16
1 Month -1.7971568 3.03 22.12 10.82
3 Month -0.3451765 8.52 19.69 12.42
1 year 5.81 -33.09 -11.12 -3.77
2 years 10.71 -37.23 -15.86 -12.09
Total Number of Issues 11 46 44 101
Source: adapted from London Stock Exchange (2014)
Figure 3: CAAR for first year and second year performance using the CAPM.
Source: adapted from London Stock Exchange (2014): The results for the CAAR using
CAPM benchmark model are illustrated graphically in figure 3. 34
34 Figure 3 shows the abnormal returns up to the 2 years period for UK IPOs from 2009-2011 using the CAPM.
-50
-40
-30
-20
-10
0
10
20
30
Day 0 Day 1 1 Month 3 Month 1 year 2 years
AverageAbnormalreturnonIPO
stocks%
IPO Performance
- Over two year period
2009
2010
2011
2009-11
29. Data for year 1 and year 2 cumulative abnormal returns of the 2009-2011 IPO stock portfolio
conveys 64 and 74 of IPOs produced negative abnormal returns respectively. IPOs results
confirm the existence of statistically and economically significant long-run IPO
underperformance of IPO stocks in our sample benchmarked by CAPM with the t statistics
of 3.859 for year 1 performance and 2.715 for year 2. (See appendix 4)
The abnormal returns vary between -98.87% and 654.49% during year 1, whilst year 2
returns vary from -104.28% to 390.07%. 2009-2011 IPOs portfolio performance indicates
under-performance over 2 year period with 12.09% abnormal returns. This is significantly
worse than that reported by Levis (1993) for his sample of UK IPOs issued during 1980-88.
Levis reports CAARs of -11% for the zero-one FTA benchmark35.
Recognition of the superior performance of 2009 IPO stocks in comparison to 2010 and 2011
IPO stocks is critical to understand. This is because cold issue period are associated with
greater certainty in the market36, thus IPOs during these period were fairly priced. However,
IPOs during hot issue period tends to be over-priced 37 in reflection of the long run under-
performance38. From the data analysed after 3 months seems to be good indication that the
IPO stocks tends to decline in value. Data support the argument by Shiller (1967) whereby
over time stocks prices tend to divert back to its fair value due to greater information
availability of IPO stocks.
During lower level of IPO proceeds, only prestigious under-writers are involved in the IPO
process and due to greater competition level for limited number of IPO proceeds lower level
of under-pricing are evident to maintain under-writer reputation39 (Donald & Chew (1999a).
However, during hot issue period there are fewer incentives for under-writers to under-price
IPO in favour of their clients (Baron & Holmstrom, 1980).
35 FTA = Financial Times Actuaries All shares index is a value weighted index comprising approximately
90% of UK stocks by value (levis, 1993)
36 Cold issue period is associated with greater financial market is certainty thereby IPO are priced
correctly. This proved by their performance in short run and long run performance.
37 Hot issue period can contain bad IPO
38 Long run under-performance in excess of the expected return indicates over-pricing. This is referred to
as market correction.
39 Under-writer chosen by issuers based on underwriters’ reputation on historical performance on the
level of under-pricing for their previous IPO clients.
30. Whilst we can conclude statistical significance of under-pricing and long run under-
performance of IPO stocks, the relationship between under-pricing and long run
underperformance will be analysed to answer whether there is the existence of positive
relationship between these two subjects.
The relationship between under-pricing and long run performance using the regression
model
Figure 4: The relationship between under-pricing and 3 month performance
Figure 5: The relationship between under-pricing and 1 year performance
y = 1.1784x + 8.7012
R² = 0.1493
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
-100.00 -50.00 0.00 50.00 100.00
1dayMAAR(%)
The relationship between 1 day return
and 3 month return
MAAR
Linear (MAAR)
y = 1.5296x - 8.6035
R² = 0.0914
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
-100.00 -50.00 0.00 50.00 100.00
1yearreturn(%)
Day 1 Return MAAR %
Relationship betweeen Day 1 return to 1
year return
Series1
Linear (Series1)
Initial Return (%)
31. Figure 6: The relationship between under-pricing and 2 year performance
Source: adapted from London Stock Exchange (2014)
From our results there appears to be positive relationship between initial return and long run
positive performance of IPOs in the short-term period, whereby relationship between 1-day
return to 1 & 3 months returns seems to indicate correlation co-efficient of 0.19086 and
0.14927 respectively. Whilst trend lines do indicate positive relationship in the long run, no
relationship can be found since correlation co-efficient are 0.002288 and 0.03343 for year 1
and 2. (See appendix 5)
Data on 2011 IPO whereby initial returns were followed by greater long run under-
performance and 2009 IPO’s weak initial return were followed by improved performance in
the long run contradicts their theory. Therefore Welch’s (1989), Allen & Faulhaber’s (1989)
and Keasey and Guiness’s (1992) hypothesis on the positive relationship between under-
pricing strategy and firm value is not supported by this study.
y = 0.9982x - 26.032
R² = 0.0334
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
-60.00 -40.00 -20.00 0.00 20.00 40.00 60.00 80.00
2yearsReturn(Abnormalreturn)
1 day return (MAAR %)
Relationship between 1 day return and 2
years return
Abnormal Returns (%)
Linear (Abnormal Returns
(%))
32. Chapter 6
Conclusion and Recommendations
Whilst results do confirm the existence of under-pricing of IPOs and the long run under-
performance for 2009-2011 IPOs, the extent of the positive relationship between under-
pricing and the positive long run performance was not established. However, in the short run
the IPOs that are under-priced to greater extent tends to gain greater firm value until 3
months trading period but perform less relative to those less under-priced. Therefore we
cannot accept the working hypothesis of this study. Further study on the monthly returns of
IPOs for 24 months period could be used to identify when specifically the IPOs start to
under-perform. This would provide an indication date to analyse whether certain IPOs are
over or under-priced.
Research on 2009 to 2011 IPO performances 40 concludes IPO performance is greatly
determined by the level of IPO activity in the financial market. During hot issue period in
2010 & 2011, there was greater level of IPO under-pricing and long run under performance.
Whereas, during cold issue period for 2009 IPOs, IPOs can be assumed to be priced correctly
and this is indicated by the mean MAAR (%) of -2.5% and positive long run performance.
To finalise the investor sentiments and lack of information about IPO firms can influence the
excessive fluctuation in IPO stocks during different periods of IPO data analysis.
Whilst this study does not provide clear conclusion of the positive implication of the under-
pricing of IPOs for long run performance benefit, under-pricing of IPO does however
provide information signal on value for investment for certain companies within short time
period. Further study on whether firm value is increased through under-pricing can be
supported by research on whether these under-priced firms offer SEO or acquire other
companies at later date and whether this leads to positive change in firm value41.
Data upon these topics could help conclude the whether there is positive relationship
between under-pricing strategy in support for the long-term performance of the IPOs;
40 IPOs that floated via placing and public offer pricing method,
41 Welch (1989) argues that reduction in IPO proceeds for the benefit of enhanced firm value can be recovered
in SEOs because higher prices can be fetched at the second stage sale (SEO), if the firm value is enhanced.
33. measurement tools include firm value level after IPO, SEOs data and level of acquisition by
these IPO firms.
As an evaluation of long run returns analysis, according to Barber & Lyon (1996) use of
BHR (Buy and hold return) method for long run performance could be used in future study
as CAR suffers from inability to reflect all information. Additionally, Barber , Lyon , & Tsai
(1999) suggests the use of matching control firm as benchmark would provide more reliable
performance analysis due to sharing of similar firm characteristics.
Future study on whether these IPO stocks during the past decades have become less under-
priced overtime due to advancement in technology is an interesting future research proposal.
42Event study based on technology advancement variables in relation to IPO under-pricing
level could be justifiable research methodology.
Furthermore, Loughran & Ritter (1995) and Brav (2000) argue test statistics reflect the
performance of sample firms negatively because it lacks in independence of observation.
Thus, long run performance of IPO analysis can be reflected negatively. To conclude, a
number of literatures have decided that this long-run under-performance is spurious and
arises mainly as a result of risk measurement problems (Espenlaub , Gregory , & Tonks ,
2000 ) and any under performance is relatively small or dis-appears altogether- especially
after period of years.
42 This future research is proposed due to result of lower under-pricing in comparison to previous study
on initial return of IPO stocks.
34. Appendices 1
Figure 7- First day return for IPO relative to the market return (%)
Source: adapted from London Stock Exchange (2014)
Figure 7 - shows that the mean MAAR (%) in day 1 return on IPO stocks from 2009-11 to
be 8.79%. 43 of the 101 IPO sample performance negatively in term of market adjusted
abnormal return. The 2011 IPOs performance was positive whereby the sample from 1 to 44
in the figure above shows the positive return ranging from -39% to 60% first trading day
return.
-100
-80
-60
-40
-20
0
20
40
60
80
1
6
11
16
21
26
31
36
41
46
51
56
61
66
71
76
81
86
91
96
101
Marketadjustedabnormalreturn(%)
First day stock return relative to the market return (%)
First day
return on the
stock (%)
First day
return on the
market (%)
Mean MAAR
(%)
35. Table 7– The IPO first day return in each market in 2001
T-Test tables for: 2009 IPOs, 2010 IPOs, 2011 IPOs, 2009-2011 IPOs
Table 8: Cold period - T test on 2009 IPO
stocks
t-Test: Two-Sample Assuming Unequal
Variances
Variable 1 Variable 2
Mean -2.677101355 -2.566540179
Variance 53.67201202 56.00037477
Observations 11 11
Hypothesized Mean Difference 0
df 20
t Stat -0.035014695
P(T<=t) one-tail 0.486207569
t Critical one-tail 1.724718243
P(T<=t) two-tail 0.972415138
t Critical two-tail 2.085963447
Source: adapted from London Stock Exchange
(2014)
36. Table 9: Hot/Cold period - T test on 2010 IPO
stocks
t-Test: Two-Sample Assuming Unequal
Variances
Variable 1 Variable 2
Mean -0.771389227 8.785275771
Variance 340.7890116 325.7923033
Observations 46 44
Hypothesized Mean Difference 0
df 88
t Stat -2.483060965
P(T<=t) one-tail 0.007461162
t Critical one-tail 1.662354029
P(T<=t) two-tail 0.014922324
t Critical two-tail 1.987289865
Source: adapted from London Stock Exchange
(2014)
Table 10: Hot period - T test on 2011 IPO
stocks
t-Test: Two-Sample Assuming Unequal
Variances
Variable 1 Variable 2
Mean 8.670738219 -0.114537552
Variance 318.0209637 2.329386875
Observations 44 44
Hypothesized Mean Difference 0
df 44
t Stat 3.255885586
P(T<=t) one-tail 0.001089425
t Critical one-tail 1.680229977
P(T<=t) two-tail 0.00217885
t Critical two-tail 2.015367574
Source: adapted from London Stock Exchange
37. (2014)
Table 11: Hot/Cold period- T-test for 2009-
2011 IPO stocks
t-Test: Two-Sample Assuming Unequal
Variances
Variable 1 Variable 2
Mean 3.134460022 -0.022484057
Variance 319.6902062 1.655612972
Observations 101 101
Hypothesized Mean Difference 0
df 101
t Stat 1.769869516
P(T<=t) one-tail 0.039883324
t Critical one-tail 1.66008063
P(T<=t) two-tail 0.079766648
t Critical two-tail 1.983731003
Source: adapted from London Stock Exchange (2014)
Appendix 2
Short term performance analysis
Figure 8 – IPO performance in one month MAAR (%)
-100.00
-50.00
0.00
50.00
100.00
150.00
200.00
1
10
19
28
37
46
55
64
73
82
91
100
Marketadjustedabnormalreturn
(%)
1 month stock return relative to
the ma return market (%)
1 month return on
the stock from the
issue price (%)
1 month market
return (%) from the
issue date market
price
Mean MAAR (%)
38. Source: adapted from London Stock Exchange (2014)
Figure 9 – IPO performance in three months MAAR (%)
Source: adapted from London Stock Exchange (2014)
Appendix 3
Long term performance analysis
Figure 10 – IPO performance in one year CAR (%)
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
1
8
15
22
29
36
43
50
57
64
71
78
85
92
99
Marketadjustedabnormalreturn(%)
3 month stock return relative to the
market return.
3 months return on the
stock from the issue
price (%)
3 month market return
(%) from the issue date
market price
Mean MAAR (%)
-200.00
0.00
200.00
400.00
600.00
800.00
1
9
17
25
33
41
49
57
65
73
81
89
97
ABnormalRetunr(%)
1st year stock return relative to the
CAPM 1 year return on the
stock from the issue
price (%)
CAPM
(Cumulative Abnormal
Return %)
CAAR (%)
39. Source: adapted from London Stock Exchange (2014)
Figure 11 – IPO performance in two year CAR (%)
Source: adapted from London Stock Exchange (2014)
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
600.00
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
Cumulativeabnormalreturn(%)
2nd year IPO stock return relative to the
CAPM
2 year return on the stock
from the issue price (%)
CAPM
Cumulative abnormal
return (%)
CAAR (%)
40. Appendix 4
T Test statistics for IPOs from 2009-2011
Table 12: Long run under-performance of IPO stocks in 1 year
T-Test: Two-Sample Assuming Unequal Variances
Variable 1 Variable 2
Mean 3.15694408 -3.774537828
Variance 325.7025438 1.2748E-29
Observations 101 101
Hypothesized Mean Difference 0
df 100
t Stat 3.859901354
P(T<=t) one-tail 0.000100606
t Critical one-tail 1.660234326
P(T<=t) two-tail 0.000201213
t Critical two-tail 1.983971519
Table 13: Long run under-performance of IPO stocks in 2 year
t-Test: Two-Sample Assuming Unequal Variances
Variable 1 Variable 2
Mean 3.15694408 -20.40474854
Variance 325.7025438 7280.852548
Observations 101 101
Hypothesized Mean Difference 0
df 109
t Stat 2.715020826
P(T<=t) one-tail 0.003853512
t Critical one-tail 1.658953458
P(T<=t) two-tail 0.007707025
t Critical two-tail 1.98196749
41. Appendix 5
Regression analysis to identify relationship between under-pricing and long run
performance
Figure 12: The relationship between 1-day return to 1-month return
Figure 13: The relationship between 1-day return to 3-month return
y = 1.2403x + 6.9713
R² = 0.1909
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
-100.00 -50.00 0.00 50.00 100.00
1monthreturnMAAR(%)
1 day return MAAR (%)
Relationship between 1 day
return and 1 month return
MAAR (%)
Linear (MAAR (%))
y = 1.1784x + 8.7012
R² = 0.1493
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
-100.00 -50.00 0.00 50.00 100.00
3monthMAAR(%)
1 day return MAAR (%)
The relationship between 1 day
return and 3 month return
MAAR
Linear (MAAR)
42. Figure 14: The relationship between 1-day return to 1-year return
Figure 15: The relationship between 1-day return to 2-year return
Source: adapted from London Stock Exchange (2014)
y = 1.5296x - 8.6035
R² = 0.0914
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
600.00
700.00
-100.00 -50.00 0.00 50.00 100.00
1yearreturn(%)
Day 1 Return MAAR %
Relationship betweeen Day 1 return
to 1 year return
Series1
Linear (Series1)
y = 0.9026x - 14.939
R² = 0.0403
-200.00
-100.00
0.00
100.00
200.00
300.00
400.00
500.00
600.00
-100.00 -50.00 0.00 50.00 100.00
2ndyearReturn.CAR(%)
Day 1 return. MAAR (%)
Relationship between Day 1 return to
2nd year return
Series1
Linear (Series1)
43. Appendix 6
The Initial public offering process
The role of the sponsor is critical for successful IPO execution whereby sponsor analysis the
composition of the board of directors, the methods of the share, the content of the prospectus.
Sponsor helps the company to set the issue price, decides on the time of the flotation and
underwrites (‘firm commitment’) against the risks that shares will not be taken up by the
public or by the institutional investors, this underwriting role usually costs about 2% of the
issue proceeds.
If the sponsor is a merchant bank, then the United Kingdom listing authority (UKLA)
requires that a broker be appointed. UKLA authority intensively enforces a set of demanding
rules and the directors will be put under strain of new and greater responsibilities both at the
time of flotation and subsequent years.
Brokers are essential agents in the IPO process whereby they advise the firm on the likely
firm on the likely demand for company’s shares from investors. The advises are derived by
marketing the company to prospective investors to generate interest and road shows are held
whereby the senior executives promotes the firm’s capabilities and potential to the potential
investors, investors include the financial institutions. In particular during the recent climate
through the study regarding the under pricing of the IPO stocks, brokers have been involved
in ‘book building’ exercises whereby the brokers contact institutional investors and obtain
tentative bids for the new shares in order to help determine a possible floatation price for the
issue. Prior to the launch day, prospectus will be produced through the help of the sponsor to
help attract demand for IPO stocks. IPO, which produces sensitive information regarding its
competitiveness, performs greater than the others due to the reduction in uncertainty
investors. Thus the value of these firms increases (Chew Jr, 1999).
44. Methods of issue & Price setting
Development of agency theory problem can occur whereby two parties have different
motives due to the asymmetric information involved (Arnold, 2005). Issuer would want to
raise required cash without suffering from excessive dilution of ownership (Donald & Chew,
1999a), whereas underwriter want to set price low to reduce risk of unsold illiquid IPO
stocks (Donald & Chew, 1999b).
However, Ibbotson (1987) recognises the underwriter has incentive to fix high prices as new
issuers choice their underwriter based upon the reputation. To conclude, due to the lack of
historical information about the IPO stocks these stocks are generally under-priced. This
particular under-pricing anomaly is the focus of the dissertation, whereby further theoretical
analysis into reasoning for under-pricing will be expressed in chapter 3.
Long run under-performance
Aggarwal & Rivoli (1990) indicates that as investment banks acts as ‘impresarios’ marketing
the IPO stocks. Its under-pricing strategy to help to attract the attention from investment
community results in greater long-run under-performance. As such, negative relation
between under-pricing and long run under-performance can be identified.
Further study recommendation
Potential future research involves who are participants that are involved in the valuation of
IPO and its relationship to the initial performance of the IPO stocks and which of the
institutional investors drive the prices of the IPO stocks. In addition development upon the
behavioural finance assumption upon the initial performance of IPO stocks, whereby data
consists of historical prices for IPO stocks and its influence in determining new prices of
newer IPO stock. This will help to analyse if IPO initial offer price are determined by
previous IPOs.
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