Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market [1 ed.] 9783842822894, 9783842872899

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Justyna Dietrich

Variables Influencing the Severity of IPO Underpricing

Copyright © 2012. Diplomica Verlag. All rights reserved.

An Empirical Analysis of the German Market

Diplomica Verlag

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Justyna Dietrich Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market ISBN: 978-3-8428-2289-4 Herstellung: Diplomica® Verlag GmbH, Hamburg, 2012

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Dieses Werk ist urheberrechtlich geschützt. Die dadurch begründeten Rechte, insbesondere die der Übersetzung, des Nachdrucks, des Vortrags, der Entnahme von Abbildungen und Tabellen, der Funksendung, der Mikroverfilmung oder der Vervielfältigung auf anderen Wegen und der Speicherung in Datenverarbeitungsanlagen, bleiben, auch bei nur auszugsweiser Verwertung, vorbehalten. Eine Vervielfältigung dieses Werkes oder von Teilen dieses Werkes ist auch im Einzelfall nur in den Grenzen der gesetzlichen Bestimmungen des Urheberrechtsgesetzes der Bundesrepublik Deutschland in der jeweils geltenden Fassung zulässig. Sie ist grundsätzlich vergütungspflichtig. Zuwiderhandlungen unterliegen den Strafbestimmungen des Urheberrechtes. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und der Verlag, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. © Diplomica Verlag GmbH http://www.diplomica-verlag.de, Hamburg 2012

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Acknowledgements I would like to thank Prof. Dr. Tomfort and Mr Dipl.-Kfm. Holler for the revision of this study and especially Prof. Dr. Tomfort for his contentual comments during the process of creation. I also wish to thank Mr Brendon Darbey for proof-reading the final version of this study and the many helpful discussions during the creation. I cannot forget to express my thanks to Miss Nicole Neumann for all her organizational support which made everything as it is now

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possible.

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Copyright © 2012. Diplomica Verlag. All rights reserved. Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Table of Content List of Figures ................................................................................ I List of Tables .................................................................................. I List of Appendices .......................................................................... I List of Abbreviations ...................................................................... II List of Symbols ............................................................................. III 1 Introduction ................................................................................ 1 2 Theoretical Aspects of an IPO ................................................... 3 2.1 Definition of an IPO .............................................................. 3 2.2 The IPO Price Setting Process ............................................ 3 2.2.1 Business Valuation ........................................................ 3 2.2.2 Share Pricing ................................................................. 9 2.3 The Special Role of the Underwriter in the IPO Process ... 11 3 IPO Underpricing...................................................................... 14 3.1 Definition of IPO Underpricing and Empirical Evidence ..... 14 3.2 The Winner’s Curse Hypothesis ........................................ 17 3.3 Market Feedback Hypothesis ............................................ 18 3.4 Bandwagon Hypothesis ..................................................... 19 3.5 Lawsuit Avoidance ............................................................. 20 3.6 Signalling ........................................................................... 20 3.7 Investment Banker’s Monopsony Power ............................ 22 3.8 Principal Agent Problem .................................................... 22 3.9 Prospect Theory ................................................................ 23 3.10 Anchoring......................................................................... 24 4 Long-Run Performance and Overvaluation of IPOs ................. 25

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4.1 Evidence on Initial Investor Overoptimism ......................... 26 4.2 Reasons for Initial Overvaluation ....................................... 27 4.2.1 Overreaction Hypothesis ............................................. 27 4.2.2 Representativeness Heuristic ...................................... 28 4.2.3 Divergence of Opinion Hypothesis .............................. 29 4.2.4 Big Winner Hypothesis ................................................ 30 4.2.5 Underwriter Conflict of Interest .................................... 30

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

4.2.6 Window-Dressing ......................................................... 31 5 Empirical Analysis of Underpricing in Germany ........................ 32 5.1 Development of Explanatory Variables .............................. 32 5.1.1 Management Ownership .............................................. 32 5.1.2 Pre-Market Demand ..................................................... 33 5.1.3 Recent Market Movements .......................................... 33 5.1.4 Underwriter Reputation ................................................ 34 5.1.5 Industry, Company Age and Firm Size ......................... 35 5.2 Theoretical Model and Statistical Method ........................... 38 5.3 Data and Descriptive Statistics ........................................... 39 5.4 Results and Interpretation .................................................. 44 5.4.1 Management Ownership .............................................. 45 5.4.2 Pre-Market Demand ..................................................... 46 5.4.3 Recent Market Movements .......................................... 47 5.4.4 Underwriter Reputation ................................................ 48 5.4.5 Industry, Company Age and Firm Size ......................... 49 6 Conclusion ................................................................................ 52 Bibliography ................................................................................. 54 List of Online Sources and Software ........................................... 59

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Appendix...................................................................................... 60

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

List of Figures Figure 1 Discounted Cash Flow Methods ..................................... 6 Figure 2 Parties Involved in IPO and Equity Offerings ................ 12 Figure 3 IPO Underpricing Across Countries .............................. 15 Figure 4 IPO Underpricing versus Overvaluation ........................ 16

List of Tables Table 1 Descriptive Statistics ...................................................... 43 Table 2 OLS Estimation Results ................................................. 44 Table 3 OLS Estimation for Breusch-Pagan Test ....................... 60 Table 4 OLS Estimation for White-Test ....................................... 62 Table 5 Variance Inflation Factors (VIF)...................................... 63

List of Appendices

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Appendix A Calculation Breusch-Pagan Test ............................. 60 Appendix B Calculation White-Test ............................................. 61 Appendix C Variance Inflation Factors (VIF) ............................... 63

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

List of Abbreviations 1st cl.

First-day closing price

AG

Aktiengesellschaft

BB BörsG

Bookbuilding Range Börsengesetz

CAPM CEO

Capital Asset Pricing Model Chief Executive Officer

DAX DCF

Deutscher Aktienindex Discounted Cash Flow

EBIT ECM Ed.

Earnings Before Interest and Tax Equity Capital Markets Editor/Edition

IPO

Initial Public Offering

M

Million

OLS OP

Ordinary Least Squares Offer Price

SEO Std.

Seasoned Equity Offering Standard

Tech

Technology Sector

VerkaufsprospektG Verkaufsprospektgesetz VIF Variance Inflation Factor

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wacc

Weighted Average Cost of Capital

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

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List of Symbols 15wd

15 Working Days

Age

Age of the Issuing Company

 BV

Beta-Factor Business Value

CF 

Cash Flow Available for Investors and Debitors Covariance

D

Debt

E

Equity

Ind

Industry the Company is Operating in

OS

Ownership Structure/Stake of Management Ownership Before the IPO

Pro PreD 

Gross Proceeds from the IPO Pre-Market Demand Closing Price of the DAX on the Day when Subscription Period Ends

Ran  

   

Underwriter Ranking Cost of Capital for Debitors Cost of Capital for Equity Holders Return of Security j Market Rate of Return Risk-Free Rate of Return

s ²

Tax Rate Variance

t TA

Time Factor Total Assets

UP

Underpricing

wacc

Weighted Average Cost of Capital

III

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Copyright © 2012. Diplomica Verlag. All rights reserved. Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

1 Introduction Detected on the US market centuries ago, underpricing is the phenomenon of abnormal first-day returns from initial public offerings (IPOs). Without doubt, any US investor would agree, that one day-returns of 11.4% on average are exceptional and a worthwhile investment. Since then many studies have proven that it is a persistent phenomenon and also occurs on markets all over the world. The most puzzling question for scientists is why companies are leaving this money on the table and don’t set an offering price that reflects the market demand at the offering date. Within that, researchers have also been trying to determine the factors that influence the severity of underpricing. Many different explanations with regard to the existence of underpricing have been derived thus far, with all claiming to be valid even if not exclusively. But despite this effort, research so far has not been able to create common sense. Some even argue that underpricing may not exist at all since most IPOs underperform severely in the long-run which leads some people to the conclusion that IPOs are in fact overpriced. The main focus of this paper is whether and how the findings of past research, primarily conducted for the US market, apply to the German IPO market. As a result, both investors and issuers shall receive practical implications for their decision-making within the

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IPO process. So far, profound underpricing research for the German market has been rather scarce. Most of the available literature concentrates either on dates before 1997 (SCHMIDT et al., 1988; LJUNGQVIST, 1997) when most offering prices have been determined by using the fixed price mechanism whereas the most recent studies

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

focus on the German stock exchange segment “Neuer Markt” exclusively (LUBIG, 2004; HUNGER, 2001; TIETZE, 2005). In contrast, this paper aims to give a more recent analysis of underpricing on the German market without distinguishing between different market segments. Additionally, a broad overview and understanding of IPO underpricing, taking the long-run performance of IPOs into account, will be included. As a result, this paper is structured as follows: The second section consists of a description of some of the important theoretical aspects that have influence on the price setting of an IPO. It will concentrate on business valuation as it is the basis for setting the price of an IPO. Furthermore, the most common price setting mechanisms shall be explained. Additionally, the special role of the lead underwriter in the IPO process will be outlined as it may also play a role in IPO underpricing. The third section depicts past research results with regard to IPO underpricing and sums up theories for why underpricing exists. Section four focuses on the long-run performance of IPOs and deals especially with the question of whether IPOs are systematically overvalued by investors and why. The empirical analysis is contained in section five. Firstly, the influencing variables of underpricing and the applying theoretical model will be derived. Subsequently follows the presentation and interpretation of the results, as well as the implications for both issuers and investors. Section six summarizes

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the results from this paper and provides an overall conclusion.

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2 Theoretical Aspects of an IPO 2.1 Definition of an IPO Among others, Fuller and Farrell (1987, p. 18) give a definition of IPOs. According to them, initial public offerings “[…] are involved with unseasoned issues – that is, the securities are being offered to the public for the first time and, thus, there is no established market price for them.” By their definition, an IPO is not narrowed down to equity issues only, but may also include the issuance of debt. However, throughout this thesis, when using the term IPO, the issuance of equity is meant, as it has its own specific characteristics.

2.2 The IPO Price Setting Process The determination of the offer price is only part of an extensive IPO process and can be split into two phases. Firstly, the issuer and its advisors need to determine the company value. This is the basis for the second phase, where the final offer price needs to be set. Thus, the two common business valuation methods in IPOs as well as the price setting mechanisms are explained in the remainder of this section.

2.2.1 Business Valuation One of the most important phases of an IPO is the determination of a business value. It is the basis for an offering price of the shares to be placed that needs to be accepted by the capital market. When it comes to the valuation of a business, the Relative

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Valuation method and the Discounted Cash Flow (DCF) approach have achieved most international acceptance in IPO practice (WIESMANN et al., 2001, p. 50) and thus will be explained here.

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2.2.1.1 Relative Valuation The main question with regard to this valuation method is, what the value of the company is based on the value of similar publicly traded companies, thus aiming to obtain a market value of the company (GEDDES, 2003, p. 77). Its underlying assumption is that similar companies must have a similar company value. The market value of companies that are not publicly traded is usually derived from the comparison of ratios of as many as possible comparable companies. These companies are either publicly traded or have changed owner recently and where the purchase price is known. However, this comparison needs to be adjusted for the specifics of the company to be valued (BORN, 2003, p. 15). The applied ratios can refer to different benchmarks, especially depending on the sector. Most commonly used are profit, cash flow and revenue ratios (MANDL & RABEL 1997, p. 45). Then, the corresponding value of the company, i.e. the EBIT, needs to be put into relation with the corresponding value of the peer company and its company value. Balz (2001, p. 71 et seq.) summarizes the main advantages and disadvantages of this method of which some shall be discussed here. The Relative Valuation method has two important advantages: First, the complexity of the valuation is reduced and thus first results can be achieved very quickly. Furthermore, this method is broadly accepted by market participants. However, the disadvantages should not be underestimated.

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Relative Valuation can easily be manipulated i.e. by the choice of the appropriate peer-group and the correction for extreme values. Depending on the number of and which peers are chosen, the resulting company value can differ extremely. For some sectors, especially “new” industries, it may be hard to find comparable companies at all.

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Furthermore,

Relative

Valuation

methods

often

follow

an

experience driven approach without underlying valuation theory. The problem is that a time stable correlation between multiple and business value is especially for “new” industries not yet given. This is especially the case when the market temporarily over- or undervalues 1 certain industries. Thus, it is questionable whether the estimated business value was still representative at the timing of the valuation. And especially with regard to IPOs, these “new” industries are usually overrepresented in IPOs. It should also be added that there is always an issue of how old the market data used is. As a result, the issuer does not know for sure, whether his or her estimated business value will be accepted by the capital market.

2.2.1.2 Discounted Cash Flow The question behind the Discounted Cash Flow (DCF) approach is what the company’s intrinsic value is (GEDDES, 2003, p. 77). Further, the intrinsic value is defined as the present value of future cash flows (BODIE et al., 2003, p. 259) and is also referred to as the fair value. There are several different approaches to determine the business value according to the DCF method (see figure 1) but which theoretically all lead to the same business value. Due to its popularity in practice, the weighted average cost of capital (wacc) approach shall be explained in more detail in the remainder of this

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section.

1

Balz (2001, p. 71 et seq.) certainly assumes that markets are inefficient, since theoretically in an efficient market over- and undervaluation do not occur.

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Figure 1 Discounted Cash Flow Methods

Applying the wacc approach, the expected cash flows available for both investors and debitors of the company are discounted at a rate that reflects the riskiness of the cash flow, which is the wacc. In a second step, the value of the debt needs to be deducted resulting in the equity value which is the company value (COPELAND et al., 2000, p. 63). The business value is formally derived (BALLWIESER, 1998, p. 84): 

BV = E = TA − D =  

CF –D (1 + wacc)

Where, BV

=

Business Value

E

=

Equity

TA

=

Total Assets

D

=

Debt

CF

=

Cash Flows available for investors

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and debitors wacc =

Weighted average cost of capital

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

The wacc is the cost of capital to be paid to debitors plus the return expectations of the owners weighted by their proportion in the total company value (BEHRINGER, 2004, p. 101). When determining the cost of capital, market values instead of book values need to be used (COPELAND et al., 2000, p. 202). The fact that the company value rises due to the deductibility of the debt capital from the taxable base is displayed in the tax shield. From that, the wacc is formally defined as (MANDL & RABEL, 1997, p. 39): wacc = r × (1 − s) ×

D E + r × TA TA

Where, r

=

cost of capital of debitors

s

=

tax rate

r

=

cost of capital of equity holders

The cost of capital for equity holders is in practice often calculated applying the Capital Asset Pricing Model (CAPM). According to this model, the return on equity depends on the risk-free rate of return, the market return and the company specific risk which is expressed as the stocks’ sensitivity in relation to market movements. The CAPM is formally stated as (BALLWIESER, 1998, p. 82): r = r + β(r − r )

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Where, r

=

Risk-free rate of return

β

=

Beta-factor

r

=

Market rate of return

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

The β-factor as a measure of a stocks’ sensitivity to market movements is calculated (PERRIDON & STEINER, 1997, p. 264): β=

Cov(r , r ) σ(r )

Where, Cov

=

Covariance

r

=

Return of security j

σ

=

Variance

According to this formula, a β-factor of one means that the return of the security fluctuates with the same intensity as the return of the market. A β-factor of 1.5 means that the security fluctuates by 1.5 when the return of the market changes by one and thus indicates a higher risk for the single security compared to the market. Vice versa, when the β-factor is lower than one it indicates a lower risk of the security compared to the market. The DCF method is a theoretically profound approach to calculate a companies‘ intrinsic value. However, as well as the Relative Valuation method, it has certain drawbacks that become apparent in implementation. For companies that are not yet listed on the capital market, as is the case for IPOs, a peer group needs to be derived in order to be able to determine an approximate β-factor. This underlies the same problems as with the Relative Valuation method.

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Another big challenge to implement the DCF approach is to derive the appropriate input factors. How can the cash flows for an indefinite period of time be predicted when they depend on a multitude of factors and unknown events that arise in the future? What is the appropriate risk-free rate of return? What is the correct market rate of return? How can the use of a historical β-factor be justified for future predictions?

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In practice, as an answer to most of these questions, certain approximation procedures have been established to match the underlying theory as close as possible. However, since these procedures still vary, and also the underlying assumptions and opinions, so will the estimated company value by investors, issuers or underwriters. For IPOs this means that the issuer, respectively the underwriter, receives only an approximate company value with its valuation. But it does not mean that this valuation reflects the expectations of the capital market and will be accepted by the same.

2.2.2 Share Pricing After the company value has been estimated by the issuer and its advisors (see sec. 2.2.1) and after at least some of the marketing, a definite offering price needs to be set. The three main mechanisms are book-building, auction and fixed-price offerings. These mechanisms allow the underwriter to different degrees to cross-check the estimated company value with the capital market before the IPO. It is reasonable to assume that the issuer will be then able to set a final offer price that matches the market demand most, the more knowledge he or she is able to obtain about it. In the following, the operating principles of all mechanisms shall be outlined briefly.

2.2.2.1 Fixed Price With the fixed price mechanism, the final offer price is set before investors are asked to hand in their purchasing orders. Instead, Copyright © 2012. Diplomica Verlag. All rights reserved.

the offer price is included in the preliminary prospectus and is determined anywhere from two weeks to two month before the offer date. The underwriter also does not actively sell the fixedprice IPOs. He rather distributes the prospectus to potential investors, collects order applications and allocates the shares (DRAHO, 2004, p.217 et seq.).

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This mechanism gives issuer and underwriter no opportunity to check whether the estimated company value will be accepted by the capital market. Thus, it can be assumed that it is the most risky in terms of the successful placement of all shares to be issued.

2.2.2.2 Auctions The auction mechanism gives the issuer and underwriter the least amount of control with regard to the outcome of the IPO. It works as follows: Investors submit their orders specifying the number of shares and the limit price at which they will buy. All the individual orders are then aggregated into a cumulative demand curve and the offer price is determined by the intersection of the demand curve and the fixed supply. Every investor who has submitted a bid above the offer price gets his or her order filled (DRAHO, 2004, p. 218 et seq.). In that case, all shares will be distributed with the highest probability. But in turn, the underwriter has no control over the final offer price.

2.2.2.3 Bookbuilding At the beginning of the bookbuilding process, an expected offer price and a preliminary offer price range needs to be set as well as published

and

distributed

in

the

preliminary

prospectus.

Subsequently follows a ‘road show’ where the issuer’s executives and the underwriter promote the IPO by traveling around the country and meeting potential investors. The road show enables the underwriter to learn about investor demand through indications of interest. (GEDDES, 2003, p. 70 et seq.)

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This process can be seen as the fine tuning of the beforehand estimated company value (BÖSL, 2004, p. 149). However, these indications of interest are not binding and can be revoked without any penalties for the investors. After the road show, the offer terms are revised based on investor indication of interest. Lastly, the issuer and the lead underwriter set the final offer price and number

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

of shares to be issued. This is done immediately prior to the date when the IPO occurs (DRAHO, 2004, p. 216 et seq.). The bookbuilding mechanism allows the issuer to learn more about the market demand than the fixed price mechanism does. Whilst this may not be true in comparison with regard to the auction mechanism, it gives the issuer in return more control about the final offer price. Putting these two advantages together, this may be the reason why the bookbuilding mechanism is overrepresented in practice. Ljungqvist et al. (2003, p.72) estimated that bookbuilding accounts for 80% of all IPOs outside Canada and the US. For the German market and the here analyzed period between 1997 and 2010, it accounts for 94%.

2.3 The Special Role of the Underwriter in the IPO Process During the IPO process, the issuer receives assistance from one or more investment banks and other advisors. Figure 2 (adapted from Geddes, 2003, p. 33) provides a schematic of the interested parties in an IPO. The schematic also shows that it is the lead underwriter who keeps everything together and is the main interface with the company. Even though solicitors, investor relations people and accountants also have direct contact with the issuer, it is far less wide-ranging. A special role is indeed involved for the investment banks as in the

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end they carry the responsibility for the successful placement of the offer. For that reason they are appointed for extensive consulting and analyzing tasks as well as the project management (WIESMANN et al., 2001, p.42).

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Figure 2 Parties Involved in IPO and Equity Offerings

The valuation of the company is also the responsibility of the lead underwriting bank. Their task is to determine a “fair price” which balances the interests between issuer and investors (WIESMANN et al., 2001, p. 50). In fact, the underwriter is the party that has the market knowledge and thus probably most of the influence on the final offer price. Depending on their interests, this may lead to conflicts between issuer and underwriter. The lead underwriter is usually paid a percentage of the offering price (GEDDES, 2003, p. 179). This acts as an incentive to achieve an offering price as high as possible since the underwriter is participating in that price. However, the lead underwriting bank is usually also part of the sales syndicate which is distributing the shares to investors. For IPOs, firm commitment contracts are very common. In these Copyright © 2012. Diplomica Verlag. All rights reserved.

contracts, it is the liability of the bank to sell the shares in the IPO. Thus each bank must be sure to have enough regulatory capital in place to meet the underwriting liability in case they are not able to sell all shares at the time of the IPO. Because if they are not able to place the shares, they have to buy the number of shares they have committed to in the underwriting agreement (GEDDES, 2003, p. 177). From that it can be derived that the lead underwriter 12

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obviously has incentives to set a reasonable price since he is taking the risk to distribute the shares and not the issuer. These two basis conflicts have been pointed out here because of their potential influence on IPO underpricing. In the following sections this issue will be further discussed. In order to be able to understand the consequences, it should be derived from this section that the underwriter has considerable power and incentives to

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negotiate a final offer price that suits their own interests.

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3 IPO Underpricing 3.1 Definition of IPO Underpricing and Empirical Evidence IPO underpricing, sometimes also referred to as abnormal initial returns of IPOs, is the often observed very high first-day trading return of initial public offerings. This underpricing phenomenon leads to the question why issuers are leaving this money on the table, when they could have achieved a higher offering price (LOUGHRAN & RITTER, 2002, p. 413 et seq.). Ibbotson (1975) as well as McDonald and Fisher (1972) among others have been the pioneers by finding that the initial performance of IPOs is positive. Ibbotson (1975, p. 246 et seq.) measured an initial performance of 11.4% during the 1960s in the United States. However, since at this time he had only access to offer prices and calendar month-end prices, this figure is not precise in terms of a first-day return. McDonald and Fisher (1972, p. 100) find a return of 28.5% with regard to the offer price and the published market price during the first trading week for the year 1969 in the US. Since they measured the return for one year only, the high figure may be a result of extraordinary circumstances during this period. More recent research confirms that IPO underpricing is not only a temporary phenomenon. Loughran et al. (1994, p. 167) summarize several studies of underpricing across countries. The underpricing Copyright © 2012. Diplomica Verlag. All rights reserved.

in Germany for example amounts to 10.9% for the years 1978-92, 33% in Mexico for the years 1987-90 and 7.2% in the Netherlands for the years 1982-91 (p. 167). Figure 3 (adapted from Loughran et al., 1994, p. 167) provides further insight on how underpricing varies across countries, without going here any further into the details.

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Figure 3 IPO Underpricing Across Countries

However, empirical studies on the long-run performance of IPOs seem to enhance a different view on the “superior” performance of equity issuers. As it will be shown in section 4, several studies find that in the long-run, IPOs underperform compared to benchmarks of companies that have not been issuing equity recently. The arising question from these findings is whether IPOs are underpriced at all and whether they are rather overpriced, taking their long-run performance into account. Purnanandam and Swaminathan (2004, p. 811) cut right to the chase of the matter, that it depends what the underpricing is with respect to. According to them, one option is that the underpricing is with respect to fair value and that in an efficient market the market price reflects fair value. Strongly generalized, an efficient market means that stocks already reflect all available information and is based on the theory of rational expectations (Kettel, 2002, p. 300 et seq.). Thus, the increase in IPO stock prices on the first day of Copyright © 2012. Diplomica Verlag. All rights reserved.

trading is taken as evidence of underpricing (and at the same time as evidence of undervaluation) at the offer. In that case the terms underpricing and undervaluation are interchangeable.

15

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A different view of underpricing, in an inefficient market, “[…] is that issuers underprice IPOs with respect to the maximum price they could have charged given the observed demand in the premarket but not necessarily with respect to the long-run fair value.” This means that IPOs may be underpriced, but not necessarily undervalued. As an example, assume that we have a situation as shown in figure 4. At the time of the offering and when the final offer price is set, the offer price is above the fair value. With regard to that fair value, the offering is overvalued. However, if we further assume that the price at the end of the first trading day is significantly higher than the offer price, we can assume that the offering was underpriced with terms to the market price of the issue. This is a situation that may occur in an inefficient market as described by Purnanandam and Swaminathan above.

Figure 4 IPO Underpricing versus Overvaluation

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Löhr (2006, p. 165) seems to put these thoughts into his definition of underpricing. He defines underpricing as the intentional or unintentional, e.g. incorrect or attributable to unexpected, „irrational“ investor behavior, determination of a bookbuilding range respectively a final offer price that is too low.

16

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Both definitions and no matter whether assuming an efficient or inefficient market, allow defining underpricing as the abnormal first-day return with regard to the offer price issuers could have achieved. This definition will be applied throughout this paper. It still raises the question why issuers are not issuing equity at the maximum offer price they could have realized. The answer may be completely independent from the long-run performance of IPOs. However, considering the “poor” long-run performance of IPOs it may be argued that IPOs in fact are overvalued at the offering, which also raises the question of whether overvaluation and underpricing of IPOs are linked to each other. Thus, the remainder of this section concentrates on theories able to explain underpricing independent from long-run performance, whereas the following section takes this factor into account. As a result, an overall view on possible reasons for IPO underpricing should be given. Nevertheless, this does not mean that the explanations offered in this paper are exclusive.

3.2 The Winner’s Curse Hypothesis The winner’s curse hypothesis has been described first by Rock (1986, p. 188 et seq.). He argues that unexpectedly strong demand for shares results in rationing. Assuming that some investors have an informational advantage, the less informed ones will be worse off. Rock also explicitly considers institutional investors as informed and retail investors as uninformed. When informed investors are more likely to buy shares when they are

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underpriced, then excess demand will be higher when there is more underpricing. While the uninformed investors will receive only a fraction of the most desirable new issues, they will receive the whole order for the least desirable ones.

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This is meant to be the winner’s curse: They get all the shares they have asked for only, because the informed investors don’t want them. Faced with this problem, less informed investors will only submit orders if, on average, IPOs are underpriced sufficiently to compensate them for the bias in the allocation of new issues. From this results that IPOs on average need to be underpriced in order to attract enough investors. In contrast to Rocks’ explanation are the findings of Hanley and Wilhelm (1995, p. 244 et seq.). They find that institutional investors receive large proportions of IPOs for which pre-market interest is strong but almost equally for which pre-market demand is weak. Thus, for some reason it does not seem that institutional investors are able to use their informational advantage. The following market feedback hypothesis presents a theory that implicates why this may be the case, based on underwriter power.

3.3 Market Feedback Hypothesis Benveniste and Spindt (1989, p. 344 et seq.) argue that investors initially have no incentive to reveal positive information about their demand since they know that it affects the offering price. This means that if they reveal strong demand, the offer price will rise which is to their disadvantage. Thus the underwriter needs to set the offering price low enough to provide profit in order to compensate investors for revealing positive information. Positive information here means information about their demand. On the other hand, investors have less incentive to bid low for an Copyright © 2012. Diplomica Verlag. All rights reserved.

issue they value high if doing so threatens their allocation. In that context, Benveniste and Spindt argue that underwriters are able to reduce underpricing by repeatedly selling to the same investors. It is possible because investors who are given regularly priority in IPO allocations earn abnormal returns. In return, the bank has then the power to menace investors to reduce an allocation in the

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future. This mechanism can be used to induce regular investors to be forthright with their information in the premarket. Even if these mechanisms may be applicable to practice, evidence has not been found, yet. Thus, it is not known, whether or to which extent this explanation affects the degree of underpricing.

3.4 Bandwagon Hypothesis Ritter (1998, p. 10 et seq.) argues that the IPO market is possibly subject to bandwagon effects. He assumes that if potential investors also pay attention to whether other investors are purchasing, bandwagon effects may develop. This means that if an investor sees that no one else wants to buy, she or he may decide not to buy even when there is favorable information. Thus, an issuer may want to underprice an issue to encourage the first few potential investors to buy, and induce a bandwagon in which all subsequent investors want to buy independent of their own information. One may argue that this theory is based on irrational investor behavior. This is not necessarily true. Investors who observe the behavior of others can be seen to be rational as in fact their profit depends on the behavior of other investors. If they don’t see anybody buying, this may lead them to the conclusion not to invest in this particular IPO. However, it is questionable whether it can be assumed that investors, especially those who know the fair value of the asset, base their decision solely on the behavior of others.

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Both assumptions have not been proven, so far.

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3.5 Lawsuit Avoidance Tinic

(1988,

p.

798)

argues

that

the

possible

negative

consequences of overpricing IPOs may enhance issuers to underprice, instead. He argues that issuers may face potential legal liabilities that overwhelm the overpricing of an offering. Another threat may be that the market demands a higher risk premium on future security offerings. In fact, for the US market, section 11 of the Securities Act of 1933 demands from investment bankers to conduct “due-diligence” investigations in order to avoid liability for false, misleading or omitted information in the registration statement about the prospects of the issuer. The law allows a purchaser of a stake in an IPO to sue anybody who has signed the registration statement, in order to recover from losses. This includes the issuer but also its advisors. Similar regulations exist for the German market and are ruled in §§ 44 et seq. of Börsengesetz (BörsG) and § 13 of Verkaufsprospektgesetz (VerkaufsprospektG). The basic statement behind these regulations is that the parties involved in the issue have to pay recovery

of

losses

to

investors

for

incorrect

prospectus

information. As a result, underpricing may be seen as an indirect insurance cost for legal liabilities, if this relationship could be proven.

3.6 Signalling Welch (1989, p. 422 et seq.) developed a model based on the Copyright © 2012. Diplomica Verlag. All rights reserved.

assumption that the company itself has the best information about its future cash flows. This leads to an asymmetric information problem as investors do not have this information. In order to overcome the asymmetric information problem, the company wishes to signal the true value of the firm by offering shares at a discount and by retaining some of the shares of the new issue in

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its own portfolio. By doing so, the company will be able to achieve higher prices at seasoned offerings. For “low-quality” firms, on the other hand, applying underpricing for the above mentioned reasons would be pointless. Assuming that between the IPO and a seasoned offering the true quality of the firm will be revealed, low-quality firms have no incentive to underprice when they know that they cannot achieve the superior cash flows. Allen and Faulhaber (1989, p. 304) come up with a similar model by assuming that high-quality firms forego a lower IPO price for a more favorable interpretation of future high dividends resulting in a higher stock price in the aftermarket. On the contrary, owners of a low-quality firm know their expected performance and the resulting valuation. They know that they could not recoup the initial loss from underpricing and for that reason cannot afford to signal. The advantage for a high-quality firm to signal its quality is that they will be able to sell a higher fraction of the firm and thus increase their funds (p. 312). However, empirical research reveals that companies with the highest underpricing perform worst in the long-run (RITTER, 1991, p. 15 et seq.). Even if this seems contradicting to the two explanations above, it is not necessarily the case. The resulting question here is rather whether “low-quality” firms need or wish to underprice, that even more than “high-quality” firms, but for

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different reasons.

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3.7 Investment Banker’s Monopsony Power Another explanation suggested by Ritter (1998, p. 10 et seq.) is that investment bankers take advantage of their superior knowledge of the market in order to underprice offerings. He argues that the more the underwriter underprices the offering, the less marketing effort he needs to expend. Thus, according to Ritter underpricing is an indirect method to cover marketing expenses. It remains the question whether these two are one to one substitutable, which method is more effective, and who in the end is paying these costs. If the underwriter is aware of this fact, he or she will probably negotiate the underwriter provision from a different point of view. This is an option or argument in negotiations in order to reduce IPO costs. Another advantage of underpricing for the underwriter that Ritter mentions is to thicken the bonds with the underwriters’ buy-side clients. Here it becomes clear that the underwriter is central to conflict of interests between issuer and investor since he is providing services for both of them.

3.8 Principal Agent Problem Ljungqvist and Wilhelm (2003, p.724) argue that underpricing possibly arises due to principal agent problems. The principal agent theory predicts conflicts of interest when principals hire agents to act on their behalf. This is due to the fact that these agents may have more incentives to act in their own interest rather than in the interest of the principal (BODIE et al., 2003, p. 17). Copyright © 2012. Diplomica Verlag. All rights reserved.

Ljungqvist and Wilhelm derive from this theory that agents will expend less effort monitoring on behalf of their principals when the agent’s stake in the transaction is smaller. Now thinking of a CEO as an issuer’s agent, this would mean that the underpricing is higher, the lower the CEOs ownership stake in the company. This thesis is congruent with their finding that IPO 22

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

underpricing is lower, when the stake of insider selling is higher. Habib and Ljungqvist (2001, p. 434) argue in a similar way by assuming that owners care about underpricing depends on how much they sell at the IPO and derive that underpricing is influenced by the extent of insider selling.

3.9 Prospect Theory Loughran and Ritter (2002, p. 422 et seq.) propose that prospect theory is the answer to the question, why companies are leaving money on the table. One feature of prospect theory is that subjects may or may not decide to sum up outcomes that are related, but which depends on whether these outcomes are losses or gains. (KAHNEMANN & TVERSKY, 1979, p. 271 et seq.) According to Loughran and Ritter, this feature of prospect theory predicts that in most situations occurring in the IPO market, issuers will sum the wealth loss from underpricing with the larger wealth gain on the retained shares from a price jump, producing a net increase in wealth for pre-issue shareholders. They assume that issuers view the whole “package”, which in the end leaves them with a net gain, thus being less resistant to underpricing. This explanation includes the assumption that owners are selling only a small fraction or none at all at the IPO. Unfortunately, their explanation does not consider that the company owners do not know before the first trading day whether their wealth from the retained shares will rise. Thus, it should be in their interest to negotiate the offering price as high as possible in Copyright © 2012. Diplomica Verlag. All rights reserved.

the first place. Further, it also does not take into account that the secondary shares of owners are in practice often locked-up for at least half a year. This means that their wealth stays under risk until these shares can be sold. For that reason, it should be in their interest to increase funds for the company as much as possible in order to be able to finance investments that keep operating performance high which in return will be reflected in the stock 23

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

price. Considering these arguments, it is questionable whether prospect theory is able to explain why issuers set the final offer price too low.

3.10 Anchoring Hanley (1993, p. 245) as well as Lowry and Schwert (2002, p. 1185 et seq.) document the ‘partial adjustment phenomenon’ by finding that the degree of underpricing is related to the revision of the offer price. In cases where the offer price has been revised upwards from what has been anticipated in the preliminary prospectus, the underpricing is highest. A possible explanation is anchoring. It is the phenomenon where people make estimates by starting from an initial value that is adjusted to yield the final answer, but where the adjustment is typically insufficient (TVERSKY & KAHNEMANN, 1974, p. 1128 et seq.). This characteristic of people has been proved in many experiments and is probably also applicable to IPOs. In fact, it is a possible explanation for why the offer price is seldom adjusted according to strong pre-market demand. The reason is that the price setter is anchoring to an initial value which for IPOs would be

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the bookbuilding range.

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4 Long-Run Performance and Overvaluation of IPOs In contrast to the underpricing of IPOs, their long-run performance seems to develop in the opposite direction and thus raises further questions. Loughran and Ritter (1995, p. 33) observe an average annual return for IPOs of 5.1% over a five year period after the IPO. By contrast, the firms they use as a benchmark exhibit a return of 11.8%. Particularly outstanding is the fact, that the worst performance is during the first year and the difference between IPO performance and matching firms is lowest in year five (p. 34). Ritter (1991, p. 15 et seq.) additionally finds that IPOs with the highest underpricing perform worst in the long-run. Researches around the world have conducted similar studies and also come to the conclusion that IPOs underperform in the longrun. Ritter (1998, p. 20 et seq.) has summarized the international results. The total abnormal return in Germany amounts to -12.1% for three years. Abnormal return means here the return difference between the performance of IPO stocks and their benchmarks that have not issued equity recently. For a range of countries it is between -8% and -46% (p. 23 et seq.). Stehle et al. (2000, p.173 et seq.) find that the abnormal long-run performance of IPOs and seasoned equity offerings (SEOs) in Germany amounts to -6% in three years for the sample period of 1960-1992. There is still some discussion in the financial literature about the extent of the poor long-run performance of IPOs due to Copyright © 2012. Diplomica Verlag. All rights reserved.

methodological issues (RITTER & WELCH, 2002, p. 1817 et seq.). However, with regard to the context of this paper, this shall not be discussed in more detail. Rather, the fact that IPOs underperform their benchmarks in the long-run is taken as given.

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But

it

leads

here

to

the

question,

why

this

long-run

underperformance exists. The main arising question is whether and why investors possibly overvalue IPO stocks in the short-run, specifically at the date of the issue and why. Section 4.1 presents some empirical evidence that IPOs are overvalued by investors in the short-run. In section 4.2 possible answers for this initial overvaluation are given.

4.1 Evidence on Initial Investor Overoptimism Helwege and Liang (2004, p. 558) find that profit ratios tend to fall from IPO levels. But they also find that only “hot” market IPOs (“hot” markets are defined as periods with high IPO volume) underperform with regard to the stock price (p. 551). Loughran and Ritter (1995, p. 24) also find that firms issuing during years when there is little issuing activity do not underperform much at all, whereas firms selling stock during high-volume periods severely underperform. These findings may be an indicator that investors overvalue equity issues in certain periods. Purnanandam and Swaminathan (2004, p. 811 et seq.) indeed find that IPOs are systematically overvalued at the offer date with respect to the fair value. The deviation from fair value for the median firm is about 50% compared to their peers. Their results are robust to various industry classifications, price multiples and matching-firm selection procedures. Another outcome of their analysis is that overvalued IPOs experience higher growth in sales in the first year after going Copyright © 2012. Diplomica Verlag. All rights reserved.

public but it declines rapidly and by year five is not appreciably different from that of undervalued IPOs. On the other hand, overvalued IPOs show significantly lower return on assets and profit

margins

than

undervalued

companies

where

the

reinvestment rate for both is almost the same. From that they conclude

that

extreme

expectations about

the

level and

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persistence of future growth rates may lead to the initial overvaluation. As described above, there is some evidence that the market is overly optimistic about the prospects of IPOs. In the following section, possible explanations for this initial overvaluation by investors are discussed.

4.2 Reasons for Initial Overvaluation 4.2.1 Overreaction Hypothesis De Bondt and Thaler (1985, p. 795) hypothesize that “[…] (1) extreme movements in stock prices will be followed by subsequent price movements in the opposite direction. (2) The more extreme the initial price movement, the greater will be the subsequent adjustment.” In their analysis, they test whether this type of overreaction is predictive. They find that prior “loser” portfolios (return measured over a five-year period) tend to outperform the market

whereas

“winner”

portfolios

tend

to

underperform

significantly (p. 796 et seq.). These findings can also be applied to IPOs by including only two assumptions. Firstly, issuing firms time their IPO at a date following unusually good operating performance and secondly, the operating

performance

is

positively

related

to

the

stock

performance. Along with the overreaction hypothesis, when the company experiences superior

operating performance,

the

company is classified as a “winner”. Accordingly, at about the date

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of the IPO, the companies’ stock performance experiences its peak. The overreaction hypothesis predicts in that case, that this positive movement will be followed by a price movement in the opposite direction, which means that shortly after the IPO the stock turns out to be a “loser”. If we further assume that the stock is highly overvalued by investors at the time of the IPO, this may explain why IPO stocks perform very poorly in the long-run. 27

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4.2.2 Representativeness Heuristic Tversky and Kahnemann (1974, p. 1124 et seq.) have detected what they call the representativeness heuristic, in laboratory experiments. They have found that people tend to evaluate objects as typical or “representative” for a specific class and to ignore the laws of probability when doing so. For example: a person has been described with certain attributes like being very helpful but withdrawn, has a need for order and structure and a passion for detail. The question is how people assess the probability that this person is engaged in a particular occupation from a list of possibilities (for example farmer or librarian). It is also known that the probability that this person is a farmer is 0.7 and 0.3 that the person is a librarian.

In the

representative heuristic, people will rather assess the probability that this person is a librarian by the degree to which he is representative of the stereotype of a librarian, rather than by the given probability. Applying this to the stock market, investors classify a stock that has a recent history of consistent earnings growth as a growth stock. But they will ignore the very low probability of stocks that grow over a very long period of time. Especially many IPOs are young companies in new industries that experience relatively high earnings growth. This may explain the initial overvaluation, since according to representative heuristics, investors misestimate the probability that these earnings will grow at the same pace

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“indefinitely”.

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4.2.3 Divergence of Opinion Hypothesis Miller (1977, p. 1153 et seq.) develops an explanation for the poor long-run performance of IPOs based on his theory of divergence of opinion which can be explained as follows: As long as the entire supply of a security can be absorbed by a minority of the potential purchasers (as it is typically the case), the market price will be above the mean evaluation of the potential investors. This implicates that the price of an asset is determined by only a small amount of optimistic investors. Given this absorption assumption, if the divergence of opinion increases so will the market price of the asset. On the other hand, if the divergence of opinion decreases, the market clearing price falls. It should be noted here, that this theorem only holds when short selling is restricted. This is due to the case that a sufficient amount of short selling would be able to increase the volume of the stock outstanding until its price is forced down to the average valuation of all investors. Miller assumes that in the real world short selling is in fact restricted and the number of short positions is usually only a small fraction of the total number of shares outstanding (p. 1162). Applying this theory to IPOs, he states that the price of a new issue, as of all securities, is set not by the valuation of the typical investor, but by the small minority who think highly enough of the investment opportunity to buy it. He assumes further that the divergence of opinion about a new issue is greatest at the time of the equity issue. This is due to possible uncertainties about the

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success of new products or the profitability of a major business expansion. Over time this uncertainty is reduced as the company acquires a history of earnings or lack of them, and the market indicates how it will value these earnings. This will lead to a reduction in uncertainty and thus a decline in divergence of opinion, thus leading to a decline in the valuation of the top x

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percent of the investors, even if the average assessment has not changed (p. 1156).

4.2.4 Big Winner Hypothesis Loughran and Ritter (1995, p. 46 et seq.) offer an explanation based on some IPO specifics. They observe that many IPOs are young rapid growth companies. This makes it easy for investors to justify a high valuation as they want to believe that they have identified “the next Microsoft”. Loughran and Ritter assume that a possible reason for why these patterns persist is that investors are betting on longshots. For example, if the true probability that a given IPO will be the next Microsoft is three percent, but investors have instead estimated that it is four percent (resulting in a 33 percent overvaluation), it takes a very large sample over a long period of time before Bayesian investors would adequately revise their estimates. This is since their sample grows only slowly over time and they will only slowly experience that a Microsoft case does not occur that often. Thus, their estimate about the chance that this will happen will be revised only slowly, too. To sum this up, investors seem to be systematically misestimating the probability of finding a big winner.

4.2.5 Underwriter Conflict of Interest Dechow et al. (2000, p. 15 et seq.) find a negative relationship between analysts’ long-term growth forecasts and the 5-year buy and hold market adjusted return of IPOs which indicates that analysts’ forecasts are overoptimistic for IPOs. Furthermore, they Copyright © 2012. Diplomica Verlag. All rights reserved.

also find that this relationship is significantly stronger, when the analyst is affiliated with the lead underwriting bank of the offering (more than twice as strong). This suggests another explanation which highlights the trade-off of underwriting banks. Usually underwriting banks provide both underwriting services to client firms and brokerage services to investor clients. A conflict of interest arises in the case when an 30

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analyst issues a negative recommendation and simultaneously is being asked for underwriting business. Assuming that investors pay strong attention to analysts’ forecasts, this may explain the overoptimism of investors and initial overvaluation of IPOs.

4.2.6 Window-Dressing Jain and Kini (1994, p. 1700) suggest that managers may attempt to “window-dress their accounting numbers prior to going public”. In fact, also Teoh et al. (1998, p. 176 et seq.) and Rangan (1998, p. 118) find that earnings as well as accruals are abnormally high during the IPO year suggesting that firms seek to boost earnings before selling stock by pushing accruals up. For example, managers can increase current accruals by moving recognition forward before cash is received with credit sales or by delaying the recognition of expenses by estimating a low provision for bad debt. It is also possible to delay recognition of expenses even when cash is already advanced to suppliers. But obviously, the earning level cannot be sustained when the abnormal accruals need to be annulled in later periods. If the increased earnings caused by window-dressing are not detected by investors, this may lead them to the assumption that these

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earning levels will persist in the future.

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5 Empirical Analysis of Underpricing in Germany So far, the focus has been on explaining why IPO underpricing and the poor long-run performance of IPOs exists. The main question of the upcoming analysis is which factors have an influence on the degree of underpricing on the German IPO market. Accordingly, the influencing variables will be derived from either the theories behind underpricing (see Section 3) or other suggestions which may have an influence on the extent of underpricing. As a result from these findings and assumptions, a theoretical model will be derived.

5.1 Development of Explanatory Variables 5.1.1 Management Ownership Ljungqvist and Wilhelm (2003, p. 724) argue that underpricing may arise partly due to principal agent problems. In the context of IPOs, they assume that managers have a higher incentive to negotiate a high offer price the higher their stake in the company is. This implies a negative relationship between the degree of preIPO ownership of managers and the degree of underpricing. In this analysis, it is assumed that every owner who is an executive board member has an influence on the offer price negotiations. As a result, the proxy for the degree of management ownership is the percentage of executive board membership Copyright © 2012. Diplomica Verlag. All rights reserved.

before the IPO. According to the principal agent theory it is hypothesized that the higher the pre-IPO management ownership, the lower the underpricing will be.

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5.1.2 Pre-Market Demand According to the anchoring hypothesis, people tend to make estimates by starting from an initial value that is adjusted to yield the final answer, but where the adjustment is usually insufficient (see sec. 3.10). With regard to IPOs, it is assumed that also issuers, respectively underwriters, anchor to an initial value when setting the final offer price. It is further assumed that the bookbuilding range represents this initial value. As a proxy for the initial value, the upper limit of the bookbuilding range is used here. Loughran und Ritter (2002, p. 427) use a dummy variable for all IPOs where the offer price is above from what has been anticipated in the preliminary prospectus. The data set in this analysis consists of only five IPOs where this is the case and which is not assumed to be representative. Interestingly however, many IPOs set their final offer price at the upper limit of the bookbuilding range stated in the preliminary prospectus. Thus, a dummy is used for all IPOs where the offer price equals the bookbuilding range upper limit or is above. The hypothesis is that the underpricing will be higher when the final offer price is set above or at the upper limit of the preliminary price range, since issuers are not adjusting the final offer price fully to pre-market demand.

5.1.3 Recent Market Movements As with the pre-market demand in the section above, the anchoring hypothesis may be used to argue that issuers also do Copyright © 2012. Diplomica Verlag. All rights reserved.

not adjust the offering price fully to recent market movements. Thus, it is hypothesized that underpricing will be higher, the greater the market return prior to the IPO. This is due to the fact that issuers anchor to the preliminary price range when setting the final offer price, even when market conditions have changed and they could have achieved a more favorable price.

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Equally with Loughran and Ritter (2002, p. 426), the market return three weeks prior to the end of the IPO subscription period is observed. As a proxy for the German market, the DAX has been chosen. Formally, the market return is defined as: Mar =

P − P!" P!"

Where, Mar

=

Return on DAX 15 working days prior the issue

P

=

Closing price of the DAX on the day when the subscription period ends

P!" =

Closing price of the DAX 15 working days prior to the day when the subscription period ends

5.1.4 Underwriter Reputation According to the signalling theorem (See sec. 3.6) a high-quality firm wishes to signal its true value in order to overcome the asymmetric information problem. Titman and Trueman (1986, p. 159) argue that the choice of the underwriter is an option for highquality companies to signal this favorable information. They assume

that

choosing

a

high-quality

underwriter

is

a

corresponding signal, as this category of underwriter will present more accurate information in the prospectus. Accordingly, the hypothesis is that if an underwriter is prestigious, Copyright © 2012. Diplomica Verlag. All rights reserved.

the result will be lower underpricing. Here, the proxy for underwriter reputation is the percentage of IPOs an underwriting bank has accompanied during the observation period. The underlying assumption is that the amount of IPOs a bank underwrites represents the degree of expertise and reputation it has in the underwriting business.

34

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Seven out of 67 underwriting banks in the sample are considered to be prestigious, as they accompanied most of the IPOs during the observation period 1997-2010. These are Bayerische HypoVereinsbank (5.24%), Commerzbank (6.11%), Deutsche Bank (10.47%), Dresdner Kleinwort2 (8.03%), DZ Bank (7.85%), Sal. Oppenheim (4.19%) and WestLB (5.06%). Together, these banks have underwritten 46.95% of all IPOs during the observation period and 49.85% in terms of the placement volume in Euro. Banks that are defined to be prestigious receive the dummy one.

5.1.5 Industry, Company Age and Firm Size Beatty and Ritter (1986, p. 213 et seq.) argue that there is an equilibrium relation between the expected underpricing of an IPO and the ‘ex ante’ uncertainty about its value. They state that the greater is the ‘ex ante’ uncertainty about the value of the company, the greater is the expected underpricing. Applying their statement to this analysis, it is further assumed that the risk of a business defines the ‘ex ante’ uncertainty about its value. In the following, several factors that have an influence on the risk of a business will be derived. Firstly, it is presumed that the age of a company is a business risk factor, resulting in higher company value uncertainty when the firm is young and thus higher underpricing. The underlying assumption is that older companies are usually more established with regard to customer bases, business experience, operations expertise, et cetera. Accordingly, the hypothesis here is that the older the Copyright © 2012. Diplomica Verlag. All rights reserved.

company, the lower the underpricing it is exposed to. The company age is here defined as the difference of the year of company foundation and the year in which the IPO takes place.

2

Dresdner Kleinwort was taken over by Commerzbank in 2009. Since the observation period is 1997-2010, it is not assumed that this fact has a significant influence on the evaluation.

35

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

But it is also assumed that the risk a company is exposed to depends very strongly on which industry the company is in (FREYGANG, 1993, p. 254). Especially “new” industries bear a high degree of risk, since they usually require relatively big investments in the beginning, business processes need to be established, sustainability and market size of the industry are not ascertained yet, et cetera. Outstanding for the period 1997 to 2010 observed in this paper is the internet boom of the years 1998 until the burst in 2000, when many young so-called “Dot-Net” companies went public. At this point in time, a new and, since not yet established, very risky industry was born. This industry, in the following called ‘technology sector’, shall be analyzed here with regard to its influence on IPO underpricing. Since these companies have been predominantly listed in the exchange segment “Neuer Markt”, all companies listed in this segment receive the dummy variable one representing the technology sector. It is further assumed that companies listed in the subsegment “Software” of the remaining exchange segments also represent this new industry. For that reason, these companies also receive the dummy variable one. It is presumed that these firms classified as technology firms are growth companies with a higher degree of risk than the average. The hypothesis is accordingly that companies operating in the technology sector will reveal a higher degree of underpricing.

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With the assumption stated earlier that riskier IPOs will be underpriced more than less-risky IPOs, another influencing factor can be examined. It is assumed here, that the size and establishment of a firm is also a risk factor since a larger firm usually spreads its risk over a bigger customer base, several economies, et cetera. As a measure for company size, the gross

36

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

proceeds in Euro, including the exercised greenshoe option, from the IPO are used. .

Since the observation period of thirteen years in this analysis is relatively long, the gross proceeds are deflated to the year 1997, beginning with the inflation rate of the year following the IPO. To do so, the yearly consumer price index of the German Federal Bureau of Statistics is used. At the time when this analysis was conducted, the inflation rate for the year 2011 was not yet available. Thus, the mean of all inflation rates used in this analysis has been applied. It is hypothesized, that the bigger the company, the lower the underpricing will be, since the company risk involved

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is lower.

37

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

5.2 Theoretical Model and Statistical Method Considering the influencing variables derived in the previous section, and further assuming a linear function, the theoretical model is defined as follows: UP = α$ + α Ran + α Ind + α% OS + α& PreD + α Mar + α' Age + α* Pro Where, UP

=

Underpricing: The Underpricing is the first-day trading return. It is the difference of the closing price of the first trading day and the offer price divided by the offer price.

Ran

=

Ranking of the underwriting bank

Ind

=

Industry dummy representing the technology sector

OS

=

Ownership structure, stake of pre-issue management ownership

PreD =

Revision of the offer price to pre-market demand

Mar

=

Revision of the offer price to movements of the DAX three weeks prior the issue

Age

=

Age of the issuing company in years

Pro

=

Gross proceeds from the IPO

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The regression analysis is conducted applying the Ordinary Least Squares (OLS) method and using the statistical software GRETL.

38

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

5.3 Data and Descriptive Statistics The IPO sample has been sourced from Deutsche Börse Primärmarktstatistik and contains all 655 primary market activities at Frankfurter Börse between 1997 and 2010. The aim was to include as many IPOs as possible. An inquiry to Deutsche Börse has resulted in the information that data for IPOs prior to the year 1997 cannot be provided. All IPO’s where the final offer price has been determined by using the fixed price or auction mechanism, have been excluded from the examination. These approaches have specific characteristics (see sec. 2.2.2) that could influence the degree of underpricing but which are not of interest here. For one IPO (emqtec, Nr93) the required values were not available, so this IPO is excluded from the sample. Furthermore, all primary market activities classified as “pure listings” have been omitted as it means that the company shares have been traded before, even if not on a stock exchange. Nevertheless, this does not match the definition of an IPO, which implies that the securities are being offered to the public for the first time. As a result, 88 more values have been dropped from the sample. All market activities classified as a “transfer” have also been dropped, as it means that solely the market segment has been swapped. This decreases the amount of values by an additional 33. Values listed as a “Dual Listing” are also excluded since they Copyright © 2012. Diplomica Verlag. All rights reserved.

are defined as an additional listing on another stock exchange apart from the home exchange, where equity is not offered for the first time. Unless declared differently in the following paragraphs, all data used in this analysis has been sourced online from the Primärmarktstatistik Deutsche Börse.

39

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

The involvement of pre-IPO owners in the operations of the issuing

company

has

partly

been

published

in

the

Primärmarktstatistik Deutsche Börse. In some cases, only the names of pre-IPO owners have been given, but not the type of involvement in the business of the company. In these cases, the position of the owner at the time of the IPO has been researched from numerous online sources, predominantly financial pages. However, the sources have not been verified for trustworthiness and reliability. Due to this fact and the numerous amounts of online pages, these are not listed in the source list. For 26 IPOs, the relationship between company and owner could not be ascertained at all. The historical price quotations of the DAX have been sourced from markt-daten.de. Also sourced online is the yearly consumer price index from the German Federal Bureau of Statistics. The year of company foundation has also been researched from numerous online sources. As with the position of pre-IPO owners, the sources have not been verified for trustworthiness and reliability. Thus, the accuracy of the information is not certain and the websites have also not been listed in the source list. For 44 IPOs, the year of foundation could not be found at all. Accordingly, these are excluded from the examination. Additionally, it has to be noted that 34 of the companies examined have a company age of zero or one. During the research, it was outstanding that some of the issuing companies descended from

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spin-offs or carve-outs. It is assumed that these firms do not have the same characteristics and especially the same risk structure as other young companies that are in the focus of this examination. This is due to the case that companies descending from spin-offs or carve-outs in fact may have already been operating successfully as more or less independent business divisions within the parent company. Thus, they may already have established 40

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

structures, customer bases et cetera, which naturally lowers their business risk and would result in lower underpricing. Since the “real” year of foundation is not available, the year of the carve-out respectively spin-off has been drawn nevertheless. As only 34 companies are of this very young age, it is presumed that this should not distort the results significantly. Due to further missing data with regard to the end of the bookbuilding period, the sample consists in sum of 443 observations for the years 1997 to 2010. Table 1 shows some descriptive statistics of the final IPO data set partitioned for each year of the IPO. Even though this analysis is not focusing on the development on underpricing over time, an inspection of single years may include hints for further examination. As shown in table 1, the mean underpricing during the observation period amounts to €7.31. The median underpricing amounts to €1.83 which indicates some outliers with very heavy underpricing. In fact, 25% of the IPOs are underpriced by more than 11€. Furthermore, almost 70% of the IPOs have been underpriced and about 22% “correctly” priced. Only about 8% of the sample show a first-day closing pricing that is below the offer price. In almost 33% of the IPOs, the offer price has been set at the bookbuilding range upper limit or above. Merely 0.66% of the IPOs in the sample had an offer price that has been revised above the bookbuilding range upper limit. Interestingly, the revisions above the initial price range

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all occurred during the years 1997 to 2000 with most of the revisions in 1997 and 1998. There are further characteristics that can be observed during this period. About two third of all IPOs in the sample occurred between 1997

and

2000.

Furthermore,

the

average

and

median

underpricing is much higher when compared to the following years, whereas offering sizes seem to be relatively low. The 41

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

statistics also show that between 30 and 50 percent of the IPOs between 1998 and 2000 have been companies operating in the technology sector. In sum, this indicates that many relatively small, technology-oriented companies went public during this period. It is also interesting to compare the degree of underpricing in this analysis to that of earlier studies. As pointed out previously (see sec. 3.1), Loughran et al. (1994) quote the underpricing in Germany to amount to 10.9% for the period 1978-92. In this sample, the relative underpricing is 35.6%. Excluding the outlying years 1998 - 2000, the underpricing amounts to only 6.46%. The median underpricing is even lower at 4.68%. However, since it is not known whether the previous study had outliers too, it is difficult to compare the results. Considering the figures only, it seems that underpricing has risen over time, however this can be doubted due to the mentioned outlying years

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in our observation period.

42

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

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Table 1 Descriptive Statistics 43

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

5.4 Results and Interpretation The results from the OLS estimation conducted by GRETL are as stated in table 2 below. OLS, using observations 1-509 (n = 443) Missing or incomplete observations dropped: 66 Dependent variable: UP Heteroskedasticity-robust standard errors, Version HC0 coefficient

std. error

t-ratio

p-value

constant 0.0243946

0.0330327

0.7385

0.4606

Ran

-0.0769222

0.0556684

-1.382

0.1677

Ind

0.166772

0.0635601

2.624

0.0090

***

OS

4.65580e-05

1.24650e-05

3.735

0.0002

***

PreD

0.542145

0.0439481

12.34

3.44e-030

***

Mar

1.61321

0.554063

2.912

0.0038

***

Age

-0.000632337

0.000564584

-1.120

0.2633

Pro

-3.13170e-011

3.76463e-011

-0.8319

0.4059

-. = /. .23456

7 = 0.225378 R

Table 2 OLS Estimation Results

Several diagnostic checks have been conducted in order to ensure that the estimation results are valid. First, the Breusch Pagan Test has been applied to check for heteroscedasticity (WOOLDRIDGE, 2009, p. 432 et seq.). The critical value for a confidence level of 10% is 1.73 (one-sided test). Since the F-statistic of 5.02 is much higher than the critical value,

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it is assumed that the required homoscedasticity is not given here. (see appendix A for the detailed calculation) As a result, the regression has been repeated with heteroscedasticity robust standard errors. The results of this regression are stated above in table 2.

44

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Furthermore, as it is not known for sure whether the residuals are normally distributed, the White-Test has been applied as it does not assume the normal distribution. (PODDIG et al., 2008, p. 328 et seq.) However, according to the test result heteroscedasticity does not need to be assumed so that no further adjustments have been made (see Appendix B for the detailed calculation). In order to test for multicollinearity, the VIF-Test was conducted. Since the values for all variables are between one and two (see Appendix C for the results) and thus far from the critical value of ten (PODDIG et al., 2008, p. 377 et. seq.), the existence of a multicollinearity problem does not need to be assumed. The coefficient of determination (R²) is 0.237645 which means that 23.76% of the variation in underpricing can be explained by this 7 ) is model. Since the adjusted coefficient of determination ( R 0.225378 and thus very close to the R², it is not presumed that irrelevant variables need to be removed.

5.4.1 Management Ownership The regression results reveal that the higher the management ownership is before the IPO, the higher the underpricing will be. Even though the coefficient is very small, thus indicating only minimal influence on underpricing, it is significant at any conventional confidence level. However, the result is contradicting to the prediction that a high degree in management ownership would be an incentive to negotiate a high offer price, since the reverse would lead to principal agent problems (LJUNGQVIST &

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WILHELM, 2003, p. 724 et seq.). A possible explanation for the unanticipated result may be provided by Aggarwal et al. (2002, p. 107 et seq.). They find that interest from analysts and media in a particular stock increases, the higher the underpricing of the IPO is. The second finding is that the more analysts and media follow the stock, the higher is the stock price in the aftermarket. Furthermore, managers usually 45

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

don’t sell their shares before a pre-defined lock-up period expires. As a result, they argue that manager owners would be happy about the increased interest since it provides them with a higher stock price at the end of the lock-up period. From this point of view, it seems that manager owners have an incentive to increase underpricing. Owners of issuing companies can consider this relationship directly. When they are selling a bigger part or all of their shares at the IPO, it makes sense to negotiate a high offering price. But in practice, most owners retain a larger portion of their shares at least until a fixed lock-up period expires. Since high underpricing leads to a higher stock price in the aftermarket, owners should consider to set the final offer price relatively low. However, they still have to bear the risk of price fluctuations until the lock-up period expires. Underpricing also causes the loss of funds for the company which may be required in order to finance required investments. All these trade-offs need to be weighed. For short-term investors, on the other hand, it means that IPOs where management ownership before the IPO is high are on average a more attractive investment compared to IPOs with relatively low pre-issue management ownership.

5.4.2 Pre-Market Demand It has been hypothesized that setting the offer price at the upper limit of the bookbuilding range or above is positively related with the degree of underpricing. Accordingly, it has been found that

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when the final offer price is set at the bookbuilding range upper limit or above, underpricing will on average increase by 0.54 percentage points. The result is significant on all conventional confidence levels and is also confirmed by earlier research in other markets and for different time periods (HANLEY, 1993, p. 245 et seq.; LOWRY & SCHWERT, 2002, p. 1185 et seq.; LOUGHRAN & RITTER, 2002, p. 427 et seq.). 46

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Obviously, issuers are not adjusting the final offer price fully to the premarket demand. The strict conclusion from this result would be that if issuers want to leave less money on the table, they should avoid anchoring to the bookbuilding range when setting the final offer price. Instead, the final offer price should be oriented more on the pre-market demand. Short-term investors, on the other hand, are able to increase their average one-day return by investing predominantly in IPOs where the final offer price has been set at the upper limit of the bookbuilding range or above.

5.4.3 Recent Market Movements The regression results also confirm that issuers do not fully adjust the final offer price to recent market movements. Corresponding with the hypothesis, it has been found that underpricing is more severe, the higher the market return three weeks prior to the IPO. The result is significant on all conventional confidence levels and is also confirmed by earlier research (LOUGHRAN & RITTER, 2002, p. 426 et seq.; HANLEY, 1993, p. 244 et seq.; LOGUE, 1973, p. 94. et seq.). Concluding from these results, issuers will be able to decrease underpricing by including most recent (three weeks prior to the IPO) market movements in the final offer price. When the market return is positive, the offer price can be revised upwards accordingly. Investors, in turn, can assume to achieve on average a higher first-day return when they invest predominantly in IPOs

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where prior short-term market returns have been positive.

47

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

5.4.4 Underwriter Reputation The sign of the regression coefficient for the ranking of the bank is negative as expected. From that it can be interpreted that the choice of a high prestige underwriter leads to lower underpricing. This conclusion is also confirmed by the work of Carter and Manaster (1990, p. 1054 et seq.) and Titman and Trueman (1986, p. 159 et seq.). However, the result in this analysis is not significant on any conventional confidence level. An explanation for that may be found in other studies that are contradicting to the result presented here. A study by Logue et al. (2002, p. 215 et seq.) finds that premarket underwriter activities are the most significant determinant of first day trading returns. With that result, they emphasize that underpricing does not depend on underwriter reputation per se. Beatty and Welch (1996, p. 588 et seq.) find a transition from the 1980s to the 1990s, confirming this prior finding to some extent. Whereas underwriter

reputation had a reverse

effect

on

underpricing in the 1980s, it had a positive correlated effect in the 1990s. As an explanation, they suggest legislative changes in the United States for this period. It is also possible, that this result is not significant due to the chosen classification of the underwriter ranking. Here, only a dummy variable for prestigious and non-prestigious underwriters has been used. Setting up a ranking that is more detailed or setting the dummy variable for the prestigious underwriter at a

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different experience level may lead to a result that is significant. Or it may even lead to a positive relationship between underwriter reputation and the extent of underpricing. Since the results for this variable are not significant and the findings of other studies partially contradicting, it is questionable what to conclude. However, if we assume, as found in this analysis, that the relationship of underwriter ranking and 48

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

underpricing is negative, it needs to be recommended that issuers should carefully choose the underwriting bank and consider that lower fees for a less prestigious underwriter may be offset by higher underpricing and vice versa. For investors, on the other hand, it means that the underwriting bank may be an indicator for the amount of profits that can be expected. The general rule is in that case, the more prestigious the underwriter, the lower the first-day trading return. If we further assume that IPOs are overpriced with regard to the fair value (see sec. 4), this would also raise the question whether prestigious underwriters overprice more. This is theoretically an option if we assume that the first-day trading price is fixed and we further assume that the only variation is the final offer price. But this argument is in fact questionable since it can be argued that especially high prestigious banks are keen to keep their level of prestige. Accordingly, Geddes (2003, p. 35) assumes that highly ranked underwriters only escort low risk IPOs and leave the rest to less prestigious banks. This may be another explanation of why IPOs managed by prestigious underwriters have lower underpricing, but at the same time it does not imply that prestigious underwriters overprice more.

5.4.5 Industry, Company Age and Firm Size As hypothesized, the degree of underpricing is linked to the sector an issuing company is operating in. According to this analysis, Copyright © 2012. Diplomica Verlag. All rights reserved.

when the issuing company is operating in the technology sector, the underpricing rises on average by 0.16772 percentage points. This outcome is significant on all conventional confidence level. It seems that issuers operating in sectors that are more risky than others have to bear a higher cost of underpricing. Investors have the opportunity to obtain superior first-day returns by investing in these more risky businesses. 49

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Also the coefficient for the company age has the expected sign, which is negative, by implying that older companies have a lower underpricing. However, it is not significant on any conventional confidence level. This may arise due to the fact that some of the issuing companies in the sample have been spin-offs or carveouts where the “real” foundation date could have not been determined. Ritter (1991, p. 4) also observes in his analysis of the period 197584 “[…] that the underpricing is concentrated among relatively young growth companies, especially those going public in the high-volume years of the 1980s.” In his examination, the oil and gas industry was especially outstanding with its 30.92% underpricing and where the median company age is only 2 years (p. 17 et seq.). A more recent study by Ljungqvist and Wilhelm (2003, p. 738 et seq.) also confirms the findings of this study that high-tech, internet-related and younger firms suffer from ‘ex ante’ uncertainty and have to accept a higher degree of underpricing. According to these results, young companies in “new” industries should consider to postpone the IPO as long as possible if they want to decrease the cost of underpricing. But since in practice especially young companies often need funds to finance largescale investments that allow them to grow quickly, it may be problematic to postpone an issue. Certainly, this trade-off needs to be weighed carefully since the funds may be essential for the survival of the company, as it often is the case in growing industries. However, these companies still have to take into Copyright © 2012. Diplomica Verlag. All rights reserved.

account that their cost of underpricing is relatively high. For investors, investment in young companies may allow for higher first-day trading returns. However, they also bear a higher risk in return.

50

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The sign for gross proceeds is negative as hypothesized. Gross proceeds as a proxy for company size point out that bigger companies have a lower risk and thus lower underpricing. However, this finding is not significant on any conventional confidence level. Nevertheless, the studies conducted by Carter et al. (1998, p. 293 et seq.) as well as Beatty and Welch (1996, p. 572) confirm that the underpricing is lower, the larger the company. It should also be mentioned that Beatty and Welch use the sales of the company the previous year of the IPO as a proxy and still come to the same result. This proxy has not been used in this analysis for practical reasons only, since sales volume before the IPO was available for only a few companies in the sample. But as the coefficient sign is as expected, coupled with the factors of company sector and firm age, it can be assumed that the individual company risk has an influence on the level of underpricing. The general rule seems to be, the higher the risk of the business, the higher the underpricing will be. For investors seeking high first-day returns, risky companies issuing equity for the first time mean an interesting investment opportunity. In return, the results indicate that risky businesses have to pay the cost of higher underpricing. Thus it may be worth wile to consider, where

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possible, to go public when the company is more established.

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6 Conclusion The focus of the empirical analysis conducted here is on which factors the degree of underpricing depends. The results are supposed

to

support

appropriate

investment,

respectively

financing decision making by issuers and underwriters. For that purpose, several influencing variables have been derived and subsequently analyzed for their influence on the degree of IPO underpricing on the German stock market. The regression estimation conducted in this paper shows that company age and size as well as underwriter prestige are negatively related with underpricing. On the contrary, the relationship is positive for industry risk, premarket demand, market return and pre-issue management ownership. Investors can directly incorporate these findings into their decisionmaking. Vice versa, the results can also be applied by issuers in order to minimize the cost of underpricing. However, this paper also provides possible reasons for why issuers may wish to underprice (i.e. lawsuit avoidance, signalling, market feedback). It has also been shown that the underwriter may have incentives and the power to increase underpricing (i.e. reducing marketing effort, bonding with buy-side clients). These factors may need to be considered when aiming to decrease potential underpricing. Even though the validity of these explanations has not been proven yet in practice, it needs to be considered that they may be of significant importance.

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Another important issue relates to the poor long-run performance of IPOs and the further finding of scientists that IPOs with the highest underpricing have the worst long-run performance. Does the latter finding simply mean that high underpricing is an indicator for a stock that will perform poorly in the long-run (for whatever reason)? Or is it possible that because the offer price was so low, expectations were forced up which in turn caused a very high first52

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

day trading price? And that after some negative news was released, this initial overreaction turned into the opposite direction and caused a long-run undervaluation by investors? Theoretically, this is in fact possible, but neither this nor the opposite has been proven in practice yet. If this is true however, issuers who focus on favorable valuation of the stock in the aftermarket, should aim to minimize underpricing in order to avoid overreactions and not only for the cost behind it. In sum, this paper provides potential answers to the question on how to minimize underpricing. But the answer to the problem whether issuers should do so, remains, as described above, still

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open and leaves space for prospective research.

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

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Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

List of Online Sources and Software Deutsche Börse AG, Primärmarktstatistik, Sourced online: http://deutsche-boerse.com/dbag/dispatch/de/ers/gdb_navigation/ trading/60_downloads/200_statistics/300_primary_market_statistic /ers_query/M_Boersengaenge.kir?boersengang=1&count=30 [2011-02-23] GRETL: All estimations in this paper had been run with the software GRETL, Version 1.9.5 [build 2011-04-24], ©2000-2010 Cotrell, A. and Lucchetti, R. Statistisches Bundesamt, Verbraucherpreisindex für Deutschland – Lange Reihen ab 1948, Sourced online: http://www.destatis.de/ jetspeed/portal/cms/Sites/destatis/Internet/DE/Content/Publikation en/Fachveroeffentlichungen/Preise/Verbraucherpreise/Verbrauche rpreisindexLangeReihen,templateId=renderPrint.psml [2011-0325]

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markt-daten.de, Daten, Sourced online: daten.de/daten/daten.htm [2011-03-25]

http://www.markt-

59

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Appendix Appendix A Calculation Breusch-Pagan Test From the initial model (see sec. 5.2), the sum of squared residuals ?@ is being used as the dependent variable in equation ?@ = G$ + G H + ⋯ + GK HK + L,

which has been estimated with OLS (see table 3) to obtain its N  = 0,074858. OLS, using observations 1-509 (n = 443) Missing or incomplete observations dropped: 66 Dependent variable: usq_model coefficient

std. error

t-ratio

p-value

constant

0.00296944

0.100703

0.02949

0.9765

Ran

-0.0468791

0.0957978

-0.4894

0.6248

Ind

0.183167

0.102749

1.783

0.0753

OS

-0.000114699

0.00018354

-0.6249

0.5324

PreD

0.455514

0.100053

4.553

6.88e-06

***

Mar

1.65529

0.993380

1.666

0.0964

*

Age

-0.000180259

0.00153754

-0.1172

0.9067

Pro

-4.74806e-01

1.46561e-01

-0.3240

0.7461

*

7 = 0.059970 R

-. = /. /35W6W

Table 3 OLS Estimation for Breusch-Pagan Test

The null hypothesis is

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Y$ : G = G = ⋯ = GK = 0 The F-statistic is computed

[=

N\]^ /` (1 − N\]^ /(b − ` − 1)\]^

60

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Where, k

=

(n-k-1)=

number of regressors in the used equation degrees of freedom in the used equation

This results in [=

0.074858/7 = 5.028298 (1 − 0.074858)/(443 − 7 − 1)

The critical value c is 1.73 for a confidence level of 10% (onesided test). When [ > h holds, the null hypothesis needs to be rejected. Since the F-statistic is higher, the null hypothesis is rejected and it is assumed that heteroscedasticity is given. Appendix B Calculation White-Test From the initial model (see sec. 5.2), the sum of squared residuals ?@ has been used as the dependent variable in equation ?@ = G$ + G H + ⋯ + GK HK + G H + ⋯ + GK HK + Gi (H ∗, … , H ) + L

which has been estimated with OLS (see table 4) to obtain its N  = 0.082528. It shall be noted here, that since the model has a relatively high number of independent variables, the cross products have been omitted. Furthermore, in order to avoid multicollinearity problems, where a dummy variable has been used, the square is not

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included.

61

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

OLS, using observations 1-509 (n = 443) Missing or incomplete observations dropped: 66 Dependent variable: usq_model coefficient

std. error

t-ratio

p-value

constant

-0.0958408

0.125816

-0.7618

0.4466

Ran

-0.0439438

0.0962847

-0.4564

0.6483

Ind

0.151825

0.105205

1.443

0.1497

OS

0.255014

0.151998

1.678

0.0941

*

PreD

0.441504

0.100784

4.381

1.49e-05

***

Mar

1.72139

0.996092

1.728

0.0847

*

Age

0.00214869

0.00356763

0.6023

0.5473

Pro

-1.34644e-

3.08615e-

-0.4363

0.6628

sq_OS

-4.70412e-05

2.80260e-05

-1.678

0.0940

sq_Mar

2.44871

14.9009

0.1643

0.8695

sq_Age

-1.13238e-05

2.00264e-05

-0.5654

0.5721

sq_Pro

0.000000

0.000000 0.4584 7  = 0.059112 R

-. = /. /W.6.W

*

0.6469

Table 4 OLS Estimation for White-Test

The null hypothesis is Y$ : G = G = ⋯ = GK = 0 The W-statistic follows asymptotically a k²(`)-distribution and is computed as follows: l = ` ∗ N\]^ For our model this results in the calculation: l = 11 ∗ 0.082528 = 0.907808 Copyright © 2012. Diplomica Verlag. All rights reserved.

The critical value c for k = 11 and a confidence level of 10% equals 17.27. Obviously, the null hypotheses cannot be rejected, as the W-statistic does not exceed the critical value. This implies that the required homoscedasticity assumption holds.

62

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

Appendix C Variance Inflation Factors (VIF) The VIF calculated by GRETL are:

Variable

VIF

Ran Ind OS PreD Mar Age Pro

1.033 1.093 1.007 1.088 1.039 1.084 1.050

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Table 5 Variance Inflation Factors (VIF)

63

Dietrich, Justyna. Variables Influencing the Severity of IPO Underpricing: An Empirical Analysis of the German Market : An Empirical Analysis of the German Market, Diplomica

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Autorenprofil

Justyna Dietrich, M.Sc., was born in 1984 in Jaslo (Poland). After finishing school in Germany, she decided to study Business Administration (B.A.) at the Berlin School of Economics and Law, majoring in Finance & Accounting in 2009. These studies allowed the author to deepen her knowledge in financial markets resulting in the successful graduation in International Finance (M.Sc.) in 2010, also at the Berlin School of Economics and Law. While still studying, she also gained several years practical experience in the IT sector. After graduation, she commenced her work in a business consulting company specializing in the financial industry. With a keen interest in Behavioral Finance and Strategy, the author decided to reflect IPO underpricing respectively from these

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two points of view.

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