Are low demand IPOs underpriced evidence from biotech IPOs

Are low-demand IPOs underpriced Evidence from biotech IPOs

ARE LOW-DEMAND IPOs UNDERPRICED? EVIDENCE FROM BIOTECH IPOs by SANGKYOO KANG A dissertation submitted to the Faculty of the Graduate School of the State University of New York at Buffalo in partial fulfillment of the requirements for the degree of Doctor of Philosophy (PhD) Department of Finance and Managerial Economics UMI Number: 3213625 3213625 2006 Copyright 2006 by Kang, Sangkyoo UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 All rights reserved. by ProQuest Information and Learning Company. Copyright by SANGKYOO KANG May 5, 2006 ii To my parents, my wife, and my Lord God iii Table of Contents List of Tables v List of Figures vi Abstract vii 1 Introduction 1 2 Pricing of low-demand IPOs 7 2.1 IPO pricing process 7 2.2 Pricing of low-demand IPOs 8 3 Explanations for low-demand IPO underpricing 11 4 Empirical implications 16 5 Sample and Data 19 6 Descriptive statistics for low-demand IPOs 23 7 Long-run performance of low-demand IPOs 30 8 Review of traditional partial adjustment model 34 9 Relation between initial return and price revision for low-demand IPOs 37 10 Robustness test 45 11 Characteristics of low-demand IPOs 50 12 Determinations of the likelihood of underpricing of low-demand IPOs 52 13 Conclusion 60 Appendix 1: Biotech companies 63 Appendix 2: Errors in the SDC’s initial filing price and shares data 63 References 65 iv List of Tables Table 1 Statistics from previous studies 12 Table 2 Biotech IPO sample selection, 1980-2004 21 Table 3 Cross-sectional statistics for biotech IPOs, 1990-2004 24 Table 4 Variations in the IPO volume and initial returns over time for biotech IPOs 25 Table 5 Statistics excluding hot issue periods for biotech IPOs 27 Table 6 Cumulative average returns over the 12 months after offer for biotech IPOs 33 Table 7 Alternative sample stratification for biotech IPOs 35 Table 8 OLS regressions of initial returns for biotech IPOs 39 Table 9 Comparison between zero and positive price revisions for biotech IPOs 45 Table 10 OLS regressions by an alternative demand measure for biotech IPOs 46 Table 11 Alternative IPO sample selection, 1990-1998 48 Table 12 OLS regressions for alternative sample 49 Table 13 Selected characteristics of low-demand IPOs 51 Table 14 Logistic regressions of the likelihood of underpricing on low- demand IPOs 53 Table 15 Statistics by offer size for low-demand IPOs 57 v List of Figures Figure 1 Time sequence in IPO pricing process 8 Figure 2 Hypothetical pricing patterns of low-demand IPOs 10 Figure 3 Long-run performance of biotech IPOs 31 Figure 4 Graphical relation between underpricing and price revision for biotech IPOs 42 vi Abstract We address the unresolved issue of how negative demand information affects the pricing of initial public offerings (IPOs). Using a sample of 557 biotech IPOs over the 1990-2004 period, we show that low-demand IPOs tend to be underpriced and the extent of this underpricing is significant. The post-IPO performance of low-demand IPOs supports the claim that low-demand IPOs are mildly underpriced in the long run and suggests potential negative overreaction in the market for IPOs with low demand. We use a new partial adjustment model to show that the traditional model generally fails to demonstrate little relation between initial return and price revision for low-demand IPOs. Our findings are robust to controlling for the measure-specific and industry-specific factors. In logistic regressions, we find evidence consistent with the view that underwriters may have difficulty in marketing a larger IPO where investor interest is low and thus are more likely to underprice. The underpricing likelihood is negatively related to pre-IPO market returns, which is consistent with the ‘a bird in the hand’ hypothesis. We also present evidence consistent with the hostile takeover avoidance hypothesis and with the prospect theory, respectively. We take the demand-dependent approach to explanation for underpricing and our approach has certain advantages. This study complements the information solicitation and price adjustment model in the literature. vii 1. Introduction Theoretical studies have predicted demand-dependent patterns in the pricing of initial public offerings (IPOs): IPOs for which there is low investor interest will not be underpriced, while those with high demand will be substantially underpriced. Yet, the present observations cannot confirm that this is the case. Defined as IPOs that are priced below the initial filing price range, low-demand IPOs have an average initial return of 3.4%; Furthermore, the proportion of these low-demand IPOs are greater than that of IPOs with high demand (25 percent and 22 percent, respectively). However, there appears to be little research on the effects of low demand information on the IPO pricing decision. In this paper, we attempt to address the unresolved issue of how low-demand IPOs are priced. We define a low demand IPO as an IPO that has negative price revision between the filing of initial price range and the offer date. 1 2 There are several reasons why research on the effects of negative information (i.e., low demand) on the pricing of IPOs is of interest. First, from an investor’s viewpoint, the existence of typical pricing patterns may provide good opportunities for active investing. Second, the finding of positive initial returns calls into question the informational efficiency of the IPO pricing process. 3 This would provide evidence consistent with underwriters giving reward to investors who provide low interest (i.e., negative information). It is difficult to conjecture why offering that reward is consistent with the efficient IPO market. Third, the extent of initial returns depends largely upon the degree 1 Some of theoretical studies that share this view include Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), Krigman, Shaw, and Womack (1999), and Loughran and Ritter (2002). 2 The 3.4% average initial return figure as well as both 25 and 22 percent proportion figures is from Loughran and Ritter (2004, p. 17), where the sample includes 6,391 IPOs during 1980-2003. See Table 2 for further evidence. 3 There are other findings that may suggest that the IPO pricing process is not efficient. See Lowry and Schwert (2004). 1 of price adjustment to demand information learned in the premarket. 4 If positive initial returns are associated with the price adjustment to negative information, this would indicate that underwriters are overadjusting the offer price to negative information. Fourth, IPOs underperformed in the long run. 5 If the poor long-run performance is associated with fads or overoptimism, this would indicate that the long-run underperformance of IPOs documented in the literature may be pertaining to the worst underperformance of IPOs with high demand. Fifth, given the higher proportion of low- demand IPOs than high-demand IPOs, the research on the pricing of low-demand IPOs would complement the information solicitation and partial adjustment model in the IPO literature. Using a sample of 557 biotech IPOs over the 1990-2004 period, we show that more of IPOs are low-demand IPOs rather than high-demand IPOs. The higher proportion of low-demand IPOs found in the sample is not driven by industry-specific factors. The volume of low-demand IPOs displays variations over time. Low-demand IPOs tend to be underpriced and the extent of this underpricing is significant. We find that the positive average initial return on low-demand IPOs is not subject to possible aftermarket price support and periods of hot issue market. We next examine the long-run performance to see if low-demand IPOs are overpriced in the long run. We compute the 12-month market-adjusted buy-and-hold returns and find little evidence for long-run underperformance for low-demand IPOs. Our 4 A few of many studies of the information solicitation and price adjustment include Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), Hanley (1993), Benveniste, Ljungqvist, Wilhelm, and Yu (2003), Ljungqvist and Wilhelm (2003), and Lowry and Schwert (2002, 2004). 5 The long-run underperformance of IPOs has been widely documented in the literature. See Ritter (1991), Hanley (1993), and Loughran and Ritter (1995). 2 [...]... clearer analysis of motives for underpricing, depending on the demand level Third, it establishes new testable implications regarding the pricing of IPOs, allowing us to connect ex ante motives with ex post outcomes We examine the characteristics of low- demand IPOs that are underpriced We divide low- demand IPOs into two groups, based on whether initial return is positive Low- demand IPOs that are underpriced. .. result suggests that more of IPOs are lowdemand IPOs rather than high -demand IPOs The alternative classifications of demand also show a higher proportion of IPOs with low demand in the sample This finding is consistent with the findings of previous studies using all IPOs, as shown in Table 1 22 These results suggest that the higher proportion of low- demand IPOs than high -demand IPOs is not driven by industry-specific... low- demand IPOs generally have lower firm value, they may be more willing to have large outside blockholders by underpricing their IPOs 16 (I.1) A low- demand IPO with more negative price revision is more likely to be underpriced (I.2) A low- demand IPO with larger offer size is more likely to be underpriced (I.3) A low- demand IPO is more likely to be underpriced in the depressed market (I.4) A low- demand. .. particularly concern to low- demand IPOs because IPOs with high demand for the shares are less subject to negative cascade So, low- demand IPOs are more likely to be underpriced to prevent a negative cascade from developing in the first place Rock (1986) argues that the winner’s curse problem leads to underpricing Uninformed investors are likely to receive a larger allocation in a low- demand IPO because informed... is below the offer price, investors will renege on their purchase in IPO and will instead buy the shares in the aftermarket 9 Investors’ reneging would be of more concern to low- demand IPOs than to high -demand IPOs, because low demand for IPO shares likely discourages subsequent investing and as a consequence, stocks are more likely to trade below the offer price in the aftermarket Therefore, low- demand. .. to low demand information revealed in the premarket Underpricing of low- demand IPOs is then a manifestation of this overadjustment effect Figure 2 describes three hypothetical patterns of price adjustment and IPO pricing for low- demand IPOs However, the evidence on the pricing of low- demand IPOs is at least mixed In Table 1, Hanley (1993) found that the average initial returns on IPOs priced below... that low- demand IPOs are at least as likely to be underpriced as they are to be overpriced or fully priced This result indicates that low- demand IPOs tend to be underpriced The average initial return on low- demand IPOs is 3.7%, which is significantly positive This finding is consistent with the findings of previous research using all IPO samples (See Table 1) By alternative classifications of demand, ... investors are also likely to demand a discount in the hand rather than more in the bush in the future if they are to participate in a low- demand IPO Litigation risk may also lead to underpricing (e.g., Ibbotson, 1975; Tinic, 1988; Hughes and Thakor, 1992; Lowry and Shu, 2002) Litigation risk is likely higher for lowdemand IPOs because these IPOs are more likely to be subject to overpricing Hence, low- demand. .. on recent IPOs for which demand is low The evidence of persistent positive initial returns on low- demand IPOs leaves us with a conundrum: Are these findings a just sampling phenomenon, are they a result of incentive compatibility constraint, or are they driven by economically 11 Table 1 Statistics from previous studies The table collects the average initial returns and percentage of IPOs from previous... an “expected -demand IPO Alternatively, Hanley (1993) classifies demand for IPO shares, based on the relation of the offer price to the initial filing price range: issues priced below the range are low- demand IPOs with bad information revealed in the premarket; issues priced above the range, high -demand IPOs with good information; and issues priced within the 8 range, expected -demand IPOs with little . of IPOs are low- demand IPOs rather than high -demand IPOs. The higher proportion of low- demand IPOs found in the sample is not driven by industry-specific factors. The volume of low- demand IPOs. characteristics of low- demand IPOs that are underpriced. We divide low- demand IPOs into two groups, based on whether initial return is positive. Low- demand IPOs that are underpriced have, on. performance of low- demand IPOs supports the claim that low- demand IPOs are mildly underpriced in the long run and suggests potential negative overreaction in the market for IPOs with low demand. We