The management board of a company rings the bell on the stock exchange floor in an evocative manner. Trading on the stock exchange has finally begun following months of the issuing process. But does the positive experience of ringing the stock market bell really persist throughout the day?
No, not all IPOs go according to plan, and anecdotal evidence is abounded, such as in the case of UBER’s $75.46 billion IPO, which was set to launch on the New York Stock Exchange in May 2019 and was eagerly anticipated by many investors. UBER’s stock market debut missed all expectations and closed its first day of trading with a negative first-day return of 7.6%.
How Is the Situation in the US?
If we look at last year, 2021, about $143 billion worth of shares were issued in U.S. IPOs, yet more than 25 percent of those offers had negative returns on the first day of trading. A quarter is not a small number. Underwriters use roadshows to assess the potential demand of the soon-to-be-issued shares. To minimize risks, it is common practice that the final offer price is set below market expectations. Thus, many IPOs close their first day of trading with a positive first-day return because their shares are underpriced. This has entered the vast IPO literature as the “underpricing puzzle,” which continues to occupy researchers and has generated a great deal of debate since the 1970s.
The Overpricing Phenomenon…
We also confirm this underpricing puzzle in our sample of 2,111 common stock IPOs over the period from 2000 to 2020, with an average first-day return of 21.11%. However, unlike other studies, we also note the extent and magnitude of overpricing in our sample, as 21.27 percent of IPOs report negative returns on the first day of trading. We define overpricing as the extent of the negative relationship between the offer price and the first closing price.
Within our sample, most negative first-day returns appear in the healthcare sector at 40.76%, while the least frequent observations are in the utilities sector, at 1.78%. The second most negative first-day returns were found in the information technology sector at 19.38%, which means that almost two-thirds of the first-day returns in the U.S. were in the healthcare and information technology sectors. The proportion of negative initial returns occurs in each year, but changes over the years. We can observe the highest values in 2004, 2007 and 2014, while the proportion of overpriced IPOs exceeds the underpriced IPOs in 2008.
Accordingly, we find that overpricing is a typical feature of U.S. IPO markets across years and industries. But what are the differences between overpriced and underpriced IPOs? Can we identify certain determinants that affect the probability of IPO overpricing?
Using univariate, linear, and probability analyses, we examine the extent and determinants of IPO overpricing to reveal the significance of this phenomenon. We assume that to some extent there are similar determinants and denominators between underpricing and overpricing, as both are extreme phenomena in terms of IPO valuation. Therefore, we use evidence and theories from previous studies dealing with the phenomenon of IPO underpricing to derive and formulate our expectations.
We find that ex-ante uncertainty and prevalent information asymmetries between the IPO firm and potential investors play an important role in IPO overpricing. A higher offer price and a larger deal size reduce information asymmetries and thus significantly reduce the likelihood of negative IPO first-day returns. While smaller offer prices increase the probability of a negative first-day return by almost 10%, smaller deal size increase the probability of overpricing by almost 4%. We find further evidence in our interaction setting: lower offer prices and smaller transaction sizes significantly increase the probability of IPO overpricing. Larger offers are mainly made by mature and established companies, whereas smaller offerings are mainly made by speculative companies with uncertain cashflows. Moreover, the probability increases by 50% if the opening price at the IPO is below the offer price (offer-to-first-day open). In addition, the presence of an over-allotment option (greenshoe option) or a larger number of over-allotment shares leads to price stability after listing and reduces the probability of negative returns on the first day by 72%. The possible post-IPO price stabilization mechanism using the over-allotment option on the part of the underwriters appears to be an effective tool. Interestingly, we cannot find any underwriter effect for the overpricing phenomenon, while non-overpriced IPOs are more often supported by reputable underwriters.
Do Corporate Governance Characteristics Matter?
Moreover, we include corporate governance variables as investors send signals to eliminate potential agency problems that arise due to the dispersed ownership structure during the IPO process. We find that agency-related variables do not appear to have a significant impact on the overpricing phenomenon. These results are contrary to expectation, as prior research has found a significant relationship between corporate governance and IPO underpricing.
Do Specific Firm Characteristics Matter?
Past studies (e.g., Engelen and van Essen, 2010) have found that being part of the technology industry is characterized by a higher level of information asymmetry, which leads to higher underpricing. We find that this reduces the likelihood of negative returns on the first day by 5%. Finally, in examining the extent of negative first-day using only the IPO overpricing sample, we find that additional IPO firm characteristics matter. A larger proportion of primary shares, venture capital support and higher leverage reduce the occurrence and magnitude of IPO overpricing.
Do Market Conditions Matter?
To study IPO pricing, market timing explanations have gained popularity. Especially in “hot markets,” investor sentiment can be exuberant and potential investors tend to be quite optimistic. Generally, periods with unusually high initial returns that are accompanied by a high volume of IPOs are referred to as “hot issue” periods. However, we cannot identify any significant influence of market conditions on the probability of IPO overpricing. We find no statistically significant evidence of the “hot” market phenomenon.
To the best of our knowledge, ours is the first study to focus on negative first-day returns exclusively, providing extensive empirical evidence. We conclude that there are common features that characterize both IPO underpricing and IPO overpricing (i.e., IPO size, offering price, technology sector), while there are pronounced differences between these two phenomena. First, it appears that stabilization mechanisms (greenshoe option) are of particular importance to avoid overpricing. Second, we cannot identify market characteristics or agency problems to affect the overpricing phenomenon. Third, certification mechanisms also fail to effectively explain negative IPO first-day returns. This leads us to conclude that a general “hot” market phenomenon cannot be symmetrically applied to the IPO overpricing phenomenon. Companies trying to “ride the IPO wave” may experience significant underpricing, but hot markets do not seem to reduce IPO overpricing to the extent we would have expected. It appears that characteristics of information provision and the IPO mechanism, along with company-specific characteristics, are the main drivers of IPO overpricing. Significant changes in legislation (Dodd-Frank Act July 21, 2010) had no impact on the magnitude and determinants of overpriced IPOs.
This topic offers a lot of further research for the future, as it is relevant for choosing an adequate pricing not only from the investor’s point of view, but also from the underwriter’s and company’s point of view. Maybe other variables that not yet played a role in the underpricing debate are driving the overpricing? What happens to companies that close their first day of trading with a negative first day return? Are there differences in the long-term performance of overpriced and underpriced issues? Future research should uncover new empirical and theoretical considerations on this in detail.
Jacqueline Rossovski is a PhD candidate in Finance at Trinity Business School of Trinity College Dublin.
Brian M. Lucey is a Professor of Finance at Trinity Business School of Trinity College Dublin.
Pia Helbing is an Assistant Professor in Finance at The University of Edinburgh.
This paper is based on their paper, “Determinants of Negative First-Day IPO Returns,“ available on SSRN.