This paper aims at establishing a link between the average level of initial return of IPO shares, existing underpricing explanations and the dot-com bubble. In years prior to the boom of the new economy, underpricing was explained by various theories, which have extensively been developed since decades. However, in the years 1998 to 2001 IPOs were overly underpriced, leading to assumptions about behavioural aspects and investor irrationality. Analysing a comprehensive dataset of 371 IPOs on the Frankfurter Börse between 1997 and 2007, this paper aims at providing evidence that the observed lower levels of initial returns in recent years can indeed be aligned with existing theories on the basis of rational behaviour of market participants.
Firstly, the IPO process and its major participants will be presented followed by a review of relevant studies on the IPO phenomenon. In the next step, established underpricing theories are recapitulated. A descriptive analysis of the data sample points out the particularities concerning the company and transaction characteristics of the sample firms. In a last step, a regression analysis relates various proxies for information asymmetry to established underpricing theories. It gives reason to believe that the irrationality at the turn of the century has vanished and that underpricing can again be explained by established theories.
Table of Contents
1 INTRODUCTION
2 INITIAL PUBLIC OFFERINGS
2.1 The IPO Process
2.1.1 Institutions and Roles in IPOs
2.1.2 IPO Transactions
2.1.3 International Equity Issuing Conditions
2.2 Empirical Evidence on IPO-Underpricing
2.2.1 Definition of IPO-Underpricing
2.2.2 Evidence on Underpricing and Country Differences
2.2.3 Long-Term IPO Performance Studies
3 THEORIES EXPLAINING IPO-UNDERPRICING
3.1 Institutional Explanations
3.1.1 Reduction of Legal Liability
3.1.2 Analyst Compensation Theory
3.1.3 Banking Relationships
3.2 Models based on Ownership and Control
3.2.1 Reduced Monitoring Theory
3.2.2 Increased Monitoring Theory
3.3 Models based on Information Asymmetry
3.3.1 Information Asymmetry between Issuer and Investor
3.3.2 Information Asymmetry between Investor Groups
3.3.3 Information Asymmetry between Underwriter and Investor
3.4 Theories related to Individual Rent-Seeking Behaviour
3.4.1 Underpricing to the Benefit of the Management
3.4.2 Underpricing to the Benefit of the Underwriter
4 THE MODEL
4.1 Sample Description
4.1.1 Investigation of Data
4.1.2 Descriptive Characteristics of Sample Firms
4.2 The Regression Model
4.3 Results of the Regression Analysis
4.4 Interpretation of Regression Results
4.5 Alternative Interpretation
5 CONCLUSION
Research Objectives and Themes
This thesis investigates the phenomenon of IPO underpricing, specifically focusing on the German market. The primary objective is to evaluate established theoretical models of underpricing using an empirical regression analysis on a comprehensive dataset of 371 IPOs, while examining the influence of market phases, such as the dot-com period, and exploring behavioral finance explanations.
- Empirical analysis of IPO underpricing determinants on the Frankfurter Börse.
- Evaluation of information asymmetry and monitoring-based theoretical frameworks.
- Assessment of the impact of "hot" IPO markets and the dot-com period on initial returns.
- Testing of rational versus behavioral finance explanations for market anomalies.
- Analysis of company and transaction characteristics influencing IPO performance.
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3.3.1 Information Asymmetry between Issuer and Investor
The first model of asymmetric information is based on diverging estimations about the quality of the IPO company between potential investors and the issuer itself. Ibbotson (1975) establishes a theoretical model by assuming that the issuing firm has superior information about the company’s present value, its future cash flows and its risk profile than the investor. In order to communicate the true (high) quality, the management can decide to intentionally underprice in equity issues. Naturally, the underpricing comes as a cost to the issuer, because it effectively means a dilution of pre-issue shareholder value and missing out on IPO proceeds. However, the aim of the issuer using this approach is to “leave a good taste in the investor’s mouth” as it improves the terms for follow-on equity issuings. A more precise model is developed by Spiess/Pettway (1997) who posit that the objective of the firm is to maximise the expected present value of the combined proceeds from the initial public offering and the follow-on seasoned equity offering. Hence, one can derive the proposition that greater underpricing improves the conditions for seasoned equity issues (SEOs).
Still it remains the question, why investors believe in the validity of signalling, as high and low quality firms both can underprice their shares in an IPO. Grinblatt/Hwang (1989) provide a scenario, in which both a high and a low quality firm issue shares in an IPO and at a later stage. As the high quality firm has the incentive to achieve better terms in the seasoned equity offering, the low quality firm tries to imitate its behaviour. Given the assumption that investors cannot estimate the firm quality before the IPO but reveal its real value at a later point in time, they buy both IPO shares. The discrepancy between the two firm types becomes apparent, when the high quality firm indeed performs accordingly, but the lower quality firm underperforms and looses reputation for the SEO.
Summary of Chapters
1 INTRODUCTION: Outlines the objective of the paper, focusing on the motives behind IPO underpricing in the German market and the structure of the analysis.
2 INITIAL PUBLIC OFFERINGS: Provides an overview of the IPO process, key participants, international issuing conditions, and empirical evidence on underpricing and long-term performance.
3 THEORIES EXPLAINING IPO-UNDERPRICING: Clusters and evaluates theoretical models, including institutional explanations, ownership/control models, information asymmetry, and rent-seeking behavior.
4 THE MODEL: Details the empirical regression model, sample description, variables used, and presents the statistical results and their interpretation.
5 CONCLUSION: Synthesizes the findings, confirming the relevance of information asymmetry and behavioral factors in explaining IPO underpricing trends.
Keywords
Initial Public Offering, IPO, Underpricing, German IPO Market, Information Asymmetry, Dot-com Period, Signalling Theory, Winner's Curse, Regression Analysis, Frankfurter Börse, Investment Banking, Behavioral Finance, Market Efficiency, Equity Issuance.
Frequently Asked Questions
What is the core subject of this thesis?
The thesis examines the phenomenon of IPO underpricing, analyzing why companies choose to offer shares at a price below their market value on the first trading day.
What are the primary themes discussed in the work?
Key themes include institutional factors, information asymmetry between various market participants, ownership and control dynamics, and the role of behavioral finance during market "hot" periods.
What is the central research question?
The research asks whether observed underpricing can be explained by established rational theories or if it requires alternative explanations rooted in behavioral finance, particularly for the dot-com period.
Which scientific method is applied?
The author uses a quantitative empirical approach, employing a linear regression model (Ordinary Least Squares) on a dataset of 371 IPOs from the Frankfurter Börse.
What is covered in the main section of the document?
The main section consists of a literature review of underpricing theories followed by a detailed description of the model, variable definitions, and the interpretation of statistical regression results.
What are the key terms that characterize this research?
Key terms include Initial Public Offering, IPO, Underpricing, Information Asymmetry, Market Efficiency, and Behavioral Finance.
How does the dot-com period influence the results?
The thesis identifies the dot-com era as a unique market phase where standard rational models struggle to explain the extreme levels of underpricing, suggesting that investor irrationality and sentiment played a significant role.
What conclusion does the author draw regarding behavioral finance?
The author concludes that while traditional models are effective for standard market conditions, behavioral finance offers a superior "alternative interpretation" for the atypical underpricing observed during the dot-com bubble.
- Quote paper
- Diplom-Kaufmann Marius Hamer (Author), 2007, Empirical Evidence on IPO-Underpricing, Munich, GRIN Verlag, https://www.grin.com/document/76172
