Asymmetric Information relating to Initial Public Offering Underpricing

Essay, 2012

30 Pages


Table of Contents

Introduction – Initial Public Offering

Assymetric information in general

Theories of asymmetric information
Information asymmetry among issuers and investors.
Information asymmetry among issuers and underwriters.
Information asymmetry among investors
Assymetric information and Signalling Theory

IPO Underpricing

Causes of Initial Public Offering Underpricing
Conditions of perfect information
Delay of negotiation and stock market rise
Underpricing as a hedge against legal risks
Underpricing and oversubscription of the share

Long-run underperformance of IPOs


IPOs in US market 1985 – 1996 and Greek Market 2002-2006

Other international research

The reasons why IPO returns in the Internet sector are higher than other sectors

Advices to Investors


Reference List

Introduction – Initial Public Offering

The main reason why companies decide to proceed with IPO is mainly to gain access to new funding. The proceeds from the share issue itself are not necessarily intended for direct expansion. The prospects for growth from acquisitions, the funds available for organizational expansion and refinancing of current borrowings have shown, among other things, to be the main motives that newly listed companies consider as very important. The general initial public offering procedure enhances the image and publicity of enterprises and gets not only an initial certification of the professionals in the financial markets but also a long-term price bidding (price signal) to suppliers, workforce and customers. According to Roell (1996), a robust equity value in the subsequent acquisition (during the trading of securities after their initial bid for public offering) reassures suppliers that they can safely grant trade credit, employees are convinced that they can expect a fairly stable job, and customers think that the products of the company will be supported as a result of their purchase (in the aftermath of their purchase).

During the initial public offering, there is high information asymmetry among investors and issuers and this forces investors to rely heavily on the company informative newsletter, which alone may contain financial statements but only for the last three to five years. From this perspective, the managers of IPOs will be motivated to use increasing income that accrued prior to the initial public offering, and shortly afterwards, in order to achieve higher rates of offer and maintain a high market price (at least for the lock-up period in which entrepreneurs are committed not to sell their personal shares). For these reasons, the IPO process may be subject to earning management philosophy.

In this context, Teoh et al. (1998) used data from the USA and they examined whether current and non-current differentiating accruals can explain the behaviour of investors regarding the fact that differentiating current accruals, which are to a large extent under management control, are high at the time of IPO compared with those differentiated accruals of non issuing companies. In addition, they documented that issuing companies with higher differentiating accruals had the worst stock performance over the next three years after their introduction on the stock exchange. Du Charme et al. (2001) used data from 171 manufacturing companies that made an IPO from 1982 to 1987 and they found that abnormal accruals, during the year of the initial offering, are related (statistically significant) negatively with the subsequent corporate equity returns. Furthermore, they found that abnormal accruals in the previous year were negatively correlated with subsequent performance and concluded that aggressive earnings management before initial public offering (pre-IPO) increases the proceeds from the IPO and reduces subsequent returns to investors. In another study, Roosenboom et al. (2003) added Dutch elements in the conclusions of Teoh et al. (1998) and documented a negative relationship between the size of differentiated accruals in the first year of the company as a public company and the long-term performance values of shares during the next three years. In addition, Ritter (1991) explored long-term performance of the new entrants on US stock market during the period 1975 - 1984 showed that the low pricing of IPOs is a short term phenomenon that suggests a market in which investors are periodically only overoptimistic for the profit potential of new developing businesses.

Assymetric information in general

In contrast to the assumptions of perfect competition, information in the real world is rarely evenly distributed. In most transactions or agreements with conflicting interests, one of the parts can be in an advantageous position relative to the information it has.

In the theory of contracts, economists classify the forms of asymmetric information typically in two categories of 'adverse selection' (Negative selection) and 'moral hazard' that is often described as the "principal-agent problem". In the first case, the asymmetry is that one party does not know the type of counterparty (hidden type). Akerlof (1970) presents a model where a buyer wants to buy a used car. In the market there are good and bad quality cars and the buyer does not have any information about their quality. Under these circumstances, the price s/he is are willing to pay, is given by the price s/he would pay for a car of average quality if it existed. At this price, the owners of good quality used cars refuse to offer their cars and the only offered cars are the ones of bad quality. The theory of contracts distinguishes two main mechanisms that can alleviate the problem of adverse selection i.e. signaling (CE) and separation (screening). In the first mechanism, the better informed party makes choices in such a way so as to send messages about its quality.

In the second mechanism the less-informed part is the one that chooses ways to distinguish the quality of the informed one. Typically, it constructs the contract in such a way so as to be attractive only to people who have the desired characteristics. The second major problem of asymmetric information i.e. the 'moral hazard” refers to the case where one party may proceed to non agreed and unobservable actions that reduce the profit of the counterparty (hidden action). A typical example is the case where there is separation of ownership and management in a business and the manager spends exorbitant and unnecessary costs (unnecessary trips, luxury offices, etc.) by showing inadequate attention to the real needs of the company s/he manages by damaging in this way the owner and decreasing the profits of the business.

Dessi (2005) presents a model where in the asymmetric information there are three types of players: the entrepreneur, foreign investors and middleman intermediary or VC) which are all neutral to risk. Most of the capital invested in the project of entrepreneur comes from outside investors but also the businessmanr and the middleman also contribute. The intermediary undertakes to oversee the entrepreneur in order to induce him to work effectively (and increase, therefore, the chances of success of the investment) but as the supervision is costly and unobservable by outside investors, the intermediary should have the right incentives. The model assumes an investment in two periods. At the end of the first period information is displayed about the potential success of the project that it can be financed either further or be abandoned. Dessi (2005) examines the characteristics that should be contained in a contract between entrepreneurs and outside investors and intermediaries so as to avoid the possibility of secret cooperation (Collusion) of Venture Capitalists and entrepreneurs at the expense of external investors. This cooperation can take two forms: a) agree that the agent can not effectively oversee b) continue to invest in while the second stage would be preferable to liquidation. He suggests that an optimal contract for the agent resembles to a convertible note or a combination of debt and equity. Moreover, the decision on whether to continue investment in the second period or realize it, should be left on completely to the intermediary thus financing is made into two rounds. Before the start of the second period, the businessman receives information on the progress of the investment.The moral hazard is when the business can manipulate the mechanism that produces this information and thus shows altered data on the quality of the project.

Theories of asymmetric information

Most theories about the IPOs’ underpricing assume that the parties involved in the process of introducing new shares of the company in the stock exchange, do not hold the same amount of information. More specifically, the information provided by the the company issuing the shares, the underwriter and investors is not the same in matters relating to the introduction of the issuing company in the stock exchange.

Information asymmetry among issuers and investors.

Many theories in the international literature converge in "Case Marking", according to which the issuing company could freely underprice its IPO shares in an effort to build a framework of trust among the company and investors. This means that a future sale of shares could be better accepted by investors and even at a higher price than the present.

According to Allen and Faulhaber (1989) companies possess more and better information about their future results compared with information available to investors. Thus, the latter cannot decide if the issuing company is of high or low quality. The initial under pricing of the share price is seen by investors as a mark for the quality of the company since only the "good" companies who are sure about their future development, can recover the cost from the sale of shares at a price lower than the one they really deserve.

The above theory is consistent with the earlier idea proposed by Ibboston (1975), according to which IPOs appear underpriced aiming at issuing future titles at higher prices. Therefore, one of the practical applications of the model is that the companies that attract attention because of their strong devaluation, they sell more shares.

Instead, according to the theory of Levis (1995), it is not proved that the issuers underprice the share price by anticipating benefits by the disposal of new shares. He only agrees that IPOs with higher initial returns are more certain to return faster to the market for a new distribution of shares.

Information asymmetry among issuers and underwriters.

Baron and Homstrom (1980) highlight the possible conflict of interest that exists between the issuing company and the contractor. The latter is driven to set a low import price in order to reduce the cost and time availability and advertising of new shares, while, on the other hand, the issuer prefers to maximize revenue from the placement.

According to Baron’s model (1982) the underpricing of the initial offerings is due to the fact that the underwriter has superior information regarding the conditions prevailing in the stock market and in assessing the possible market value of listed shares. According to this view, the underwriter is essentially responsible for the easy and fast disposal of shares to investors by underpricing the initial offer of share, he creates increased demand resulting in oversubscription of the share (thus the underwriter apart from the normal underwriting fee, he wins from the reduction of cost disposal by increasing, therefore, his revenues). Otherwise, if a high initial offer increases the probability of failure of the coverage of the issue with an impact on the company's inability to raise the capital it wishes then simultaneously a negative climate is created against the reputation and credibility of the underwriter.

The Baron model concludes that it is in the interest of the company to use the services of an underwriter to determine the price and availability of shares.

Information asymmetry among investors

Rock (1986) approaches the effect of IPOs’ underpricing from the side of investors, subdivided them into non-informed and into knowledgeable. Well-informed investors participate in public offering for new securities only when they know that the shares are underpriced and so they will be able to achieve high yields in the trading of the titles in the stock exchange. All other non-informed investors are subscribed in all public offerings making the demand of underpriced shares higher than the one of overvalued since in the first well informed investors participate while they avoid the second. This results in non-informed investors taking larger stake of shares that are eventually overpriced and record overall negative returns from their participation in IPOs. This prevents non-informed investors to participate gradually in the market of new titles, thus significantly reducing the demand for them (case of the winner misfortune). So, the underwriters, in order to maintain their non-informed investors as buyers of new titles, they define an undervalued initial price so as to enable them to cover their losses from their participation in overpriced versions while the well informed investors earn an initial profit price that rewards their informational advantage.

In the theories related to the case of asymmetric information among investors, the research of Welch (1992) is added, according to which well-informed investors subscribed in an offering drag with them all the rest who are non- knowledgeable. However, in case the well-informed investors participate in an initial public offering, the non-informed and indecisive investors by seeing low demand and little interest, they will be lured and they will not participate in their turn to the offering. Therefore, since the objective of underwriters is the coverage of the offering, they determine the price at low levels compared to the market price in order to attract good knowledgeable investors who in turn will drag the less knowledgeable and thus ensure full availability of new shares (Case of influences).

Assymetric information and Signalling Theory

As mentioned above, in practice there may be asymmetric information. This means that under circumstances, the issuers of new titles are likely to possess more information about the course of a business than the information held by investors, so investors are reluctant to purchase the new shares. In this very imperfect information situation, the theory of signaling is based on (Ross 1977). According to this theory the firm uses its capital structure as a mechanism of disclosing to the general investing public its actual value.

The Financial managers can choose to use their financial decisions in order to convey information to the market. Any potential changes to the capital structure of a company constitute a signalling medium to the market on the progress of the company and its configurable value. The announcements of increased debt are accompanied by an increase in the stock price, while decreases are accompanied by price reduction. Dividend increases are usually accompanied by an increase in stock price, and the reductions in stock price declining.

According to Ross (1977), the Financial managers as internal (insiders) factors of the business possess monopolistic access to information on expected cash flows and they will choose to reveal specific signals for the future of the company if they have the right motive to do it. In addition, Ross (1977) suggests that greater financial leverage can be used from managers to reveal an optimistic picture for the future of the business. In contrast, according to Ritter (2003), businesses can initially use the retained profits. When such profits are exhausted, they use borrowed funds and when their borrowing capacity is exhausted then they proceed to raise share capital.


Excerpt out of 30 pages


Asymmetric Information relating to Initial Public Offering Underpricing
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ISBN (Book)
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finance, economics, IPO, assymetric information, underpricing, investors
Quote paper
Fotini Mastroianni (Author), 2012, Asymmetric Information relating to Initial Public Offering Underpricing, Munich, GRIN Verlag,


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