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E-MailJay R. Ritter is Joe B. Cordell Eminent Scholar at the University of Florida. This post is based on a recent article by Professor Ritter; Chun Chang, Executive Dean and Professor of Finance at Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University; Yao-Min Chiang, Professor of Finance at National Taiwan University; and Yiming Qian, Associate Professor of Finance at the University of Iowa.
The underpricing of initial public offerings (IPOs), with stocks going public having an offer price that is on average below the market price once the stock starts trading, is a worldwide phenomenon. Explanations for the positive first day returns, which average 10-30% in most countries, largely fall into two categories: 1) compensating investors for the uncertainties, including adverse selection risk, associated with buying newly issued stock of unknown value, and 2) agency problems between issuers and underwriters that result in excessive underpricing.
It is frequently the case that there is a lot of uncertainty about the valuation of a stock before it starts trading. In some cases, there is limited trading before a firm’s IPO, in which case valuation uncertainty is reduced. An example is Facebook’s 2012 IPO, for which there had been trading on SharesPost and SecondMarket. By studying the only mandatory pre-IPO market in the world—Taiwan’s Emerging Stock Market (ESM), we document that pre-market prices are very informative about post-market prices and that the informativeness increases with a stock’s liquidity. Since 2005, Taiwan has required firms going public to trade on the ESM for at least six months before the IPO. The ESM price-earnings ratio shortly before the initial public offering explains about 90% of the variation in the price-earnings ratio using the offer price. However, the average IPO underpricing level remained high during 2005-2011, at 55%, suggesting that agency problems between underwriters and issuers can lead to excessive underpricing even when there is little valuation uncertainty.
There are several features to Taiwan’s IPO market that differ from that of the U.S., aside from the mandatory pre-market trading. First, the direct underwriter fees are low, on average less than 2%, whereas U.S. IPOs with proceeds of $25-125 million almost always pay underwriters exactly 7% of the proceeds. Second, in Taiwan underwriters earn small fees from prospective individual investors, which gives them an incentive to underprice the IPO and attract many potential investors. During 2005-2011 individual investors oversubscribed the median IPO by a factor of 6000%. Third, most of the offerings in Taiwan are much smaller than those in the U.S., with the mean and median proceeds both being only one-tenth as big.
In Taiwan, underwriters collect revenue from three sources when they take a company public. First, they collect direct fees from the company. Second, underwriters collect indirect payments from institutional investors, who are willing to overpay on commissions on other trades in return for receiving allocations of underpriced IPOs. Third, individual investors pay a small fee when they apply to buy an IPO, a source of revenue that is not present in the U.S. The first two sources of revenue are also present in the U.S. when issuers use bookbuilding, but only the first source of revenue is present when issuers use an auction. Our evidence suggests that underwriters deliberately underprice shares for their own benefit. In Taiwan, the revenue of investment banks from underwriting IPOs increases as underpricing increases. With bookbuilding, the procedure used in Taiwan, the U.S., and many other countries for selling IPO shares, underwriters have discretion regarding which institutional investors are allocated shares if an offering is oversubscribed. Consistent with the hypothesis that the underwriters allocate underpriced shares to their favored clients in exchange for brokerage business, we show that an underwriter’s brokerage revenue from other trades also increases with the money left on the table in the IPOs that it underwrites. In addition, the underpricing level increases with the lead underwriter’s incentive and bargaining power to underprice.
Most IPOs in Taiwan are from small companies that sell shares equal to only about 10% of their pre-IPO shares, whereas in the U.S. the companies are bigger and issuers offer shares equal to close to 50% of the pre-issue amount outstanding, on average. The small percentage issue size in Taiwan may partly be a response to the high level of underpricing.
Regulators viewed the average first-day return of 55% during 2005-2011 as excessive, and in 2011 imposed a requirement that the offer price cannot be less than 70% of the pre-market price. This regulation appears to have been binding for many IPOs, and the average underpricing has dropped to 27% since then.
The full article is available for download here.
