Underpricing and the long-run performance of initial public offerings (IPOs) in the U.K

Abstract

The underpricing and long—run underperformance of initial public offerings (IP0s) of common stock are well documented anomalies. The aim of this thesis is to examine why these two anomalies occur. For this purpose we employ a sample of 653 U.K. IPOs listed in the Main Market (official list) and the Unlisted Securities Market (USM) during the period 1984-1992. The thesis has been primarily motivated by the fact that there are not many comprehensive studies examining these anomalies for IPOs in the U.K., particularly with regards to IPOs obtaining a quotation on the official list. We begin the thesis by examining the initial and aftermarket performance of IPOs. In line with previous studies, we find that the IPOs in our sample are underpriced on average by 10.42%. To assess long—run performance after the initial offering we employ the cumulative return and the buy and hold return measures. We compute IPO abnormal returns relative to two market indexes by using three different models: (1) the market—adjusted model, (2) lbbotson's (1975) RATS model and (3) the Fama and French (1993) three factor asset pricing model. We find that new offerings perform poorly in the long—run. A one pound investment in IPOs is worth less than 90 pence after three years. The thesis continuous by investigating the causes of underpricing. We examine the underpricing anomaly from several angles. First, we test the hypothesis that IPOs produce positive short—run returns because of the ex ante uncertainty surrounding their post—issue value. Employing OLS regression analysis, we find the influence of ex ante uncertainty on the level of initial returns to be rather weak. Second, we examine whether issuers intentionally underprice their IPOs in order to signal firm quality. The empirical findings, however, obtained through logit and OLS regression analysis, provide limited evidence in support of this signalling hypothesis. Third, we investigate whether new issues are deliberately underpriced in the IPO premarket. For this purpose we employ the stochastic frontier model pioneered by Aigner et al. (1977). Although we find that IPOs are deliberately underpriced in the premarket, we fail to establish a significant relation between premarket and initial underpricing. Lastly, we evaluate the underwriter price support hypothesis, which posits that the high IPO initial returns are the result of aftermarket inefficiencies. We find, however, on the basis of statistical analysis and Tobit analysis, that this hypothesis cannot explain away positive first day returns. Overall, the results presented in the current thesis point to the conclusion that newly listed firms generate positive returns in the short—run and negative returns in the long— run because they are initially overvalued by optimistic investors.