We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective is threefold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena. Instead, we believe future progress in the literature will come from nonrational and agency conf lict explanations. We describe some promising such alternatives. From 1980 to 2001, the number of companies going public in the United States exceeded one per business day. The number of initial public offerings ~IPOs! has varied from year to year, however, with some years seeing fewer than 100 IPOs, and others seeing more than 400. These IPOs raised $488 billion ~in 2001 dollars! in gross proceeds, an average of $78 million per deal. At the end of the first day of trading, their shares traded on average at 18.8 percent above the price at which the company sold them. For an investor buying shares at the first-day closing price and holding them for three years, IPOs returned 22.6 percent. Still, over three years, the average IPO underperformed the CRSP value-weighted market index by 23.4 percent and underperformed seasoned companies with the same market capitalization and book-to-market ratio by 5.1 percent. In a nutshell, these numbers summarize the patterns in issuing activity, underpricing, and long-run underperformance, which have been the focus of a large theoretical and empirical literature. We survey this literature, focusing on recent papers. Space constraints force us to take a U.S.-centric point of view and to omit a description of the institutional aspects of going public. The interested reader can consult Ellis, Michaely, and O’Hara ~2000!,

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A Review of IPO Activity, Pricing, and Allocations

Brokerage analysts frequently comment on and sometimes recommend companies that their firms have recently taken public. We show that stocks that underwriter analysts recommend perform more poorly than “buy” recommendations by unaffiliated brokers prior to, at the time of, and subsequent to the recommendation date. We conclude that the recommendations by underwriter analysts show significant evidence of bias. We show also that the market does not recognize the full extent of this bias. The results suggest a potential conflict of interest inherent in the different functions that investment bankers perform.

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Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

We find that the underperformance of IPO stocks relative to the market over a three-year holding period is less severe for IPOs handled by more prestigious underwriters. Consistent with prior studies, we also find that IPOs managed by more reputable underwriters are associated with less short-run underpricing. Among the various existing proxies for underwriter reputation, the Carter-Manaster measure is the most significant in the context of initial returns and also in the context of the three-year performance of IPOs. The study also provides an updated list of the Carter-Manaster measure for various underwriters. A SUBSTANTIAL BODY of work within the initial public offering (IPO) of common stock literature examines the effects of underwriter reputation on the initial performance of IPOs (see, among others, Logue (1973), Beatty and Ritter (1986), Titman and Trueman (1986), and Maksimovic and Unal (1993)). The financial press provides some evidence of the correlation between IPO performance and underwriter reputation (see Forbes June 20, 1994). However, no prior academic work has documented the relation between the long-run performance of IPOs and different proxies for underwriter prestige. This study has two primary objectives. First, it examines the initial returns and the three-year returns following the IPOs and the relationship of those returns with underwriter reputation. Second, the study provides a comparative evaluation of three existing measures of underwriter prestige in the context of initial returns and also in the context of the three-year performance of IPOs. Several proxies for underwriter reputation have been developed -in the IPO literature. Logue (1973) and Beatty and Ritter (1986) are among the first to develop a measure of underwriter reputation. Carter and Manaster (1990) use underwriters' relative placements in stock offering "tombstone" announcements. The Carter-Manaster (CM) system is not unlike the starring order appearing in Hollywood's billboards. The compilation of the CM measure is a fairly tedious process because each tombstone has the potential to impact the ordering of each underwriter's relative position in the data bank. On the other hand, the Johnson and Miller (1988) and Megginson and Weiss (1991) measures require less effort to construct. Johnson and Miller (JM) use a modified form of the Carter and Manaster method. JM classify

https://www.jstor.org/stable/pdfplus/117442.pdf

Underwriter Reputation, Initial Returns, and the Long‐Run Performance of IPO Stocks

This paper empirically analyzes the determinants of an initial public offering (IPO) and the consequences of this decision on a company's investment and financial policy. We compare both the ex ante and the ex post characteristics of IPOs with those of a large sample of privately held companies of similar size. We find that (i) the likelihood of an IPO is positively related to the market-to-book ratio prevailing in the relevant industrial sector and to a company's size, (ii) IPOs are followed by an abnormal reduction in profitability, (iii) the new equity capital raised upon listing is not used to finance subsequent investment and growth, but to reduce leverage, (iv) going public reduces the cost of bank credit; (v) it is often associated by equity sales by controlling shareholders, and is followed by a higher turnover of control than for other companies.

Why Do Companies Go Public? An Empirical Analysis

We investigate the long-run underperformance of recent initial public offering (IPO) firms in a sample of 934 venture-backed IPOs from 1972-1992 and 3,407 nonventurebacked IPOs from 1975-1992 We find that venture-backed IPOs outperform nonventure-backed IPOs using equal weighted returns Value weighting significantly reduces performance differences and substantially reduces underperformance for nonventure-backed IPOs In tests using several comparable benchmarks and the Fama-French (1993) three factor asset pricing model, venture-backed companies do not significantly underperform, while the smallest nonventure-backed firms do Underperformance, however, is not an IPO effect Similar size and book-to-market firms that have not issued equity perform as poorly as IPOs RITTER (1991) AND LOUGHRAN and Ritter (1995) document severe underperformance of initial public offerings (IPOs) during the past twenty years suggesting that investors may systematically be too optimistic about the prospects of firms that are issuing equity for the first time Recent work has shown that underperformance extends to other countries as well as to seasoned equity offerings We address three primary issues related to the underperformance of new issues First, we examine whether venture capitalists, who specialize in financing promising startup companies and bringing them public, affect the long-run performance of newly public firms We find that venture-backed firms do indeed outperform nonventure-backed IPOs over a five-year period, but only when returns are weighted equally

Myth or Reality? The Long‐Run Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital‐Backed Companies

We test the empirical implications of several models of IPO underpricng. Consistent with the winner’s-curse hypothesis, we show that in markets where investors know a priori that they do not have to compete with informed investors, IPOs are not underpriced. We also show that IPOs underwritten by reputable investment banks experience significantly less underpricing and perform significantly better in the long run. We do not find empirical support for the signaling models that try to explain why firms underprice. In fact, we find that (1) firms that underprice more return to the reissue market less frequently, and for lesser amounts, than firms that underprice less, and (2) firms that underprice less experience higher earnings and pay higher dividends, contrary to the models’ predictions.

The Pricing of Initial Public Offerings: Tests of Adverse-Selection and Signaling Theories

To investigate the effect of reputation on auditor business decisions, we look at the relationship between auditor reputation and the characteristics of the IPOs that auditors take to the market. Consistent with our hypotheses, we find that: 1) More prestigious auditors are associated with IPOs that seem a priori less risky; 2) the market perceives as less risky the IPOs that are associated with more prestigious auditors; and 3) IPOs' long-term performance is related to the prestigious of the auditor employed.

Does the Choice of Auditor Convey Quality in an Initial Public Offering

This study analyzes how firms choose between a spin-off and an equity carve-out as a way to divest assets. Using a sample of 91 master limited partnerships that were issued to the public, we find that riskier, more leveraged, less profitable firms choose to divest through a spin-off. The spin-off firms are smaller and less profitable than the carve-out firms. This suggests that the choice is affected by a firm's access to the capital market: Greater scrutiny and more stringent disclosure are required in carve-outs relative to spin-offs. We do not find support for the hypotheses that management attempts to leave undervalued assets in the hands of current shareholders or that parent organizations' need for cash are the driving motives behind the divestiture choice. Little, if any, support is found for operating efficiencies as a reason for these transactions. Both spin-off and the carve-out firms underperform the market by a wide margin. The spin-off parents experienced significantly poor performance, while carve-out parents' performance was commensurate with their control groups.

Wayne H. Shaw

Papers

The Pricing of Initial Public Offerings: Tests of Adverse-Selection and Signaling Theories

Does the Choice of Auditor Convey Quality in an Initial Public Offering

The choice of going public: spin-offs vs. carve-outs