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Unformatted text preview: Financial Management Autumn 2004 pages 5 - 37 Why Has IPO Underpricing Changed Over Time? Tim Loughran and Jay Ritter* In the 1980s, the average first-day return on initial public offerings (IPOs) was 7%. The average first-day return doubled to almost 15% during 1990-1998, before jumping to 65% during the internet bubble years of 1999-2000 and then reverting to 12% during 2001-2003. We attribute much of the higher underpricing during the bubble period to a changing issuer objective function. We argue that in the later periods there was less focus on maximizing IPO proceeds due to an increased emphasis on research coverage. Furthermore, allocations of hot IPOs to the personal brokerage accounts of issuing firm executives created an incentive to seek rather than avoid underwriters with a reputation for severe underpricing. What explains the severe underpricing of initial public offerings in 1999-2000, when the average first-day return of 65% exceeded any level previously seen before? In this article, we address this and the related question of why IPO underpricing doubled from 7% during 1980-1989 to almost 15% during 1990-1998 before reverting to 12% during the post-bubble period of 2001- 2003. Our goal is to explain low-frequency movements in underpricing (or first-day returns) that occur less often than hot and cold issue markets. We examine three hypotheses for the change in underpricing: 1) the changing risk composition hypothesis, 2) the realignment of incentives hypothesis, and 3) a new hypothesis, the changing issuer objective function hypothesis. The changing issuer objective function hypothesis has two components, the spinning hypothesis and the analyst lust hypothesis. The changing risk composition hypothesis, introduced by Ritter (1984), assumes that riskier IPOs will be underpriced by more than less-risky IPOs. This prediction follows from models where underpricing arises as an equilibrium condition to induce investors to participate in the IPO market. If the proportion of IPOs that represent risky stocks increases, there should be greater average underpricing. Risk can reflect either technological or valuation uncertainty. Although there have been some changes in the characteristics of firms going public, these changes are found to be too minor to explain much of the variation in underpricing over time if there is a stationary risk-return relation. The realignment of incentives and the changing issuer objective function hypotheses both We thank Hsuan-Chi Chen, Harry DeAngelo, Craig Dunbar, Todd Houge, Josh Lerner, Lemma Senbet and James Seward (the Editors), Toshio Serita, Ivo Welch, Ayako Yasuda, and Donghang Zhang; seminar participants at the 2002 Chicago NBER behavioral finance meetings, the 2002 Tokyo PACAP/APFA/FMA meetings, the 2003 AFA meetings, Boston College, Cornell, Gothenburg, Indiana, Michigan State, Penn State, Stanford, the Stockholm School of Economics, Vanderbilt, NYU, SMU, TCU, and the Universities of Alabama, California (Berkeley), Colorado,...
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This note was uploaded on 02/17/2012 for the course FIN 4504 taught by Professor Banko during the Spring '08 term at University of Florida.
- Spring '08