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Allocations, Adverse Selection and Cascades in IPOs

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1Allocations, Adverse Selection and Cascades in IPOsEvidence from IsraelYakov Amihud1, Shmuel Hauser2 and Amir Kirsh3October 2001Comments are welcome1 Ira Leon Rennert Professor of Entrepreneurial Finance, Stern School of BusinessNew York University2 Associate Professor, School of Management, Ben-Gurion University3 PhD Student, Faculty of Management, Tel Aviv UniversityWe thank Amir Barnea, Eli Berkovitch, Iftekar Hasan, Alexander Ljungqvist and OdedSarig for helpful comments and suggestions. The research was partially financed by theIsraeli Institute for Business Research, Recanati Graduate School of Business, Tel AvivUniversity. We thank Dorit Korner for research assistance and the Library of the TelAviv Stock Exchange for providing data on IPOs.2AbstractThis paper examines three theories of IPO underpricing, using data from Israel where theallocations to subscribers are equally prorated and publicly known. Rock’s (1986) theoryof adverse selection is supported: subscribers receive greater allocations in overpricedIPOs. And, while the average IPO excess return is 12%, the simulated allocation-weighted return to uninformed investors is slightly negative. Welch’s (1992) theory ofinformation cascades is supported by the pattern of allocations: demand is eitherextremely high or there is undersubscription, with very few cases in between. Finally,the theory that underpricing is a means to increase ownership dispersion is tested usingdata on accepted subscriptions and obtains a strong support.11. IntroductionStocks issued in IPOs appear to be underpriced: they earn an average positivereturn immediately following the IPO. This phenomenon has been documented in manycountries.1 This paper tests three theories of underpricing in IPOs by using data from theTel Aviv Stock Exchange (TASE) which make these tests feasible. In addition, a numberof other explanations of underpricing, which are not feasible in Israel, are excluded.The high positive returns observed in IPOs cannot be earned in practice becauseof adverse selection. Rock (1986) proposed that uninformed investors are allocatedgreater quantities in overpriced IPOs and smaller quantities in underpriced IPOs. This isbecause investors who are informed about the issuing company’s value select to invest inunderpriced IPOs. Underpricing is then needed to attract uninformed investors. Inequilibrium, "weighting the returns by the probabilities of obtaining an allocation shouldleave the uninformed investor earning the riskless rate" (Rock (1986), p. 205).Rock's (1986) theory cannot be directly tested in the U.S. where the allocation ofshares to subscribers in IPOs is at the discretion of brokers and varies across subscribers.2It is therefore impossible to simulate the return that would be earned by uninformedinvestors, nor is it possible to examine whether allocations are related to underpricing.In Israel, however, the allocation of securities in IPOs is done by equal prorationto all subscribers and the allocation rate was publicly announced. This enables us todirectly test Rock’s (1986) theory, which we do in two ways.(i) We test for adverse selection by examining whether the allocation to subscriberswas greater in overpriced IPOs. 1 See Loughran, Ritter and Rydkvist (1994), Ritter (1998), Jenkinson and Ljungqvist (2001).2(ii) We simulate the excess return earned by investors who would act as uninformedones -- participate equally in each and every IPO (or subscribe randomly to someIPOs).We obtain that there is adverse selection in IPOs, consistent with Rock (1986). Inaddition, while the average IPO excess return is about 12%, the simulated excess returnto uninformed investors is slightly negative albeit with marginal statistical significance.This may mean that IPOs may have been slightly overpriced. However, investors whomwe call partially informed could slightly improve their performance and earn zero return,as proposed by Rock (1986). These investors were uninformed about the issuing firm,but they could use publicly available information about the market and participateselectively in IPOs that were preceded by high market return or low volatility.The second theory that we examine is that of Welch's (1992) on informationcascades or herding. If investors learn about the value of the issued company byobserving the behavior of other investors, issues will underprice their stock to create acascade or herding of buyers. We finds that indeed investors either subscribedoverwhelmingly to new issues or largely abstained, with very few cases in between,which is consistent with information cascades.Thirdly, we examine the theory that underpricing is a means to increaseownership dispersion after the IPO. Booth and Chua (1996) proposed that the benefit ofgreater ownership dispersion is that it increases stock liquidity which in turn reduces thefirm’s cost of capital. Brennan and Franks (1997) proposed that greater ownershipdispersion serves the interest of managers who do not want to be monitored by large 2 Michaely and Shaw (1994) find results that are consistent with Rock’s (1986) theory by relating IPOunderpricing to the extent of subscription by informed investors which are considered informed.3shareholders, in which case underpricing may be viewed as agency cost. We find strongsupport for this theory: greater underpricing is associated with a larger number ofaccepted subscription in the IPO, controlling for the firm’s size.We find that underpricing is done deliberately: it is a function of some factors thatare known before the IPO price is set. These factors also affect the excess demand in theIPO. The evidence on deliberate underpricing casts doubt on the view that the initial IPOreturns, which measure underpricing, are a result of fads and irrational demand, as hasoften been suggested. Our evidence shows that underpricing is greater when the IPO ispreceded by a rise in market prices, meaning that issuers are not fully raising the issueprice when market conditions are favorable. This evidence is consistent with theLoughran and Ritter’s (2001) proposition that issuers do not mind “leaving money on thetable” when they raise in the IPO more than they have expected.Our setting enables us to exclude some theories on underpricing which are notaccommodated by the institutional framework in Israel. Ruud (1993) suggested that IPOsgenerate an average positive excess returns because underwriters are engaged in


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