Empirical evidence on book-building method and IPO underpricing
by Wong Yui Cheong Andrew
vi, 54 leaves : ill. ; 30 cm
Over the past few decades, the phenomenon of under-pricing in initial public offerings ("IPOs") has been widely studied. Many theories have been proposed in an attempt to solve the well-known mystery of IPO under-pricing. In this paper, I will conduct a brief survey on some profound IPO studies. Some major research areas and findings will be discussed....[ Read more ]
Over the past few decades, the phenomenon of under-pricing in initial public offerings ("IPOs") has been widely studied. Many theories have been proposed in an attempt to solve the well-known mystery of IPO under-pricing. In this paper, I will conduct a brief survey on some profound IPO studies. Some major research areas and findings will be discussed.
In particular, I will study the impact of the US book-building method on the IPO's short-term performance. Up to now, there has been relatively little research attempting to relate the US styled book-building method and the pronounced under-pricing of new issues. Built on the traditional theories of information asymmetry, I do expect that the degree of IPO under-pricing should be reduced when the book-building method is adopted to "arrow" the information gap between the investors, issuers, and the underwriter.
According the theories of information asymmetry, information gap between the issuer and the underwriter lead to share under-pricing so as to compensate the underwriter for bearing the additional perceived risk. Lesser degree of under-pricing is expected on the book-building method where more market information, e.g. market demand, about the shares is revealed to the concerned parties. Underwriters will have a better idea on the prospective market demand on the issues through meeting with the institutional investors, conducting roadshows as well as other advertising programs.
Considering the book-building method is an effective means of conveying valuable signal to the investor, I proposed that the book-building method might reduce the degree of under-pricing of new issues in two perspectives. First, it reduces the perceived uncertainty on the true value of the new issue. Assuming investors are risk-averse, the required rate of return decreased and degree of under-pricing reduced. Second, the book-building method does not only reduce the perceived uncertainty of the new issue, but also acted as an effective means to reveal the true type of the firm to the investor. It is because only good firms are willing to "burn the money" (the book-building method is costly) and the bad type firm will find it too costly to mimic the good firm as there is always a chance that their true type is revealed to the public during the process. Therefore, firms going book-building can be interpreted as a good signal to the investors.
In this paper, I will, in particular, study the effect of the book-building method on the degree of IPO under-pricing with the use of IPO data in Hong Kong. The Hong Kong IPO data was used because its unique regulatory feature regarding the methods of issuing new shares. The primary market of Hong Kong is special in a sense that it allows both the US styled book-building method and the UK styled fixed price offer to be used.
In this study, 246 Hong Kong IPO data from 1993 to 1997 were selected and reviewed. Unlike most of the previous studies where the initial returns of IPOs are adjusted by the market return over a one-day period, the initial returns of all IPOs are adjusted by the market return over the period from the first day of subscription to the first day of trading. It is believe that this new definition of market adjusted initial return better reflects the degree of under-pricing as the issue price of a new issue is usually determined shortly before the first day of subscription period. The empirical results suggest that the adoption of the book-building method does play a role in affecting the degree of under-pricing in new issues. The captioned theoretical propositions are not objected to.