Over-Going Public, IPO Mispricing, and Long-Run Underperformance .1 Over-Going Public and IPO Mispricing

Purnanandam and Swaminathan (2004) proposed that if security prices are not efficient in the short run, then the IPO “fair value”is not identical to the first-day market price, but presumably to some notion of the long-run fair value. Extended from this thought, we propose that the long-run fair value is the intrinsic value of the firm’s equities as all the private information is revealed. (In our model, the firm’s type will be realized as long as the project is completed.) So, in comparison with the firms’intrinsic value, we find that good management quality firms underprice their IPOs, but bad ones overprice their IPOs. In such a circumstance, IPOs are not necessarily underpriced. Next, in Corollaries 4.1 and 4.2 we are going to demonstrate how IPOs are mispriced due to the existence of asymmetric information.

Corollary 4.1 From the proof of Proposition 4.2, the equilibrium m_^G 1 pushes good firms to underprice their IPOs and forms a situation of over-going public.

Considering the case when there were no information asymmetry between the firm and outside investors, the investors could fully identify a firm’s management quality. In the case where  equals approximately one, the intrinsic value of a sure

good firm going public, V_^G, is J;⁹ while that for a non-going public firm, NVG

1, is .¹⁰ The first-best decision for the good firm should not go public.

However, why does the good firm choose to go public even though it is not the first-best decision? We prove that asymmetric information does exist, which pushes the good firm to go public so that the firm would not be regarded as a bad one. This is regarded as a phenomenon of over-going public.

A further comparison is made between the expected value of a good firm’s IPOs and the intrinsic value of a good firm’s equities. The expected value of the good firm’s IPOs is expressed as p_^I (1 )(1p_^I )J

1

1 

 and the intrinsic value of its

equities is J. Except under the circumstance of symmetric information where

1 1



pI , the good firm underprices its equities to go public.

This corollary is similar with the prediction from Welch’s model (1989). In that model, the asymmetric information also originates from the unverified management quality, but there are three different features of the reputation model. First, this model identifies how IPOs are mispriced at the offering price relative to their

“intrinsic value”. Second, the model proposes that good management quality firms underprice their IPOs to certify they are good, so that going public feeds back the reputation value to their remaining equities. In Welch’s model, high-quality firms underprice at their IPOs in order to obtain a higher price at a seasoned offering.

Third, we are going to propose in Corollary 4.2 that bad management quality firms overprice at their IPOs. In Welch’s model, a high imitation cost may induce low-quality firms to reveal their quality voluntarily. This is a distinctive feature which differs a lot from the predictions of most theoretical models, ending with the conclusion that the average IPO is undervalued at the offer price. Next, a detailed analysis on it is offered.

The other result from Proposition 4.2 concludes that firms with good reputations

9 Calculated from equation (4.6) asp_^I 1. 10 Calculated from equation (4.3) as 1

1 

NI

p .

will choose to go public, no matter whether they are good or bad. Hence, a poor management quality firm chooses to go public as long as it has a good name. This raises another question here: what about a golden goose that is not golden any more?

The model proposes that a low quality firm may take advantage of its good name to go public, while unfortunately it fails in its new project.

Corollary 4.2 From the proof of Proposition 4.2, the equilibrium m_S^B 1 prompts bad firms to overprice their IPOs and forms a situation of over-going public.

Due to the existence of asymmetric information, investors are also unable to identify the quality of a firm. In the case where  equals approximately one, the intrinsic value of a sure bad firm going public, V_^B, is 1J;¹¹ while that for a non-going public firm, NV^B

1, is1.¹² The first-best decision for the bad firm should be to not go public. However, why does the bad firm choose to go public even though it is not the first-best decision? We prove that the asymmetric information does exist, and that the bad firm takes the chance to mimic the good firm’s strategy of going public so that the real type of the bad firm is not revealed.

Again, this is also regarded as a phenomenon of over-going public.

A comparison is also made between the expected value of a bad firm’s IPOs and the intrinsic value of a bad firm’s equities. The expected value of a bad firm’s IPOs is expressed as p_^I (1 )(1p_^I )J

1

1 

 and the intrinsic value of its equities is

J



1 . Except under the circumstance of symmetric information where 0

1 

I

p ,

the bad firm takes the chance to overprice its equities.

As we identify the magnitude of IPO mispricing by comparing the offering price with the firm’s intrinsic value, instead of with the first-day market price, this

11 Calculated from equation (4.7) asp_^I 0. 12 Calculated from equation (4.3) as 0

1 



pNI .

theoretical model consequently offers a different perspective on IPO mispricing and further supports the empirical evidence of IPO overpricing (Purnanandam and Swaminathan, 2004). Behavioral theorists also have suggested that investors’ overconfidence about private information could cause an initial overvaluation on securities (Daniel, Hirshleifer, and Subrahmanyam, 1998). This section proposes that investors’overconfidence may originate from the firm’s good reputation. When observing the firm’s past success, investors tend to be optimistic about the firm’s prospects and there is no doubt that the bad firms will take advantage of their good names to overprice the IPOs.

4.4.2 IPO Long-Run Underperformance

Following from the analysis of Corollary 4.2, the phenomenon of over-going public as well as IPO overpricing offers an alternative perspective to interpret the IPO long-run underperformance and the sharp decline in survival rates found in some empirical studies (e.g. Ritter, 1991; Teoh et al., 1998; Fama and French, 2004 and Purnanandam and Swaminathan, 2004, etc.).

First, this model proposes that bad firms overprice their new equities to go public, but firms’types will be realized after the project is completed. At that time, the overpriced equities will revert to their intrinsic value, and long-run underperformance emerges. As stated in Purnanandam and Swaminathan’s study (2004), IPOs are overvalued at the offer price, tend to run up in the after-market, and are follow ultimately by long-run reversals.

Second, firms with good reputations are more likely to go public. Bad firms which take advantage of their good names to go public are more likely to face long-run underperformance. Schultz (2003) offered an explanation for the phenomenon that more IPOs follow successful IPOs. When the followers carry a large fraction of the sample and also underperform in the market, then the average returns of all the IPOs tend to be low. Shefrin (2002) summarized his study from the viewpoint of behavioral finance. He suggested that firms are more likely to issue new shares when they face a window of opportunity and that their stocks are overvalued. The investors at the same time expect a continuation and bet on trends.

They overweight the recent past when making long-term projections and thus suffer

from long-term underperformance. Teoh et al. (1998) attributed the long-run underperformance to the deliberate manipulation of the IPO firm’s reputation by adopting discretionary accounting accrual adjustments that raise reported earnings relative to actual cash flows before IPO.

Third, the activity of the bad firm going public also ends up with a sharp rise in the de-listing rate. According to Fama and French (2004), the ten-year de-listing rates for new listings rose from 26% for 1973-1979 to 44.2% for 1980-1991. They suggested that the sharp decline in survival rates is due to a drop in the cost of equity that allows firms of poorer quality as well as firms with distinct future payoffs to go public.

The reputation model also concludes a similar implication regarding the long-run underperformance and the sharp decline of IPOs’survival rates. This model implies that as long as the bad-quality firm is able to obtain a good name before going public, no matter by luck or through deliberate manipulation, then it takes advantage of its good name to go public so as to be perceived as a good-quality firm. Under such a circumstance, reputation plays a negative role in IPO activity.