IPO Underpricing, Insider Selling and Subsequent Equity Offerings: Is Underpricing a Signal of Quality?

Jon A. Garfinkel

doi:10.2307/3665967

Recent papers posit that a firm may deliberately underprice its IPO in order to inform the market that the firm is of high quality. These papers argue that underpricing is a vehicle whereby firms can signal their favorable private information and thereby increase the price received in subsequent securities offerings. Similarly, insiders may also recoup the costs of underpricing through subsequent open market sales of their shares at a more favorable price. I test the implications of these models and find evidence generally inconsistent with their predictions. Specifically, I examine the relationship between IPO underpricing and the likelihood of returning to the market with a seasoned equity offer or an open market insider sale. Overall, I find no significant relation between IPO underpricing and the probability of reissue, after controlling for factors that may affect both underpricing and the probability of reissue. In addition, I find no relationship between underpricing and the probability of an open market insider sale. Thus, it appears that firms are not underpricing in a deliberate effort to inform the market of their quality. This paper builds on previous research that tests the implication of signalling by underpricing theories, that underpricing is positively related to the probability of the firm selling additional equity in the future. In particular, this is the first paper that recognizes the importance of open market insider sales as a means for recouping the losses due to underpricing. It is also the first paper that controls for the partial adjustment phenomenon in underpricing as well as other factors that may affect both underpricing and reissue activity, in the tests of the signalling theory implications. Specifically, prior research has noted the possibility that factors affecting underpricing may also affect the likelihood that a firm will reissue equity. For example, proxies for growth opportunities may affect underpricing since growth opportunities are more difficult to evaluate than tangible assets, causing greater uncertainty about the value of the firm. Moreover, firms with many growth opportunities are more likely to require additional outside financing in the future, implying a greater probability of returning to the equity market with a seasoned equity issue. However, other research has shown that underpricing is also related to the partial adjustment phenomenon. Briefly, partial adjustment occurs when investment bankers partially adjust the share price and number of shares issued in response to strong demand for an IPO during the pre-offer period (the time when underwriters gather information on demand for the issue). Since this adjustment is partial by design, the share price will rise in the secondary market once trading begins. Thus, underpricing is greater for issues where the price has been adjusted during the pre-offer period than for issues that have not. Moreover, upward adjustment in price and shares offered leads to greater proceeds at the IPO, perhaps mitigating the need to reissue equity. As a result, this partial adjustment phenomenon must be controlled for when testing for a relation between underpricing and the likelihood of a seasoned equity offer. I find that underpricing does not materially affect the likelihood of reissuing equity for a sample of 494 IPOs issued between 1981 and 1983 inclusive, after controlling for proxies for ex-ante uncertainty and the partial adjustment phenomenon. Specifically, my measure of the sensitivity of the probability of reissuing equity to underpricing is statistically indistinguishable from zero when I include proxies for ex-ante uncertainty and partial adjustment variables in my analysis. I find the same lack of a relationship when I examine the effect of underpricing on the probability that an insider will sell shares in the open market within two years of the IPO. My findings have implications for both investors and entrepreneurs of firms preparing to "go public." Investors should recognize that observed underpricing of the IPO does not guaranty high quality of the firm. Entrepreneurs can better understand the factors affecting underpricing and the importance of it (or lack thereof) in influencing investors' beliefs about firm quality.

IPO Underpricing, Insider Selling and Subsequent Equity Offerings: Is Underpricing a Signal of Quality?

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