IPO underpricing of A-shares in China

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UNIVERSITEIT VAN AMSTERDAM

IPO underpricing of

A-shares in China

Ruben Fuentes Rodriguez (10460810) Supervisor: P.V. Trietsch

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Statement of originality

This document is written by Student Ruben Fuentes Rodriguez who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

In this thesis, the high first day returns of Chinese IPOs are examined in the period 2006-2015. For this study a sample of 527 Chinese A-shares IPOs issued in China is used. The average underpricing found in the period 2006-2015 is 17.1%. Although this underpricing is significantly lower than previous studies in the period 1990-2006, the drivers of underpricing are still consistent with previous literature. The time gap between announcement and issuing the IPO has a positive effect on underpricing. Also, the size of the offering is found to be significant with a negative relationship. Furthermore, during “the great recession,” a period of increased underpricing is found.

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1. Introduction

When a company issues its stock to the public for the first time, it is called an Initial Public Offering (IPO). An IPO is underpriced when the first day closing price is higher than the offering price. IPO underpricing is a well-known phenomenon in finance literature. Therefore, many studies have been conducted on IPO underpricing. Ibbotson (1975) and Ritter (1986) find that on average, almost all IPOs are underpriced. Studies by Ibbotson (1975) and by Beatty and Ritter (1986) report 11.4% and 18.8% underpricing, respectively. Issuing an IPO can bring several general costs, such as underwriter fees and administration expenses. However, a third interesting cost can arise, which is often referred to as “money left on the table” (Ritter, 1987). This is, in other words, the underpricing of an IPO because the share is priced below market value.

In China however, underpricing is significantly higher than in other stock markets. China has a relatively new stock market, the foundation of which was laid in 1990. In 1990, the Chinese state introduced three kinds of shares: A-shares, B-shares, and H-shares. A-shares were only available to Chinese investors, whereas B- and H-shares were only available to foreign investors. Previous literature states that underpricing in China is above average, mainly with regards to the shares. Chan et al (2004) report an average underpricing of 178% on shares’ IPOs on the first trading day, and Tian (2011) measures a 247% initial return for A-shares. The initial return is the return on the first trading day.

Practically all research done on underpricing in the Chinese market has been conducted examining the period 1990-2006. In the period 2004-2011, China reformed the pricing of IPOs, aiming to fight the high underpricing. For this reason, looking at the existing literature and the change in pricing IPOs, most studies are outdated. A more recent study is needed to update existing literature and to include the financial crisis of 2007-2009. This study provides a contribution to the existing literature by using a dataset covering the period 2006-2015. The research question of this paper is as follows: Were newly issued A-shares underpriced in the period 2006-2015, and what are the determinants of this underpricing?

The model used in this study contains the following main variables: Lag, deal size, and two dummy variables: underwriter and crisis. Lag is defined as the time between the announcement and the issue date of the IPO. Deal size is the value of the IPO. A high deal value is associated with an established company, which reduces underpricing (Carter, et al, 1998). The underwriter dummy variable takes the value 1 if the underwriter is prestigious, and 0 if the underwriter is not. “Prestigious” indicates that the underwriter is part of the six biggest underwriters in China. The dummy variable crisis takes the value 1 if the IPO occurred during the financial crisis (2007-2009) and 0 otherwise.

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5 The sample used, consists of 527 Chinese IPOs from the period 2006-2015. The offer price and underwriters were retrieved from the Thomson One database. The announcement date and deal value were retrieved from Zephyr, and the closing price was obtained from DataStream.

This thesis is constructed as follows: chapter 2 describes the features of the Chinese market, chapter 3 contains the literature review of classical IPO underpricing theories, chapter 4 includes methodology, regression and results obtained, and chapters 5-7 contain the conclusion, limitations, and recommendations, respectively.

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2. Features of the Chinese market

2.1 The Chinese IPO market

This chapter describes the features of the Chinese market. First, it provides a short summary of the history of the stock exchanges. Then, the regulatory characteristics of the stock markets are explained, followed by the process required for companies to issue an IPO. Following the pricing mechanism of IPOs in China is discussed. The last part of this chapter contains a summary of existing literature. Also relevant variables from previous literature are examined and serve as a foundation for the regression used in chapter 4.

2.1.1 China’s exchanges

The Chinese stock market is one of the youngest stock exchanges in the world. The Chinese stock market consists of two separate exchanges, the Shanghai Exchange, which was established on December 19, 1990, and the Shenzhen Exchange, established on July 3, 1991 (Chiu et al. 1998). Since the Chinese economy is one of the fastest growing economies in the world, the importance of the Chinese stock markets is rising.

According to Chan, Wang and Wei (2004), there were three types of shares in China:

• A-shares, which are ordinary domestic shares, but which are only available to Chinese investors, not to foreigners.

• B-shares, which are shares available to foreigners, but not Chinese investors. • H-shares, which are available to foreigners, but listed in Hong Kong.

A- and B-shares have the same voting and ownership rights. The difference, however, is that A-shares are denominated in Chinese Renminbi, and B-shares in U.S. dollars. H-shares are denominated in Hong Kong dollars. Another difference arises in prices, as Chinese and non-Chinese investors pay for practically the same shares, but B-shares are generally traded at a discount (below par value) compared to A-shares (Bailey,1994). The majority of shares issued are A-shares. The issuance of B-shares is limited by the Chinese government. The difference in shares, lies in the motivation of the Chinese state. Fernald and Rogers (1998) argue that China is motivated to restrict access by foreign investors, in order to control capital flows.

In 2002 however China adopted the Qualified Foreign Institutional Investor Program (QFII). This program allows foreign investors to buy A-shares. Foreign investor can buy A-shares once a month and no more than 20% of his Chinese shares (Robinson et al, 2013). Although the access for foreign investors is limited, the most interesting shares at the moment are A-shares.

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2.1.2 Regulatory characteristics

China has a stock market that is far from a free stock market. The Chinese state appointed a commission to monitor, and when necessary, intervene in the stock market. The interventions can lead to ex-ante uncertainty among investors. Ex-ante uncertainty is one of the drivers of the winner’s curse theory (see chapter 3), which is a possible explanation for underpricing. This commission is called the China Securities Regulatory Commission (CSRC) (Aharony et al, 2000).

One of the most important characteristics looking at the Chinese stock market is the quota of new shares. The state council sets a quota for new shares annually, so only some of the companies actually succeed in going public. (Aharony et al,2000). Since the CSRC only gives permission to a select amount of companies to go public, the supply of new shares is limited. One consequence is that Chinese investors only have limited investment options for their capital. They can either deposit their money into their bank account, or invest in the limited amount of shares (Tian,2011).

Another reason for the limited supply of shares in China is the proportion of state-owned shares in China. The state-owned shares are not part of an IPO, but companies have to offer shares to the government so that the state has control over the stock market (Liao et al, 2014). Mok and Hoi (1998) mention there are some “unique Chinese characteristics” regarding stock ownership structure and institutional arrangements. Chinese companies can only issue a limited amount of shares, because the government on average owns 60% of the shares. This proportion of shares cannot be traded on exchanges, and therefore contributes to the limited amount of shares available (Pistor & Xu,2005). In other words, the new issued shares on the market only represent a small proportion of the outstanding stocks. Because the majority of shares are owned by the government, the speculation on the first trading day will be higher (Chan et al, 2004). Therefore, when the government owns a large proportion of the stock a positive correlation with underpricing can be expected.

2.2 IPO process

2.2.1 Approvals

Because of the limited options for Chinese investors to allocate capital, when a new issue is announced there is a run on these newly issued shares. For example, in August 1992, over half a million people queued for days to get application forms for a lottery to buy shares from 14 new issues. The people in the queues did not know which company the shares were for, let alone information about the value of the companies (Mok & Hui, 1998). After this so called

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8 “lottery system,” China chose another system, and now uses an allocation system for new shares. With this new system IPOs are announced months before the issue. This creates a large gap between the announcement and the issue date, which is an important characteristic in the Chinese stock market.

A company seeking listing has to go through a multi-step selection progress. The first step is to get approval from the CSRC, which is the overseer of the entire process. After this first step another approval is necessary from the relevant local and national authorities. The next step is an inspection by the listing committees of the relevant stock exchange (Aharony et al, 2000). After the approvals, the IPO has to be officially announced by the company or underwriter. The CSRC also determines which companies are selected to go public, and the same goes for the amount of shares issued. In contrast to, for example, the Securities and Exchange commission in the United States, the CSRS is not independent, it functions as a ministry of the Chinese state (Chan et al, 2004).

2.2.2 Pricing

Kimbro (2005) explains that the prices of new shares in China are also determined by the CSRC. From 1993 to 1999 the prices for IPOs were “fixed.” The prices were set around a multiplication of 13-15 times the earnings per share (EPS). In July 1999, a new method was introduced by the CSRC: the cumulative auction method (Cheung et al,2009) In this method, underwriters determine a price by setting a price range and then seek investors within that range. The idea was the method should bring IPO pricing more in line with the demand of investors. This works well for developed markets, but did not work for the Chinese stock market because high underpricing continued.

In 2000 the cumulative auction method caused more underpriced IPOs. In 2001, the cumulative auction method was adjusted to cool down IPOs that had an extremely high EPS ratio, by setting an upper limit. This restriction was subject to all industries; although every industry is different, the CSRC ignored the different characteristics of each industry. In 2005 the cumulative price inquiry from the institutional investor method was introduced. With this method, underwriters are allowed to seek demand from institutional investors.

In 2010 China introduced the so-called Book-Building system, which had become dominant across the world at that time. The Book-Building system was introduced and the somewhat fixed-price systems were abandoned, which was a significant step for China. The purpose of this system was to make the offer price more accurate and deal with the extreme underpricing in the Chinese market (Linh et al, 2013).

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2.3 IPO underpricing in China

The limited supply of shares (see chapter 2.1.2) causes a spike in demand when a new IPO is announced. This increased demand results in a price increase on the first trading day, also known as underpricing (Chan et al, 2004). The previously mentioned initial return of 247% calculated by Tian (2011) is not the only study reporting such extreme returns. The most extreme first day return measured in the Chinese stock market is 949% (Su and Fleisher, 1999). The table below contains a summary of the most important papers on underpricing in China, with initial returns ranging from 145% to 949%. Practically every study on IPO underpricing in China reports this is a short-term phenomenon, and the shares do not outperform the market in the long run. The average initial return in emerging markets is 60%, which is lower than the returns measured in China (Jenkinson & Ljungqvist, 2001).

Table 1: Summary of existing literature

Papers Average initial return

Mok and Hui (1998) 289%

Kim, Rui, and Xu (1999) 594%

Su and Fleisher (1999) 949%

Chau et al (1999) 546%

Chen, Firth an Kim (2000) 546%

Chi and Padgett (2002) 127%

Chen et al (2004) 145%

Tian (2003) 267%

Source: Ting and Tse (2006). (Initial return is the first day return of the share)

The studies listed above have several, sometimes different explanations for the extreme underpricing. In the remainder of this chapter the most important variables will be defined. The variables explained, serve as a foundation for the regression used in chapter 4. The other variable used in chapter 4 is underwriter which will be defined in chapter 3.

Lag

The first determinant mentioned in practically every study is the time between the announcement date and the issue date, sometimes referred to as “lag” or “time gap.” When an IPO is announced investors can subscribe for shares. Before the issue gets listed and actually goes public the investors have to wait (the time gap). In this period investors who subscribed for the IPO cannot trade their shares, the shares are illiquid. This illiquidity, caused by the time gap induce a so called ‘’lock-up risk’’, a form of ex-ante uncertainty (Tian, 2003). According to Ting and Tse (2006), the ex-ante uncertainty results in high underpricing, which is a compensation for the ‘’lock-up risk’’. The relationship between underpricing and ex-ante uncertainty is also supported by Beatty and Ritter (1986). Ex-ante uncertainty also causes a winner’s curse problem, which will be discussed in chapter 3.

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Size

The second often mentioned determinant of underpricing is the size of the offering, seen for example in the study by Chau et al (1999). The size of the offering is related to more established firms. So the bigger the size of the offering, the more ‘’established’’ firms are. With more established firms, investors believe there is more certainty – for example that there is less chance of the company going bankrupt (Chi and Padgett, 2002). Beatty and Ritter (1986) explain that small offerings, often referred to as “less safe,” have higher uncertainty. The higher uncertainty is, the higher speculation is, and this causes underpricing.

Recession

China is one of the fastest growing economies globally, and therefore is connected to almost every economy in the world. When the “great recession” broke out in 2007, the Chinese stock market also was affected because of its connection to other economies. The Chinese stock market dropped continuously during the period from 2007-2009. Mahmood et al. (2011) reported increased uncertainty in the period 2007-2009. This increased uncertainty was due to the financial crisis.

Government

According to many studies, a high percentage of state-owned shares is one of the reasons for underpriced IPOs. High ownership by the state might indicate high ex-ante uncertainty, and may signal that the share has a low level of marketability (Keasey and Short, 1992). Furthermore, as was previously shown, high ex-ante uncertainty causes higher underpricing in the IPO market. On the other hand, high equity retention could signal the owner’s faith in the company and thereby lower ex-ante uncertainty (Mok et al,1998). Thus, evidence can be found supporting both sides, which makes this an interesting factor in underpricing. There are many more factors that could cause underpricing, but for the Chinese market the variables time-gap, size and ‘’ the great recession’’ are the most important and occur most frequently in studies.

Another important variable in the examination of underpricing is the age of the firm. Similar to the size of the offering, an older firm signals a more trustworthy company. Because a company is older, investors have more faith in future earnings (Kim et al,1999). This trust results in less underpriced IPOs for older firms. Unfortunately, no information about the age of firms was available from the databases consulted. A possible explanation for the fact that other studies do have this data is due to their ability to access Chinese databases.

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11 Another possible cause mentioned in several studies is the lottery system, which results in huge speculation. The initial returns are largest under the previously mentioned lottery system and the smallest under the auction system (Tian, 2003). The Chinese IPO market adopted the Book-Building approach, which is used by many developed countries. For this reason, the lottery system is not a relevant factor of the underpricing in China today.

3. Literature review

The literature review consists of examining three general IPO underpricing theories. Namely, the underwriter theory and theories based on asymmetric or symmetric information.

3.1 IPO underpricing theories

IPO underpricing is a well-known phenomenon in finance literature. A large body of literature exists regarding the underpricing of IPOs. Ibbotson (1975) and Beatty and Ritter (1986) find that on average, almost all IPOs are underpriced, with 11.4% and 18.8% underpricing, respectively. A more recent study of Hopp and Dreher (2013) report an average underpricing of 20% in 29 countries. Underpricing in developed economies is about 10-20%. However emerging markets report 60-80% underpricing (Jenkinson & Ljungqvist, 2001). Several theories exist in which an explanation of underpricing is sought. This section describes theories, and is divided into: underwriter theory, asymmetric information, and symmetric information.

3.1.1 Underwriter theory

The underwriter and administrative costs are the direct costs of going public. Unfortunately, this is only one component of the total costs. The second, indirect costs, are the underpricing costs, also known as “money left on the table.” Investors are prepared to pay more “money” than the initial offer price, and the offer price is lower than the market value (Ritter,1987). While the investors have no disadvantage of the underpricing, companies do. The firm could have a target to raise a certain amount of capital but due to the lower offer price not achieve that target (Ruud,1993).

The underwriter works closely with the issuing company to arrange the listing of a company. The responsibility of the underwriter is to handle the administration and the selling of shares. In some cases underwriters agree to take over the unsold shares (Ellis et al, 2000). Looking from the underwriter’s perspective, there should be an incentive to set the offer price lower than the market value, with the result that there are no leftover shares to absorb.

As mentioned in the previous paragraph, the underwriter could be motivated to set the offer price below the market value to ensure no shares will have to be absorbed. However, Mok et al (1998) argue that underwriters underprice shares in order to protect their reputation. An

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12 IPO with unsold shares is seen as unsuccessful (Ruud,1993). By setting the price lower and ensuring all shares will be sold, the IPO will be successful and underwriter’s reputation is “protected". However, underwriters setting the offer price below market value could have the loss of potential clients as a consequence (Tinic,1988).

As the previous arguments suggest, underwriters underprice IPOs to ensure they will not damage their reputation or have to buy leftover shares. The opposite is found in other studies in underwriter theory. Within each stock market there are some “prestigious” underwriters who either underwrite the most IPOs or sign the biggest IPOs in terms of deal value. Assuming Tinic’s theory is correct, prestigious underwriters should not underprice their IPOs. The study by Carter and Manaster (1990) indeed indirectly supports Tinic’s theory. They find a negative relation between an underwriter’s reputation and the underpricing of IPOs. Looking at the different studies and theories within the “underwriter theory” field, there is no one clear answer that explains the underpricing.

3.1.2 Asymmetric information

In most cases investors are less informed than the issuing companies about the market value of a share (information asymmetry). According to Leland and Pyle (1977), information asymmetry affects the price of shares and the amount of underpricing needed to sell them. This is because information asymmetry leads to adverse selection. In order to sell the newly issued shares, the shares have to be priced at lower than market value to counter the adverse selection. Chemmanur and Fulghieri (1995) explain that this adverse selection cost is more likely to occur for small and young firms. Small and young firms have little track record. In comparison to larger firms, it is more difficult for investors to obtain information about the value of the firm. The information being harder to obtain creates asymmetric information, which causes adverse selection. As will be seen in the rest of this chapter, asymmetric information is the foundation of the “winner’s curse.” The winner’s curse is often seen as one of the most important explanations of underpricing in China.

With regards to asymmetric information, two models will be discussed. The first model is the winner’s curse model and secondly the signaling model. Rock (1986) found an explanation for underpricing: the winner’s curse model. In this model he assumed the presence of informed investors and uninformed investors. Informed investors acquire information about the value of a share, which in this case the shares are issued with an IPO. Uninformed investors do not possess this information. The informed investor imposes adverse selection costs on the uninformed investors (Ritter & Welch,2002). The reason behind this, is that informed investors only bid on underpriced IPOs. This means that if there are shares “left,” it implies informed investors have information that the shares are not underpriced. When an

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13 uninformed investor receives the requested shares, he faces the winner’s curse. The return will be less than average because the shares are not underpriced (Beatty & Ritter,1986). Investors who are less informed are aware of the possibility that they will receive shares that are overpriced. Therefore, IPOs need to be underpriced to compensate the uninformed investors (Rock,1986).

The probability of receiving overpriced shares is a form of ex-ante uncertainty. The higher the uncertainty is, the higher underpricing is. Su (2004) finds strong evidence for the winner’s curse model in the Chinese stock market. The evidence found is due to the high ex-ante uncertainty in the Chinese market. The high economic uncertainty in China contributes to the information asymmetry associated with the winner’s curse model.

The second model based on asymmetric information is the signaling model. In the signaling model, the issuer has superior information about the intrinsic value of the firm (Welch,1989). One of the assumptions in this model is that the mean and variance of the cash flows are unknown to investors. The offer price, however, is used as a signal for these unknown variables. Allen and Faulhaber (1989) explain that there are two types of firms: high-quality and low-quality firms. High-quality firms signal their quality by underpricing their issue, while a low-quality firm does not. The reason for this signaling is that high-quality firms can afford this underpricing, and that these firms expect to bring more equity in by issuing a Seasoned Equity Offering (SEO). This secondary offering is priced more favorably for the issuing firm. In short, the signaling model states firms underprice IPOs because after the IPO, SEOs are priced more favorably. Su and Fleisher (1999) state that in China, there is asymmetric information about the intrinsic value of the firm between the issuer and the investor, and they find that the signaling model explains the IPO underpricing in China rather well.

3.1.3 Symmetric information

The last theory is based on symmetric information, where investors and issuers have the same information. Tinic and Seha (1988) doubt whether it is reasonable to believe some investors possess more information than the issuer about the value of a firm. The underlying principle of this theory is that issues are underpriced in order to protect themselves against legal liabilities. High initial returns reduce the chance of lawsuits, because the share is priced fairly in the eyes of investors (Hughes and Thakor, 1992). In short, this theory suggests that companies use underpricing as an insurance against legal liabilities. In China however, the proportion of asymmetric information is high. It is unlikely that this theory is very relevant in China because of this asymmetric information.

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4. Methodology and results

In this chapter, methodology and results are discussed. First, a short explanation about collecting the data is given. Second, the regression that was used for this analysis is discussed, together with all its relevant variables. The regression is followed by the hypothesis and results. In the last part of this chapter, the proposed hypotheses are answered.

4.1 Data

The sample used in this thesis consists of 722 Chinese A-share IPOs in the period 2006-2015. First, the offer price was retrieved from the Thomson One database. Matching the ISIN-codes to Datastream provided the relevant first day closing prices. Announcement dates and deal values are retrieved from Zephyr. Unfortunately, 87 observations were lost because no closing price or opening price was available. Another 108 observations were lost because no deal value or announcement date was available. After 195 observations were lost due to missing values, 527 IPOs were left. The dataset only considers A-shares. The reason for this is that the Thomson One database only includes B-shares till 2000. From the H-shares in the dataset, almost all observations were unsuitable because no data on either closing or opening price was available. However, looking at previous literature such as (Su,2004), (Tian,2011), and (Chan et. al, 2004), the severe underpricing mainly regards the A-shares. B-share and H-share underpricing is significantly lower.

4.2 Regression

The empirical research in this study was conducted with ordinary least squares (OLS). Since underpricing is measured by the difference of stock prices, the dependent variable will be share return (R). Based on most IPO underpricing literature, the best variable to measure IPO underpricing is the stock return of the first day.

The return will be measured by: 𝑅𝑅 =𝑃𝑃1−𝑃𝑃0

𝑃𝑃0 * 100

In the formula used to calculate first day return, 𝑃𝑃0 stands for offering price. 𝑃𝑃1 indicates the closing price of day one.

The regression equation: 𝑅𝑅 = 𝛽𝛽₀+ 𝛽𝛽₁𝐿𝐿𝐿𝐿𝐿𝐿 + 𝛽𝛽₂ln (𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆) + 𝛽𝛽₃𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝛽𝛽₄𝑈𝑈𝑈𝑈 + 𝛽𝛽₅𝐿𝐿𝑂𝑂𝑂𝑂 + 𝛽𝛽6𝑆𝑆𝐸𝐸𝑐𝑐 + 𝜀𝜀

In the regression equation there are five explanatory variables and one control variable The time between announcing and listing the IPO is indicated by the variable LAG. The variable LAG is measured in days. In developed markets there are short time periods between the announcement date and the trading date. In China however, it is common to announce the

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15 IPO for public subscription two months before trading date (Chan, Wang & Wei,2004). Due to asymmetric information distribution with regards to the issuer, a larger time gap will bring higher risk, and thus a greater initial return. A positive relationship between LAG and underpricing can therefore be expected.

The second variable is SIZE, which is measured by the deal value of the IPO. Smaller offerings are more speculative due to larger uncertainty (Beatty & Ritter,1986). Also, larger offerings are usually linked with more established firms (Carter, Dark & Singh,1998). A negative relation is expected between SIZE and initial return. The dummy variable crisis becomes the value 1 if the IPO is issued during the period 2007-2009, and 0 if the period is different. Mahmood et al, (2011) reports a 10% increase in average underpricing during the financial crisis. In addition to the 10% underpricing, they find a significant positive relation between “the great recession” and underpricing. Therefore, a positive relationship is expected between underpricing and the dummy variable crisis.

According to Chen et al (2004), the reputation of the underwriter is an important determinant for underpricing in the Chinese market. According to different studies, the choice of a prestigious underwriter reduces underpricing. In contradiction to this, other studies report increased underpricing because underwriters want to protect their reputation by making sure all issues are sold. The direction of the relationship is not clearly ex-ante. Therefore, I have added a dummy variable underwriter (UW) which takes the value 1 if the IPO is underwritten by one of the “big six” underwriters in China and 0 otherwise. The big six underwriters are: Guotai Securities, Nanfang Securities, Junan Securities, Shenyin-wanguo Securities, Haitong Securities, and Huaxia Securities (Chen, Firth, & Kim,2004).

Government (GOV) is a dummy variable indicating whether the government owns shares in the issuing company. Because the majority of shares are owned by the government, the speculation on the listing day will be higher (Chan et al, 2004). Therefore, when the government owns a large proportion of the stock a positive correlation with underpricing can be expected. Listing exchange is added as a dummy variable (Ex). By adding this dummy variable, underpricing can be examined regardless of which exchange the share is listed on.

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4.2.1 Hypothesis

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Hypothesis 1 will test whether the variable LAG has a significant effect on the underpricing of IPOs. In other words, this hypothesis will check if the time between the announcement date and the listing date has an effect on initial return. Tian (2003) and Mok et al (1998) argue time-gap is a positive function of initial return. Therefore a positive relation is expected. H0: 𝛽𝛽₁= 0

H1: 𝛽𝛽₁> 0 (2)

The second variable that will be tested is size, which considers the size of the IPO. Tse (2006) and Ritter (1998) argue that size has a negative relation with IPO underpricing. A negative relationship is expected.

H0: 𝛽𝛽₂ = 0 H1: 𝛽𝛽₂ < 0 (3)

There are different hypothesis for the underwriter theory. The research of Mok et al (1998) contains a hypothesis with a positive relationship between underwriter reputation and underpricing. However Tinic (1998) expects a negative relationship. Therefore the relationship of the dummy variable underwriter is not clear.

H0: 𝛽𝛽₄= 0 H1: 𝛽𝛽₄≠ 0 (4)

H0: 𝛽𝛽₃ = 0 H1: 𝛽𝛽₃ > 0

In hypothesis 4, there will be tested whether the crisis in the period 2007-2009 contributed to the underpricing of IPOs in China. The study of Mahmood et al. (2011) shows there will be a positive relationship between the dummy variable Crisis and initial return.

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In the last hypothesis there will be tested if government ownership of shares has influence on underpricing. According to Chan et al. (2004) underpricing increases when the government owns shares in the issuing company. A positive relation is expected.

H0: 𝛽𝛽₅ = 0 H1: 𝛽𝛽₅ > 0

4.2.2 Regression validity

Before running the regression previous literature is examined to determine what the best estimation method is. The studies of Chan et al. (2004), Chi and Padgett (2002) and Mok and Hui (1998) all use OLS as estimation method. Following existing literature, an OLS regression is used to estimate the determinants of underpricing. To make sure OLS is a proper estimation method, a few tests were performed to make sure no assumptions are violated.

As can be seen in the descriptive statistics in table 3 there are no major outliers. To make sure there is no multicollinearity, the correlations between independent variables were checked. Farrar and Glauber (1967) report a rule of thumb to check for multicollinearity: correlations between explanatory variables should be smaller than 0.8. Table 2 below displays the correlations between the explanatory variables. As can be seen in table 2 the highest correlation is 0.35. So no multicollinearity issues should occur.

Table 2: Correlations

Variable lnsize Lag crisis uw gov Exch

lnsize 1.00 Lag -0.14 1.00 crisis -0.31 -0.02 1.00 Uw -0.06 0.05 0.04 1.00 Gov -0.03 0.01 0.12 0.03 1.00 Exch -0.18 0.07 0.35 0.03 0.26 1.00

In order to prevent violation on the no-heteroscedasticity assumption robust standard errors were used. To check whether the errors are normally distributed the Skewness-Kurtosis test was performed. With a p-value of 0.40 the null hypothesis of normality is not rejected. To test for autocorrelation a Durbin-Watson test is conducted. The d-statistic is 1.872 which indicates there is no autocorrelation. Looking at the tests performed, the output produced in chapter 4 is reliable.

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4.3 Results

Below, figure one shows the average underpricing of A-shares. The mean in the period 2006-2015 is 17.1%. Compared with the study by Tian (2003), there is a decline of almost 250%, the underpricing of A-shares found in this study is much lower. The steepest drop in underpricing took place from 2010. The decline in underpricing is consistent with the introduction of the Book-Building system introduced in 2010. This Book-Building pricing system was introduced to address the extreme underpricing that was occurring (Linh et al, 2013). Another remarkable observation in the graph is that there is only 1% underpricing in the year 2013. A possible explanation for this is that many observations in 2013 were unsuitable due to a missing announcement date/deal value.

Figure 1: Average underpricing of A-shares 2006-2015

Table 3 contains the statistics of underpricing, offer price, closing price, lag and size. The offer price, closing price and size are expressed in U.S. dollars. The variable lag is measured in days. Underpricing is measured as the first day return, as defined previously.

Table 3: Descriptive statistics variables Variable Mean Std.Dev Min Max Underpricing 17.10% 75.85% 77.76% 377.80% Offer price 22.86 9.79 8 60 Closing price 23.37 13.99 5.41 143.35 Lag 39.34 51.766 5 665 Size 68892.77 33481.21 8914.57 1801173.5 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Average underpricing 2006-2015

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19 In table 4 the descriptive statistics of the dummy variables used in the regression can be found. Crisis takes the value 1 if the IPO took place in the period 2007-2009, and 0 in another period. The variable underwriter takes the value 1 when the underwriter is prestigious and 0 if not. The variable exchange takes the variable 1 when the IPO is listed on the Shanghai exchange and 0 when listed on the Shenzhen exchange.

Table 4: Dummy variables

Variable Value 0 Value 1 Total

Crisis 496 31 527

Underwriter 218 309 527

Exchange 490 37 527

Below, table 4 displays the regression results. Three regressions were run to determine whether leaving or adding a variable changed the coefficients of other variables. Another reason behind running three separate regressions was to see if the r-square might increase. By adding the control variable exchange, the r-square increased by 0.0002. This increase does not necessarily imply increased causality. As can be seen in the table below, there are no significant changes between the variables when adding underwriter and exchange. For answering the hypothesis, regression 3 will be used. Furthermore the variables size, lag and crisis are significant at a 1% level.

Table 4: Regression results

Variables 1 2 3 Ln (size) -.492*** (.059) -.495*** (.059) -.493*** (.060) Lag .004*** (.0006) .004*** ( .0006) .004*** (.0006) Crisis .497*** (.152) .487*** (.153) .471*** (.141) Government .103 (.1343) .077 (.124) .063 (.129) Underwriter -.003 (.056 ) -.002 (.056 ) Exchange .0481 (.119 ) Constant 5.386 (.669 ) 5.492 (.699) 5.453 (.713 ) R-squared 0.294 0.294 0.2942 N 527 527 527

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20 In table 5 the results of the hypotheses tests are displayed. The testing of the coefficients is done with the t-test. As can be seen in the table the null hypotheses of hypothesis 1, 2 and 4 are rejected.

Table 5: results hypotheses

Hypothesis t-score Significance level (1) 6.99 1%

(2) -8.07 1% (3) -0.04 - (4) 3.5 1% (5) -0.49 -

There is a positive relationship between the variable lag and underpricing. This relationship is consistent with the expectation stated in hypothesis 1. Therefore hypothesis 1 is consistent with Tian (2003) and Mok et al (1998). For hypothesis 2, a negative relationship was expected because small offerings are often referred to as “less safe” and thus have higher uncertainty. As table 4 and 5 show, there is a negative relationship between size and underpricing. This relationship is consistent with the study of Beatty and Ritter (1996). The coefficient crisis indicates there is a positive relationship between IPOs issued in 2007-2009. This relationship can also be seen in figure 1, where underpricing increases in the year 2007. This graphical display of the increase in underpricing complies with the significant relationship found. This relationship is verified by Mahmood et al (2011), they found increased underpricing due to an increase in uncertainty during the period 2007-2009.

Consistent with previous literature there is a positive relationship between lag and underpricing. This relationship is driven by the increased ex-ante uncertainty the time-gap causes. According to the winner’s curse model increased uncertainty leads to higher underpricing. Secondly, a negative relationship between size and underpricing is found, also consistent with previous literature. The smaller the size of an offering is the more ex-ante uncertainty there is among investors. The relationship between size and underpricing can again be explained by the winner’s curse model. As increased uncertainty leads to higher underpricing. Therefore this study contains evidence the winner’s curse model still holds in China.

Surprisingly, no significant relationship between underwriter and underpricing was found in one of the three regressions. This is surprising because the study of Chen et al (2004) found a significant negative relationship. In regression 2 and 3 a negative coefficient does exist, but with rather large standard errors, which indicates an insignificant relationship. The variable

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21 government is measured by whether the government owns shares in the issuing company. Unfortunately, no significant effect for the variable government was found, which is strange considering the existing literature. A possible explanation might be that in previous studies, the variable government is measured as a percentage of shares the government owns in the company. The Thomson One database, Datastream, Zephyr, and other databases do not provide this information. The control variable exchange is insignificant in all three regressions. This indicates underpricing does not differ across the Shanghai exchange and the Shenzhen stock exchange.

5. Conclusion

Using an empirical study, this thesis examines the underpricing of A-shares in the period 2006-2015 in China. This study was done with a sample of 527 IPOs. In chapter 3, several explanations are given for the underpricing phenomenon: underwriter theory, winner’s curse, signaling model, and the legal liability explanation. The winner’s curse model is the most well-known theory explaining underpricing in China, so the expectation was to find support for the winner’s curse theory in the period 2006-2015.

The main research question of this paper is: Were newly issued A-shares underpriced in the period 2006-2015 and what are the determinants of this underpricing?

The average underpricing found for Chinese A-shares in the period 2006-2015 was 17.1%, which is lower than the studies in the period 1990-2006. Compared with the study by Tian (2003), there is a decline of almost 250%, the underpricing of A-shares found in this study is much lower. A logical explanation for this lower underpricing is the Chinese government attempting to reform the stock market, for example with the new Book-Building pricing system to prevent extreme underpricing of IPOs. According to Beatty and Ritter (1986), the average underpricing in developed economies is 11.4%. Thus, for the IPO market, China’s plan to prevent extreme overpricing has been effective.

Although the underpricing in the Chinese IPO market is significantly lower than the existing literature reports, this underpricing has several drivers. The first (positive) relationship found, consistent with hypothesis 1, was the time between announcing and issuing the IPO. As the gap between announcement and issuing increases, so does the underpricing. This is due to ex-ante uncertainty regarding the investors. When this ex-ante uncertainty caused by the time gap increases, underpricing increases as well. Second, consistent with hypothesis 2, a significant relation between the size of the IPO and underpricing was found. The smaller the deal value of an IPO is the larger underpricing. The explanation for this is that smaller deal values are associated with less established firms. The less established firms have less

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22 certain future earnings, thus investing in these more risky shares requires compensation. This compensation is expressed in terms of underpricing. Also, in the years of “the great recession,” IPO underpricing increased, as indicated by the dummy variable crisis. This increased underpricing in the years 2007-2009 is consistent with hypothesis 4.

In contrast, hypothesis 3 and 5 are not consistent with the regression results. Hypothesis 3 considers the dummy variable underwriter. Surprisingly the variable underwriter is not significant, contradicting existing literature. Hypothesis 5 considers the variable government which is also not significant. A possible explanation for this might be that the data on this variable was less accurate than existing literature.

Both the variable lag and the size of the offering indicate asymmetric information and ex-ante uncertainty among investors. Therefore, the winner’s curse model of Rock (1986) provides an explanation of the underpricing measured in the empirical part of this thesis. The winner’s curse states that uninformed investors have to be compensated for facing the winner’s curse. This compensation consists of underpriced IPOs.

In brief, newly issued A-shares are underpriced, but at a lower level than during the period 1990-2006. The main determinants are the variables gap and IPO size, both of which are significant. The two significant variables have a relationship with underpricing that indicates the winner’s curse. Following the winner’s curse model and looking at the underpricing of 17.1%, there is less asymmetric information found in the Chinese IPO market compared to studies done in the period 1990-2006.

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6. Limitations

Unfortunately, not enough information on H-shares was available to run a reliable regression on the underpricing of these shares. The lack of information is due to the unsuitable observations because no offer or closing price was available. The number of lost observation may cause an unrepresentative image of underpricing for example in the year 2013, in which the underpricing is only 1%. Another key determinant of underpricing in China is the age of the firm issuing the IPO. Just like the size of an IPO, an older company signals trust for investors. Although age is an important variable, it could not be included in the regression. Searching all the available databases gave zero observations for the variable age. The same was true for the variable government, which was only partly available. The coefficients might be significant if the percentage of shares owned in the issuing company was available.

7. Recommendations

Even though a large body of IPO research exists, there is still room for further research, especially since the Chinese stock market is relatively young and is subjected to a lot of changes. The following example illustrates that the Chinese stock market is subject to major developments in a relatively short period of time. Developments affecting the stock market can also affect the underpricing of IPOs.

In the beginning of 2016, the Chinese government froze all exchanges in China because the stock markets declined by 6%. This freeze of trading is caused by so called “circuit breakers.” The circuit breakers suspend trading when a large decline like the one in January takes place. Although this study might point out a more stable stock market and fewer interventions by the Chinese government, the opposite is true. The Chinese government still tries to control volatility by intervening in stock markets, as the previous example demonstrates. These interventions might create higher ex-ante uncertainty when issuing an IPO. This uncertainty creates underpriced IPOs according to, for example, the winner’s curse theory.

The control of volatility in markets through interventions makes IPO underpricing a subject that can be explored further. An interesting study could look at the effect of circuit breakers on IPO underpricing. The circuit breakers cause uncertainty and asymmetric information among investors, so a recommendation for further research would include a dataset, preferable retrieved from a Chinese databank to limit unsuitable observations. Aside from a more accurate dataset, the effects of circuit breakers like the one in January 2016 can be included in further research.

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IPO underpricing of A-shares in China