UNDERPRICING OF
IPOs IN CHINA
An Empirical Examination of IPO Underpricing
in China’s Stock Markets
IPO Underpricing in China
An Empirical Examination of IPO
Underpricing in China’s Stock Markets
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Abstract
Purpose – This thesis investigates the initial underpricing on Chinese IPOs. In the past, many researchers have described this phenomenon to be present in IPO pricing. The most common theories and explanations on IPO underpricing are asymmetric information, symmetric information, hot issue markets and underwriter reputation. Furthermore, multiple
characteristics of the Chinese markets affect the degree of IPO underpricing. However, most of the existing literature is outdated. In the past decade, there have been many developments in the Chinese economy. This, combined with the recent worldwide financial crisis in the period 2007-2009, make additional research on Chinese IPO underpricing necessary. The purpose of this thesis is to examine the effects of these recent developments on the degree of underpricing in China and Hong Kong.
Design/methodology/approach - In my sample of 470 IPOs issued from 2004 to 2014 in China and Hong Kong, I examine cross-sectional data through ordinary least squares (OLS) regression models. These models are used to calculate the degree of underpricing and to test which
independent variables have a significant effect on IPO underpricing in China. The data includes information on some of China’s unique market characteristics such as the differences in share types and the number of days between IPO announcement and first trading day. With these regression I will look for relationships between these characteristics and the level of IPO
underpricing. Furthermore, the impact of the Great Recession on underpricing will be examined using an OLS regression model.
Findings – On the average, I found a degree of underpricing of 19 percent in the Chinese and Hong Kong exchanges, including severe underpricing of Chinese A-type IPOs. These shares were priced 37 percent below their market value by underwriting companies at the moment of initial offering. Hong Kong H-type shares are also underpriced, but only with 9 percent, on the average. Furthermore, I have found a significant positive relationship between the number of days between the IPO announcement date and the first trading day and the degree of IPO
underpricing. Finally, I found a significant positive relationship between the dummy variable of the Great Recession and the level of underpricing. There is more underpricing in the 2007-2009 period in China, compared to the 2004-2014 period. Generally, the level of Chinese IPO
underpricing has decreased over time, as a result of the fact that Chinese investors have become more informed by sudden movements of markets.
Originality/value – This thesis contributes to the existing IPO literature by examining the underpricing in China and Hong Kong in recent years, as most of the research is outdated.
Furthermore, the causes of underpricing in China have been studied by multiple researchers, but this thesis brings together all the previous literature, and focuses on the main drivers of Chinese IPO underpricing.
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Table of contents
Abstract _______________________________________________________________________________________________ 1
List of figures and tables __________________________________________________________________________ 3
1.
Introduction ____________________________________________________________________________________ 4
2.
Background information _____________________________________________________________________ 6
3.
Literature review ____________________________________________________________________________ 10
4.
Data & Methodology ________________________________________________________________________ 17
5.
Results & Analysis ___________________________________________________________________________ 20
6.
Limitations ____________________________________________________________________________________ 23
7.
Conclusions ___________________________________________________________________________________ 24
8.
Recommendations for future research __________________________________________________ 25
Acknowledgements _______________________________________________________________________________ 25
List of references __________________________________________________________________________________ 26
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List of figures and tables
Figures:
Figure 1: Underpricing in non-European countries 6
Figure 2: Underpricing in European countries 6
Figure 3: Average initial returns during 1960-1982 15
Figure 4: IPO activity during 1960-1982 16
Figure 5: IPO activity in China 20
Figure 6: Average underpricing in China 20
Tables:
Table 1: List of independent variables 18
Table 2: Descriptive statistics of the Chinese A-share IPOs 21 Table 3: Descriptive statistics of the Hong Kong H-share IPOs 21 Table 4: Regression output including China’s key characteristics 21
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1. Introduction
Many companies start as a privately held small company. As they expand, they may do an initial public offering (IPO). The decision to do an IPO is one of the most studied questions in corporate finance. An IPO allows companies to access capital more easily by selling stock to a large number of investors. Shares that are publicly traded are more liquid than privately held shares, which allows investors to diversify their investments. Shareholders that already had shares are now able to sell these. Furthermore, by going public the company can increase its reputation. However, with these benefits, also costs arise. There are ongoing costs, associated with the obligation to provide information to investors on a regular basis. There are also certain one-time costs like underwriting, auditing and legal fees. The most interesting one-time cost, however, is underpricing. This is the phenomenon that occurs after the first trading day when there are the high initial returns on the IPO. It is caused by the fact that firms value their newly issued stocks lower than its market value.
Research showed that IPO underpricing exists on almost all stock markets in the world, but that its magnitude varies between different countries and continents (Ritter, 1998). In France for example, Ritter (1998) found that initial returns are on average 4.2% in the years 1983 till 1992, while in many Asian countries the initial returns are much higher. In Malaysia it reached 80.3% between the years 1980 and 1991, and 388.0% in China between 1990 and 1996 (Ritter, 1998). Other studies on Chinese underpricing report underpricing of 289% (Mok and Hui, 1998) and even staggering at 948% if the sample included IPOs from before 1990 (Su and Fleisher, 1999). A more recent report by Wu (2001) finds an initial return of 218% on A-share IPOs listed between December 1990 and March 2000.
Primarily there are two categories of theoretical models that are used to explain IPO underpricing. The first assumes asymmetric information, the second assumes symmetric information. Theories with the symmetric information assumption are limited, but state that every player involved in the IPO process has the same information. Theories based on asymmetric information are most common and include the winner’s curse model and the signaling model. Rock (1986) developed the winner’s curse model, in which certain investors are assumed to be more informed than others. The issuer must underprice the IPO to compensate this information asymmetry and to induce investors to purchase shares. The signaling model assumes that the issuing company has more information on stock value than other stakeholders as the underwriter and investors. Underpricing is used in high quality IPOs to signal their superior quality to investors.
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Many researchers (Chi & Padgett, 2005; Hughes and Thakor, 1992; Mok and Hui, 1998; Su, 1999; Su and Fleisher, 1999; Tinic, 1988 and Wu, 2001) have applied these models to the Chinese markets. However, most of this research is outdated, as there is very little research done from the year 2005. This thesis contributes to the existing literature by examining the IPO underpricing in China using the classical models. It is necessary to research the years after 2005, since the international financial markets have been disrupted as a result of the financial crisis in the period 2007-2009. There have also been many developments in China’s economy in the past decade. With its population of 1.3 billion and an average GDP growth of 10 percent per annum, China has become the second largest economy in the world and an influential player in the global economy. Its rapid economic growth has also brought on challenges, including income inequality and rapid urbanization (Worldbank, 2014). But to what extent have these both domestic and international developments affected the Chinese IPO market?
Based on this, the main research question of this thesis is as follows:
What’s the extent of IPO underpricing in the Chinese stock market between the years 2004-2014 and what are its most important drivers?
The rest of the thesis is organized as follows. Chapter 2 provides background information about the Chinese stock market. Chapter 3 describes previous literature on IPOs and underpricing in general. Chapter 4 formulates the hypotheses to be examined and describes the data and methodology. Chapter 5 presents the implications of the empirical results. Chapter 6 describes the limitations of this research. Chapter 7 summarizes and draws conclusions. Chapter 8 provides recommendations for future research.
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2. Background information
This paragraph provides background information on the Chinese stock markets. Background knowledge of these markets is necessary to fully understand the differences of these markets compared to western markets. Section 2.1 gives an introduction of the IPO underpricing phenomenon in China. Section 2.2 will discuss possible explanations for this by providing information about the history and structure of the Chinese stock markets.
2.1 IPO underpricing in China
The three largest stock markets in China are the Shanghai Stock Exchange(SSE), the Shenzhen Stock Exchange (SSE) and the Hong Kong Stock Exchange. Unlike the markets of Shenzhen, Hong Kong and western markets, the Shanghai stock exchange is still not entirely open to foreign investors. As a result, the SSE currently has zero foreign companies listed. A unique characteristic of the Shanghai and Shenzhen stock markets is that its domestic shares have exorbitant initial returns on the first trading day. Ritter’s (1998) research showed an average underpricing level of 388% in the years 1990-1996. Su and Fleisher (1999) even found an average underpricing level of 948.6% when earlier years were included in the sample. In other words, the market closing price after the first trading day was on average almost eleven times as high as the initial offering price according to Su and Fleisher’s (1999) research.
Figure 1: Underpricing in non-European countries (Ritter, 2008)
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The high level of IPO underpricing makes the Chinese stock market unique, but raises questions as: (1) Why are IPOs so heavily underpriced in China? (2) What is the reason for the difference in underpricing level of domestic A-type shares versus international B-type and H-type shares? In the next paragraph we will focus on the history of the Chinese stock exchanges and describe its characteristics to answer these questions.
2.2 History and structure of the Chinese stock market
Currently, the stock exchanges of Hong Kong, Shanghai and Shenzhen are ranked 2nd, 3rd and 4th
largest in Asia and the 6th, 7th and 16th largest in the world in 2013, respectively. The exchanges
have a total market capitalization of $6,4 trillion in 2013, which makes these markets very influential players in the worldwide economy.
Late 1980s and early 1990s there was an increased interest in Chinese stock markets. These developments began when the Chinese Communist Party (CCP) started their mandate. A reason for this was the government’s plan to help firms raise more equity capital and reduce its debt burden. The CCP played a significant role by proposing a modern corporate system which was comparable to the Western system. This was part of their economic reform plans. These plans resulted in the opening of the Shanghai and Shenzhen stock exchanges in 1990.
In 1997, the CCP introduced a new shareholder system that restructured public listing resulting in an even more increased number of listed firms (Jefferson et al. 2003). Formal privatization wasn’t allowed based on ideological grounds, but the CCP’s new shareholder system was viewed as a disguised request for privatization (Li et al., 2000). Consequently, the amount of state-owned companies declined by nearly 50 percent during the period 1997-2001. Meanwhile, it led to a large increase in the number of large and medium-size companies. During the same period, the number of enterprises grew from 1,801 to 5,659 (Gang, 2002). The ‘conversion’ of state-owned companies to collective-state-owned companies proved to contribute to both productivity and innovation. Employment grew together with the number of R&D activities, according to Jefferson et al. (2003). However, there are also downsides to these developments. Changes in company ownership are likely to enlarge the regional inequality within China, as most of the conversion happens in the wealthy coastal areas (Jefferson et al., 2003).
To get a better understanding of the Chinese markets, I will now discuss some key characteristics that distinguish the Chinese stock markets from other markets:
1. Different type of shares. China’s privatization of enterprises started with offering investors two types of shares: A shares and B shares (Abdel-khalik et al. 1999). A-type shares are denominated in Chinese currency and designated for private Chinese citizens,
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while type shares are denominated in US dollars and only sold to foreign investors. B-shares that are traded on the Hong Kong Stock Exchange are called H-B-shares. H-type shares are denominated in HK dollars and can be traded by both local and foreign investors. A shares are offered by all listed firms, but to be able to offer B shares, a firm must follow the International Accounting Standards. This is why only less than a fifth of the firms in the SSE sell B shares. Firms that issued A shares only have to meet local Chinese accounting regulations. This makes the environment of A shares more influenced by the domestic regulations at the moment of trading or offering, while B shares have a more structured information environment.
The initial returns for B and H shares are a lot lower than for A shares. Yu & Tse (2006) found that A shares are underpriced with 350% compared to 39% for B-shares. According to Chan et al. (2004) is because foreign investors have more alternative investment options outside China and therefore there is less speculation on the market for B and H shares, resulting in an average initial returns of the IPOs of 11.6%. Furthermore, the environment of A shares can be affected by state officials, and seems to limit the chances to monitoring externally. This is amplified by the fact that most of the Chinese accounting firms are government owned. In contrast, financial statements of B-type and H-B-type shares are audited by international accountancy firms. Moreover, because of the open information environment of B shares, foreign investors can also act as external monitors (Abdel-khalik et al. 1999). Besides A, B and H shares, there are government shares –which are held by the State Assets Management Bureau–, legal entity shares –which are also called C shares– and employee shares, which are held by employees. However, A, B and H shares are the only shares that are tradable in the official exchanges (Su and Fleisher, 1999).
2. Annual quota for new shares. The State Planning Commission, the China Securities Regulatory Committee and the central bank of China decide the yearly amount for new shares to be issued (Su and Fleisher, 1999). As a result of the shares quota set by the government, the demand of Chinese investors cannot be satisfied as they have very few alternative investment choices. Before 1990 the Chinese could only invest in bank deposits and Treasury bonds since the domestic stock exchanges were poorly developed. Muirin & Sommariva (1993) found that actual returns on Chinese Treasury bonds were negative, because of China’s high inflation rate. This makes it not surprising investors buy A-shares instead of hold Treasury bonds. Chi & Padgett (2002) found the same relationship in their own studies and state that the quota system for IPOs is the most important reason for underpricing in China in the 1996-1997 period. Tian (2003)
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confirms this and states that listing quota account for more than 50 percent of the initial underpricing on IPOs.
3. Time gaps. Many firms from China use a different offering mechanism from those in older stock markets. According to Su and Fleisher (1999), the time between the day of the IPO announcement and the first trading day is too long and has a positive correlation with the level of underpricing. This time gap could be more than three years, according to Mok and Hui (1998). But since 1994, it is less than two months. Investors require higher returns if there is a large time gap between the announcement date and the offering date. The return must compensate them for the increased risk. This is confirmed by the studies of Chen et al. (2004) and Mok & Hui (1998).
4. Corruption. For an efficient privatization process of state-owned firms, newly issued shares of those firms must be offered to Chinese bureaucrats who had control over these firms in the past (Basu and Li, 1998). These government officials have inside information on the firms that is useful for the firm to be successful in the future. Corruption arises when the bureaucrats need to reveal this information. The shares are offered to these bureaucrats at a discount as a compensation for sharing inside information (Basu and Li, 1998). This results in IPO underpricing since the offer price is lower than its real market value. Gu (2003) states that bribery affects underpricing of A-share IPOs as well. He finds that if management and employees of the issuing company are allowed to purchase a portion of the shares at an IPO, they are incentivized to underprice the shares for personal gain. Su and Fleisher (1999) argue that corruption may have an effect on the degree of underpricing, but it’s not the main reason.
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3. Literature review
This chapter will provide an overview of the various theories about initial public offerings in general and the underpricing phenomenon. Section 3.1 defines the IPO process. Section 3.2 presents the different theories there exist on IPO underpricing and creates a link with the situation in China.
3.1 The definition of an IPO
When a company issues stocks for the first time, this is called an initial public offering (IPO). By performing an IPO, the company tries to attract additional capital on the stock market. This process is also called ‘going public’, as a privately owned company sells shares to public investors for the first time. If a company wants to raise additional equity capital but is already publicly-listed, this is called a seasoned equity offering (SEO). In return the public investors become part-owner of the company.
The IPO process often takes several months and is usually led by an underwriter firm, which has more knowledge about the financial markets than the private company. It is important to carefully choose an underwriter, because the underwriter’s reputation and promotion strategy can influence the outcome of an IPO. The underwriter uses its knowledge to set the proper price for the issued shares (Smith, 1986). This is done by guessing the market value of the firm and gathering information about the company. Other tasks of the underwriter include: advising the company about the IPO process, advising which type of shares should be issued, bearing the risk of the IPO. Finally, the underwriter certifies the shares in order to approve the quality and thus also determine the rating of the shares.
The two most common ways underwriters sell a firm’s shares to public investors are the contract and the ‘firm-commitment’-contract. If the shares are sold on a ‘best-effort’-basis, the underwriter tries his best to sell the most shares possible. This contract is often linked to riskier securities, as the underwriter doesn’t commit itself to selling a certain amount of shares. If the IPO fails, the underwriter cannot be held responsible. The downside risk is therefore limited for the underwriter, but so is the underwriter’s upside potential. This is because the underwriter’s fee is fixed with this contract (Smith, 1986). With a ‘firm-commitment’-contract on the contrary, the underwriter is held responsible for the success of the IPO by guaranteeing the issuing company a certain amount of sold stocks. The underwriter is held accountable when it is unable to sell all the shares it promised to sell (Smith, 1986). In this contract, the underwriter bears more risk but has much more upside potential.
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3.2 Theories on going public
There are several theories on why firms go public. This paragraph will provide an overview of the existing literature that examines the benefits and the costs that arise with an IPO.
Benefits of going public
1. Access to additional equity capital. By performing an IPO, firms can attract additional equity capital which can be used for investment activities. This is the most important motive for firms to perform an IPO. Besides this, an IPO increases liquidity and transfers wealth from new shareholders to existing shareholders. The original shareholders of the privately held firms usually have large stakes in the company. Hereafter they get a chance to receive cash for their initial investment in the company (Kim and Weisbach, 2008). The capital structure preferences of Chinese companies differ from firms in developed economies. In 1991, the long term book-debt ratio in the G-7 countries was 0.41 compared to 0.07 in China. This demonstrates the fact that Chinese companies prefer to use equity capital rather than debt to finance investments, as opposed to companies in developed economies (Chen, 2004). The main reason for this may be the incomplete corporate governance system. As mentioned in chapter two, managers can gain large personal benefits from IPO underpricing through secondary share trading (Gu, 2003).
2. Increased liquidity. A second benefit of an IPO is that the original shareholders and entrepreneurs of the private company are able to trade their shares on the secondary market. After a firm has gone public, their shares will become more liquid (Pagano et al., 1998). This means that a stock can be sold or bought on the stock markets more easily. Liquid markets are characterized by high levels of stock trading, which creates opportunities for investors for diversification. A way to do this is directly selling their shares from the company and reinvest in another company. High risk companies are expected to go public more often, since their shareholders can lower the risk of their personal portfolio after selling a portion of their shares of the high-risk company (Pagano and Roell, 1998). As for the Chinese markets, A-shares and H-shares are easily traded because of the many investors that are active on those markets. However, the liquidity of Chinese B-shares is very poor, according to the World Bank (1995). This may be explained by the revelation of information to foreign investors. These investors can already predict how the shares will be priced in the B-share market, after observing the performance of those shares in the A-share market (Fernald & Rogers, 2002).
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3. Publicity. Another reason for private companies to go public is publicity. Being listed on a large stock exchange creates awareness among investors that a firm exists. Demers (2003) found evidence for the marketing role of IPOs during her research on internet stocks. Public awareness can be measured well with the data of internet stocks, because internet traffic can be easily monitored and compared between periods. Demers & Lewellen (2003) found that there are marketing benefits associated with going public, and that these benefits extend beyond the internet sector. Examples of these benefits are additional investor interest and revenue increases after additional product sales. These sales are the result of greater brand awareness among consumers (Chemmanur, 1993).
4. Better monitoring. Firms may also choose to go public because of monitoring reasons. When a firm is active on a stock market, the price of the stocks can be used to create remuneration schemes for the company’s managers. For example, by giving them stock options as additional compensation next to their salaries. Holmström (2008) also found another reason. If a firm is performing poorly, this firm may be the target of a hostile takeover. In the case that managers will be fired if such a takeover succeeds, this will prevent misbehaviour of managers. The company’s managers will be incentivized to keep the stock prices rising, because they know that every change is visible to the public. Boubakri et al. (2005) argues that this is less relevant for countries with partial state-ownership.
Costs of going public
There is also a large amount of costs associated with an IPO. These costs may not be disregarded as they lower the benefits of going public. The most important costs associated with an IPO are indirect and arise from underpricing. These costs are normally between 10 and 15 percent in western markets, but has reached the level of 948% in the aforementioned Chinese market (Su and Fleisher, 1999). This amount is known as the money ‘left on the table’ (Ritter, 1987). Companies should also take this into their cost calculations. It is very undesirable to have high underpricing levels, since this is the amount of equity public investors are willing to pay, but the company doesn’t receive with the offering. Once a company is publicly listed, there will be some additional costs that private companies don’t have. These costs include quarterly reporting of financial statements, which need to be done by hired accountants. A public firm should also organize shareholder meetings and communicate with institutional shareholders and financial analysts. This requires a lot of time and can lead to a disadvantage compared to private firms, as
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the private firms are able to review this information. This gives private firms a competitive advantage (DeMarzo et al., 2007).
Next to these indirect costs, there are direct costs associated with the initial public offering process. The issuing company needs to hire a syndicate of an investment company, a lawyer company and accountants. However, the biggest direct cost is the fee for underwriting. The total direct costs of an IPO are 11 percent of the collected money, according to Lee et al (1996). These costs lower the amount of funds that the company can use for financing activities.
3.3 Theories on IPO underpricing
The previous paragraph described the benefits and costs that arise when a company goes public. In China, the most important cost of going public is underpricing. There is written a lot about the underpricing phenomenon. Primarily there are two categories of theoretical models that are used to explain IPO underpricing. The first assumes asymmetric information, the second assumes symmetric information. This paragraph will provide an overview of the existing literature and link these theories with China.
3.3.1 Asymmetric information
Theories based on the assumption of asymmetric information include the winner’s curse model and the signaling model. Rock (1986) developed the winner’s curse model, in which certain investors are assumed to be more informed than others. The informed investors only bid on attractively priced shares, while uninformed investors submit purchase orders for all new shares. During an IPO a fixed amount of shares is sold at a fixed price. If demand for the shares is strong and this wasn’t expected, it may result in rationing (Ritter, 1998). When some investors have less information relative to others, the less informed investors can be worse off. If some investors are more willing to buy shares if they are underpriced, then the excess demand is higher if the shares are more underpriced. Only a small portion of the most wanted new shares are allocated to the other investors, even though they receive most of the least desirable shares. This is called a winner’s curse: if an investor receives all the shares he asked for, it is because the better informed players don’t want them (Ritter, 1998). This is a problem of adverse selection. The less informed investors will only buy shares when IPOs are sufficiently underpriced, so they are compensated for the allocation bias of new shares. Leite (2007) also finds evidence for Rock’s argument. According to Leite‘s (2007) research, high market returns are an indication of conservative pricing by the underwriter. This creates a negative correlation between the public signal and the level of underpricing. Chowdhry & Sherman (1996) found that in the markets of Hong Kong, Indonesia, Thailand, Malaysia and Singapore the winner’s curse is reduced by
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favouring small investors over large investors. In Hong Kong for example, more than 80 percent of IPOs between 1986 and 1992 were allocated in favour of small orders. Chowdhry & Sherman (1996) reason that informed investors invest more than uninformed investors when they have the same amount of capital. A study of Yu and Tse (2006) found evidence that the winner’s curse is the main reason for the high level of underpricing in China. This is caused by the fact that over 90% of the Chinese investors don’t have sufficient access to information on seasoned equity offerings (SEO) or don’t have sufficient investing experience.
Another type of asymmetry arises when the interests of the underwriter and the issuing company are not aligned. This model is called the agency theory. The agency theory states that the underwriter is hired to work as an agent of the issuing firm (Baron, 1982). The theory appoints the misalignment of interests of the underwriter and the issuing firm. In his theory, it is conditional that the underwriter has more information than the issuing firm. If the issuing company has great uncertainty about the capital markets, it will value the underwriter’s services more. As a result of this, Baron (1982) argues that the degree of underpricing is high, when the issuing firm has little knowledge about the market.
The signaling theory is also based on the information asymmetry assumption. This theory states that there is asymmetric information between the company that issues shares and the investors. This asymmetry arises from the fact that the company has more knowledge of its own expected (financial) performance. When the prospectus is good, the company will issue its shares below market value. This way, a signal is given out to investors that (high) future earnings can be expected in the future. This will benefit companies that are planning to issue more shares in the near future. Investors will remember the positive returns of the IPO and be more willing to buy extra shares during a later issuance. Chen et al. (2004) found that Chinese firms with a long period between their first and second public offering list their IPO shares cheaply. Firms that make SEOs in the first two years after their IPO set a lower price for the IPO, on average. Su and Fleisher (1998) also found a positive correlation between IPO underpricing and the time period between offering and new listings of Shanghai firms.
3.3.2 Symmetric information
Theories on IPO underpricing with the assumption information is symmetric are very limited. However, Tinic (1988) argues that issuing companies underprice their shares to reduce their legal liabilities. Hughes and Thakor (1992) agree on this theory and state that companies are less likely to be sued when stocks are offered at a higher priced. For example, when an IPO is offered at $10 and starts trading at $20, the company is less likely to be sued than if the IPO would have been offered at $20. The aftermarket share price is more likely to drop below $20
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than below $10. Furthermore, Lowry and Shu (2002) agree that firms underprice their shares more, when they are more likely to be sued in the future. However, a study by Drake and Vetsuypens (1993) states that IPO underpricing doesn’t protect firms from being sued. They found that sued companies had higher levels of underpricing. In China there haven’t been lawsuits concerning IPOs so far (Hughes & Thakor, 1992), which makes theories based on symmetric information less relevant.
3.3.3 “Hot issue” markets
The “hot issue” market phenomenon is the fact that the number of filed IPO varies by period. The first researcher to document about this were Ibbotson and Jaffe (1975), who found that there are periods in which the initial returns of IPOs are far greater than the initial returns in other periods. A “hot issue” market starts as a ‘domino’-effect when a firm observes another firm earning high initial returns by going public, and subsequently the firm desires to go public as well. This results in a large amount of firms going public within a period (Ritter, 1998). This has been happening since the beginning of the 1970s, 1980s and the years of the internet bubble 1999 and 2000. “Cold issue” markets are the opposite of “hot issue” markets. In “cold issue” markets are periods in which a significant lower amount of IPOs are issued with lower initial returns than usual.
The following figure shows the height of the initial returns in the years 1960 – 1982. It's clear to see that ‘hot’ and ‘cold’ periods alternate.
Figure 3: Average initial returns during 1960-1982 (Ibbotson and Jaffe, 1975).
The next figure shows the IPO activity during the same period. Clearly, the high initial returns earned during the late 1960s triggered many other firms to go public in the 1970s creating a ‘hot issue’ market.
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Figure 4: IPO activity during 1960-1982 (Ibbotson and Jaffe, 1975).
Why would firms want to go public, while there is a high level of underpricing in “hot issue” markets? Loughran and Ritter (1995) suggest that this is caused by low quality firms who want to utilize the ‘momentum’ overoptimistic investors are in during a “hot issue” market. In the long run, low quality firms have lower returns than high quality firms, which is why they want to earn high initial returns on their IPO. This is confirmed by Helwege and Lang (2004), who also find that IPOs in “cold” markets perform better than in “hot” markets. Another explanation is provided by Maksimovic and Pichler (2001), who argue that “hot issue” markets are the result of highly productive firm clusters from the same industries. This productivity is caused by technological innovations (Maksimovic and Pichler, 2001).
In general, when economic prospects are optimistic and positive, there is a greater demand for IPOs in the global capital markets (Saha et al., 2012). And according to Ritter and Loughran (2004), underpricing levels during the prosperous two years before the burst of the internet-bubble exceeded any level that was previously seen before. However, since the start of the financial crisis in July 2007, western capital markets were disrupted which affected the worldwide economy for the past few years. Economist named it “The Great Recession”, since it is the worst financial crisis since the Great Depression. It caused a significant drop in economic activity and decline in consumer wealth. It also caused a significant drop in the number of IPO issues worldwide. This is in line with Ritter’s (1984) “hot issues market” phenomenon, the degree of underpricing is positively related with annual IPO volume with 0.51. China’s economy was only slightly affected, due to their earlier strong economic growth, a stable Yuan and the absence of a debt crisis. Chen et al (2014) find that in China, market sentiments are related to IPO underpricing. Furthermore, their findings are consistent with the hot market theory of Loughran & Ritter (2002). The research of Chen et al. (2014) find that Chinese IPOs have higher initial returns during hot issue markets.
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The reputation of the assisting investment bank can also have an influence on the underpricing level of an IPO. This reputation can be built by having repetitive contact with investors and achieving good results. If an issuing firm hires an prestigious underwriter, the risks that are associated with the IPO can be lowered. Beatty and Ritter (1986) state that underwriters are incentivized to underprice stocks, when the following three conditions are met:
1. Underwriter loses clients when its prices are not set in line with the general expectations, resulting in losses of the investors
2. Underwriter cannot perfectly predict the aftermarket price of the issued stock 3. Underwriter must have a good reputation at stake
The relation between underwriter reputation and underpricing level is confirmed by Dimovski et al. (2011). He found evidence that reputation has a positive correlation with the underpricing level in the Australian stock market. There are several legal factors that need to be taken into account during the IPO process. As mentioned just before, underpricing is used to protect the underwriter against reputation damage caused by not selling all the shares. Lowry and Shu (2002) find evidence that legal insurance leads to underpricing. In other words, the chances of facing a lawsuit have an effect on the amount of underpricing. However, after investigating the relationship between initial returns on IPOs and underwriter reputation Wu (2001) didn’t find significant evidence in China.
4. Data & Methodology
This chapter describes the data and methodology. The first paragraph contains an of the data. The second section explains how the data is used to test the hypotheses.
4.1
Data
Data used in this thesis consists of 470 IPOs listed at the stock exchanges of Shanghai, Shenzhen or Hong Kong. The sample period is from 1 January 2004 to 31 December 2013. Originally there were 897 observations, which is higher than the amount of IPOs. This is caused by the fact that at most IPOs issued domestic and foreign shares separately, leading to an increased number of observations. The data on the amount of IPOs, the initial returns, number of issued shares, offer prices, share classes and announcement dates are gathered using the Thomson One database. Closing prices of the stocks and market betas are obtained using the Datastream database. These are retrieved using both the Stock Exchange Daily Official List (SEDOL) and International
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Securities Identification Number (ISIN) codes. Due to missing information on offer and closing prices, 96 observations were lost. All the prices are given in US dollars.
4.2
Methodology
The degree of underpricing is defined as the percentage difference between the offer price and the closing price on the first trading day. This percentage is also known as first-day return or initial return. It can be calculated with the following formula:
Initial return (IR) = [ (P1 – P0) / P0 ] * 100
where IR is the degree of underpricing, P0 is the initial offering price and P1 is the first-day market closing price of the share. We examine how the initial returns are achieved and what factors exert influence. Independent variables used in my empirical work include:
Table 1: List of independent variables
Variable Proxy Measure
Time gap LAG Number of days between announcement date and the first trading day of an IPO. Recession dummy REC Great Recession Dummy. Value ‘1’ if an IPO occurred during the years
2007-2009. Value ‘0’ if an IPO occurred in any other year between 2004-2014. Offer price PRICE The price of the offered shares.
Issue size SHARES Number of shares issued at the time of an IPO.
Share type CLASS Class of the share. Value “1” if A-share. Value “0” if H-share.
Market beta BETA Correlation between the 10 day company returns and the 10 day market returns after an IPO.
Interaction dummy RECxCLASS Interaction dummy that investigates the difference in the effect of the Recession on underpricing for the different share classes.
A cross-sectional regression model is used to test which independent variables have a significant effect on the underpricing phenomenon in China. An OLS regression model is constructed that includes China’s characteristic variables as LAG and CLASS. The variables BETA and SHARES are included as control variables to improve the model’s explanatory power. Including these variables increases the adjusted R^2 of the model by 2 percent. I used the JHCSE estimator to overcome heteroskedastic error terms in the models, according to MacKinnon and White (1985). The following model will be estimated:
Based on existing literature, the following hypotheses are presented: (1) H0: IR=0
H1: IR>0
This hypothesis tests if there is underpricing in the sample. This is predicted by Ritter (1998), Mok and Hui (1998), Su and Fleisher (1999) and Wu (2001), among others.
LAG
SHARES
CLASS
BETA
PRICE
RECxCLASS
REC
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(2) H0: β3= β6= 0
H1: β3= β6>0
This hypothesis tests if the class of a share is related to the level of underpricing. According to the studies by Mok & Hui (1998), Chan et al. (2004) A-shares have higher initial returns than H-shares.
(3) H0: β1= 0
H1: β1>0
Furthermore, I want to investigate the relationship between underpricing and the number of days between the listing of the IPO and the first trading day. According to studies by Su (1999), Chen et al. (2004), Mok & Hui (1998), Wu (2001) the time gap has a positive correlation with underpricing.
(4) H0: β6= β7=0
H1: β6= β7≠0
This hypothesis performs a F-test on the variables REC and RECxCLASS to determine if the Great Recession had a significant influence on the level of underpricing in China. Mahmood et al. (2011) studied the effects of the Great Recession on Asian IPOs and found that IPO activity was shrinking as the period of recession approaches its critical point. However, Mahmood et al. (2011) finds that underpricing has increased 10 percent during the recession.
Hereafter, there is a second regression model controls for year effects. Dummy variables are added to the regression to show the relationship between the year of IPO issuance and the level of underpricing. There is a dummy variable added for each year, but to prevent generating biased results due to a dummy variable trap, the dummy of the year 2006 is excluded.
The second model is formulated as:
0 1LAG 2SHARES 3CLASS 4BETA 5PRICE 6RECxCLASS 7REC 8Y13 9Y12 ... 14Y7 16Y5 17Y4
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5. Results & Analysis
The figures below present the annual IPO activity and the average amount of underpricing in China. In 2010, IPO activity reached its peak with 75 performed IPOs in one year. The underpricing percentage is the highest in 2004, with an average of 56%. In Figure 5 and Figure 6, the period 2004-2007 shows characteristics of a hot issue market, as IPO activity rises proportionally to the amount of average underpricing in those years. This is consistent with the theory by Ibbotson and Jaffe (1975).
Figure 5: Annual amount of initial public offerings in China (Source: Thomson One)
Figure 6: Average underpricing in China, measured in percentage (Source: Datastream)
The descriptive statistics of the sample are given below in Table 2 and Table 3. Offer prices and underpricing percentages are collected using the Thomson One database. In the 2004-2014 period, A-shares have an average initial return of 37.2%, which is four times as high as the average initial returns on shares that are traded in Hong Kong. H-shares have an average initial return of 9.4%. Mok & Hui (1998), Chan (2004) and Yu & Tse (2006)
0 20 40 60 80 2004200520062007200820092010201120122013
IPO activity in China, 01/2004 -
01/2014
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The results of the first regression model are presented in Table 3. All the explanatory variables are significant at the 1% level, except for the dummy variable Y7 and the Great Recession dummy variable REC, which are significant at the 5% level.
Table 4: Regression output including China’s key characteristics.
Variable Coefficient Std. Error t-Statistic P-value
This leads to the following hypotheses results: (1) H0: IR=0
H1: IR>0
Table 1 and Table 2 show that there is underpricing on A-share and H-share IPO with 37.2 percent and 9.4 percent, respectively. Furthermore, the mean of initial returns is 19.04 in the first regression model. This relation is consistent with the existing theories. The F-statistic of this model is 51.45, with a p-value of 0.000. Therefore, the null hypothesis is rejected.
(2) H0: β3= β6= 0
H1: β3= β6> 0
The class of a share, controlled with CLASS and RECxCLASS, is found to have a significant positive relation with the degree of underpricing in China. The F-statistic based on 790 observations was 23.577 with p-value 0.000. Therefore, the null hypothesis is rejected at the significance level of 1 percent (using JHCSE).
Variable Mean Median Max Min Std. Dev
Offer Price 19.81 1.42 13.58 0.10 1.76
Underpricing (%) 37,21 24.025 329.52 -23.16 48.79
Table 2: Descriptive Statistics of Chinese A-share IPOs
Variable Mean Median Max Min Std. Dev
Offer Price 0.50 0.35 6.58 0.04 0.53
Underpricing (%) 9.39 1.00 192.59 -39.99 23.47
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(4) H0: β6= β7= 0
H1: β6= β7≠0
The Great Recession, controlled with REC and RECxCLASS, is found to have a significant positive relation with the degree of underpricing in China. The F-statistic is 16.306[0.0000] based on 790 observations, and significant at the 1 percent level (using JHCSE). Therefore, the null hypothesis is rejected. The output implies that, during the years 2007-2009, shares are underpriced with 13 percent points more compared to the other years. This is consistent with the theory by Mahmood et al. (2011), who found an increase of 10 percent during the years 2007-2009. The difference of 3 percent can be explained by the different data samples. I only studied the Chinese and Hong Kong markets, Mahmood et al. used the Asian market as a whole.
The output also shows that, during the recession, A-share IPOs are more underpriced than H-shares with an additional 44 percent points. Based on the p-value of the variable RECxCLASS, which is 0.007, the relationship is significant at the 1 percent level (using JHCSE). This might be caused by the fact that the Chinese market is still closed for foreign investors, making it harder to be affected by financial crises in western countries. It also takes away arbitrage opportunities. (3) H0: β4=0
H1: β4>0
The time gap, measured with LAG, is found to have a significant positive relation with the degree of underpricing in China. The first regression predicts a marginal increase of 1.2 percent points in underpricing for each day between the announcement date and the first trading day. This result is consistent with the theories of Mok & Hui (1998) and Wu (2001) and equivalent to the predictions made by Chen et al. (2004), who claim that the marginal effect on underpricing is 1.8 percent points for each additional day in the time gap. The F-statistic is 16.306 with p-value 0.000 based on 790 observations. Therefore, the null hypothesis is rejected at the significance level of 1 percent (using JHCSE).
The results of the second regression model are presented in Table 4. After including the dummies for the different years, the variable for LAG became insignificant. The dummy variable for the year 2004 (Y4) is also highly insignificant, as its p-value of 0.76 exceeds the 5 percent significance level. Other explanatory variables are all significant at the 1% level, except for the dummy variable for 2007 (Y7) and the Great Recession dummy variable REC, which are significant at the 5% level. This may be caused by multicollinearity, as the crisis started in the year 2007. Multicollinearity occurs when two or more explanatory variables are highly correlated.
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Table 5: Regression output with annual effects.
Variable Coefficient Std. Error t-Statistic P-value
This model shows the relationship between the year the IPO is performed and the degree of underpricing. For example, the variable Y10 predicts that IPOs in 2010 were, on average, 22 percent less underpriced compared to other years. In the year 2011, IPOs were underpriced 29 percent less compared to other years, on the average.
6. Limitations
There are be some limitations to this research. For example, there are 136 observations lost due to missing values. The exclusion of these observations can have changed the regression output and the significance of the used variables. Furthermore, when calculating the market beta and the performance of the IPO after 10 trading days, some observations might be missing because of closed stock markets. When this happens, for example because of a national holiday, the cell in Excel is empty. This might be unfairly interpreted as a zero return on that day. This is caused by a Datastream setting to prevent last available information repeating itself. The data can also be less accurate because of rounding. Stock volumes are measured in thousands of shares. Rounding can lead to changes in the effect of the stock volume on the IPO’s initial returns.
Another limitation of this study is that there is only Chinese Class B shares coverage until 2000 in the Thomson One database. There is a suspension of issuing class B shares after 2000. However, there are no official announcements from China Securities Regulatory Commission. The media reports have been focusing on B share revolution (either through A-shares or H-Shares listings). In future research, other databases may be consulted to find data on B-shares.
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Previous studies (Ritter, 2008; Chan, 2004; Yu & Tse, 2004) mainly use the ordinary least squares regression method, which is based on the normal distributions assumption. However, Tian (2011) states that the data of Chinese underpricing on initial public offerings is heavily skewed. To investigate the data of Chinese IPOs, the ordinary least squares method was rejected using the Shapiro–Wilk W test. Therefore, the empirical conclusions of previous literature need to be revised (Tian, 2011).
7. Conclusions
In this thesis, I have studied the underpricing of 470 IPOs in the markets of China and Hong Kong in the 2004-2014 period. There are several theories on underpricing, namely theories based on asymmetric information, symmetric information, hot issue markets and underwriter reputation. Furthermore, multiple characteristics of the Chinese markets affect the degree of IPO underpricing.
This research is based on the following research question:
What’s the extent of IPO underpricing in the Chinese stock markets between the years 2004-2014 and what are its most important drivers?
Consistent with findings of existing literature based on asymmetric models and the key characteristics of the A-share market in China, my findings include the presence of an average degree of underpricing of 19 percent in the Chinese and Hong Kong markets. I also found severe underpricing of Chinese A-type IPOs. On the average, A-shares are priced 37 percent below their market value by underwriting companies at the moment of initial offering. Hong Kong H-type shares are also underpriced, but only with 9 percent, on the average. Furthermore, I have found a significant positive relationship between the number of days between the IPO announcement date and the first trading day and the degree of IPO underpricing. Finally, I found a significant positive relationship between the Great Recession and the level of underpricing, even though Ritter’s (1984 ) “hot issue” market theory predicts the contrary. However, Mahmood et al. (2011) agree on this positive relationship in the 2007-2009 period.
As the Chinese government has chosen to use their stock markets to finance their growth plans, they must further develop their stock exchanges towards becoming more efficient. This way, China can continue to become an strong player in the global economy. This can be achieved through providing more information to Chinese investors. When they continue to gain knowledge and experience about the financial markets, the markets will become more efficient. Furthermore, having more experienced and knowledgeable investors active in the Chinese
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market will most likely lead to a lower degree of IPO underpricing as this will improve the distribution of information between investors and firms (Rock, 1986). It is also interesting to see what will happen when the Chinese government removes the annual shares quota. Likewise, this is expected to lead to a reduction in underpricing as demand and supply are more balanced.
8. Recommendations for future research
Although the IPO underpricing phenomenon has been widely studied, I believe there are some issues that can be further explored. For example, it may be interesting to investigate corporate governance issues related to the underpricing of IPOs. This is a relatively new area of research which is hardly studied, particularly in China. In general, after a firm goes public, ownership by the company’s managers is lowered due to the transfer of ownership to the new shareholders. A study by Chen & Kao (2005) showed that company managers have sufficient ownership to control the company at the moment of issuance, and it would be harmful to the company’s performance if managerial ownership would increase in the early aftermarket. Future research may consider whether this is also true for the Chinese market.
Another interesting issue that can be researched is the optimal moment for a company to go public. When is the right time in a company’s lifecycle to perform an IPO? A study by Pagano et al. (1998) didn’t find a model that gives clarification on this. It can also be interesting to explore if this moment is different in China compared to older stock exchanges. This same study (Pagano et al., 1998) argues that it is not clear why the amount of IPOs varies greatly between countries and between periods. Does the amount of IPOs have an effect on the level of underpricing? Hot issue markets are one explanation, but specific models that can explain the variation in IPO volume are still absent.
Furthermore, additional research on the relationship between the Chinese laws and the performance of IPO can be done. What will happen when the Chinese government removes the annual share quota? I believe this is would be a very special event, which could alter the Chinese IPO market. When this occurs, academics should do empirical research on the effects on the degree of underpricing.
Acknowledgements
I would like to thank Philippe Versijp (the thesis coordinator) and Ieva Sakalauskaite (the thesis supervisor) for the writing assistance and for many insightful comments, which led to improvements in the paper. I thank Bjorn Witlox for his excellent support in collecting data.
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