Abstract: Negative returns of shares in the long run after initial public offerings have been confirmed on many markets however, the explanation for the cause of this phenomenon is ambiguous. Investigating underperformance is important because it allows a better understanding of the role of the stock markets in the financial system. Such market anomaly influence the behaviour of investors in the long run. Underperformance is featured in an extensive body of empirical literature and has been confirmed in most cases. However, it is inconclusive what affects such phenomenon on the markets. The purpose of this paper is to present the explanatory theories which are based on the behaviour of market participants and to summarize the explanatory variables of underperformance that stem from the theory.
<a href="https://dx.doi.org/10.15611/fins.2022.2.0…">DOI: 10.15611/fins.2022.2.0…</a>
<p>JEL Classification: G14, G32, G34</p>
<p>Keywords: IPO, initial public offering,underperformance, long-run performance, behavioural theories</p>
<h2>1. Introduction </h2>
<p>Price reactions after the initial public offering (IPO) have been
analysed for a long time. It has been observed that new issuers tend to
underperform on the broad market for up to five years after their debut.
Finding abnormal aftermarket performance of new listings raises doubts
about the informational efficiency of the IPO markets. Such behaviour of
abnormal rates of return may discourage investors from undertaking
long-term investments and therefore lead to shortening their investment
horizon – this also contributes to incorrect assessment of risk and
expected rates of return.</p>
<p>Ritter (2021) described in the summary of underperformance in the USA
a negative average abnormal market-adjusted return of 15.8% in the
period 1980-2019. International evidence of the phenomenon was outlined
by Álvarez and González (2005). With the exception of the Korean and
Swedish markets, the remaining eleven analysed countries (Australia,
Brazil, Chile, France, Germany, the UK, Hong Kong, Japan, Singapore,
Switzerland, and the United States) demonstrated negative abnormal
returns in the long run after IPO, where the highest level was
recognised in Australia (51%). Underperformance was also confirmed in
many other countries such as China (Tan & Kim, 2017), Spain (Álvarez
& González, 2005), Poland (Mizerka & Lizińska, 2017), New
Zealand (Dang & Jolly, 2017), Tunisia, Egypt, Oman and Morocco
(AlShiab, 2018).</p>
<p>Despite numerous empirical studies concentrating on the phenomenon of
underperformance, it has not been definitively established which factors
affect long-term rates of return. For example, in the group of factors
based on company characteristics, the age of the issuers at the time of
the IPO has been analysed quite often. Goergen, Khurshed and Mudambi
(2007) did not find any statistically significant relation between the
age of the issuing company and its performance in the long run. The same
results were obtained by Killins and Egly (2018). Que and Zhang (2019)
obtained mixed results when calculating the relation between age and
underperformance as depending on the method used to calculate rates of
return, their results showed either an insignificant or positive and
statistically significant relation. A positive and significant relation
was found by Szyszka and Zaremba (2016), who found that older companies
perform significantly better than the younger ones. These results were
confirmed by Al-Shawawreh and Al-Tarawneh (2015). Das, Saha and Kundu
(2016) described a significant negative relation between the company’s
age and abnormal returns, showing that the higher the age of the issuer,
the lower the long-term returns. Company’s size (usually measured by its
total assets or market capitalisation) is another frequently analysed
feature. The opposite relation between size and long-term returns was
established by Colombo, Meoli and Vismara (2019), indicating that the
valuation of smaller firms benefits from higher growth opportunities. A
positive impact of the company’s size was presented by Czapiewski and
Lizińska (2019). The same authors in the earlier study (2014) found a
negative impact on post-IPO long-run performance among a group of
smaller firms, yet Que and Zhang (2019) established that smaller issuers
experience better aftermarket performance. Chen, Lin, Chang and Lin
(2013) and Das et al. (2016) found that the size of the firm does not
explain long-term returns after IPO. Studies of venture capital (VC)
involvement in the ownership structure of IPO firms also showed
different results. Belghitar and Dixon (2012) showed that VC-backed and
unbacked IPOs underperform benchmark portfolio, but their findings are
statistically insignificant. Killins and Egly (2018), as well as Goergen
et al. (2007), found that issuers backed by VCs experience poorer
returns in the long run.</p>
<p>Many researchers also took into account characteristics of the offer,
and the influence of initial returns on long-run performance was
investigated. Consistent with the expectation of Cai, Liu and Mase
(2008), initial returns are negatively related to long-run performance.
Otchere, Owusu-Antwi and Mohsni (2013) also confirmed such a relation
for up to six years after IPO, but with the exception of three-year
performance when the coefficient is insignificant. No influence of
initial returns on long-run returns was found by Das et al. (2016).
According to these authors, the issue size is also not significant when
explaining long-run performance. However, Cai et al. (2008) obtained a
negative coefficient implying that the larger the size of IPO, the worse
the underperformance. In line with the research of Al-Shawawreh and
Al-Tarawneh (2015), there is a significant positive relation between the
size of offers of the IPO firms and their long-run performance.
According to Khan, Ramakrishnan, Haq, Ahmad and Khan (2018), the
underwriter’s reputation also has a positive impact on the long-run
performance of IPOs, thus IPOs led by more prestigious underwriters
perform better in the aftermarket. Dong, Michel and Pander (2011)
suggested that issuers with high-quality underwriters perform
significantly better than those with the lower-quality underwriters, as
the latter IPO companies earn negative abnormal returns. Additionally,
the effect of underwriter quality is strongest among IPOs with a high
level of uncertainty. Thomadakis, Nounis and Gounopoulos (2012) obtained
mixed results as – depending on the method used – they found that there
is either a negative relation or no significant relation at all,
therefore according to these authors, underwriter reputation offers the
evidence of the determinants of long-term returns to some extent.</p>
<p>In addition to the analysis of individual factors related to the
characteristics of the debuting companies, numerous theories have been
presented to explain the behaviour of price reactions after IPOs. This
article presents theories related to the behaviour of various market
participants, which can therefore be classified into a group of
behavioural theories.</p>
<h2>2. Behavioural
theories of long-run performance </h2>
<p>This group of behavioural theories assumes that underperformance is
caused by the particular behaviour of a given market participant. The
theories considered in the article include: earnings management,
divergence of opinion, windows of opportunity and fads theory.</p>
<h3>2.1. Earnings management theory</h3>
<p>Earnings management theory refers to the scope of the information
that managers of IPO companies publish in their financial statements.
The company, by shaping individual items of the report, and thus by
creating given level of profit, can increase the attractiveness of such
entity. The concept of information management does not, however, refer
to data manipulation and creative accounting. In order to reflect the
financial situation fairly, the legal system allows a certain degree of
flexibility in the demonstration of individual accounting items in the
financial statements. Such elasticity is meant to enable a company to
reflect its financial situation as accurately as possible. However, it
can also be a source of abuse on the part of managers who try to present
the financial condition in a better light than it really is (Lizińska
&Czapiewski, 2016).</p>
<p>From the issuer's point of view, the use of earnings management is a
good way to window-dress the results before the initial public offering.
This allows to increase the attractiveness of the company in the eyes of
other market participants and raise their expectations about the
company's future, and as a result, increase the possibility of obtaining
more share capital by the company.</p>
<p>When considering the theory with regard to long-term returns, it is
considered that a higher level of earnings management is associated with
a greater long-term price correction after the issuance of shares. Based
on the assumption of Ritter (1991) that young companies attract overly
optimistic investors who are highly positive about the future
performance of such issuers, Teoh, Welch and Wong (1998) considered
earnings management theory in the context of underperformance. Companies
that plan to enter the market may manipulate their financial statements
around the listing date in order to increase the attractiveness of their
shares. For investors who make their decisions based on the reported
financial results, it may be difficult to distinguish whether earnings
have been artificially inflated or if the ‘boost’ was caused by the
operational performance of the issuer. Consequently, an investor unaware
that the company has been managing their earnings may agree to pay too
high a price. However, with the passage of time, when the information
about the true condition of the firm is acknowledged, investors become
less optimistic about the future of the company. As a result, the stock
prices of ‘deceptive’ issuers may be negatively affected.</p>
<p>The literature concentrated on earnings management theory, where
discretionary accruals are used as a proxy to verify the theory. Teoh et
al. (1998) used accrual data from the financial statements published in
the year of IPO. The authors concentrated on current accruals as
managers have more discretion over them than over long-term accruals;
the sample used consisted of 1649 IPOs conducted between 1980 and 1992
on the US market divided into quartiles based on how aggressively the
companies manage earnings. The results showed that the most aggressive
accruals portfolio (the fourth quartile) underperformed more than the
portfolio with the most conservative accruals (the first quartile) when
calculating returns three years after the IPO. When adjusted by the
Nasdaq Composition Index, the cumulative abnormal returns (CAR) within
aggressive and conservative groups differed by 25.4% and by 26.2% when
calculating value-weighted returns. The difference was greater when
considering buy-and-hold returns. Using the same benchmark, the
difference between the two extreme quartiles was 29.2% and 30.7%,
respectively. The authors interpreted their results as proof that
issuers manage earnings to inflate their offering price.</p>
<p>DuCharme, Malatesta and Sefcik (2001) confirmed these results. They
based their work on a sample of 171 companies that entered the US market
over the period of 1982-1987. Using the regression model, they proved
that positive accruals in the IPO year, as well as the preceding year,
are negatively related to the three-year buy-and-hold abnormal return.
The same relation of earnings management and long-run performance was
obtained on the Chinese (Shen, Coakley, & Instefjord, 2014), Dutch
(Roosenboom, van der Goot, & Mertens, 2003) and French markets
(Miloud, 2013).</p>
<p>Armstrong, Foster and Taylor (2016) confirmed the existence of
positive abnormal accruals in the year of the IPO. However, they stated
that these accruals result from the economic activity of the IPO
companies as the IPO proceeds are being invested in working capital. The
authors proved that the positive accruals are not linked with the
benefits of the management.</p>
<p>Sletten, Ertimur, Sunder and Weber (2018) analysed quarterly data
regarding accruals, and proved that debuting companies manage earnings,
not before IPO but before the lock-up expiration date, in order to
inflate the price before the sale of shares by pre-IPO shareholders.
Consistent with this study, Ball and Shivakumar (2008) found no evidence
of positive abnormal accruals prior to the IPO.</p>
<h3>2.2. Divergence of opinion theory</h3>
<p>Divergence of opinion theory is another theory explaining the
behaviour of long-term rates of return based on the behaviour of
investors. It states that due to uncertainty regarding the true value of
stocks, there is a divergence of opinion about expected rates of return
from a given investment and its risk. The prices reflect the sentiments
of all investors, i.e. those who perceive the company positively and
negatively. However, under the condition of no short selling (and
therefore excluding the opinions of investors that are pessimistic about
the company's value), the prices are determined only by the marginal,
optimistic investors. Due to the amount of publicly available
information, the divergence of opinion about the share value is in
particular greater for companies that are just entering the market.
Thus, offers from investors who are able to pay a high price for shares
may cause the market prices to exceed their offer price shortly after
the IPO. As time passes and more information about the company becomes
available, the divergence of opinion among investors decreases, in
effect causing the rates of return to diminish in the long run (Miller,
1977). In line with the theory, the higher the divergence of opinion,
the higher the underperformance.</p>
<p>The research of Houge, Loughran, Suchanek, and Yan (2001) based on
2,025 US IPOs that took place in 1993-1996 supported the hypothesis and
associated poor long-run returns of IPOs with a higher divergence of
opinion. As a proxy of divergence of opinion, the authors applied three
factors: percentage opening bid-ask spread, exact time of the first
trade and flipping ratio. When considering the regression model, all
three proxies negatively influenced the long-run performance.</p>
<p>The US market was also examined by Gao, Mao and Zhong (2006), however
they used return volatility for the first 25 days after IPO as a proxy
of divergence of opinion. Using such a proxy, the authors also confirmed
that the divergence of opinion is negatively related to subsequent
long-run abnormal returns of IPOs.</p>
<p>Based on data from Polish IPOs, Jewartowski and Lizińska (2012) found
a significant positive relation between early aftermarket volatility;
however, the returns in the long term were insignificant. As divergence
of opinion is correlated with uncertainty (Miller, 2000), the authors
decided to apply factors used as proxies of uncertainty, i.e. size of
the issuing company and market-to-book value, representing either value
or growth company, depending on the level of the ratio. Based on this,
they also confirmed that smaller issuers underperform on the market
after three years from their listing, and issuers with higher MV/BV
(reflecting growth companies) or ROE (according to the authors,
above-average profitability should attract overoptimistic investors)
have higher initial returns but underperform issuers with lower ratios
in the long run. Thus, their results only partially confirm the theory
of divergence of opinion.</p>
<p>Narayanasamy, Ibrahim, and Kyid (2018) confirmed that retail
investors' participation influences the relation between initial
performance and aftermarket opinion of investors in the Malaysian IPO
market. According to the authors, retail investors that participate in
IPOs take advantage of the divergence of opinion effect.</p>
<h3>2.3. Window of opportunity theory</h3>
<p>The window of opportunity theory anticipates that managers are able
to distinguish periods when investors are overoptimistic, and therefore
they can successfully time the most favourable moment for their IPO.
Going public during ‘hot’ periods provide issuers with an opportunity to
sell shares at a higher price in comparison to ‘cold’ periods.
Poor-performing entities may take advantage of such a situation and
carry out a successful IPO which ends up with being valued above their
fair value. Obtaining share capital on such attractive terms may not be
possible for worse-performing companies in other periods. Therefore it
may be expected that in periods with high IPO activity, not only ‘good’
companies entered the market, but also the ‘bad’ ones. A concentration
of IPO volume followed by low long-run returns indicates that issuers
take advantage of windows of opportunity and that such companies are the
most likely to provide high initial returns and poor long-run
performance (Ritter, 1991). Schultz (2003) demonstrated that
underperformance is related to IPO clustering at market peaks.</p>
<p>Coakley, Hadass, and Wood (2008), based on 591 UK IPOs that took
place between 1985 and 2003, distinguished 46 hot periods out of the 228
analysed months. Although the authors did not find a confirmation of
underperformance based on the entire sample, they obtained negative
long-run abnormal returns in hot periods (3-year CAR for the hot markets
was -18.52%).</p>
<p>Kooli and Suret (2004) confirmed that hot IPOs underperform more than
issues conducted in cold periods. The authors analysed the aftermarket
performance of 445 IPOs that took place during 1991-1998 on the Canadian
market. The 5-year returns were -4.6% in the cold period, and -39.08% in
the hot period.</p>
<p>Consistent with previous research, Helwege and Liang (2004) confirmed
the windows of opportunity as a reason for underperformance. Based on
3698 IPOs from the US market from 1975 to 2000, the authors calculated
1, 3 and 5-year wealth relatives for the sample using value and
equal-weighted Nasdaq indices as benchmarks. A wealth relative compares
average raw returns on the IPO firms with average returns on the equal
number of benchmark observations. Wealth relatives for all analysed
periods in the cold market were bigger than 1, and for the hot periods,
all the wealth relatives were below 1, except for the 5-year wealth
relative based on the equally-weighted benchmark.</p>
<h3>2.4. Fads theory</h3>
<p>Another theory is based on the assumption that IPO markets are prone
to the occurrence of fads (Shiller, 1990), which are temporary
overestimations of the value of shares caused by the excessive optimism
of investors. Aggarwal and Rivoli (1990) focused on verifying this
theory with regard to long-term post-IPO price reactions. In their
opinion, the IPO market is particularly prone to fads as estimating the
intrinsic value of securities on such markets is difficult due to the
lesser availability of public information, and therefore there is a
greater likelihood of fads. The other arguments they used for testing
IPO markets are: noise trading is more likely for more risky securities;
it is assumed that decisions made by IPO investors are more often based
on speculation; a marginal investor is overly optimistic. Aggarwal and
Rivoli (1990) found that market valuation immediately after issuance
ineffectively reflects the true value of the issuer because investors
are irrational. Due to the fact that investors are overly optimistic
about the value of companies going public, IPOs are underpriced. In
time, with the inflow of new information about the issuing company,
investors' excessive optimism cools down, which is reflected in rates of
return through underperformance. Therefore, the fad theory states that
IPOs are priced correctly, but overoptimistic investors overvalue them
shortly after their debut.</p>
<p>In line with the fads theory, high initial returns are positively
correlated with the long-run underperformance, however there are no
direct proxies reflecting market fads. Instead, the measures of the fads
hypothesis focus on the relationship between underpricing and long-term
rates of return. Aggarwal and Rivioli (1990) confirmed that when
adjusting for the Nasdaq index, the returns 250 days following the
offering were significantly negative (-13.7%).</p>
<p>In terms of the fads theory, the negative relation between
underpricing and underperformance was also confirmed based on the Indian
market (Bhatia & Singh, 2012). The 648 Bombay Stock Exchange
companies that conducted IPOs between June 1992 and March 2002 were
categorised by the size of initial returns. The results confirmed that
when analysing the rates of return calculated by BHAR for up to 5 years
after IPO, underpriced companies recorded negative rates of return in
the long run, except for the 1-year return (in this period, a negative
relation with underpricing was indicated only in the group of companies
with the highest level of initial returns). The group of companies with
the highest initial returns underperformed at most for up to 4 years
after IPO.</p>
<p>A negative relation between underpricing and underperformance was
also confirmed, i.e. on the market in Malaysia (Ahmad-Zaluki & Kect,
2012), Canada (Kooli & Suret, 2004), Turkey (Durukan, 2002) and
Japan (Kirkulak, 2008).</p>
<h2>3. Conclusion</h2>
<p>The article concentrates on the behaviour of long-run stock returns
after initial public offerings. Based on the research, IPO markets
recorded average negative rates of return. The literature on the subject
not only focuses on underperformance itself but also attempts to explain
the cause of such phenomenon. Therefore, this article took into
consideration not only the levels of underperformance but also presented
the explanatory theories, as well as the proxies that stem from each
theory.</p>
<p>The described theories can be attributed to the group of behavioural
theories that state that the cause of underperformance lies in the
behaviour of particular market participants. The earnings management
theory assumes that issuers window-dress their information published in
the financial statements before IPOs to attract more investors. The
divergence of opinion theory is based on the assumption that there is a
divergence of opinion among investors about expected rates of return of
the issuing company. The window of opportunity theory assumes that
management can time the market and issue shares when investors are
overly optimistic. The fads theory states that underperformance is
caused by the overoptimism of investors regarding the value of issuers
shortly after IPOs. Depending on the adopted theory, the proxies used to
verify each of them will differ.</p>
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