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WHAT CAUSES AN INITIAL PUBLIC OFFERING TO BE UNSUCCESSFUL?
AN EMPIRICAL ANALYSIS
Xiaofeng Zhao
By
A Dissertation Submitted to the Faculty of Mississippi State University in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Business Administration in the College of Business and Industry
Mississippi State, Mississippi May 2005
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Copyright by Xiaofeng Zhao

2005
WHAT CAUSES AN INITIAL PUBLIC OFFERING TO BE UNSUCCESSFUL? AN EMPIRICAL ANALYSIS
By Xiaofeng Zhao
Approved:
Edwin H. Duett Professor o f Finance (Director o f Dissertation)
Kartono Liano Professor of Finance (Committee Member)
William G. Hardin III Associate Professor o f Real Estate (Committee Member)
Kevin E. Rogers Associate Professor of Economics (Committee Member)
Brian T. Engelland Professor o f Finance (Director o f Dissertation)
Barbara A. Spencer Professor o f Management Director of Graduate Studies in the College o f Business and Industry
Sara Freedman Dean o f the College o f Business and Industry
Name: Xiaofeng Zhao Date of Degree: May 7, 2005 Institution: Mississippi State University Major Field: Business Administration (Finance) Major Professor: Dr. Edwin H. Duett Title of Study: WHAT CAUSES AN INITIAL PUBLIC OFFERING TO BE UNSUCCESSFUL? AN EMPIRICAL ANALYSIS Pages in Study: 127 Candidate for Degree o f Doctor of Philosophy in Business Administration
Every year a substantial number of privately held companies file with the Security and Exchange Commission (SEC) in an attempt to go public. However, not every firm is successful in completing its issue. Both the number of successful initial public offerings (IPOs) and withdrawn issues fluctuate considerably over time. This study explores whether security market conditions, financial characteristics of IPO firms, and signaling factors can discriminate completed IPOs and unsuccessful ones and investigates the differences between IPOs in hot and cold markets. The research shows that financial market conditions are important determinants of the outcome of the IPO process in both statistical and economic terms. Firms are more likely to complete their IPOs when market conditions are favorable. On average, financial characteristics of firms going public in the hot market are weaker than those of cold firms, and signaling factors indicate lower value for hot firms. However, investors show stronger interest in hot IPOs, and it takes less
time to complete an issue in a hot market. Stocks starting to trade in a hot market have worse postoffering performance than their counterparts in a cold market. These findings can be explained by the theory of investor overoptimism in hot markets.
DEDICATION
I would like to dedicate this research to my parents.
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ACKNOWLEGEMENTS
I would like to express my sincere gratitude to my committee members: Dr. Edwin H. Duett (the committee chairman), Dr. Kartono Liano, Dr. William G. Hardin III, Dr. Kevin G. Rogers, and Dr. Brian T. Engelland. I greatly appreciate them for the countless time they spent on guiding me and sharing their valuable insights with me. Without their guidance and assistance, this dissertation could not have been possible. I would also like to thank Dr. Liano for sharing with me the Thomson Financial Securities U.S. Corporate New Issues database and RATS software. Expressed appreciation is also due to my colleagues at Southern Arkansas University. Particularly, I would like to thank Dr. David Ashby and Dr. Terrye A. Stinson for their support and assistance. Finally, special thank should be given to my family whose sacrifice, love, motivation, and support allowed for the completion of this project.
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TABLE OF CONTENTS
Page DEDICATION ...................................................................................................... ii iii vi vii
ACKNOWLEGEMENTS .......................................................................................... LIST OF TABLES ................................................................................................. LIST OF FIGURES ................................................................................................ CHAPTER I. INTRODUCTION .................................................................................. Benefits and Advantages of Going Public ......................................... Costs and Disadvantages of Going Public ......................................... Objectives of the Study ........................................................................... Statement of the Hypotheses.................................................................. Justifications of the Study ..................................................................... Contributions of the Study .................................................................... Organization of the Study ...................................................................... II. LITERATURE REVIEW ........................................................................ Initial Public Offering Process .............................................................. Research on IPO Withdrawal ............................................................... Literature on the Role of Market Conditions in the IPO Market ....... Research on the Investors ex ante Valuation of IPOs ........................ Literature on Signals of the Value of IPOs .......................................... III. DATA AND METHODOLOGY............................................................ Sample Selection and Data ................................................................... Explanatory Variables and Predicted Effects on Probability of IPO Success .............................................................................................. Factors Indicating Market Conditions ......................................... Factors Affecting the Investors ex ante Valuation of IPOs ..... Factors Signaling the Value of IPOs ........................................... - iv 1 2 4 7 8 11 15 16 17 17 21 23 28 32 39 39 42 42 45 48
CHAPTER Methodology .......................................................................................... IV. EMPIRICAL RESULTS AND ANALYSIS.......................................... Sample Characteristics ........................................................................... Descriptive Statistics ............................................................................. Logistic Analysis of the Outcome of IPO Process ............................ Window of Opportunity ........................................................................ Characteristics of Hot and Cold IPOs ................................................... Stock Performance of Hot and Cold IPO Firms ................................... V. SUMMARY, CONCLUSIONS, and LIMITATIONS........................... Summary ................................................................................................. Conclusions ........................................................................................... Limitations o f This Research .................................................................. REFERENCES ...................................................................................................... APPENDIX A Additional results of the logistic analysis of the decision to withdraw an IPO ........................................................................... Additional Results o f the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on Sample o f Completed IPOs ........................................................ Additional Results of the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on the Withdrawn Sample ............................................................... Long-Run Stock Returns in the Year Following the IPO for Hot and Cold Market IPOs and Their Benchmarks Without Delisted Firms ...................................................................
Page 52 56 56 65 75 83 89 96 102 102 106 108 110
118
B. 1
121
B.2
123
125
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LIST OF TABLES
TABLE 1. 2. Number of Initial Public Offerings by Year .......................................
Page 24
Definition And Predicted Effect of Variables Used in the Logistic Analysis of the Probability of IPO Success ................................. Sample Selection Process .....................................................................
53 58
3. 4.
Distributions of Completed and Withdrawn IPOs by Month over the Period o f 1999-2002 ......................................................................... Industry Affiliation o f Firms with New Issue Filings ........................
59 62
5. 6.
Industry Distribution o f Completed and Withdrawn IPOs, and Firms in General ................................................. Descriptive Statistics on Sample Firms Conditional on Outcome of the Filings ......................................................................................... Pearson Correlation Coefficient of Variables ............................................ Logistic Analysis of the Decision to Withdraw an IPO .....................
63
7.
66 72 76
8. 9. 10.
Logistic Analysis of the Window of Opportunity for Initial Public Offerings ........................................................................................... Ordinary Least Squares Regression Results on IPO Activity ............
85 87
11. 12.
Comparison o f Security Market Conditions, IPO and Firm Characteristics between Hot and Cold Market ............................... Ordinary Least Squares Regression Results with the Time Frame (Days) to Complete an IPO as the Dependent Variable ................ Long-Run Stock Returns in the Year Following the IPO for Hot and Cold Market IPOs and Their Benchmarks ........................ - vi -
90
13.
93
14.
99
A. Additional results of the logistic analysis of the decision to withdraw an IPO ........................................... B. 1. Additional Results of the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on the Sample of Completed IPOs ................................................. B.2. Additional Results of the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on the Withdrawn Sam ple......................................................... C. Long-Run Stock Returns in the Year Following the IPO for Hot and Cold Market IPOs and Their Benchmarks Without Delisted Firms ....................................................................
119
122
124
126
- vii -
LIST OF FIGURES
FIGURE 1. Initial Public Activity and the NASDAQ Composite Index .....................
Page 60
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CHAPTER I INTRODUCTION
Initial public offerings (IPO) of securities are among the most important events in capital markets. By providing access to public markets, the IPO is both the channel for new capital to flow to fledgling companies and the mechanism for the existing owners to realize a return for their efforts. Ibbotson, Sindelar, and Ritter (1988) report that there were 8,668' companies successfully going public during the period of 1960-1987. This number gives an indication of the dynamic nature of the U.S. economy. It is far in excess of the number of publicly traded firms that have disappeared through bankruptcy, mergers, or takeovers during this period. These new public firms raised more than $84 billion, excluding real estate investment trusts (REITs) and closed-end mutual fund offerings, over the same period. The IPO market was even more active in the 1990s than the previous decades. On average, approximately 511 firms per year successfully went public in 1990s, which is higher than in any other decade. However, in conflict with the efficient market
1 Actually, this understates the number by several thousand, since they exclude small Regulation A offerings (less than $1.5 millions in gross proceeds) and some smaller offerings are omitted unintentionally.
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-2 theory, this large number of IPOs does not occur uniformly and randomly over time. For example, there were just 9 IPOs completed in 1974 while more than 950 in 1986 (Ibbotson, Sindelar, and Ritter 1999). This research explores the factors, which may contribute to the success or failure of IPOs, and investigates how security market conditions affect IPO markets. The management of a firm initiates the IPO process by filing registration with the Securities and Exchange Commission (SEC). After a long IPO process, some companies fulfill their plans and make their company stocks tradable in the public capital markets. In this study, the completed IPOs are defined as successful IPOs. However, not every firm is successful in its IPO effort. Many companies register with the SEC and intend to go public but do not succeed. These are referred to as unsuccessful IPOs. The more precise definition of a failed IPO is given in a later section. Before discussing the research questions, the next section will briefly summarize the advantages/disadvantages and benefits/costs of going public. An understanding of these issues will justify the importance of this study.
Benefits and Advantages of Going Public There are many advantages of having the stock of a company traded publicly in security markets, including the ability to raise additional equity capital; the ability for the original entrepreneurs or investors to realize some of their investments; the ability to inspire more faith in the firm from other investors, customers, creditors, and suppliers; and the opportunity to set up employee share options plans.
-3 According to a survey of 542 entrepreneurs who had just taken their firms public, by far the most important reason for going public was to infuse a significant amount of investment capital into the firm (Arkebauer 1999). Companies may have plans to expand into new areas, bring out new products for diversification, open new markets, or establish plants abroad. Many corporations, however, find themselves in a position where retained earnings and short-term loans do not meet their capital requirements. By going public and bringing in additional capital from new stock issuance, a company increases its net worth and builds a larger and broader equity base. On the other hand, the firm may use the proceeds of a stock offering to lower its debt level and consequently reduces its financial leverage and improves its balance sheet. In prospectuses filed with the Securities and Exchange Commission, 38 percent of firms going public from 1984 to 1994 state explicitly that the proceeds will be used to pay down debt (Busaba, Benveniste, and Guo 2001). The improved debt-to-equity ratio will help the firm raise funds as needed in the future. In particular, if the stock performs well in the continuing after-market, the firm will be able to raise additional equity capital or borrow debt on more favorable terms. The benefits o f going public go beyond merely raising a large amount of cash in a single transaction. EPOs are a source of liquidity that the public market provides for original stockholders. A liquid and transparent secondary market will encourage investors to participate in the stock market, increase the availability of equity capital, and lower investors required rate of return. In some cases, new equity capital may not be required, and the original investors simply want to sell part, or all, of their stake in a
-4 company. The ability to do this efficiently through an IPO will encourage entrepreneurship and, ultimately, economic growth. Public trading can also, in itself, add value to the firm, as it may inspire more faith in the firm from other investors, customers, creditors, and suppliers. Going public will boost the firms name recognition without increasing advertising expenses. Going public can broaden the firms customer base by turning some investors into patrons or attracting new consumers. Using Internet companies as an example, Demers and Lewellen (2003) demonstrate the advertising and marketing benefits that going public creates in a companys product markets. The firm may also gain attention from more suppliers and prompt competition among them, which may reduce a firms cost. Taking firms public can also help a company attract and retain key personnel by offering shares or stock options that have a public market. In addition, IPOs give a company the ability to consummate mergers and acquisitions through the funds derived from offerings or the available securities of a company (Swaney 1997). The publicly traded price also provides management and shareholders with important outside information about the firms value (Rock 1986).
Costs and Disadvantages of Going Public Going public involves two types of costs. First, there are the direct costs of an issue, including underwriter commissions; legal, printing, and auditing expenses; and other out-of-pocket costs. In addition, there are less quantifiable direct costs, such as management time. Ritter (1987) and Chen and Ritter (2000) estimate that the direct costs
-5 of going public are equal to approximately $250,000 plus 7 percent of the gross proceeds as underwriter commissions. A second cost is the indirect cost of the initial underpricing. If the shares had been sold at the closing market price rather than the offer price, the proceeds of the offering would have been higher. Loughran and Ritter (2002) document that companies going public in the United States left more than $27 billion on the table during 19901998, with the money left on the table being defined as the first-day price gain multiplied by the number of shares sold. With mean IPO proceeds of $68.1 million, each IPO leaves on average $9.1 million on the table. This number is approximately twice as large as the fees paid to investment bankers. It is usually argued that initial underpricing constitutes a transfer of wealth from the original owners of the company to the new shareholders. Otherwise the same proceeds could have been raised by selling fewer shares, resulting in less dilution for the preissue shareholders and, as such, should be regarded as a cost of raising equity finance. Together, the direct and indirect costs average 21.22 percent of the realized market value of the securities issued for firm commitment offers (Ritter 1987). Besides the quantifiable costs, other disadvantages associated with going public must be considered. Depending on the proportion of shares sold to the public, original investors, particularly founders of young firms, may be at risk of losing control of the firms. Of course, retaining at least 51 percent of the shares will ensure control for now, but subsequent offerings and acquisitions will dilute the control. Widespread distribution of the shares among public investors will ensure that there is no concentration of voting
-6 power in a few hands, and, therefore, the immediate threat to the control by the original investors will be minimized. However, the firm may be susceptible to an unfriendly takeover particularly if the stock of the company is undervalued. When stock shares of a small firm are primarily owned by individual investors, it will be relatively easy for an acquirer to gather necessary shares to initiate a hostile takeover. Additional reporting requirements may also be considered a disadvantage. As a public company, management will be subject to the periodic reporting requirements of the Securities and Exchange Commission. These requirements include quarterly financial reporting (Form 10-Q), annual financial reporting (Form 10-K), prompt reporting of current material events (Form 8-K), and various other reporting requirements, such as those for sale of control shares and tender offers. These reporting requirements may call for improved accounting systems, more accounting staff, and increased use o f lawyers, accountants, and other outside advisors. Securities analysts and the financial press will also make demands on managements time. In short, some costs of doing business will undoubtedly increase. In addition, information disclosure may damage the firms competitiveness by providing useful information to business competitors or potential entrants. Early public financing may also encourage new entries and, inevitably, stimulate product market competition, particularly in an emerging industry (Maksimovic and Pichler 2001).
-7 Objectives of the Study Going public offers a great number of benefits, such as raising additional equity capital, improving capital structure, providing ways for the original investors to cash out, and so on. Thus, many private firms in the United States have the goal of going public. Over the last decade, an average of two firms have gone public in the U.S. each business day, and thousands of additional firms have done the same in other countries. Every year hundreds of privately held companies file with the SEC in an attempt to go public. However, not every firm is successful in going public. Busaba, Benveniste, and Guo (2001) and Dunbar (2000) report that 717 filings were withdrawn during the 11-year period of 1984-1994. This accounts for about 14 percent of firm-commitment, new common equity issues filed with the SEC by American industrial firms. The value of these filings was $19.62 billion, in 1984 dollars. Busaba, et al. find that the withdrawal of initial public offerings was not specific to a particular period, to particular industries, or to issues of particular size. They, however, suggest that clustering of the withdrawal of IPOs during weak markets is possible. Additionally, withdrawn offerings are filed by firms that are as large and as profitable as firms that complete their IPOs, and such offerings are marketed by underwriters that are as reputable as the ones underwriting successful IPOs. This information raises several questions. Why, among the equal quality firms, did some young companies go public successfully while others failed? What are the determinants of successful IPOs? Surprisingly, little empirical studies could be found on exploring the reasons for successful or failed IPOs. This research is designed to provide additional insight toward answering these questions.
-8 In addition, both the number of IPOs and the total IPO proceeds vary substantially over time (Lowery 2003). There are often distinctive hot and cold IPO markets (e.g., Ibbotson and Jaffe 1975 and Ritter 1984) with an unusually high volume of offerings in the hot markets and a lower volume in the cold ones. Why does IPO volume fluctuate? What are the differences between hot and cold IPOs? These questions are related to the ones raised above and will hopefully be in this study.
Statement of the Hypotheses In a study of the choice of the underwriting contract, Dunbar (1998) finds that offering size, offering price, underwriter reputation, and clustering of filings affect the success of the filing. Despite the fact that the IPO market is highly cyclical and correlated with the general stock market performance, Dunbar ignores the factor of financial market conditions, which might have an impact on the success of the IPO attempts. In addition, operating performance of IPO firms is not taken into consideration even though earnings ability of public firms is the foundation of stock valuation. Busaba et al. (2001) include mostly financial variables in a probit analysis of the decision to withdraw an IPO. They conclude that the decision is impacted by revenues, expected issue size, leverage levels, and intended use of proceeds, but not by firm size, profitability, or the quality of the underwriter. This research extends these studies by estimating a model of withdrawal for the 1999-2001 period to test the following hypothesis:
-9 The probability o f withdrawal from the IPO process is impacted by financial strength o f IPO firms, security market conditions, and IPO stock quality signaling factors.
A number of studies (Lowery 2003, Koop and Li 2001, Loughran, Ritter, and Rydqvist 1994, etc.) show that IPO volume fluctuates over time. These studies suggest that there are windows of opportunity in the IPO market. During these windows of opportunity when investors are generally optimistic, stock markets are more acceptable to new equity issues, and equity is less likely to be misvalued. As a result, managers may have opportunities to time their financial decisions. Many young firms, even with poor operational performance, may be able to take advantage of the window of opportunity and successfully complete their IPO process. In contrast, during the cold market period when the window o f opportunity is closed, the stock market will more likely be closed to financially weak firms and may be only open to some high-quality companies. Therefore, it is expected that firms going public during the hot market should be of lower quality than those during the cold market, which leads to the following hypothesis:
The financial characteristics of firms successfully going public during windows of opportunity are weaker than those completing IPOs while windows of opportunity are closed.
Welch (1992) show that failures are more common in offerings underwritten by regional underwriters than national underwriters because national underwriters usually have more access to the capital markets. During a cold market when it is considerably difficult to go public, issuers will more likely hire more reputable national underwriters to
-10maximize the likelihood of bringing their firms public even though it may mean higher underwriting expenses. On the contrary, when the window of opportunity exists, it is relatively easier to complete the IPO process, and firm managers may be more tempted to use lesser known underwriters and pay lower underwriting fees. Additionally, there are more firms filing for IPOs during the hot market. Less prestigious investment bankers may find it easier to find underwriting business, and prestigious investment bankers may not seek the small amount of underwriting revenue from small firm issuance. Therefore, this research tests the following hypothesis:
Underwriters hired by firms going public while the IPO market was cold will be more prestigious than those investment bankers underwriting IPOs during the hot IPO market.
As stated above, if the window of opportunity exists, it would be easier for firms to complete their IPO process because investors are generally more optimistic during these periods and more willing to own relatively riskier new stocks. However, during the cold market, it will be harder for IPO firms to find enough investors to purchase their stocks. Firms may be forced to delay or even simply withdraw their IPOs. Therefore, the following hypothesis will be tested:
The time frame to complete IPO is shorter in a hot market as opposed to a cold market.
Lowery (2003) uses closed-end mutual fund discounts to proxy investor optimism. She finds that, since individual investors are occasionally overoptimistic and
-11 willing to pay more for firms than they are worth, value-maximizing managers will take advantage o f the window o f opportunity and issue equity during these periods of high investor sentiment. So, there are reasons to believe that firms going public during the window of opportunity will be more likely overpriced than other stocks taken public during the cold market. In the long run, stocks will revert to their true value, which leads to the following hypothesis:
Firms going public during windows of opportunity have significantly weaker post-offering stock performance than those issued during cold markets.
Justifications of the Study The questions raised above are of great importance to the parties concerned with IPOs, including issuers, investment bankers and investors. The reasons identified in this study could help the issuers to better time their IPOs, avoid a failed EPO, and reduce the costs of going public. On average, an issuing firm spends approximately $250,000 preparing for IPOs and makes years of preparation before filing with the SEC to go public. These firms want to maximize the probability of going public and take advantage of the benefits enjoyed by all public companies. Earlier literature suggests that withdrawal is an extremely unfavorable event. Lemer (1994, p. 312) states A firm that withdraws its IPO may later find it difficult to access the public marketplace. Even if the stated reason for the withdrawal is poor market conditions, the firm may be lumped with other businesses whose offerings did not sell because of questionable accounting practices or gross overpricing.
-12Dunbar (1998) and Ritter (1987) find that withdrawn offerings rarely return to the public marketplace. Less that 8 percent of issues that have previously failed are ever completed, and those that are successful generally occur several years after the failed initial attempt. It is also desirable for investment bankers to successfully bring their clientele public, both for earning underwriting fees and for avoiding damage to their reputation. Chen and Ritter (2000) find that in recent years in the U.S. more than 90 percent of moderate size initial public offerings paid gross proceeds of exactly seven percent. Investment bankers readily concede that the commission fees are high. Dunbar (2000) reveals that the withdrawal of offerings has a negative impact on the ability of reputable banks to compete for future business. Investment banks that are only associated with withdrawals in a given year will find it difficult to attract underwriting business in the future. However, the extant empirical studies on the determinants of a successful EPO are sparse, despite the large literature on IPOs. Only three related studies could be found in academic journals. In a similar study to empirically test the determinants of successful IPOs, Brau and Osteryoung (2001) analyze a sample of micro-IPOs made under Small Corporate Offering Registration (SCOR) procedure and collected from the state of Washington. The maximum size of the offer for the firms in that sample was one million dollars. However, most IPOs in the market are S-l offerings (greater than $7.5 million in gross proceeds) and S -l8 offerings (less than $7.5 million but more than $1.5 million). There are tremendous differences between regular size IPOs and micro-IPOs. For example, unlike regular EPOs, aftermarket trading data are not available for micro-IPOs.
- 13These two types of IPOs are subject to different regulations and different stock offering procedures. Therefore, further research may be needed before extending the findings from this study to larger initial public offerings. In a study o f the choice of the underwriting contract, firm-commitment or bestefforts offering, Dunbar (1998) estimates a probit model to predict the success of firmcommitment EPOs. In that article, no variables reflecting stock market conditions were examined, even though weak market conditions were most frequently cited as the reason for unsuccessful IPOs. Attempting to analyze the impact of the option to withdraw on IPO underpricing, Busaba, Benveniste and Guo (2001) construct a probit withdrawal decision model to estimate the ex ante expected probability of withdrawal and then examine whether the imputed probability has power in explaining the variation of initial returns. Two variables are included in the model to proxy market conditions, which are (1) the NASDAQ average 30-day return over the period between filing and issuing/withdrawal (RETF), and (2) the NASDAQ return over the 30 trading days immediately following the filing of an IPO with the SEC (RET30). Between the two variables, the latter is statistically significant, confirming the conventional wisdom that IPO withdrawal is more pronounced in weak markets. However, some control variables, such as earnings, may need to be added, and some variables reflecting security market conditions may be missed. The importance of stock market conditions on the success of an IPO may be understated.
-14Lemer (1994) shows that firms in the biotechnology industry have been able to time their IPOs, taking companies public at times when industry valuations are highest. Ritter (1991) points out that many firms go public near the peak of industry-specific fads. When firms prepare to go public, much attention is paid to IPOs of other companies in their industry. If another company in the same business recently completed a successful IPO or the firms in the same industry have good stock performance, it is more likely for the issuing company to succeed in its IPO. The company can market its IPO to potential investors with an analogy to the prior successful IPO or the solid price increases of firms in the same business. Thus, the stock performance of firms in the same industry will be an important predictor to the success or failure of IPOs. In the real financial world, a popular belief of practitioners is that timing is everything. Many people agree that there are IPO windows of opportunity, during which investors are especially optimistic about the growth potential of companies going public. As a response, many firms attempt to time their IPOs to take advantage of these swings in investor sentiment. Hot issue markets represent the windows of opportunity. In the hot issue markets, where new issue volume is usually high, IPOs can be sold at relatively high price-eamings and market-to-book ratios or at high levels relative to other measures of value. Practitioners also realize that IPO windows of opportunity open and close repeatedly with the change of market conditions. Investor acceptance of new issues is cyclical but often not in any predictable fashion. A detailed analysis of the impact of security market conditions on the success of an IPO will be conducted in chapter 2.
-15 In this research, successful initial public offerings are defined as completed IPOs. Before the stocks are sold to the general public, the issuing firms can cancel their proposed security offerings by filing withdrawal (Form RW) with the Securities and Exchange Commissions (SEC). If a registration statement has been on file at the SEC for 270 days, the SEC writes a letter to the firm and declares the offering abandoned. Often firms do not make public announcement to withdraw abandoned IPOs. In this study, unsuccessful offerings are defined solely as the spontaneous withdrawal of IPOs and do not include abandoned IPOs since there is no way to determine the time when the firms management decides to withdraw their IPOs. Hereafter, the withdrawal and failure of IPOs will be treated in the same manner and will be used interchangeably.
Contributions of the Study This study should prove to be of interest in many areas of IPO research and provide insight into IPO practices. First, it will further the literature on IPOs. This study integrates the findings in various aspects of IPO researches including market condition, valuation, and signaling literature, in order to address the big question: what determines the outcome of the IPO process. Second, the findings in the study may point out the direction for issuing firms to better time their BPOs, select underwriters, and/or disclose information, so as to increase the probability of IPO success. Third, the study may also help underwriters in selecting their customers, setting time to bring their clientele public, and pricing IPOs. If underwriters perform correctly in all these areas, they will be able to
-16maximize the chances o f IPO success, realize commission fees, and uphold their reputation.
Organization of the Study The remainder of this study proceeds as follows. Chapter Two reviews the IPO process and discusses the decision to withdraw IPOs and its consequences. Chapter Two also reviews the previous research and analyzes the factors leading to success or failure of IPOs. Chapter Three explains the data collection, discusses the research design, and develops the theoretical models. Chapter Four presents and analyzes the results. Finally, Chapter Five summarizes the research findings, presents the overall conclusions, and describes the limitations o f the research.
CHAPTER II LITERATURE REVIEW

The following literature review is broken into five distinct but pertinent sections. The first part describes the initial public offering process, which helps understand the steps an IPO firm has to go through before being successfully transitioned from a private to public company. The second section reviews the literature on the BPO withdrawal, which is defined in this paper as the unsuccessful initial public offering. This section also explains the situations under which EPO companies decide to terminate their IPO attempts Subsequent sections review three categories of factors, which may be the determinants of the success or failure of initial public offerings. The first group of factors measures market conditions; in most cases, failed IPOs are attributed to adverse market conditions. The second group includes the fundamental factors determining the firms ex ante value. The third group consists of the signaling factors, which are often used by entrepreneurs to convey superior private information to outsider investors.
Initial Public Offering Process Based on Lipman (2000), Benveniste and Spindt (1989), Sherman and Titman
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-18(2002), Ibbotson, Sindelar, and Ritter (1988), and Bartov, Mohanram, and Seethamraju (2002), the IPO process is summarized as follows. The first step of the going public process involves the choice of the book-running manager and the co-managers (if any). The lead manager is also responsible for assembling the syndicate to assist in the sale of the shares to the public. One of the lead underwriters first-agenda items is to draft a letter of intent. Among other issues, the letter contains clauses protecting the underwriter against any uncovered expenses in the event that the offer is withdrawn, the percentage of gross spread as a function of the proceeds (almost always seven percent, Chen and Ritter 2000), and a commitment by the company to grant a 15 percent over-allotment option to the underwriter. At this stage the underwriter starts the due diligence process in which the underwriter reviews the issuers financial statements; talks with management, customers, and suppliers; and starts to plan the structure of the deal. Concurrent with the due diligence process, the company and its counsel draft the registration statement for filing with the SEC. The Securities Act of 1933 makes it illegal to offer or sell securities to the public unless they have first been registered. Once the registration statement is filed with the SEC, it becomes the preliminary prospectus (or Red Herring). The preliminary prospectus is one of the primary tools in marketing the issue. The marketing of the offering begins following the filing o f the registration statement with the SEC. The Red Herring is sent to the sales people and to institutional investors around the country. At the same time, the company and the underwriter promote the IPO through the road show, and the underwriter solicits indications of interest from investors. At this stage, prior to the effective day, no shares can be
-19officially sold, so any orders submitted are only indications of interest and are not legally binding. On the day prior to the issuance date, after the market closes, the firm and the lead underwriter meet to discuss the final offer price and the exact number of shares to be sold. Setting the price of an initial public offering is crucial to a successful offering. During the pricing decision, particular attention is given to the order books where institutions and other investors indications are recorded. After those final terms are negotiated, the underwriter commits to sell the securities at the agreed upon price. Once approved, the distribution o f the stocks begins. The lead underwriter and the rest of the syndicate members distribute the stock to their customers. In most cases, the managing underwriter over-allots the issue, creating a short position by accepting more orders than there are shares to be sold. The following morning, the companys stock opens for the first time, but the IPO is far from being completed. Once the issue is brought to market, underwriters have several additional activities to complete. These include the decision on whether to use the over-allotment option, aftermarket stabilization obligations, and investment analysts coverage on the company. The over-allotment option (known as the green shoe) grants an option to the underwriter to purchase from the company, within 30 days, an additional 15 percent of the shares sold in the IPO at the offer price. (The NASD sets the 15 percent limit for the green shoe option.) With this option, an underwriter can (and virtually always does) sell 115 percent of the firms shares at the offering2. The motivation for
2 Note that this option can be exercised solely to cover overalloted shares at the offering.
-20this option is to provide buying support for the shares without exposing the underwriter to excessive risk. If the offering is weak and the price goes down, the underwriter does not exercise the option and, instead, buys back all or part of the extra 15 percent of shares in the market, thereby supporting the stock price. The over-allotment option thus provides the underwriter with buying power in the aftermarket, enabling him to support the price of the newly traded security. The underwriter typically has 30 days to decide to exercise all or part of this option. The underwriters use of the over-allotment option is part of his larger responsibility to support the price of the issue. Price support refers to stabilizing bids, trades, and penalty bids made by the underwriter to influence the price by slowing price declines (see Regulation M SEC release #34-38067, December 1996). Although there is no legal restriction about the price level at which stabilizing trades can be made, stabilizing bids can be made only at or below the offering price3. Stabilization is intended to be temporary in nature, in order to facilitate the distribution of the securities, and typically only lasts for a short time period after the registration becomes effective. The final stage o f the IPO begins 25 calendar days after the IPO when the socalled quiet-period ends, and analysts recommendations are available. After the quiet period, underwriters (and other syndicate members) can comment on the valuation and provide earnings estimates on the new company. The SEC mandates this quiet period, which marks a transition from investor reliance solely on the prospectus and disclosures mandated under security laws to a more open, market environment where research
3 For an excellent discussion o f the revised legal restrictions (Regulation M) on stabilization, see Aggarwal
( 2000 ).
-21 analysts interpret information and provide estimates and recommendations to their clients regarding the new firm. An underwriters role thus evolves in this aftermarket period into an advisory and evaluatory function.
Research on IPO Withdrawal As described above, in the process of price discovery, the underwriter sends the Red Herring to sales people as well as to institutional investors around the country. At the same time, the company and the underwriter promote the IPO through a road show in which company officers make numerous presentations to (mainly) institutional investors. As the road show progresses, the underwriter solicits indications of interest from investors. The initial prospectus filed by an issuer with the SEC includes only a suggested offer price range; the final price may be set inside or outside of that range depending on investor feedback during the price discovery process (Ritter 1987, and Hanley 1993). For example, Microsoft successfully went public in 1986. When they registered with the SEC in February 1986, the initial offering price was set at $16-$ 19 a share. During the road show, feedback from investors (in particular big institutional investors) was very encouraging. Many investors indicated that they would take as much Microsoft stocks as they could. Concurrently, the bull market that began in September 1985 remained strong, pushing up P/E multiples for other software companies. The leading underwriting manager, Goldman Sachs, suggested that the $16-$ 19 price would have to be raised, as would the number of shares to be sold. After negotiation, the offering price
-22was finalized at $20 to $22 on March 12. On the next day, Microsofts stock traded publicly on the over-the-counter market for the first time at $25.75 and closed at $27.75 by the end o f the first day of trading {Fortune July 21, 1986, pp.66-70). In contrast to Microsofts successful experience in going public, many other firms could not complete their IPO and get their stocks traded publicly. Accounts of firms postponing or withdrawing their equity offerings are common in the financial press and industry magazine. Ryan (2001) reports that a total of 709 companies filed with the SEC for initial public offering in 2000, whereas only 440 successfully came to the market. Some were postponed to the next year, and some were simply withdrawn due to adverse market conditions or because the firm management could not accept the low offering price set by the investment bankers. For example, the president of Kwil Goal, Vincent Caruso, decided to withdraw the stock offering of his firm although he had been spent over $200,000 in legal, accounting, and printing fees in preparation for the IPO. Carusos decision was based on the fact that, on the day before the issue date, the underwriter could only set the offer price at $3 per share instead of the $6 the company filed for according to the feedback from potential investors {National Business June 1996, pp.5759). In an attempt to analyze the impact of the option to withdraw on IPO underpricing, Busaba, Benveniste and Guo (2001) develop a probit withdrawal decision model to estimate the ex ante probability of withdrawal using data from the preliminary prospectuses filed by IPO firms. Their results indicate that larger issues in terms of shares filed, issues made by firms with higher financial leverage, and those intending to
-23use IPO proceeds to pay back debt are more likely to be withdrawn. On the other hand, venture-backed issuers and issuers with larger revenues are less likely to withdraw. The likelihood of withdrawal is higher while many issues are filed together but lower when the equity markets are strong. They also find that the withdrawal of initial public offerings was not specific to a particular period, to particular industries, or to issues of particular size. Withdrawn offerings are filed by firms that are as large and as profitable as firms that complete their IPOs, and withdrawn issues are marketed by underwriters that are as reputable as the ones underwriting successful IPOs. They suggest, however, that clustering of the withdrawal of IPOs during weak markets is possible. In a study of the choice between firm-commitment and best-efforts offering methods in IPOs, Dunbar (1998) estimates a probit model for firm-commitment IPOs. He finds that firms hiring prestigious underwriters are more likely to succeed. Consistent with Busaba, Benveniste and Guo (2001), he also finds that the number of contemporaneous filings has a negative effect on offering success. In addition, firms with large offering size and low offer price are more likely to withdraw.
Literature on the Role of Market Conditions in the IPO Market Anecdotal evidence in capital markets suggests that timing is every thing for initial public offerings. The window of opportunity for IPOs is not open all the time. Both the number of initial public offerings and the total proceeds raised in these offerings vary substantially over time. Table 1 illustrates the extreme fluctuations in IPO volume since 1960. For example, sample data in Ibbotson, Sindelar, and Ritter (1994) show that
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Table 1
Number o f Initial Public Offerings by Year
The number of IPOs excludes Regulation A offerings (small issues, raising less than $1.5 million), real estate investments (REITs) and closed-end mutual funds. Data are from updated data (January 1960 - December 1999) in Ibbotson, Sindlar, and Ritter (1994)," The Market's Problems with the Pricing of Initial Public Offerings," Journal o f Applied Corporate Finance, 66-74. The data set is downloaded from the web site: http://bear.cba.ufl.edu/ritter/inodata.htm.
Year
Number of IPOs
Year
Number of IPOs
1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1960-1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1970-1979
269 435 298 83 97 146 84 100 368 781 2661 358 391 562 105 9 14 35 35 50 81 1640
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1980-1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 1990-1999
238 450 232 886 552 507 953 630 227 204 4879 172 367 509 627 568 566 845 602 344 505 5105
-25the IPO market closed swiftly after the stock market crash in October 1987. There are totally 227 and 204 IPOs completed in i988 and 1989, compared to 953 and 630 in 1986 and 1987, respectively. This confirms the widely held belief of the investment community that certain periods offer a window of opportunity in which initial public offerings are more likely to succeed and that investors are less receptive of new issues while the market is cold. Baker and Wurgler (2000) use equity and debt issues data and aggregate market returns from 1927 to 1996 to examine the possible pattern of security issuance. They show that equity issues increase right after a year of high equity market returns and, more interestingly, that firms issue relatively more equity around market peaks, just prior to periods of low market returns. For example, when the equity share4 in new issues is in the bottom historical quartile (below 0.14), the average CRSP equal-weighted market return in the next year is 27 percent. When the equity share is in the top historical quartile (above 0.27), the average return in the next year is -8 percent. Baker and Wurgler examine three potential efficient market explanations for this phenomenon and find no support for the results. Instead, they find that the equity share in new issues has stable predictive power for one-year-ahead market returns after controlling for other known predictors. Their findings suggest that the stock market as a whole may be inefficient and that managers exploit this inefficiency and time their financing decisions. Loughran, Ritter, and Rydqvist (1994) and other studies of hot issue markets show that equity issues tend to cluster around market peaks. This suggests that issuers try
4 Equity share is defined as the proceeds from equity issues (including common*and preferred stocks) divided by the sum o f proceeds from equity and debt (including public and private) in the same year. In the typical year between 1927 and 1996, equity issues represent about 21 percent o f the value o f all new issues.
-26to time both their idiosyncratic return and the market return. Ljungqvist and Wilhelm (2003) find that the ratio of withdrawn offerings to completed offerings increased to 38 percent, a proportion much higher than normal, in 2000, when the NASDAQ Composite index had the lowest return in the NASDAQs 30-year history. Lucas and McDonald (1990) develop an asymmetric information model and show that a firm postpones its equity issue if the firm knows its stocks are currently undervalued. If a bear market places too low a value on the firm, given the knowledge of entrepreneurs, then the firm will delay its IPOs until a bull market offers more favorable pricing. Evanson and Beroff (1999) state that industry-specific fads are the second most important factor for an IPO to be successful. If a specific industry is not in favor with investors, it is even hard to get an appointment with an investment banker to discuss an IPO. Similarly, Ritter (1991) suggests that many firms go public near the peak of industry-specific fads. Deeds, DeCarolis, and Coombs (1996) find that the amount of capital raised by a biotechnology firm is significantly higher during the years 1983, 1986, 1991, and 1992, which are hot markets for biotech IPOs identified by Burrill and Lee (1994). Deeds et al. suggest that the market conditions under which a firm issues an IPO matter and that a firm manager needs to provide the firm with as wide a window of time as possible within which to issue the IPO. The market condition is the most obvious, and least controllable, factor in a companys decision to attempt an IPO. Frequently, firms blame the failure of their IPOs
-li on adverse market conditions, but what do they really mean? There are generally few detailed comments on adverse market conditions in the IPO literature. In a study to investigate substantial IPO volume fluctuation during the last four decades, Lowery (2003) uses closed-end mutual fund discounts to proxy investor optimism. She finds that the level of investor sentiment, as well as companies demand for capital, explain a significant amount of the variation in IPO volume. Her findings indicate that temporary overvaluations contribute to the periods of high IPO volume. That is, since individual investors are occasionally overoptimistic and willing to pay more for firms than they are worth, value-maximizing managers will take advantage of this window of opportunity and issue equity during these periods of high investor sentiment. Neal and Wheatley (1998) examine the forecast power of three popular measures of individual investor sentiment: the level of discounts on closed-end mutual funds, the ratio of odd-lot sales (sales of fewer than 100 shares) to purchases, and net mutual fund redemptions. They find that fund discounts and net redemptions predict the size premium, the difference between small and large firm returns. In other words, discounts on closed-end mutual funds and net mutual fund redemptions are good measures of investor sentiments. However, Neal and Wheatley find little evidence that the odd-lot ratio predicts returns. Klein and Ozmucur (2002) compare the performance of UBS Index o f Investor Optimism with the older surveys in existence to see how it performs in terms of accuracy, economic insight, timeliness, and breadth of scope. They find that UBS Index is at least
-28as good as the competing indices judging from its degree of correlation with key economic magnitudes, such as consumer spending, personal income, industrial production, employment, and stock market averages. The UBS Index also has excellent timeliness; it is available early each month for use in prediction of major economic variables with outstanding accuracy.
Literature on the Investors ex ante Valuation of IPOs According to standard finance theories, stock value is equal to the present value of future cash flow. Following this theory, a few valuation models have been established to measure equity value, such as discounted dividend model and discount free cash flow model. However, standard formulas for valuing the equity of going concerns require forecasting payoffs to infinity. Apparently, it is very difficult to accurately project future cash flow even for well-established firms, not to mention infant IPO companies. As an alternative, various theories and models using historical accounting numbers have emerged in academic or practitioner publications. Two decades of empirical research in capital markets have produced considerable evidence of the information content of accounting numbers of security pricing. The simple earnings capitalization model, for example, expresses stock price as a function of earnings or the components o f earnings under the assumption that earnings follow a random walk and current earnings are sufficient to determine the stock price. That is, earnings reflects information about expected future cash flow. Evidence in recent studies, however, raises questions about the simple earning
-29capitalization approach. First, stock prices reflect information about future earnings, but current earnings used in the price-eamings specification records the firms past performance. Therefore, the simple earning capitalization approach is biased to predict stock prices. Easton and Harris (1991), Biddle and Seow (1991), Ohlson (1991), Kothari and Sloan (1992), Kothari (1992), and Kothari and Zimmerman (1995) note that omitting anticipated future earnings reduces the explanatory power of the simple earnings capitalization model. Therefore, other researchers modified the simple earning capitalization model by introducing an earnings proxy for the markets unexpected earnings. Second, Hayn (1995) separates firms into those reporting losses and those reporting profits. She finds that the cross-sectional retum-eamings relation for loss firms is much weaker than that for profit firms, and she attributes the weaker relation to the markets perception of losses as being transitory. Jan and Ou (1995) document a nonhomogeneous price-eamings relation across profit and loss firms. More strikingly, they find that the relation is reliably negative for loss firms. That is, the more negative is a firms earnings per share, the higher is its stock price. To explain the anomalous significantly negative price-eamings relation using the simple earnings capitalization model for firms that report losses, Collins, Pincus, and Xie (1999) include book value of equity in the valuation model and find that the anomalous negative price-eamings relation, documented in the above literature, disappears. They conclude that the simple earnings capitalization model is misspecified because book value is believed to be a value-relevant factor in its own right and that the negative
-30coefficient on earnings for loss firms is a manifestation of that misspeciflcation. When a firm is viewed as a going concern, its book value proxies for expected future normal earnings (Ohlson 1995, Penman 1992). Alternatively, when the firms going concern status becomes questionable, its book value will then proxy for the adaptation or abandonment value5 (Berger et al. 1996, Barth et al. 1996, Burgstahler and Dichev 1997). Given these roles of book value, it follows that when a firms current earnings is not perceived to be a good indicator of future earnings, due to either a large transitory component in current earnings or a change in the firms future prospects (such as an increased possibility of liquidation), market participants will likely turn to book value for guidance in valuation. The value-relevance of book value will thus increase. Several studies have reported specific conditions under which book value is more value-relevant than current earnings. Penman (1998) shows that, on average, book value carries more weight than earnings in equity valuation for firms with a low price/book ratio. Burgstahler and Dichev (1997) report that when the eamings-to-book value ratio is low (high), book value (earnings) is a more import determinant o f equity value. Barth et al. (1998) show that pricing multiples on book value and the incremental explanatory power of book value (earnings) increase (decrease) as a firms financial health deteriorates. Jan and Ou (1995) demonstrate that for firms reporting net losses, earnings explain very little equity price, while book value is an important determinant of equity price. These findings are all consistent with the premise that when current earnings are
5 Abandonment value is akin to the value from liquidation o f the entity, while adaptation value is somewhat more general and reflects the value o f a firms net resources in their next best alternative use. Adaptation value can include internal redeployments o f resources, including restructuring and external adaptations such as sell-offs, spin-offs, divestitures and, in the extreme, liquidation.
-31 less likely to be a good indicator of future earnings, the valuation importance of book value will increase. In highly praised seminal papers6, Ohlson (1995) and Feltham and Ohlson (1995) show that, assuming the clean surplus relation and a specific linear information dynamic, equity value can be represented as a linear function of earnings and book value. The analysis starts from the assumption that stock value equals the present value of expected dividends. It next assumes the clean surplus relation to replace dividends with earnings and book values in the present value formula. The clean surplus relation states that dividends reduce book value but leave current earnings unaffected. The model brings earnings and book value, the bottom-line items in the income statement and balance sheet, into valuation. The model also admits information beyond earnings, book value, and dividends, and it does not rule out other value-relevant events. The analysis shows that while the accounting data will be incomplete indicators of value, the weighted average of capitalized earnings and book value still provide the core of the valuation function. Subsequent empirical studies show great success of Ohlsons Model. Using firmlevel regressions, for example, Hand and Landsman (1998) obtain R2 in excess of 80 percent and confirm the core role of earnings and book value in equity valuation.
6 For example, Lundholm writes: The Ohlson (1995) and Feltham and Ohlson (1995) papers are landmark works in financial accounting (1995, p. 749), and Dechow, Hutton, and Sloan state: Existing empirical research has generally provided enthusiastic support for the model (1998, p.2). Lo and Lys (2000) find an average o f nine annual citations in the Social Sciences Citation Index (SSCI) for Ohlson (1995). They further state if this citation rate continues, Ohlsons work is not just influential but will become a classic. See Lo and Lys (2000) for detailed review o f the Ohlsons contribution to valuation theory.
-32As to initial public offerings, Klein (1996) examines the association between the prices of IPOs and a large set of information provided in the prospectuses filed by IPO companies. She finds that the prospectus provides value-relevant information about initial public offerings. Both offering price and after-market price are related positively to earnings per share, book value of equity per share, the amount o f equity retained by insiders, the prestige of the underwriter, and the proceeds raised. Downes and Heinkel (1982) and Ritter (1984) find that sales and earnings as well as managerial ownership were highly significant in explaining initial prices of firms making new issues of common stock. Ou and Penman (1989) state that firms fundamental values can be determined by the systematic analysis of publicly available accounting data, but they also warn that stock price could deviate from fundamental values.
Literature on Signals of the Value of IPOs When entrepreneurs raise new equity capital, they must reveal certain information about their ventures. The Securities Act of 1933 requires that issuing firms file a prospectus containing detailed information about their history, their past performance, their business environment, their future prospects, and other items. This prospectus must be made available to all prospective investors a few months before the actual share issue. These observable characteristics of the venture are used by outsiders to assess expected future cash flows and the uncertainty associated with these cash flows. However, there are other characteristics of the venture which cannot be easily reported or observed but which might be useful in valuing the venture. Such characteristics include the quality of
-33management, the possibility of the entrepreneur developing valuable products that are the property of this venture in the future, etc. Obvious entrepreneurial incentives for misrepresentation prevent outsiders from believing the unsupported claims of entrepreneurs. Thus, entrepreneurs must revert to actions to convince outsiders of their insider knowledge and expectations for the future of the venture. Outsiders not only evaluate the observable characteristics but also interpret entrepreneurial actions or signals in order to estimate the value of a new venture. In the seminal work, Leland and Pyle (1977) state that information asymmetries are particularly pronounced in financial markets. Typically, entrepreneurs know more and better about their own projects for which they seek financing than do outsiders. They show that the entrepreneurs willingness to invest in his own project can serve as a signal of the project quality. When valuing firms in the non-market setting, like the determination of an offer price in IPOs, it is often assumed that insiders of IPOs have better information about the expected value of their projects than do outside investors. Accordingly, most academic IPO studies have used signaling models to explain the valuation of IPOs, and the key variable has always been a signaling variable, such as the ownership retained by insiders, as in Leland and Pyle (1977). Studies by Ritter (1984), Kim et al. (1995), Klein (1996), Van der Goot (1997) and others find that IPOs with a larger fraction of the equity retained by pre-issue shareholders have higher market valuations. When making an initial public offering, the owners of a private firm are trying (among other things) to share the firms risk with well-diversified investors. Leland and
-34Pyle (1977) developed a model and show that if the owner retains a high percentage of stock and remains under-diversified, this may communicate private information about the value of the firm to prospective investors. A risk-averse entrepreneur is the sole owner of a private firm and wants to share its risk with outside investors. The owner can shed some of the firm-specific risk and get a better-balanced investment portfolio by making an initial public offering of the firms shares. There may, however, be difficulty in convincing investors, who know very little about the firm, to pay the true value of its shares. Although the entrepreneur has superior knowledge about the firms future performance, there is a credibility problem in the market since all entrepreneurs, whatever the quality of their firm, have the incentive to boast about its high value. Leland and Pyle (1977) suggest that the owner can send a signal to the market about the value of the firm by retaining part of its equity (and, thus, of its risk). This signal is costly for the owner since it prevents the holding of a completely diversified portfolio and exposes the owner to the firm-specific risk. In order to be an effective communication device, the signal must have a lower marginal cost for entrepreneurs with high quality firms than for those with low quality firm. After all, the low quality firm stands more chance of loss than a better firm, and the difference is sufficient to discourage mimicking by the former. To explain new issue underpricing, reported by numerous studies, Grinblatt and Hwang (1989) developed a signaling model with two signals. In contrast to the Leland and Pyle (1977) model, Grinblatt and Hwang (1989) show that the issuers fractional holding alone is not sufficient to signal the expected firm value. Since the equilibrium
-35signaling schedule is a function of both the firm value variance and the issuers fractional holding, a second signal, the degree of underpricing per share, is also needed to infer the variance. In other words, the issuer signals the true value of the firm by offering shares at a discount and by retaining some of the shares of the new issue in his personal portfolio. Gale and Stiglitz (1989) show that the issuers fractional holding at the time of the initial offering is not sufficient to fully communicate private information: if the entrepreneur can sell the retained shares on the secondary market immediately after the issue, the signaling strategy will not be convincing to investor. As a result, Courteau (1995) extends the classical signaling model of Leland and Pyle (1977). She introduces, in addition to the retained ownership, the length of the holding period to which the owner commits in the prospectus as a signal of firm value. The length of the holding period is found to be a signaling mechanism that complements ownership retention. In general, higher quality firms are more likely to have to resort to a long holding period (ceteris paribus), since it takes a higher level of retention to convince investors of their firm value than it would have for a lower quality firm. Hughes (1986) integrates the financial signaling and disclosure literature by extending Leland and Pyles (1977) univariate signaling model to include disclosure as a second signal o f firm value. In her bivariate signaling model, communication of insider information by direct disclosure is used by investors to infer firm value because of the contingent contract with the entrepreneur under which a non-dissipative penalty is imposed for outcomes considered low relative to disclosed value. She argues that, since the variance of cash flows enters the penalty cost of disclosure and is unknown by
-36investors, a second signal is necessary to unambiguously communicate firm value which is independent of the variance. The two signals, disclosure and firm ownership, are related through their cost structures and are chosen simultaneously to minimize the cost of signaling value. In a study to investigate the change in operating performance of firms as they make the transition from private to public ownership, Jain and Kini (1994) find that IPO firms where entrepreneurs retain higher ownership generally demonstrate superior performance relative to their pre-IPO levels, compared to other firms both before and after adjustment for industry effects. Furthermore, overall IPO firms exhibit a significant decline in post issue operating performance, as measured by the operating return on assets and operating cash flows deflated by assets over a six-year period extending from the year prior to the IPO until five years after the offering, relative to their pre-IPO levels. This finding is consistent with the predictions of both the Jensen and Meckling (1976) agency theory and the Leland and Pyle (1977) signaling hypothesis, even though it is difficult, if not impossible, to determine whether the relatively superior operating performance occurs as a result of lower agency conflicts when there is higher ownership retention, as a result of entrepreneurs signaling quality of ownership retention, or for other reasons. Besides the insider ownership discovered in the Leland and Pyle (1977) model and other extension models, many other studies have identified a number of other signals, which are used to convey superior private information in the context of information asymmetry. These signals will be utilized by outside investors in the valuation of unseasoned new equity issues in the context of uncertainty.
-37In IPO markets, selling mechanisms are viewed as critical elements. This anecdotal evidence is supported by Clancy (1994), who argues that marketing is the most important aspect o f a successful offering. Generally speaking, reputable underwriters have more expertise in promoting IPO shares. The financial press provides some evidence of the correlation between IPO performance and underwriter reputation (see Forbes June 20, 1994, pp. 77-81). A substantial body of work within the initial public offering of common stock literature examines the effects of underwriter reputation on the initial performance of IPOs (see, among others, Logue 1973, Beatty and Ritter 1986, Titman and Trueman 1986, and Maksimovic and Unal 1993). Carter and Sinch (1998) find that, consistent with prior studies, IPOs managed by more reputable underwriters are associated with less short-run underpricing. They also find that the underperformance of IPO stocks relative to the market over a three-year holding period is less severe for IPOs handled by more prestigious underwriters. Welch (1992) finds that failures and higher IPO underpricing are more common in offerings underwritten by regional underwriters than national underwriters. Dunbar (1998) reveals that underwriter reputation is a significant factor in predicting the ex ante probability of an IPO success. According to Hughes (1986), underwriters compensation will be higher for companies that are more likely to suffer from information asymmetry problems. Dunbar (1998) suggests that, for successful issuers, the ex ante probability of offering success has a negative impact on investment bank compensation (cash spread, expense and warrants). Hence, in order to maximize the chance to successfully complete offerings, IPO firms
-38would rather incur higher initial costs to hire prestigious investment bankers to underwrite their new issues. Allen and Faulhaber (1989) find that a low IPO price and low number of shares filed can be used to signal firms superior prospects. Grinblatt and Hwang (1989) state that high firm value is signaled through high dividends, since dividends essentially give money away to the government in the form of higher taxes. They also suggest that managers may signal high firm value through the retaining of high-priced investment bankers, auditors, and advertising.
CHAPTER III DATA AND METHODOLOGY

This chapter describes the data sources and sample selection, justifies explanatory variable selection, and provides an in-depth review of the methodology utilized for the statistical analysis. The first part of this chapter details the various data sources, sample selection criteria, and sample properties of the data. The next part defines and describes explanatory variables, which may potentially determine or affect the probability of IPO successes, and their possible effects will also be discussed in this section. The last part of this chapter reviews the methodology employed in this study.
Sample Selection and Data The sample used in this study covers withdrawn and completed firm commitment7 IPOs of U.S. industrials filed with the Securities and Exchange Commission (SEC)
7 All initial public offerings o f common stock in this study are under firm commitment contract and all best effort IPOs are excluded from the sample. Virtually all firms going public use either best-effort or firmcommitment methods to market their initial public offerings. In a firm commitment underwriting, the investment bank purchases the stock from the issuer for a guaranteed price and resells them to investors at a higher price. In a best-effort offering, the underwriter does not guarantee a price to the issuer, while it acts more as a placing or distribution agent and only pledges to provide its best efforts to sell between some pre-specified minimum and maximum number o f shares. A number o f differences between firmcommitment and best-effort underwriting contracts have been documented. For instance, Dunbar (1998) finds that while the likelihood o f success is virtually identical for the two offering methods, investment bank reputation, offering size and offering price are apparently greater for firm-commitment offerings. Smith (1986) states that best efforts contracts become relatively more attractive, compared to firm
-39-
- 40 during the four-year period 1999-2002. The period 1999-2002 contains sufficient numbers of successful and withdrawn initial public offerings to support the planned study. For example, Ryan (2001) reports that a total of 709 companies filed for going public in 2000; of these 440 successfully came to the market and 180 were withdrawn. To evaluate the hypotheses presented in chapter I, a sample of IPO firms was identified from the Thomson Financial U.S. Corporate New Issues database. This database provides offer data (filing date, initial offer price range, IPO type, underwriting contract form, offering date, gross proceeds (excluding funds from exercising the over-allotment option), the portion of secondary shares, offer price, number of shares offered, lead underwriter and co-managers, venture capital status, underwriter spread, and issue postponement/withdrawal date) and issuer data (Standard Industrial Classification code, company name, assets; sales revenue, net income after taxes, debt-to-capital ratio, net tangible asset value, shares outstanding prior to offering; and pre-and post-offering retention rate). To be more homogeneous, the sample excludes unit offerings and American Depository Receipts (ADRs) . The sample is restricted to domestic operating companies and excludes closed-end mutual funds (SIC code 6726), real estate investment trusts (REITs), and foreign corporations (F-l filings). Missing and suspicious accounting
commitment offering, with more uncertainty about after-market prices. Ritter (1987) finds that small, more speculative firms tend to raise small amounts o f money using best efforts offers, and larger, more established firms tend to raise large amounts o f money using firm commitment contracts. He also reveals that the average transaction costs are much higher for best efforts offers that firm commitment offers. 8 Unit offerings are bundles o f securities (frequently, a share plus a warrant to buy a share at some exercise price), commonly issued in small IPOs by young, speculative companies taken public by less-prestigious investment bankers. Unit offerings are eliminated to avoid separating the values o f the share and the warrant. American Depository Receipts (ADRs), also called American Depository Shares, are a dollardenominated negotiable certificate that represents ownership o f shares in a non-U.S. company. This foreign company stock is traded on an exchange outside the U.S. ADRs provide a convenient way for U.S. investors to own foreign stocks.
S
-41 numbers will be checked and, if necessary, corrected in the prospectus filed by offering firms with the SEC through the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). The data set will also be corrected according to corrections from Jay Ritter9. Returns on the NASDAQ composite index and S&P 500 index, computed from closing levels of the indices, are retrieved from the Center for Research in Security Prices (CRSP) daily tapes to control for the general market movements. The NASDAQ composite index is employed as a measure of stock market performance since the overwhelming majority of IPOs are first listed there, and also IPO firms are small on average and tend to be high-tech companies. Data are supplemented by the updated Carter and Manaster rankings10 of underwriters, obtained from http://bear.cba.ufl.edu/ritter/Rank.HTM and updated by Loughran and Ritter (2004). Additional data are also obtained from the UBS Index o f Investor Optimism, which measures investor confidence and is available at: http://www.ubs.eom/e/about/research/indexofmvestoroptimism.html. In addition, Conference Boards index o f leading economic indicators is used to account for the business cycles. The average monthly IPO underpricing (the average
9 Ritter posts corrections o f the database in his home page: http://bear.cba.ufl.edu/ritter/SDCCQR.PDF. 10 The updated Carter-Manaster ranking is based (1) on Cater and Manaster (1990) for underwriters in the 1980-1984 period, (2) on Carter, Dark and Singh (1998) for underwriters from 1985 through 1991, and (3) on the relative placement o f 120 underwriters in the May 1999 Goldman Sachs prospectus for underwriters in the 1992-2000 period. Some alterations have also been made to the Carter and Manaster rankings and the Carter, Dark, and Singh rankings. The maximum ranking o f Cater and Manaster (1990) and Carter, Dark and Singh (1998) is nine, and the minimum is zero. All o f the rankings that Loughran and Ritter (2004) have assigned are integers followed by a 0.1 (1.1 up to 9.1) to be distinguished from Carter and Manaster and Carter, Dark, and Singh, which never end with a 0.1.
-42first-day return of IPOs) data is obtained from Ritters homepage (see http://bear.cba.ufl.edu/ritter/ipodata.htm.)
Explanatory Variables and Predicted Effects on Probability of IPO Success One of the questions this study addresses is why some managers succeeded in bringing their companies to public while others failed. That is, what are the determinants of IPO success? In this research, a logistic model is employed to determine the significant factors leading to the success of some IPOs and withdrawal of others. The dependent variable is, therefore, the outcome of IPOs. It is an indicator variable, with a value of one when management successfully takes their firms public, and zero for unsuccessful IPOs. Three groups of variables, which possibly explain the dependent variable, are identified. They are factors indicating market conditions, factors affecting the investors ex ante valuation of IPOs, and factors signaling the value of IPOs. This section will explain why and how these variables might determine or affect the results of IPOs.
Factors Indicating Market Conditions Previous studies by Ritter (1991), Lemer (1994), Burrill and Lee (1994), Evanson and Beroff (1999), Baker and Wurgler (2000), and Lowery (2003) show that there is a window of opportunity for IPO markets, and, therefore, timing is everything. Four variables are identified to reflect market conditions: leading economic indicators, investor optimism, monthly IPO underpricing, and stock market movement. First, during an economic upturn, investors perceptions of firms prospects will be better than during an
-43 economic downturn, and, likewise, during economic upturns, investors are more optimistic about the stock market. Thus, if all other things are equal, IPO firms are more likely to succeed if they attempt to take their firms public in growth phases of the business cycle, and the probability of failure will be higher in contract phases. Therefore, LEICHANGE, which indicates the monthly change of the leading economic indicators, is included in this study to account for the state of the economy. The index of leading economic indicators is considered a recognizable barometer of business cycles and is broadly representative of the economy. Leading economic indicators are widely used by policymakers, players in the financial markets, and business people in making key decisions about the state of the economy because these indicators typically foreshadow changes in the direction of the economy. Second, IPO firms decide whether to continue their attempts to go public or withdraw after underwriters collect indications of interest from investors through the road show promoting the IPOs. If investors do not show sufficient interest in the firm, the IPO may be withdrawn, suggesting the failure of the IPO. Investors interest in these particular firms should be related to their confidence in the general stock market. If investors are not confident in firms, which are already traded on the stock markets, there are few reasons to believe that they will be interested in IPOs, which are relatively riskier. In this study, UBS Index o f Investor Optimism, OPTIMISM, is employed to measure investor confidence. Higher readings of The Index reflect higher in vestor confidence. Stock markets may be more receptive to IPOs when the Index shows strong investor confidence. As a result, firms should be more likely to succeed in their IPO
-44attempts. UBS Index o f Investor Optimism is a monthly survey, carried out among private investors across the United States. The Index is widely recognized as the premier information source on attitudes of private investors, due to its correlation with key economic indicators. The Index is also an excellent predictor because it is available early each month, and can, therefore, be used to predict major economic variables with outstanding accuracy. The quality of the Index has been acknowledged by Klein (1999). Third, Ibbotson, Sindelar, and Ritter (1988, 1994) find striking evidence of pronounced cycles in volume and underpricing (i.e. first-day stock return) of IPOs. Specifically, high-volume months are almost always followed by high-volume months until unexpected market events change the pattern, such as sharp market drops experienced in October 1987 when the market crashed. The first-order autocorrelation of monthly volume is 0.88. The underpricing of IPOs is also cyclical with the first-order autocorrelation of 0.62 for the 1960-1987 period. In other words, current months average initial return of IPOs is related to the previous months average with a high degree of accuracy. Ibbotson, Sindelar, and Ritter (1988) further analyze the correlation between the average initial return and the number of new offerings; and they conclude that average initial returns lead volume by roughly 6 to 12 months. They state that many firms apparently initiate the IPO process when they observe a very receptive market, especially if the market is receptive to firms in their own industry. In this study, UNDERPRICING is used to reflect the receptiveness of the IPO market and it is defined as the average first-day return of all IPOs occurring in the preceding month.
-45 Last, to control for market movements, the variable RET30 is included in the logistic model. RET30 measures the returns of the NSADAQ Composite Index over the 30 trading days prior to the offering of successful IPOs or withdrawal of failed ones. Because the decision to go one step further or quit is generally made immediately after the road show and solicitation of indications of investor interest, market movement during that period arguably has a critical impact on investor interests and the fate of an offering. If the returns during this period are encouraging, investors should be more positive about new issue markets, and new issues should be more likely to succeed.
Factors Affecting the Investors ex ante Valuation of IPOs Standard finance models (e.g. discounted cash flow (DCF) approach, and dividend discount model (DDM)) imply that the value which the market places on a firms equity should reflect the firms expected future profitability. However, most firms conducting initial public offerings in the U.S. are young companies with limited operating histories, and it is difficult to forecast future cash flows. There is also little publicly available information about these firms at the time o f IPO other than the information contained in the offering prospectus. The prospectus provides the firms accounting information for up to three years prior to the IPO. To value these companies, investors often heavily rely on the accounting numbers in the prospectus. Previous studies (e.g. Krinsky and Rotenberg 1989, Ritter 1984) have shown a positive relationship between historical accounting information and the firm value. In this study, the accounting variables: earnings per share, book value per share, sales revenue, return
-46on asset, asset turnover, and debt/asset ratio are used to proxy for the firms expected future profitability. First, according to Toh et al (1998a, 1998b), and DuCharme et al (2001), earnings are the ultimate bottom line for stock valuation. Earnings should be a critical factor, if not the only important one, to determine the attractiveness of an IPO. Thus, the variable EPS, which is defined as earnings per share for the most recent 12 months prior to the IPO offering or withdrawal, is included in the model. A positive relationship is expected between the EPS and the possibility of IPO success11. Second, finance and accounting literature show that book value is the next most important accounting variable when valuing stocks. Penman (1998) combines earnings and book value into one valuation and shows that predictions of price using this approach reduce the typical error of predictions from earnings and book value alone. Collins, Pincus, and Xie (1999) show that including book value in the valuation specification eliminates the anomalous significantly negative price-eamings relation using the simple capitalization model for firms that report losses. However, it is not uncommon in the USA for firms, which have never turned a profit to be brought to market. Beatty and Zajac (1995) report that 58 percent of the 1984 IPO cohort were unprofitable in the year
11 The Price/Eamings (P/E) ratio could have been used in this study but was not for two reasons. First, most companies set a range o f offer price and this range o f offer price could be amended in the IPO process. This will lead to a problem about what offer price should be used in computing P/E ratio. However, compared to the P/E ratio, earnings per share is more stable. Therefore, EPS is more relevant and a better measure than the P/E in this research. Second, when earnings per share is positive, i.e. in the range o f (+ oo, 0), its P/E ratio falls in the range o f (0, +co); while if earnings per share is negative, i.e. in the range o f (0, -oo), its P/E will in (-co, 0). In other words, P/E ratio is not continuous given earnings per share ranging from -go to +oo. Unlike P/E ratio, EPS has a continuous property, which means EPS falls in (-oo, too). Thus, EPS is superior over P/E ratio, though the later is often used in valuation literature.
-47prior to going public. Thus, a variable BOOKVALUE is included in this study, which is defined as net tangible asset value per share in the year prior to IPO. Supposedly, the higher the BOOKVALUE, the more likely it is that the IPO stocks will be accepted by the security market and succeed in their IPOs. Most IPO firms in the U.S. are very young. A large majority of these firms do not earn profits and have small book value. In the absence of a history of profits and meaningful book values, investors rely on revenue as an important financial value driver. In some cases, revenues become the basis for measuring the success and failure of a company. Davis (2001) finds that revenues are value relevant for Internet firms. Downes and Heinkel (1982) and Ritter (1984) find that sales, combined with earnings and managerial ownership, were highly significant in explaining initial prices of firms making new issues of common stock. Therefore, REVENUE, defined as annual sales revenue before the IPO offering or withdrawal, is included in this study to see whether it can justify the success or failure of IPOs. Firms with higher REVENUE should be viewed more favorable by the stock market and, therefore, will be more likely to succeed in their IPO attempts. Also included in the model is ROA, defined as the return on assets in the year prior to the IPO and ASTTRNOVER, which is sales revenue divided by total assets. Due to the scarcity of available information about an IPO firms management, ROA and ASTTRNOVER are used to proxy management efficiency. Higher ROA or higher ASTTRNOVER usually implies higher management efficiency and should increase the probability of a successful IPO.
-48Finally, DEBTRATIO, which is defined as total debt over total assets, is included in the model to proxy the financial risk level of IPO firms. Based on standard finance theory, stock value can be computed as the present value of future cash flows, discounted by the required rate o f return on equity. For firms with a heavy burden of debt, their equity risk will be correspondingly high because equity holders have a residual claim on firms assets and earnings. As a result, the required rate of return of equity should be large. The present value of future cash flows should consequently be low and so should the stock value. In other words, a high DEBTRATIO level will lead to low stock value and make the initial public offering less attractive.
Factors Signaling the Value of IPOs Most of initial public offering firms are relative small with limited operating histories. Generally, there is little publicly available information about these firms other than that contained in the IPOs offering prospectuses. Prospectuses provide some potentially useful information, such as risk factors of the firms business and financial statement from the previous years. However, there is other valuable information, which cannot be easily reported or observed but which is known by entrepreneurs. Useful information, such as the possibility of the entrepreneur developing valuable products, might help in valuing the venture. Consequently, an information asymmetry exists between entrepreneurs taking their firm public and potential investors, with entrepreneurs knowing more about their business than outsider investors. In this context, entrepreneurs must use their actions to convince outsiders of their insider knowledge and expectations for the future of the venture in order to lure
-49potential investors. To evaluate an IPO firms future prospects, investors must rely on the signaling information from entrepreneurial actions. Accordingly, most academic IPO studies have used signaling models to explain the valuation of IPOs. As explained by Leland and Pyle (1977), the key variable has always been a signaling variable, such as the ownership retained by insiders. Five signaling variables, which might convey management insider information and help outsider investors to assess the IPO stocks, are included in the logistic model for this study. These variables are insider ownership, underwriter reputation, filing size, primary use of proceeds, and venture capital backing. First, when entrepreneurs retain a high percentage of the equity, they send a signal to the market about their confidence in the venture and the value of the firm. In this case, investors would valuate the stock highly. Ritter (1984) and Van der Goot (1997) confirm that IPOs with a larger fraction of the equity retained by pre-issue shareholders have higher market valuation. As such, RETENTION, the fraction o f total shares retained by the issuers, is included in the logistic specification for every IPO sample. Theoretically, IPOs with high RETENTION should convey positive insider information to the market, should be viewed favorably by the perspective investors, and, therefore, should increase the possibility of a successful IPO. Second, investment bankers play an important role in bringing firms to public by providing various services, including underwriting, advising, distributing, and price supporting. Due to the fact that prestigious underwriters have better marketing networks to help the issuing firms and more expertise in underwriting and setting offering price, one would expect that IPOs underwritten by reputable investment banks are more likely
-50to succeed. Thus, REPUTATION, an indicator of underwriter reputation, is included in the logistic model to account for the effect of underwriting service on the probability of IPO success. REPUTATION is adopted from the updated Carter and Manaster rankings of underwriters, provided by Loughran and Ritter (2004). The updated Carter-Manaster ranking is estimated via the relative placement in IPO prospectus from 1980 through 2000. The maximum ranking is 9.1, representing the highest level of underwriter reputation, and minimum is 0, indicating the lowest level. Third, the size of offering firms varies dramatically. Some firms have been held privately for almost a hundred year before going public. For example, United Parcel Service (UPS) was founded in 1907 and was worth about $25 billion when it went public in 1999. On the other hand, some companies were in an infant stage when the original entrepreneurs tried to bring them to public. There are reasons to believe that a bigger firm may be viewed by potential investors as a more established {i.e. less risky) business, and may have a broader investor base. Bigger firms may also be better known by financial market and are more likely to be accepted by the primary market than young small firms with little or no operating history. For firm-commitment offerings, Dunbar (1998) finds that the percentage of successful offerings increases with offering size. Thus, FILESIZE, mid-offering-price multiplied by shares expected to be issued, should be positively related to the chance of success of IPOs, and, therefore, is included in the logistic analysis. Next, an IPO firm has to disclose the primary use of the proceeds, such as reducing indebtedness or general corporate purpose in the prospectus. One can argue that
-51 the minimum acceptable offer price would be higher if the proceeds are to be used to refinance existing debt than for other purposes, since selling equity to pay down debt is just an indicator of the presence of an alternative financing vehicle. As a result, firms that issue equity to refinance debt will be more likely to withdraw their IPOs than those under immediate needs of capital for expansion because the former will demand a relatively higher offer price, making the offer less attractive. A dummy variable, PRIUSE, which equals one for firms using proceeds to pay down debt, and equals zero otherwise, is included in the logistic model. Last, venture capitalists, who specialize in providing funds to privately held firms and generate the bulk o f their profits from firms that go public, may play an important role in bringing private firms public. The venture investors have usually experienced more IPOs than the firms managers1 2 and, consequently, have more expertise in deciding when and how a firm should go public. Lemer (1994) shows that privately-held, venturebacked biotechnology firms go public when equity valuations are high and employ private financing when values are lower. He also finds that seasoned venture capitalists appear to be particularly proficient at taking companies public near market peaks. Therefore, there are reasons to believe that those firms backed by venture capitalist are more likely to succeed in their IPO attempts due to the venture investors superior experience and expertise. So, VENTURE, a dummy variable equaling one when IPO firms are supported by venture capital, is also included in the logistic model.
12 Venture Economics (1988) report that 30 percent o f the firms backed by venture capitalists over the past two decades have gone public.
Table 2 provides a summary of the variables used to predict the probability of success of IPOs along with the hypothesized effect of each variable.
Methodology The primary model in this study is the logistic regression model, which is employed to find out the significant determinants of IPO success and is specified as follows:
logit1 3 (p) = +
+ a
OPTIMISM +
2 CHANGE
a
3 UNDERPRICING +
4 RET30
+ a 5 Log(7 +REVENUE) + a 6 Log (ASTTRNOVER) + a 7 EPS+ a 8 ROA + a 9 Log(7 +DEBTRATIO) + a1 0 BOOKVALUE + a RETENTION + a1 2 REPUTATION + a 1 3 Log (FILESIZE) + a ,, PRIUSE +
a
]5 VENTURE
(1)
where p = Probability (SUCCESS = 1) and SUCCESS is a binary variable that takes the value of one for completed IPOs and zero for withdrawn issues. The independent variables include factors indicating security market conditions, factors affecting the
1 3 Since these variables are known at the time an IPO is offered or withdrawn, the logistic model provides an estimate o f the ex ante probability o f offering success
Table 2
Definition and Predicted Effect of Variables Used in the Logistic Analysis of the Probability o f IPO Success
Independent Variables
Description
Predicted Effect on Probability of Success of IPO
Factors indicating market conditions Monthly change of leading economic indicators UBS Index o f Investor Optimism in the month of the completion or withdrawal of IPOs UNDERPRICING Average IPO underpricing in the previous month NASDAQ cumulative 30-day return before the completion RET30 or withdrawal Factors affecting the investors ex ante valuation of IPOs EPS BOOKVALUE REVENUE ROA ASTTRNOVER DEBTRATIO Earnings per share Net tangible asset value per share Annual sales revenue in the most recent 12 months prior to the completion or withdrawal Return on assets Annual sales revenue over total assets Debt/asset ratio before the offering or withdrawal Factors signaling the value of IPOs RETENTION REPUTATION Fraction of total shares retained by executives The updated Carter and Manaster ranking by Loughran and Ritter (2004), proxy for reputation of the leading underwriter Mid offer price times shares expected to be issued Dummy variable indicating debt payment as the primary use of proceeds Dummy variable indicating backing by venture capitalists + + + + + + LEICHANGE OPTIMISM + + + +
FILESIZE PRIUSE VENTURE
+ + +
-54investors ex ante valuation of IPOs, and signaling factors, as defined previously. In this analysis, different sub-models using different combination of variables will be explored to find the best-fit model. The logistic model will also be used to check whether market condition variables can predict the window of opportunity for IPOs. The model is defined as follows:
logit (p) = b0+ bi OPTIMISM + b2 CHANGE + b3 UNDERPRICING + b4RET30 (2)
where p = Probability (WINDOW = 1) and WINDOW is a dummy variable that takes the value of one when the window of opportunity is open while IPOs were completed/withdrawn during the period of January 1999 - March 2000 and zero otherwise. To analyze the association between IPO activity and market condition factors, the following ordinary least square linear regression will be performed:
N, - al0 + bj, OPTIMISM+ba CHANGE + bj3 UNDERPRICING + bi4RET J O (3)
Ni = the number of initial public offering filings per month, the number of completed IPOs per month, or the number of withdrawn issues per month.
-55In addition, regular t-test will be conducted to compare the difference of the characteristics between hot and cold IPOs.
CHAPTER IV EMPIRICAL RESULTS AND ANALYSIS

This chapter presents empirical results. The first part describes sample characteristics, focusing on the distribution of completed and withdrawn issues over time and across industries. The second section discusses descriptive statistics of independent variables conditional on the outcome of the filings. This section presents a univariate analysis and compares the differences between completed and withdrawn IPOs. The next part of this chapter presents and interprets results of the logistic analysis, and identifies factors that are significant in discriminating completed IPOs and withdrawn issues. The following section analyzes the window of opportunity for IPOs. Then, this chapter proceeds to examine the differences between IPO firms going public in the hot market and in the cold market. The last part of this chapter analyzes the long-term stock performance of hot and cold IPO firms.
Sample Characteristics This study uses a sample of 966 completed initial public offerings and 545 withdrawn issues from 1999 to 2002. The sample period is restricted to 1999-2002 for two reasons. First, it covers a period with heavy initial public offering activity and an IPO cold period. Second, there are substantial numbers of both completed and -56-
-57withdrawn IPOs during this period. The sample is identified from the Thomson Financial U.S. Corporate New Issues database. First, the database was screened, and, 1211 completed and 595 withdrawn firm commitment IPOs were recognized. To achieve a homogeneous sample, the following types of issue are excluded from the sample: unit offerings, ADRs, foreign offerings (FI filings), closed-end mutual funds (SIC code 6726), and real estate investment trusts (REITs, SIC code 6798). Table 3 reports the number of issues excluded as a result of the various sample-selection criteria. Table 4 provides the distribution of completed and withdrawn issues by month over the period of 1999-2002, and Figure 1 depicts the NASDAQ Composite Index, and the number of completed IPOs, withdrawn issues, and IPO filings over the same period. In the booming stock market of January 1999 through March 2000, the IPO market was very active. Approximately 40 firms per month went public, and approximately 56 companies per month filed with the SEC for initial public offerings. During the same period, only 105 firms withdrew their IPOs, averaging 8.33 per month. From April 2000 to April 2001, an increasing number of firms withdrew their IPOs as the stock market started to decline from its historic peak. In total, about 313 companies terminated their IPO process during this 13-month period, averaging over 28 per month. The often-cited reason was adverse market conditions. However, the number of companies completing IPOs stayed high until about November 2000. As the stock market continued to decline in 2001 and 2002, the IPO market turned cold. In fact, the period 2001-2002 is among the coldest IPO periods since 1960, averaging only 6 completed IPOs and less than 7 filings per month. September 2001 was the first month since the 1970s during which no
- 58Table 3 Sample Selection Process
The sample is obtained from the Thomson Financial Securities Data U.S. Common Stock Initial Offerings database. Unit offerings, American Deposit Receipt, offerings of foreign companies F-l filings), closed-end mutual funds (SIC code 6726), real estate investment trusts (REITs, SIC code 6798) are excluded from the sample. Panel A: Completed Initial Public Offerings Universe of firm commitment IPOs Less: unit offerings Less: ADRs Less: foreign offerings Less: closed-end mutual fund (SIC code 6726) Less: REITs (SIC code 6798) Net Panel B: Withdrawn Initial Public Offerings Universe of firm commitment IPOs Less: unit offerings Less: ADRs Less: foreign offerings Less: closed-end mutual fund (SIC code 6726) Less: REITs (SIC code 6798) Net 595 (13) (0) (11) (20) (6) 545 N 1211 (22) (24) (68) (128) (3) 966
Table 4
Distributions of Completed and Withdrawn IPOs by Month over the Period of 1999-2002
The sample is obtained from the Thomson Financial Securities Data U.S. Common Stock Initial Offerings database. Unit offerings, American Deposit Receipt, offerings of foreign companies F-l filings), closed-end mutual funds, real estate investment trusts (REITs) are excluded from the sample. 1999 CompletedWithdrawn Withdrawn IPOs IPOs 12 31 21 33 48 57 56 37 39 55 49 36 474 6 6 9 8 6 14 9 11 9 6 10 11 105 2000 CompletedWithdrawn Month January February March April May June July August September October November December IPOs 16 51 43 30 21 30 39 55 23 20 15 6 349 IPOs 7 7 6 17 27 28 12 18 20 31 26 34 233 Month January February March April May June July August September October November December 2001 CompletedWithdrawn IPOs 3 8 8 3 9 13 7 3 0 6 9 10 79 IPOs 20 24 35 21 8 11 6 6 11 10 3 6 161 Month January February March April May June July August September October November December 2002 Completed IPOs 3 5 6 7 10 6 3 0 0 10 8 6 64 IPOs 1 3 2 4 1 2 4 3 7 11 5 4 47
I
V i
Month
January February March April May June July August September October November December Subtotal
VO
I
I Number o f completed IPOs CZZI Number of W ithdrawn IPOs
Number of Filings
NASDAQ Composite Index
140 T
120
T 5000
100
> o c o 3 w 0 )
^3333333
o f'
<f'
c fi
< f
of
Figure 1 Initial Public Offering Activity and the NASDAQ Composite Index o\
o
Index
-61 IPO was completed. August 2002 was the second such month. During this period, the number of withdrawn issues was also low as well as the number of filings. It is obvious from Table 4 that the withdrawal of initial public offerings is not specific to a particular period of time, but it seems to cluster during the transition period when the EPO market turns from hot to cold. The breakdown of the sample of withdrawn and completed IPOs by industry is presented in Panel A of Table 5. These IPOs fall into a great number of industry categories if they are defined by three or four digit standard industry codes (SIC). To develop more useful information, this study, therefore, uses the industry affiliation based on two-digit SIC codes14, which refer to a major industry group. Table 5 shows that the industry distributions o f both completed IPOs and withdrawn issues are heavily concentrated in four industries. The top four industries, which account for 68.43 percent of completed issues include computer software15 (SIC 73), electronic and electric equipment (SIC 36), transportation (SIC 40 through 49), and service (SIC 70 through 89 except 73). The top four industries, which account for 69.91 percent of withdrawn issues, include computer software (SIC 73), transportation (SIC 40 through 49), service (SIC 70 through 89 except 73), and wholesale and retail (SIC 50-59). The percentage of IPOs from top industries is highlighted in Table 6.
1 4 The Thomson Financial U.S. Corporate New Issues database and the CRSP tape both provide SIC codes for completed IPO firms. However, they are often in conflict with each other, even for the first two digit of the SIC code. In that case, this study uses the SEC EDGAR system to check the final prospectus filed by IPO companies usually on the day or one day before they went public. The SIC code from the final prospectus is considered the true SIC code. For withdrawn issues, this study uses the SIC codes from the Thomson database. 1 5 Including internet-related companies.
-62Table 5 Industry Affiliation of Firms with New Issue Filings
The sample consists of 966 completed initial public offerings and 540 withdrawn IPOs during the period o f 1999-2002. Panel A Distribution o f completed and withdrawn IPOs by SIC code Industry Two-digit SIC codes 01-17 Completed EPOs N % 22 2.28 Withdrawn IPOs N % 14 2.57
Agriculture, Mining, Construction Other Manufacturing Industrial Machinery Computer Equipment Electronic and Electric Equipment Instruments and Related Products Transportation Wholesale, Retail Financial Service Service Computer Software and other Technology Public Administration Total
20-27,29-34,37,39 36 28 35 48 35
3.73 4.97 3.62
17 26 9
3.12 4.77 1.65
36 38 40-49 50-59 60-67 70-72,75-89
101 38 100 57 69 81
10.46 3.93 10.35 5.90 7.14 8.39
38 23 57 52 36 53
6.97 4.22 10.46 9.54 6.61 9.72
73 91-99
379 0 966
39.23 0 100
219 1 545
40.18 0.20 100
Panel B Pair-wise Test o f Equality o f Fraction o f Completed and Withdrawn IPOs Mean Completed IPOs 8.3333% Withdrawn IPOs 8.3342% 0.00 0.9987 T-statistic p-value
-63Table 6 Industry Concentration of Completed and Withdrawn IPOs, and Firms in General
Column 3 and 4 list the percentage of completed and withdrawn IPOs from the top 4 industries defined by two-digit SIC codes during the sample period of 1999-2002. Column 5 displays the percentage of firms from five industries on January 1, 1999, measured as the number of companies with the specified first two digits of SIC code divided by the total number of firms with trading information listed in the CRSP tape Top four Industries Industry (1) Two-digit SIC Codes (2) Completed IPOs (3) Withdrawn IPOs (4) Firms in General (5)
Computer Software and other Technology Electronic and Electric Equipment Transportation Service Wholesale, Retail
73
39.23%
40.18%
11.47%
36 40-49 70-72, 75-89 50-59
10.46% 10.35% 8.39% 10.46% 9.72% 9.54%
8.48% 9.18% 9.47% 12.57%
To check whether this breakdown represents the concentration of firms in general, the CRSP tapes were screened for the number o f all corporations with stocks traded on the New York Stock Exchange, American Stock Exchange, or NASDAQ, and the percentage of firms from each of the above industries. On January 1, 1999, a total of 8,745 firms were actively traded and listed in the CRSP tapes. Among them, there are 1,003 (11.47%) from the computer software industry (SIC 73), 742 (8.47%) from the
-64electronic and electric equipment industry (SIC 36), 803 (9.18%) from the transportation industry (SIC 40 through 49), 1,099 (12.57%) from the wholesale and retail industry (SIC 50-59), and 828 (9.47%) from the service industry (SIC 70 through 89 except 73). These results are also listed in Table 6 for comparison with completed and withdrawn issues. Comparing the percentage of completed and/or withdrawn IPOs from the top 4 industries during the period of 1999-2002 with the percentage of existing public firms from these same industries on January 1, 1999, this study finds that completed and/or withdrawn IPOs are highly concentrated in only the computer software industry (SIC 73). The percentage of firms completing or withdrawing IPOs in other industries is similar to the historical level. Obviously, during the sample period of 1999-2002, a great number of Internet-related firms successfully went public, particularly in 1999, so the period displays an enormous degree of concentration in the computer software industry (SIC 73). To check whether withdrawn IPOs are concentrated in certain industries, an analysis is conducted on the distribution of SIC codes between completed IPOs and withdrawn IPOs and several points are worth noting. First, Table 5 shows that three out of the four most frequent industries are common for completed and withdrawn IPOs. They are computer software (SIC 73), transportation (SIC 40-49), and service (SIC 70-79 except 73). Second, 9.54 percent of withdrawn IPOs are from the wholesale and retail industry (SIC 50-59), which is 3.64 percentage points higher than 5.90 percent, the percent of completed IPOs from the same industry. Firms going public in the electronic and electric equipment industry during 1999-2002 account for 10.46 percent of all completed IPOs, which exceeds the percentage of withdrawn firms in this industry by
-653.49 percentage points. Except for these two industries, the percentages of completed IPOs from other industries are very close to those of withdrawn IPOs. The differences are within two percentage points. Third, when a pairwise t-test is performed to compare the percentage of completed issues from each industry to that of withdrawn IPOs, the test fails to reject the null hypothesis that the proportion of completed and withdrawn IPOs from major industry groups is equal, with p-value equal to 0.9987. Therefore, there is strong evidence to show that withdrawn IPOs are not from any particular industries. They appear to be distributed among industries in proportion to completed issues.
Descriptive Statistics Table 7 provides descriptive statistics of independent variables conditional on the outcome of the filings. Significant differences can be observed in the market condition variables between completed initial public offerings and withdrawn issues. In the months when IPO firms successfully went public, the UBS Investor Optimism averages 142.90. This is significantly higher than the average of Investor Optimism, 119.07, in the months when firms terminate their initial public offering. In a typical month when there is a firm going public, the index o f leading economic indicators increases by 0.12, while it decreases by 0.04 in the month when there is a withdrawn IPO. The difference is statistically significant at 1 percent level. During the 30 trading days prior to issuing date of completed IPOs, the NASDAQ Composite Index, on average, generates a 3.94 percent return. However, it declines by 5.26 percent in the 30 trading days before firms withdraw
Table 7
Descriptive Statistics on Sample Firms Conditional on Outcome of the Filings
This table provides descriptive statistics for all firm-commitment IPOs filed with the SEC from 1999 to 2002. Unit offerings, American Deposit Receipt, foreign offerings, closed-end mutual funds, REITs are excluded from the sample. Completed IPOs Standard Maximum Deviation Withdrawn IPOs Standard Median Minimum Maximum Deviation p-vaiue ior Test of Mee Difference
Variables
Mean
Median Minimum
Mean
OPTIMISM LEICHANG
142.90 0.12
149.00 0.20
29.00 -0.70
178.00 1.30 1.1620 0.3402 85,010.30 26,532.00 12.96
30.46 0.39 0.3289 0.1128 3,840.73 1,159.98 0.94
119.07 -0.04 0.3322 -0.0526 114.54 104.04 0.87
132.00 0.00 0.2380 -0.0457 30.42 12.75 0.40
29.00 -0.70 0.00 -0.3242 0.35 0.00 0.00
178.00 1.30 1.1620 0.2949 5,226.00 5,402.00 12.69
38.21 0.37 0.2984 0.1443 383.51 397.69 1.34
<0.0001 <0.0001 <0.0001 <0.0001 0.060 0.312 0.132

I
ON ON
UNDERPRICING 0.5633 RET30 Total Asset ($ million) REVENUE ($ million) ASTTRNOVER 0.0394 387.09 153.34 0.73
0.5120 0.0190 0.0377 -0.3051 30.05 12.10 0.46 0.20 0.00 0.00
Table 7 (Continued) Completed IPOs Standard Maximum Deviation 3.72 0.67 3.55 18.24 0.98 9.10 9,792.00 1.00 1.00 1.83 0.65 0.47 3.60 0.21 1.59 603.63 0.31 0.50 Withdrawn IPOs Standard Median Minimum Maximum Deviation -0.60 -0.27 0.05 0.35 0.48 9.1 60.00 0.00 0.00 -18.59 -4.03 0.00 -16.43 0.00 0.00 1.00 0.00 0.00 6.21 1.01 3.54 15.00 0.91 9.1 1,120.80 1.00 1.00 1.96 0.61 0.40 3.95 0.23 1.75 113.79 0.44 0.50 p-value for Test of Mean Difference 0.313 0.541 0.085 0.066 0.969 0.269 <0.0001 <0.0001 0.877
t
Variables EPS ($) ROA DEBTRATIO BOOKVLAUE ($/share) RETENTION REPUTATION FILESIZE ($ million) PRIUSE VENTURE
Mean -0.88 -0.39 0.26 0.12 0.46 8.18 171.14 0.11 0.49
Median Minimum -0.45 -0.21 0.06 0.10 0.47 9.10 66.00 0.00 0.00 -19.81 -5.33 0.00 -18.47 0.00 0.00 5.00 0.00 0.00
Mean -1.02 -0.41 0.21 0.61 0.46 8.08 88.19 0.27 0.49
ON
-68their IPOs from the market. In addition, the average first-day return of all IPOs occurring in the previous calendar month prior to a firm going public is 56.33 percent, while the average first-day return for a withdrawn IPO is 33.22 percent. The difference is 23.11 percent and statistically significant. This is consistent with Ibbotson, Sindelar, and Ritter (1994) who find that high IPO underpricing will encourage more firms to go public. These differences in the market condition variables support the notion that firms are more likely to succeed in going public when market conditions are favorable. From Table 7, it seems that the average firm that withdrew was smaller with $114.5 million in assets and $104.0 million in revenue compared to its successful counterpart with $387.1 million in assets and $153.3 in revenue. This is consistent with the findings by Henning and Shaw (2004). However, these figures are skewed by a few mega-offerings. If BPO firms with revenue greater than $5 billion are excluded from the sample16, the mean revenue of completed IPO firms declines to $75.3 million, which is then lower than the $87.0 million of withdrawn companies. The average assets of withdrawn IPO firms, however, remain smaller than the completed IPOs. Apparently, the revenue and assets are highly skewed to the right. Therefore, it is more appropriate to compare the median numbers. The median firm that withdrew had $30.4 million in assets and generated $12.8 million in revenue, while its counterpart completed IPO firm had the
1 6 Five completed IPO firms record more than $5 billion in revenue in the year prior to going public. They are (with revenue and issuing date in parenthesis): Pepsi Bottling Group Inc. ($7,041 million, 03/30/1999), Kraft Food Inc. ($26,532 million, 06/12/2001), Principal Financial Group Inc. ($8,885 million, 10/22/2001), Aramark Worldwide Corporation ($7,789 million, 12/10/2001), and Thomson Corporation ($6,452 million, 06/11/2002). Out o f 545 withdrawn IPOs, there is only one firm generating revenue larger than $5 billion in the year before it filed for going public - Cendant Corporation with $5,402 million in revenue. In addition, there are in total 15 completed and 6 withdrawn IPO firms with revenue more than $1 billion, including the ones listed above.
-69median assets of $30.1 million and $12.1 million in revenue. The differences are small and neither is significant at conventional levels. The asset turnover ratio is also mixed between completed issuers and withdrawn firms. The median asset turnover ratio of completed IPO firms is 0.46, which is higher than 0.40 of withdrawn firms, but the mean asset turnover ratio o f 0.73 for completed issuers is lower than the 0.87 from withdrawn issuers. This implies that firms successfully completing their IPOs may not manage their assets more effectively than companies that failed in their IPO process. As Table 7 shows, the withdrawn firms were less profitable reporting a mean (median) loss of $1.02 ($0.60) per share compared to a loss of $0.88 ($0.45) for the successful firms. Consistent with earnings per share, the return on asset ratio also reveals lower profitability for the withdrawn sample with a mean return on asset ratio of -0.41 compared to -0.39 for completed issues. However, neither difference is significant at conventional levels. In contrast to profitability measures, debt/asset ratios show that firms successfully completing their IPOs are significantly more leveraged, with debt averaging 26 percent (6 percent median) of total assets compared to 21 percent (5 percent median) for withdrawn firms. Completed EPO issuers also have significantly lower book value of equity with mean (median) net tangible asset value per share of $0.12 ($0.10) compared to $0.61 ($0.35) for withdrawn issuers. In summary, the impact which the financial performance of filing firms has on the outcome of IPO process is mixed. Completed IPO firms show higher profitability, measured by earnings per share and return on assets. However, an average (or median) withdrawn company has financial risk, evidenced by lower debt/asset ratio, and is worth
-70more in net tangible asset value per share. In addition, withdrawn issuers are not smaller in terms of revenue and total assets, and do not manage their assets less effectively, compared to their successful counterparts. The last five rows of Table 7 provide information of variables signaling the value of IPO stocks. Executives of completed IPO firms and withdrawn firms own about the same percentage of post-offering shares of stock (46 percent). Companies successfully completing IPOs seem to hire more prestigious investment bankers with average underwriter reputation ranking of 8.18 compared to 8.08. However, the difference is marginal and not statistically significant at conventional levels. The mean file size, defined as the offer price multiplied by the planned offering shares, is $171.14 million for the completed sample, which is significantly higher than the mean file size of $88.19 million for withdrawn issues. The median file size is far smaller for both sample with $66.0 million for completed samples and $60.0 for withdrawn sample. Like revenue and total assets, the file size is also right-skewed due to a handful of mega-offerings. However, after excluding the IPO firms with revenue higher than $5 billion, the mean (median) file size o f completed IPOs declines to $156.04 million ($66.0 million), which is still significantly larger than the $88.09 million ($60.0 million) of withdrawn issues17. This suggests that firms with large stock offerings seem more likely to succeed. Furthermore, 11 percent o f completed IPO firms disclosed in their prospectus that the primary use of proceeds from the stock issuance is to pay off debt and reduce financial leverage, compared to 27 percent for withdrawn firms. The difference is highly
17 If excluding the IPO firms with revenue higher than $1 billion, the mean file size o f completed IPOs will be $151.0 million, which is still significantly larger than $87.5 million o f withdrawn issues
-71 significant. This implies that firms planning to raise equity capital to reduce debt level and to rebalance their capital structure are less likely to succeed in their IPO attempts. Finally, the percentage o f firms backed by venture capitalists is about the same (49 percent) for completed as well as withdrawn issues. Overall, completed IPO firms seem to show slightly higher signaling value in the way to use the IPO proceeds and in the underwriter reputation. Table 8 lists the Pearson Correlations between explanatory variables and the binary variable that equals one for a successful offer and zero otherwise. These correlations directly test whether and how each variable influences the probability of success of an IPO. First, all four market condition variables are positively related to successful offers beyond a one percent significance level. This finding shows the importance of market conditions on initial public offering. Second, two out of six financial variables (namely, asset turnover ratio and book value) are marginally correlated to the successful completion of an BPO. Third, two signaling factors significantly influence the outcome of an initial public offering. Between them, the primary use of proceeds from an IPO is negatively related to a successful offer while the file size has a positive impact. Table 8 also lists the Pearson Correlations among explanatory variables. These correlations will be discussed in the next section in details when the multicollinearity problem is examined.
Reproduced w ith permission o f th e copyright owner. Further reproduction prohibited without permission.
Table 8
Pearson Correlation Coefficient of Variables
SUCCESS SUCCESS (p-value) OPTIMISM LEICHANGE UNDERPRICING RET30 REVENUE ASTTRNOVER EPS 1.0000
OPTIMISM 0.3238 <0.0001 1.0000
LEICHANGE 0.2044 <0.0001 0.0472 0.0666 1.0000
UNDERPRICING 0.3294 <0.0001 0.7061 <0.0001 0.1354 <0.0001 1.0000
RET30 0.3333 <0.0001 0.3677 <0.0001 0.4637 <0.0001 0.6423 <0.0001 1.0000
REVENUE 0.0228 0.4642 -0.1646 <0.0001 0.0376 0.2273 -0.0860 0.0057 0.0037 0.9059 1.0000
ASTTUNOVER -0.0569 0.0769 -0.0184 0.5667 0.0793 0.0136 0.0068 0.8330 -0.0162 0.6140 0.0384 0.2331 1.0000
EPS 0.0321 0.3129 -0.0364 0.2518 0.0899 0.0046 -0.0028 0.9302 0.0190 0.5505 0.0781 0.0143 0.2004 <0.0001 1.0000
- 72-
Table 8 (continued)
ROA
DEBTRATIO
BOOKVALUE
RETENTION
REPUTATION
FILESIZE
PRIUSE
VENTURE
SUCCESS OPTIMISM LEICHANGE

_
UNDERPRICING RET30 REVENUE ASTTRNOVER EPS
0.0196 0.5410 -0.0646 0.0441 0.0824 0.0102 -0.0426 0.1851 0.0188 0.5581 0.0755 0.0189 0.1307 <0.0001 0.2972 <0.0001
0.0518 0.1088 0.0293 0.3645 0.0520 0.1072 0.0174 0.5906 0.0267 0.4090 0.0375 0.2472 0.0243 0.4532 0.0099 0.7608
-0.0603 0.0562 -0.0950 0.0026 0.0540 0.0871 -0.0565 0.0735 -0.0049 0.8779 0.1369 <0.0001 -0.0061 0.8504 0.1888 <0.0001
0.0014 0.9690 0.0335 0.3388 0.0084 0.8102 0.0753 0.0314 0.0125 0.7208 -0.0868 0.0134 0.1162 0.0009 0.0833 0.0178
0.0293 0.2557 -0.0599 0.0199 -0.0924 0.0003 -0.1003 <0.0001 -0.1085 <0.0001 0.0633 0.0417 -0.1865 <0.0001 -0.0921 0.0037
0.0660 0.0208 -0.1196 <0.0001 0.0129 0.6520 -0.0986 0.0005 -0.0542 0.0576 0.9173 <0.0001 -0.0258 0.4527 0.0495 0.1469
-0.1835 <0.0001 0.0530 0.0637 0.0499 0.0808 -0.0144 0.6146 -0.0081 0.7767 0.0444 0.1654 0.1545 <0.0001 0.1349 <0.0001
0.0044 0.8873 0.1693 <0.0001 -0.0715 0.0124 0.1471 <0.0001 0.0245 0.3916 -0.1105 0.0005 -0.1753 <0.0001 -0.1816 <0.0001
Table 8 (continued)
ROA
DEBTRATIO
BOOKVALUE
RETENTION
REPUTATION
FILESIZE
PRIUSE
VENTURE
ROA DEBRATIO BOOKVALUE RETENTION REPUTATION FILESIZE PRIUSE VENTURE
1.0000
0.0369 0.2537 1.0000
0.2041 <0.0001 -0.1466 <0.0001 1.0000
0.0776 0.0270 0.0079 0.8239 -0.1179 0.0008 1.0000
0.1256 <0.0001 -0.0625 0.0528 -0.0056 0.8595 0.0253 0.4692 1.0000
0.0681 0.0472 0.0387 0.2625 0.0994 0.0034 -0.1248 0.0004 0.1214 <0.0001 1.0000
0.0776 0.0156 0.1623 <0.0001 0.0379 0.2409 0.0124 0.7236 -0.0674 0.0182 -0.0149 0.6242 1.0000
-0.1058 0.0010 -0.1964 <0.0001 -0.1585 <0.0001 0.0001 0.9977 0.1904 <0.0001 -0.1418 <0.0001 -0.1324 <0.0001 1.0000
-75Logistic Analysis of the Outcome of IPO Process The following multivariate logistic model, as discussed in chapter 3, is estimated on the outcome of the IPO process in order to identify significant factors that lead to the success of an initial public offering. logit ( p ) = a 0 + a , OPTIMISM + a 2 CHANGE + a 3 UNDERPRICING + a 4 RET30 + a B Log(l+REVENUE) + a 8 Log( 1+ASTTRNOVER) + a 7 EPS + a 8 ROA + a 9 Log( 1+DEBTRATIO) + a 1 0 BOOKVALUE + a RETENTION + a 1 2 REPUTATION +a 1 3 Log(FILESIZE) + a 1 4 PRIUSE + a 1 B VENTURE where p = Probability (SUCCESS = 118) and SUCCESS is a binary variable that takes the value of one for completed IPOs and zero for withdrawn issues. The estimation results are presented in Table 919. Model 1 in the table reports the estimated coefficients and the significance level of all the independent variables defined in Table 2. All four market condition variables, including UBS investor optimism, monthly change o f leading economic indicators, the average first-day return of all IPOs in the previous month, and the average return of NASDAQ Composite Index during 30
1 8 The SAS LOGISTIC procedure is performed to conduct the estimation. The LOGISTIC procedure, by default, models the probability o f the lower response level. Thus, in the SAS program, SUCCESS=0 is set for completed IPOs and SUCCESS=1 for withdrawn issues. When presenting results in this study, it is transformed back to SUCCESS=1 for completed issues and SUCCESS=0 for withdrawn issues in hope that
it w ill be easier to follo w .
19 There are significant pairwise correlations between independent variables that could affect the interpretation o f the logistic estimates. Revenue is significantly positively correlated with filing size (correlation o f 0.9173). Most market condition variables are significantly positively correlated with each other.
-76Table 9 Logistic Analysis of the Decision to Withdraw an IPO
This table provides the logistic regression coefficients for the regression of market condition, financial, and signaling variables on the outcome of IPO filings. The sample is 1511 issues filed with the SEC from 1999-2002, of which 966 are completed and 545 withdrawn. The p-value (of a Chi-square Wald test) of whether an individual coefficient is different from zero is under coefficient estimates. The dependant variable is zero for withdrawn offerings and one for completed offerings. Definitions of independent variables and their predicted sign are in Table 6. A logarithmic transformation was used for REVENUE, ASTTRNOVER, DEBTRATIO, and FILESIZE to minimize the effect of outliers on the estimation process. Listed under testing global null hypothesis: Beta=0, are p-values.
Independent Variable
Model 1
Model 2
Model 3
Model 4
Model 5
Intercept (p-value) OPTIMISM LEINDXCHANGE UNDERPRICING RET30 Log(l+RE VENUE) Log(l+ASTTRNOVER) EPS ROA Log( 1+DEBTRATIO) BOOKVALUE RETENTION
-2.5767 0.0172 0.0158 0.0044 1.0195 0.0041 0.7826 0.1881 1.9736 0.1414 0.2112 0.0669 -0.7660 0.0442 0.0818 0.2816 -0.2119 0.2764 0.2483 0.6237 -0.0723 0.0407 -0.1220 0.8226
-2.7197 0.0056 0.0190 0.0002 0.9085 0.0065 0.3566 0.5198 2.4217 0.0552 0.1898 0.0660 -0.7279 0.0318 0.1075 0.1108 -0.2573 0.1680 0.2669 0.5696 -0.0639 0.0429
-2.6921 0.0055 0.0211 <0.0001 0.9085 0.0050
-2.5700 0.0059 0.0206 <0.0001 0.8592 0.0066
2.7930 0.0058 0.2046 0.0419 -0.7522 0.0242 0.0988 0.1475 -0.2388 0.1951
2.6841 0.0069 0.1645 0.0811 -0.6505 0.0447
-1.3968 <0.0001 0.0131 <0.0001 0.6843 0.0001 0.5007 0.1143 2.8841 <0.0001
-0.0728 0.0178
-0.0648 0.0320
-77Table 9 (Continued)
Model 1
Model 2
Model 3
Model 4
Model 5
REPUTATION Log(FILESIZE) PRIUSE VENTURE
0.0235 0.7884 0.3855 0.0847 -1.9361 <0.0001 0.0439 0.8646 780
0.0528 0.4822 0.2841 0.1523 -2.0486 <0.0001
0.3581 0.0323 -2.0540 <0.0001
0.3470 0.0334 -1.9211 <0.0001
Number of Observations
818
827
830
1511
Testing Global Null Hypothesis: Beta=0 Likelihood Ratio <0.0001 <0.0001 Score <0.0001 <0.0001 <0.0001 Wald <0.0001 <0.0001 <0.0001 Model Goodness-of-fit Generalized R2 0.2567 0.2713 Somers D 0.565 0.571 Hosmer and Lemeshow Goodness-of- fit Test 0.0382 (p-value) 0.0099 0.0368 Percent Correct Predictions
<0.0001 <0.0001 <0.0001
<0.0001 <0.0001 <0.0001
<0.0001
0.2685 0.565 0.0049
0.2536 0.548 <0.0001
0.2194 0.475
85.4
84.0
84.0
84.2
74.3
-78trading days prior to an IPO completion or withdrawal date, have positive coefficients and two o f them are significant. This is consistent with the notion that managers are more likely to complete their IPOs and take their firms to public when market conditions are favorable. As to factors affecting investor valuation, the revenue variable is significant and the coefficient on log(l+REVENUE) is positive, indicating that it m aybe easier for firms with higher revenue to be accepted by the stock market. Both asset turnover ratio and book value per share are significantly correlated with the completion of IPOs, although, the coefficients of log(l+ASTTRNOVER) and UNITBVALUE show opposite signs to those predicted. Unlike the univariate analysis, earnings per share and return on assets are not significant in discriminating completed IPOs and withdrawn issues. The coefficient of log(l+DEBTRATIO) is neither significant nor assuming the sign as predicted. As in the univariate analysis, financial factors do not appear to have a clear impact on the completion of IPOs when they are taken account together in the multivariate analysis. Four coefficients of six financial variables assume signs opposite to the predictions so that the positive impact that the other two variables have on the IPO process is offset and reduced. The combined impact of these variables on the outcome of IPO process is slightly higher than that of the underwriters reputation and far lower than that of UBS investor optimism as shown in the footnote .
20 A median completed initial public offering has revenue o f $12.10 million, asset turnover ratio o f 0.46, earnings per share o f -0 .4 5 , return on asset o f -0.21, debt/asset ratio o f 0.06, book value per share o f $0.10, underwriter reputation o f 9.1, and investor optimism o f 149. The partial impact o f financial variables o f a median IPO firm on the logit(p) can be calculated as follows (coefficients are from Model 1): 0.2112 x log(l + 12.10) + (-0.7660) x log(l+0.46) + 0.0818 x (-0.45) + (-0.2119)x (-0.21) + 0.2483 x log( 1+0.06) + (-0.0723) x 0.10 = 0.2594. The partial impact o f underwriter reputation on the logit(p) is:
-79In Model 1, the percentage of postoffering shares owned by executives does not appear to have a significant impact on whether investors accept their companys stock. The updated Carter and Manaster underwriter ranking, REPUTATION, and the dummy variable indicating venture backing also fail to assume significant coefficients. This implies that either these variables do not provide signaling value to IPO stock, or the signaling effect is insignificant compared to other factors. The variable FILESIZE is significant and assumes a positive coefficient in line with the argument that investors are more receptive toward firms with a big offering size. Such companies are likely to be more established, more mature and stable, of lower ex ante valuation uncertainty, and less risky to generally risk-averse investors. Last, the coefficient of PRIUSE is negative and
significant. This indicates that the intention to pay back debt with the IPO proceeds will prevent firms from going public. The primary use of the proceeds to repay debt may provide a signal to investors that firms choose to issue stock not for capital needs but to take advantage of high stock valuation. Overall, the model is well-specified with the Generalized R2 equal to 0.256721. The likelihood ratio test, Score test, and Wald test all reject the global null hypothesis: all coefficients=0. In addition, the model has high predictability with the Somers D22 of
0.0235 x 9.1= 0.2139. However, the partial impact o f investor optimism on the logit(p) is: 0.0158 x 149 = 2.3542. 21 Generalized R2=R2/max(R2). R2=1-{L(0))/L( p )}2/n, where L( p ) and L(0) denote the likelihood o f the specified model and the likelihood o f the intercept-only model, and n is the sample size. Max(R2)= lL(0)2/n. Generalized R2 has the interpretation as the proportion o f explained variation (Nagelkerke, 1991) 22 Choose one observation from each o f the two groups: completed and withdrawn IPOs. Let the (i,j) pair be such that i e Completed IPOs and j e Withdrawn IPOs. Let A and A be the predicted probability of Completion o f IPOs for the ith and j* individuals, respectively. If A > A , then the pair (i,j) is concordant. If A < A , then the pair (i,j) is disconcordant. Let N c be the number o f concordant pairs and N d be the number o f disconcordant pairs. Somers D is then defined as (Nc-Nd)/(Nc+Nd).
-800.565 and the percent correct predictions23 of 85.4 percent using 0.5 as the cutpoint for the prediction. In order to reduce the potential effect of multicollinearity, two or three redundant variables are eliminated from the logistic model each time, if they do not show up with significant coefficients in Model 1. The results are listed under Model 2 through Model 4 in Table 9. Model 4, the most parsimonious, draws a clearer picture of the variables closely correlated with an IPOs outcome. The probability to successfully bring a private firm public appears to increase when the security market conditions are favorable with high investor optimism, improvement of leading economic indicators and rising stock indices. Issuers with higher revenue are more likely to complete their IPOs. However, it seems that the likelihood to withdraw IPOs from the market is higher for firms with higher asset turnover ratio and book value of equity. This is contrary to the prediction and hard to comprehend. A possible explanation could be the fact that a great number of Internet firms successfully went public in 1999 and 2000 even though they had low asset turnover ratio and small or negative book value of equity. The model further shows that firms selling a larger number of shares are more likely to complete their IPOs, confirming the prediction that investor reception is stronger for larger, more liquid offerings. Last, the primary use of proceeds to repay debt will reduce the chance to successfully go public.
23 Percent correct predictions have to be interpreted with caution as a goodness-of-fit measure o f the logistic model. If the 15 independent variables identified in this research are included individually in the model, percent correct predictions o f the 15 models range from 63.9 percent to 84.2 percent with the mean o f 72.7 percent.
-81 Model 5 is the logistic model of the outcome of IPO process on only four market condition variables24. Three variables (UBS investor optimism, monthly change of leading economic indicator, and the return of NASDAQ Composite Index during the 30 trading days prior to the completion or withdrawal date) are significant at the one percent level, and the other variable, the average first-day return of all IPOs in the previous month, is marginally significant. The model also fitted with the Generalized R of 0.2194 and the Somers D o f 0.475. This model further confirms the conventional wisdom that timing is everything for IPOs and demonstrates the importance of favorable market conditions to the successful completion of IPOs . In a study of the choice of the underwriting contract, Dunbar (1998) estimates a probit model to predict the success of firm-commitment IPOs and finds that offering size, offer price, underwriter reputation, and clustering of filings affect the success of the filing. In his model, no explicit market condition variables are employed to measure the impact of investor demand on the success of initial public offerings. Henning and Shaw (2004) developed a logistic model to predict the probability that an IPO will be withdrawn and included three dummy variables to measure the investor demand. These variables
24 Due to substantial amount o f missing financial data, the number o f observations in Model 1 is only 780 compared to 1511 in Model 5. It may undermine the comparability o f Model 1 and Model 5. I reran Model 5 on the same 780 observations as in Model 1, and present the results under Model 5 in Appendix A. No big differences can be found between the two models. 25 One might wonder whether financial variables or signaling factors have similar predictive power on the completion o f IPOs as market condition variables. I run the logistic model on only six financial measures and five signaling variables, respectively, and list the results in Appendix A under Model 6 and Model 7. Although the percent correct predictions are 73.4 percent and 84.2 percent, it needs to be interpreted with caution as explained in footnote 9. To some extent, Generalized R2 and Somers D are a better measure o f goodness-of-fit and predictability o f the model. Generalized R2 is 0.0174 and 0.1019 for Model 6 and 7, suggesting that only 1.74 percent and 10.19 percent o f the variance o f the dependant variable is explained by the independent variables. Somers D o f 0.122 for Model 6 implies the poor predictive power. Therefore, financial variables or signaling factors appear not to have similar predictive power on the completion o f IPOs as market condition variables.
-82measure whether the initial filing stated an offer price range, whether the firm changed the price range in a subsequent filing, and whether the change was an increase in the price range in a subsequent filing. The last two variables reflect the investor interest solicited during the road show and, therefore, measure the consequence of investor demand for individual companies. These variables can hardly explain, in general, the reasons why some firms complete their IPOs and other withdraw. In a study to demonstrate that the option to withdraw an IPO from the process reduces initial underpricing by strengthening an issuers bargaining power with investors, Busaba, Benveniste, and Guo (2001) develop a probit withdrawal decision model. Two variables are included in the model to measure market interests: NASDAQ average 30-day return over the filing-issuing/withdrawal period (RETF) and NASDAQ return over the 30-day period after filing (RET30). They find that RET30 is statistically significant, confirming the anecdotal evidence that an initial public offering is more likely to succeed in strong markets. However, this study argues that one variable, RET30, may not be able to fully measure market interests for IPOs. For instance, the S&P 500 Index increased by 26 percent, and NASDAQ Composite Index rose by 50 percent in 2003. Strong stock market performance, however, did not trigger a strong IPO market. There were only 80 firms completing their IPOs, less than the number of companies going public in only two months in 1999. In addition, Lowery (2003) finds that investor sentiment (measured by the discount on closed-end mutual funds), capital needs, and adverse selection considerations can explain the fluctuation of the number of completed IPOs over years.
-83Window of Opportunity In the above section, a logistic model was performed to estimate the probability that an IPO will be completed based on security market condition factors, financial characteristics, and signaling variables. Even though the model shows that the outcome of an IPO is affected by all three groups of factors, security market condition variables are more significant, economically and statistically, in discriminating completed and withdrawn issues. Next, this study will explore how security market conditions affect the IPO markets. It has been well documented that the market for IPOs experiences periods in which the value o f firms going public is substantially higher (Ibbottson and Jaffe 1975, Ritter 1984). What appears to happen is that investors are periodically overoptimistic about the earnings potential of young growth companies (Ritter 1984). These so-called Hot markets are windows of opportunity that entrepreneurs may use to improve their access to capital. Within the sample period o f 1999-2002, there were 584 completed issues from January 1999 to March 2000, averaging 40 per month, while there are only 382 firms going public during the 33 month period from April 2000 to December 2002, averaging only 11.6 per month. The former is commonly viewed as a hot market (Helwege and Liang 2004) and window of opportunity for IPOs is apparently open during this period. The later is a typical cold market. To check the relationship between security market condition variables identified in this research and the window of opportunity for IPOs, a logistic model is conducted
-84with two subsamples: 966 completed IPOs and 545 withdrawn issues. The dependent variable, WINDOW, takes the value of one for all IPOs that were completed or withdrawn between January 1999 and March 2000 since the window of opportunity for IPOs is open during this period. WINDOW takes the value o f zero during other time period. The results are listed in Table 10. All independent variables but RET30 are significant and assume positive coefficients whether using the completed subsample or the withdrawn subsample. The Generalized R2 and Somers D are close to 1.0 and the percent correct prediction is near 100 percent. This indicates the significant impact that general market conditions have on the window of opportunity for IPOs. The variable RET30 fails to assume a significant positive coefficient, probably because of high correlation between it and other market condition variables. The correlation coefficients between RET30 and the three variables UNDERPRICING, CHANGE, and OPTIMISM, are 0.6423, 0.4637, and 0.3677, respectively, and significantly different from zero. If RET30 is excluded from the model26, the coefficient estimates of other independent variables are marginally changed and measures of goodness-of-fit of the model are little changed. In summary, three or four security market condition variables are highly successful in predicting the window of opportunity for IPOs. To explore how general security market conditions affect the IPO market activity, a linear regression model is estimated with the number o f IPO filings, the number of completed IPOs, or the number of withdrawn issues per month, as the dependent variable. The explanatory variables are four market condition factors: UBS investor optimism
26 Appendix B .l and B.2 provide results o f various alternative models with different combination of independent variables.
-85Table 10 Logistic Analysis of the Window of Opportunity for Initial Public Offerings
This table provides the logistic regression coefficients and statistical significance levels for the regression o f market-condition variables on the window of opportunity. There are two samples: 966 firm-commitment initial public offerings completed during the period of 1999 to 2002 and 545 withdrawn IPOs occurred in the same period. The dependant variable takes zero when a firm completed/withdrew its IPO during the period of April 2000 to December 2002. This period is an IPO cold market. The dependant variable is one when an IPO was completed/withdrawn between January 1999 and March 2000 since the IPO market was hot during this period. Independent variables are defined in Table 6. The p-value (of a Chi-square Wald test) of whether an individual coefficient is different from zero is under coefficient estimates. Listed under testing global null hypothesis: Beta=0 are p-values. Completed IPOs Sample Independent Variable Intercept (p-value) OPTIMISM LEICHANGE UNDERPRICING RET30 Model Cl -71.6097 <0.0001 0.4216 <0.0001 15.8851 <0.0001 17.7947 <0.0001 -1.6553 0.540 Model C2 -69.5813 <0.0001 0.4104 <0.0001 15.8625 <0.0001 16.9956 <0.0001 Withdrawn IPOs Sample Model W1 -70.0389 0.0004 0.4104 0.0008 14.9345 <0.0001 16.0472 0.0006 -1.4879 0.7003 Model W2 -66.5964 <0.0001 0.3902 0.0002 14.8442 <0.0001 15.0884 <0.0001
Testing Global Null Hypothesis: Beta=0 Likelihood Ratio <0.0001 <0.0001 Score <0.0001 <0.0001 Wald <0.0001 <0.0001 Model Goodness-of-fit Generized R2 0.9089 0.9087 SomersD 0.972 0.972 Hosmer and Lemeshow Goodness-of-fit Test (p-value) <0.0001 <0.0001 Percent Correct Predictions
<0.0001 <0.0001 <0.0001
<0.0001 <0.0001 <0.0001
0.9132 0.974 0.3222
0.9131 0.974 0.4464
96.2
96.2
98.0
98.0
-86-
index, monthly change of leading economic index, average IPO underpricing in the previous month, and the 30-trading-day return o f the NASDAQ Composite Index prior to the first trading day or each month. The regression estimation results are presented in Table 11. The first column shows that UNDERPRICING is significant, both statistically and economically in influencing the number of IPO filings. An increase of twenty percentage points in the average underpricing of all IPOs in a given month (which has a standard deviation of 34.09 percent) will lead to 11 more firms filing for initial public offering in the following month. This indicates that high IPO underpricing, often viewed as the success of IPOs, will encourage more firms to tap the capital market. In addition, investor optimism is also a significant factor in increasing companies intention to go public. The second column in Table 11 shows that the investor optimism is a significant determinant of the number of completed issues per month. An increase of 20 points in the UBS Investor Optimism Index (which has a standard deviation of 42.81) will result in 4.5 additional firms to complete their initial public offerings. CHANGE and UNDERPRICING have positive impacts on the number of completed IPOs, but the effect is not significant. The third column reveals that the stock market movement has a significant impact on the decision to withdraw an IPO. As the stock market declines, investors may gradually lose their interest in IPOs, and more firms may have to withdraw their issues. CHANGE and UNDERPRICING are also negatively related to the number of withdrawn issues. In all three models, the coefficients of at least one variable have opposite signs to those predicted. This might be due to the correlation among market condition variables as shown in Table 8 shown previously. To investigate the potential
-87Table 11 Ordinary Least Squares Regression Results on IPO Activity
Nj = ai0 + bj,OPTIMISM + bi2CHANGE + bi3UNDERPRICING + bi4RET_30. Nf is the number of initial public offing filings, completed IPOs or withdrawn issues of each calendar month during the period of 1999-2002. OPTIMISM is UBS Investor Optimism index released at the beginning of each month. CHANGE is the monthly change of leading economic index. UNDERPRICING is the average underpricing of all IPOs in the previous
1 n P j j PjQ
month and is measured as: ---------- , where P;o is the offer price of an IPO, Pn is its firstn i=i P io day closing price, and n is the number of completed initial public offerings in the previous month. UNDERPRICING data is from Jay Ritters IPO data website: http://bear.cba.ufl.edu/ritter/ipodata.htm. RET_30 is the cumulative 30-trading-day return before the first trading day of each month. T-statistics for estimated coefficients are in parentheses. The signs before coefficient estimates are the predicted direction o f coefficients. Dependent Variable Number of Filings per Month (?) (+) (+) (+) (+) -10.5321 (-1.38) 0.1650* (1.84) -6.1752 (-1.02) 55.4771*** (4.37) -18.7171 (-0.77) 0.7100 (?) (+) (+) (+) (+) Number of Completed IPOs per Month -11.4356* (-1.92) 0.2253*** (3.22) 0.7475 (0.16) 15.9671 (1.61) -4.7167 (-0.25) 0.5827 (?) (-) (-) (-) (-) Number of Withdrawn IPOs per Month 2.1622 (0.55) 0.0975** (2.10) -4.6853 (-1.49) -4.3914 (-0.67) -27.8048** (-2.22) 0.2643
Independent Variable Intercept (t-statistic) OPTIMISM CHANGE UNDERPRICING R ET30
Adj. R2
* Significant at the 10% level ** Significant at the 5% level *** Significant at the 1% level
-88existence of multicollinearity, values of Variance Inflation Factors (VIF) and Condition Indices were examined for all four independent variables. The largest VIF value is found to be 4 for UNDERPRICING, which is well below 10, the typical threshold. The biggest Condition index is 11 for RET30, which is also lower than the conventional cutoff value of 30. Thus, results of collinearity diagnostic indicate possible existence of multicollinearity, but the degree of multicollinearity does not appear to be severe. The adjusted R2 for three models are 0.7100, 0.5827 and 0.2643, respectively. This indicates that general market conditions exert more direct impact on IPO filings than on the completion of IPOs or the IPO withdrawal. This may be interpreted in the following way: when many firms observe favorable IPO market conditions, they quickly respond to file for going public and take advantage of the opportunity. Therefore, four market condition variables explain 71 percent of the variance of the number of filings per month. However, the completion of IPOs depends not only on market conditions but also other factors, such as financial characteristics of IPO firms and signaling factors, as discussed in the previous section. Therefore, only 58.27 percent of variation in the number of completed issues per month is explained by the market condition factors. The impact of market conditions on the decision to withdraw an initial public offering may be less direct and delayed. After market conditions deteriorate and investor interest on new issues disappears, IPO firms will most likely wait for the market to turn around before they decide to terminate their IPO process. This waiting time should vary from firm to firm. As a result, it is not surprising to see that the current market conditions explain only 26.43 percent o f the variation of the number of withdrawn issues.
-89-
Characteristics of Hot and Cold IPOs The study will now examine the differences between IPO firms going public in the hot market and in the cold market. The analysis covers three areas: market conditions, IPO characteristics, and firm financial characteristics. The results are presented in Table 12. First, the market conditions, under which firms went public in the hot market, are far more favorable than those in the cold market. The average investor optimism was 157.47 when IPOs were completed in the hot market, while it was 120.63, or more than 20 percent lower, in the cold market. The difference is significant. In the hot market, leading economic indicators improved by 0.1973 per month, significantly higher than the increase of 0.0141 in the cold market. The average underpricing of all IPOs in the preceding month before there was an IPO in the hot market is 75.13 percent, compared to its counterpart of 27.59 percent in the cold market. The difference is highly significant. In addition, the NASDAQ Composite Index went up by 7.98 percent during the 30 trading days before an IPO completed in the hot market, while it declined by 2.23 percent in the cold market. The difference is 10.21 percent and statistically significant. Second, IPO characteristics are significantly different between the hot market and the cold market. The mean offer price of IPOs completed in the hot market is $15.29, significantly larger than $14.36 per share in the cold market. The median offer price is also higher though the difference is smaller. This suggests that, in general, investors might give higher valuation for IPOs in the hot market than in the cold market. The mean first-day return o f IPOs in the hot market is 74.65 percent, compared to 27.63 percent in
-90Table 12 Comparison of Security Market Conditions, IPO and Firm Characteristics between Hot and Cold Market
The sample consists o f 966 new issues completed between 1999 and 2002. This table provides the mean figures of various variables except stated explicitly. Medians for financial variables are disclosed in parentheses. The equally weighted average first-day return is measured from the offer price to the first CRSP-listed closing price on 950 observations since security information of 16 IPO firms is not included in the CRSP tape. Days to complete IPOs measure the time period from the filing date to the issuing date.
Hot Market Conditions Mean UBS investor optimism Average monthly change of leading economic indicator Average IPO underpricing in the previous month Average 30-trading-day return of Nasdaq before IPOs IPO Characteristics Number of IPOs Number of IPOs per month Mean offer price ($) Mean first-day return (%) Percent of shares retained by Management or Founders Percent of firms using proceeds to repay debt Percent with venture capital Underwriter ranking Days to complete IPOs Firm Financial Characteristics 83.1(10.8) Sales revenue (Smillion) Total assets (Smillion) 176.2(25.6) Debt/asset ratio 0.293(0.06) Percent with negative earnings 77.7% EPS ($) -0.93(-0.47) 584 39.9 15.29 74.65 48.68% 14.21% 51.54% 8.05 102.5 157.47 0.1973 75.13% 7.98%
Cold
Difference
p-value
120.63 0.0141 27.59% -2.23%
36.84 0.1831 47.54% 10.21%
<0.0001 <0.0001 <0.0001 <0.0001
382 11.6 14.36 27.63 41.05% 5.76% 46.07% 8.38 128.7
202 27.3 0.93 47.02 7.63% 8.45% 5.47% -0.33 -26.2
N/A N/A 0.0317 <0.0001 <0.0001 <0.0001 0.0967 0.0008 <0.0001
295.4(13.4) 812.4(43.1) 0.202(0.06) 72.8% -0.80(-0.44)
-212.3 -636.2 0.091 4.9% -0.13
0.0932 0.1330 0.0043 N/A 0.3402
-91 the cold market. The difference is also significant. This indicates higher investor demand on IPO shares in the hot market. In the hot IPO market, 48.68 percent of postoffering shares are retained by executives and founders of the firms, significantly more than 41.05 percent in the cold market. As will be discussed below, firms going public in the cold market are, on average, bigger as evidenced by larger sales revenue and total assets. Shares of bigger corporations are usually more widely distributed among investors. Thus, the difference in the size of issuing firms may explain the difference of insider ownership between the hot and cold market. In the hot market, 14.21 percent of firms stated in the final prospectus that the primary use of IPO proceeds is to repay debt, compared to 5.76 percent in the cold market. Even though investors have a tendency to avoid this type of firm as shown in the last section, disproportionately more firms raise capital to pay back debt in the hot market. This is probably due to the exceptionally high investor optimism in the hot market, which makes investors less risk-averse than they otherwise would be. In the hot market, 51.54 percent of IPO firms are backed by venture capitalists, while only 46.07 percent in the cold market. This is consistent with Lemer (1994), who finds that venture capitalists have more expertise in deciding when and how a firm should go public. As hypothesized, underwriters of IPO firms in the hot market have lower average ranking at 8.05 compared to 8.38 for those underwriting IPOs in the cold market, possibly for two reasons. First, in the hot IPO market when market conditions are favorable, less prestigious investment bankers maybe able to assist IPO firms complete their IPOs even though they may be less experienced in promoting initial public offerings
-92and know fewer institutional investors. Thus, there may be no need for IPO firms to hire prestigious underwriters, who, as Chen and Ritter (2000) find, charge higher management fees. As the author examines underwriters, he finds that a few little-known investment bankers27 managed only one IPO in 1999 and that is the only one during the four-year period from 1999 to 2002. Second, in the hot IPO market, there are a great number of firms in the pipeline. Prestigious investment bankers may get sufficient business and lack motivation to seek new business. This provides those less-known underwriters opportunities to win some clients. In the hot market, it takes IPO firms 102.5 days, from the filing date to the issuing date (the waiting period), to complete their IPOs compared to 128.7 days in the cold market. The difference is more than 26 days and significant. To check whether this difference is because the window of opportunity is open or for some other reasons, a linear regression model is estimated. The dependent variable is the waiting period, and the independent variables are the factors contributing to the completion of IPOs and listed in Table 2. An additional dummy variable, WINDOW, is included in the model, which takes zero if an IPO was completed in the hot market and one otherwise. The results are presented in Table 13. In Model 1, the estimated coefficient WINDOW is positive but not significant, possibly because the predictive power of WINDOW is captured by four market condition variables. After excluding these four variables from the model, WINDOW becomes significant in Model 2. The coefficient of WINDOW is 26.0972,
27 Examples are: Whale Securities Co., Westport Resources Investment Services, Inc., Somerset Financial Group, Redstone Securities, Inc., Network 1 Financial Securities, Inc., Howe Bames Investments, Inc., Gmntal & Co., Donald & Co. Securities Inc., Dirks & Company, Inc., BlueStone Capital Partners, L.P., and Allen & Company.
-93Table 13 Ordinary Least Squares Regression Results with the Time Frame (Days) to Complete an IPO as the Dependent Variable
This table provides OLS regression of time frame to complete an IPO against financial strength variables of IPO firms, security market condition variables, and signaling variables. The definition of all independent variables but WINDOW is in Table 6. WINDOW is a dummy variable indicating the window of opportunity for IPOs. It takes zero if an IPO was completed during the period of January 1999 to March 2000 while the IPO market was hot, and one for IPO firms going public from April 2000 to December 2002 while the IPO market turned cold. T-statistics of testing coefficients equal to zero are in parentheses.
Independent Variable Intercept (t-statistic) OPTIMISM LEICHANGE UNDERPRICING RET30 REVENUE ASTTRNOVER EPS ROA DEBTRATIO BOOKVALUE RETENTION REPUTATION FILESIZE
Model 1 302.2759*** (7.81) -0.6903*** (-3.30) -7.3362 (-0.64) 8.9672 (0.44) 26.4073 (0.57) 2.5001 (0.27) 6.9209* (1.75) 0.1607 (0.07) 5.4544 (0.93) -12.9095 (-1.58) -0.5074 (-0.48) -41.2531** (-2.40) -9.2220*** (-3.85) -0.0165 (-0.58)
Model 2 203.2429*** (9.50)
3.4333 (0.37) 7.5339* (1.90) 0.1282 (0.06) 6.0624 (1.04) -12.6314 (-1.54) -0.1533 (-0.15) -40.5581** (-2.36) -9.4137*** (-3.93) -0.0146 (-0.51)
-94Table 13 (Continued)
Model 1
Model 2
PRIUSE VENTURE WINDOW
17.5140 (1.49) -10.9198 (-1.36) 16.0980 (1.39) 0.0742
15.2827 (1.31) -12.6168 (-1.57) 26.0972*** (3.44) 0.0638
Adjusted R2 * Significant at the 10% level ** Significant at the 5% level *** Significant at the 1% level
indicating that it takes about 26 more days for a firm to complete its IPO during the cold market. In other words, the variable WINDOW exactly explains the difference of time frame to complete IPOs between the hot and cold market. Table 12 also shows that financial characteristics of firms going public in the hot market are weaker than those completed in the cold market. IPO firms in the hot market are smaller in terms o f sales and total assets. The mean (median) sales revenue of firms completed their IPO in the hot market and in the cold market is $83.1 (10.8) million and $295.4 (13.4) million. The difference is significant at the 10 percent level. The average total assets of firms in the hot market is $176.2, which is also smaller that of $812.4 million of their counterparts in the cold market. However, the difference is not significant at conventional levels. Firms completing IPOs in the hot market are also more financially risky, evidenced by a significantly higher debt/asset ratio of 29.3 percent,
-95compared to 20.2 percent of IPOs in the cold market. In addition, these firms are also less profitable, recording -$0.93 per share, while a typical firm going public in the cold market loses $0.80 in the year prior to its IPO. Overall, 77.7 percent of companies going public in the hot market generate negative net income, higher than 72.8 percent in the cold market. The percent of firms with negative earnings in the whole sample period of this study is consistent with the number reported by Ljungqvist and Wilhelm (2003) and higher than that before 1999. All financial variables reported in Table 12 are affected by a few extreme values and right-skewed. So it is more appropriate to compare the median than the mean. However, the findings based on the analysis of the mean financial characteristics are not changed except debt/asset ratio. The median debt/asset ratio is the same for IPO firms in the hot and cold market, indicating that they are equally financial leveraged. The above analysis can be summarized as follows. Firms going public in the hot market are, on average, smaller in terms of revenue and total assets. They had higher losses in the year prior to their IPOs, and their financial leverage is not lower than their counterparts in the cold market. More firms intend to use IPO proceeds to repay their debt in the hot market, signaling less investment value of their stocks. Besides, on average, hot firms hire less prestigious investment bankers to underwrite their IPOs. Despite all these facts, their mean offer price and average first-day return are higher, and it also takes less time (about 26 days less) to complete IPOs in the hot market. These findings point to one explanation. During the hot IPO market, investors are excessively optimistic and give higher valuation to IPO stocks than they should. This overoptimism
-96provides many firms, which in normal market condition should have stayed privately held, a window of opportunity to access the capital market. Other explanations are not ruled out. For example, firms in the hot market may show or be perceived to have a high growth prospects and, therefore, are valuated high by investors.
Stock Performance of Hot and Cold IPO Firms The above section discussed financial characteristics and IPO characteristics of firms going public while the IPO market was hot and cold. In this section, a comparison will be made of the long-term stock performance between IPO firms completed in the hot market and the cold market. The sample consists of 950 completed IPOs after excluding 16 firms from 966 completed issues studied in this research. The trading information of these 16 IPO firms is either not listed within 10 trading days in CRSP tape or not recorded at all. Among the 950 firms, 808 firms are traded on the Nasdaq, 16 on the American Stock Exchange, and 126 on the New York Stock Exchange. To avoid survivorship bias due to stocks with limited return histories, these stocks are kept in the sample when calculating the average of buy-and-hold returns of IPO stocks or the abnormal returns for as long as they appear in the CRSP tape. If an issuing firm is delisted prior to its first six-month trading period or its first anniversary date, its total return is truncated on that date as well as its benchmark index return. Thus, the percentage buy-and-hold return for firm i is
m in [T,delist]
R iT =
II
(1+ ru) -1
x 100%
(4)
t=start
-97where start =1 for the first-six-month return or the first-year return and start =127 for the second-six-month return; m in[J ) delist] is the earlier of the last day of CRSP-listed
JO
trading or the end of the six-month (T= 126 ) or one-year (T = 252) window, and rjt is the daily return for firm i on date t. The buy-and-hold return measures the total return from a buy and hold strategy where a stock is purchased at the first closing market price (listed in the CRSP tape) after going public and held until the earlier of (i) the holding period (six months or a year) or (ii) its delisting. The benchmark index is selected in the following way: if an IPO firm is traded in the NASDAQ, the NASDAQ Composite index will be used as the benchmark. Otherwise, if an IPO firm is listed in New York Stock Exchange or American Stock Exchange, the S&P 500 index will be the benchmark. Incidentally, it is well documented that the quantitative measurement of the long-run performance of initial public offerings is very sensitive to the benchmark employed (Ritter 1991 and Helwege and Liang 2004). The percentage buy-and-hold return for the benchmark index, RmT, is calculated in the same way as equation (4) with the benchmark index return truncated on the day when a firm is delisted during the holding period. The average buy-and-hold return of IPO stocks is the equally-weighted average of the IPO stock returns: ARiT = YJRiT N< = i (5)
The average buy-and-hold return of benchmark indices, ARm r, is also calculated as the equally-weighted average of the benchmark index returns, as in equation (5).
28 A year is defined as twelve 21-trading day intervals (252 days) and a half-year as six 21-trading days (126 days in total).
- 98 The average abnormal buy-and-hold return (ABHR) adjusted by benchmark indices is the equally-weighted average of differences between the buy-and-hold returns IPO firms and their benchmark indices: ABHR = (Ru-Rrnt) (6)
To compare IPO stock performance with benchmark indices, wealth relatives (WR) are also computed as a relative performance measure, defined as 1 + average buy-and-hold return on IPOs WR = -----------------------------------------------------------------------------1 + average buy-and-hold return on benchmark index A wealth relative of greater than 1.0 can be interpreted as IPOs outperforming their benchmark index; a wealth relative of less than 1.00 indicated that IPOs underperformed. The average cumulative abnormal return (CAR) is another relative performance measure and calculated as: CAR = Am
1 N
rnm[T,delist]
(7)
t=\
(ru - rmt)
(8)
The stock performance of IPO firms and the benchmark indices in the year after going public is reported in Table 14. First, IPO firms as a whole underperform their benchmark indices in the year after going public. The buy-and-hold return of all IPO firms in the first year is -7.95 percent, which is significantly lower than -1.11 percent, the return of corresponding benchmark indices. The cumulative abnormal return is -4.3 percent, also showing that IPO companies underperform their benchmark indices. This is consistent with previous research (Loughran and Ritter 1995, Teoh, Welch and Wong 1998a, Brav and Gompers 1997, for example). However, similar to Helwege and Liang
-99Table 14 Long-Run Stock Returns in the Year Following the EPO for Hot and Cold Market IPOs and Their Benchmarks
The sample consists o f 950 completed IPOs after excluding 16 IPO firms from 966 completed issues studied in this research due to the lack of trading information in CRSP tape. The abnormal buy-and-hold return (ABHR) is calculated as:
vcm[T ,delist\
t are the daily returns on stock i + ru) + r j ) , where r;t and rm t-tO t-t0 Nm and the corresponding benchmark index, respectively, min[T, delist] is the earlier of the last day of CRSP-listed trading or the end of the six-month (T= 126) or one-year (T = 252) window, and N is the sample size. The benchmark index is selected in the following way: if an IPO firm is traded in the NASDAQ, the NASDAQ Composite Index will be used as the benchmark. Otherwise, if an IPO firm is listed in New York Stock Exchange or American Stock Exchange, the S&P 500 index will be the benchmark. The daily returns are from the CRSP daily NASDAQ returns tape and the daily NYSE-AMEX tape. Column 4 lists the wealth relative, measured as:(l+average buy-and-hold return on IPOs)/(l+average bay-andhold return on benchmark indices). Column 5 lists the cumulative abnormal return (CAR), which is calculated as: N ;=i
2
N
m i n [ T , delist]
n (1
m i n |T
n (1
^delist]
(ru - rmt). t= to Cumulative Abnormal Return (CAR)
Buy-and-Hold Return -----------------------------------------------------------------IPO Benchmark ABHR WR Panel A First six Months 0.0929 0.2692 -0.1739 0.0518 0.2260 -0.2118 0.0411 0.0432 0.0379 1.039 1.035 1.048
Whole Period Hot Cold Panel B
0.0082 -0.0440 0.0876***
Second six Months -0.1598 -0.1715 -0.1419 -0.0798 -0.0377 -0.1434 -0.0800*** -0.1338*** 0.0015 0.913 0.861 1.002 -0.0512** -0.1204*** 0.0537*
Whole Period Hot Cold Panel C
First Year -0.0795 0.0413 -0.2624 -0.0111 0.1906 -0.3163 -0.0684* -0.1493** 0.0539* 0.931 0.875 1.079 -0.0430 -0.1650*** 0.1413***
Whole Period Hot Cold *, **, ***
Significant at the 10%, 5%, and 1% level
-100 (2004), this study finds that hot market firms are worse performers than cold firms. Firms going public in the hot market significantly underperform the benchmark indices in the first year by 14.93 percent measured in buy-and-hold return (BHR). If the relative stock performance is measured by cumulative abnormal return (CAR), the difference is even larger and is 16.5 percent significant at one percent level. However, the cold period IPOs actually outperform the benchmark by 5.39 percent in BHR and by 14.13 percent in CAR, and the wealth relative is above 1.0. Second, IPO firms do not underperform the benchmark indices immediately after they start to trade publicly. In fact, IPO firms as a whole, hot period IPOs, and cold period IPOs all have better post-offering performance than the indices in the first six months, even though this outperformance is not statistically significant. The abnormal buy-and-hold returns of IPOs in the whole period, hot period, and cold period are 4.11 percent, 4.32 percent and 3.79 percent, respectively. Third, the difference of postmarket performance between hot firms and cold ones appears in the second six months. During this period, the abnormal buy-and-hold return between hot firms and the benchmark indices is -13.38 percent, compared to 0.15 percent between cold IPOs and the corresponding indices. According to cumulative abnormal returns, hot firms underperform the market by 12.6 percent while firms going public in the cold market outperform the benchmark indices by 5.61 percent. These differences are both statistically significant. Overall, IPOs as a group significantly underperform the benchmark indices in the second six months despite of the outperformance of cold IPOs. This is probably due to the fact that there are more hot issues than cold ones and the underperformance o f hot firms probably outweighs the outperformance of cold IPOs.
-101 The above findings hold if post-market performance is measured by cumulative abnormal returns. If delisted firms are excluded from the sample, the findings will also be similar. The results of the sample without the delisted firms are listed in Appendix C. Much of the literature attributes the underperformance of IPOs in general to managers taking advantage of investor overoptimism (see Lemer 1994, Loughran and Ritter 1995, and Raj an and Servas 1997). The findings in this study provide more evidence to that theory. In the hot market, investors are generally more optimistic on the growth prospect of new IPO firms earnings than in the cold market. As a result, hot firms will be priced higher than cold firms if all else is equal. In the long run, however, a stock will revert to its true value. Therefore, long-run underperformance of IPOs is expected, and hot firms are expected to be even worse underperformers than cold firms. Since the overoptimism does not fade away and the value correction process does not start immediately after firms go public, there will be a delay of the postmarket underperformance.
CHAPTER V SUMMARY, CONCLUSIONS, A ND LIMITATIONS

This chapter presents the summary of the results, conclusions, and limitations of the research. The first part of this chapter summarizes the various analyses and findings in this study. The next part discusses the conclusions. The last part of this chapter describes limitations of this research, due to which findings in this paper may not be generalized in the IPO market.
Summary Going public offers a firm a great deal of benefits, such as raising additional equity capital, improving the capital structure, providing ways for the original investors to cash out, and so on. Thus, many private firms have the goal of going public. Not every firm, however, is successful in its attempt to go public. During the period of 1999-2000, approximately 1,430 firms filed with the SEC for initial public offering. Among them, 966 firms completed their IPOs, but 545 firms did not succeed and withdrew their issues. These completed IPOs and withdrawn issues are not distributed uniformly and evenly over time. From early 1999 to March 2000, a total of 584 firms went public, averaging 40 per month, compared to 125 IPO withdrawals in total, averaging less than 9 per month. Then, during the 13-month period of April 2000 and April 2001, a total of 313 companies
-
102
-103 terminated their IPO process, averaging over 28 per month. The often-cited reason was adverse market conditions. The IPO market was cold during 2001 and 2002, averaging only 6 completed IPOs and less than 7 filings per month. Three groups o f factors were identified in this study to determine the reasons underlying the outcome of IPO process. They are market condition variables, financial variables of IPO firms, and signaling variables. To identify the factors significant in discriminating completed IPOs and withdrawn issues, a multivariate logistic model was estimated on the outcome of IPO process. This study found that three out of four market condition variables are significant after controlling for financial characteristics of IPO firms and various signaling effects. These three variables are UBS index o f investor optimism, monthly change of leading economic indicators, and the return of NASDAQ Composite Index in the 30 trading days prior to the issue/withdrawal date. The model confirms the conventional wisdom that timing is everything for IPOs. The model also shows that firms o f larger size in terms of revenue and file size are more likely to compete their IPOs. This is in line with the prediction that investor reception is stronger for larger, more liquid offerings. Unlike Henning and Shaw (2004) who found that withdrawn firms are weaker, this research found that companies withdrawing IPOs were not smaller in size in terms of total assets, not significantly less profitable, but significantly less financially leveraged, and had higher net tangible asset value per share. In addition, the primary use of IPO proceeds to repay debt reduces the chance to go public because it may signal firms intention to take advantage of market optimism and
-1 04high valuation. Unlike Dunbar (1998), this study did not find that underwriter reputation is significant in predicting the completion of an IPO. If only market condition variables are included in the model, the same three variables are still significant and estimated coefficients are stable. Goodness-of-fit measures indicate that the model is fitted as well. This finding further demonstrates the importance of favorable market conditions to the successful completion o f IPOs. The sample period of 1999-2000 was divided into two subperiods: January 1999March 2000, and April 2000-December 2002. The former is commonly viewed as a hot market (Helwege and Liang 2004) and the window of opportunity for IPOs is apparently open during this period. The latter is a typical cold market. A logistic analysis of the window of opportunity for initial public offerings shows that three or four market condition variables identified in this study can distinguish the hot and cold market with high precision. To explore how financial market conditions affect the IPO market activity, a linear regression model was performed with the number of IPO filings, the number of completed IPOs, or the number of withdrawn issues per month, as the dependent variable. The explanatory variables are four market condition factors. The results show that market condition variables explain 71 percent of the number o f IPO filings. This suggests that firms intending to go public are sensitive to market condition changes. When they observe favorable IPO market conditions, they quickly respond to file with the SEC for going public to take advantage of this opportunity.
-1 0 5 This study then examined the differences between IPO firms going public in the hot market and in the cold market. The analysis covered three areas: market conditions, IPO characteristics, and firm financial characteristics. First, as expected, market conditions are significantly more favorable in the hot market than in the cold market. Second, IPO characteristics are different between two periods. Both the offer price and the mean first-day return of hot market IPOs were significantly higher than their cold market counterparts. This suggests that investors might give higher valuation to and show more interest in IPOs in the hot market. Executives and founders of hot firms held significantly higher percentages of postoffering shares than in the cold market. This is probably because hot IPO firms are, on average, smaller, and shares of small companies are usually more concentrated among investors. Moreover, disproportionately more hot firms intended to use IPO proceeds to reduce debt even though investors tended to avoid these type of firms as discussed above. Hot firms are more likely backed by venture capitalists. This is consistent with Lemer (1994), who finds that venture capitalists have more expertise in deciding when and how a firm should go public. Companies completing IPOs in hot market, on average, hire less prestigious underwriters, implying reduced importance of underwriters in promoting IPOs in the hot market. In addition, it takes less time (26 days shorter) to complete an IPO in the hot market. To investigate the reason, a linear regression was performed with the time frame (days) to complete an IPO as the dependent variable. The explanatory variables include four market condition variables, six financial variables, five signaling variables, and an additional dummy variable distinguishing the hot and cold market. The result shows that
- 1 06the dummy variable is not significant, probably due to the fact that the dummy variable is correlated with market condition variables. After excluding four market condition factors from the model, the dummy variable becomes significant and exactly explains the 26-day difference between the hot market and the cold market. In other words, the difference is not because o f financial characteristics or signaling factors but rather the window of opportunity for IPOs. Third, comparison of financial characteristics indicates that hot IPO firms are weaker than firms going public in the cold market. Hot firms are smaller in terms of sales revenue and total assets in the year prior to going public, more financially leveraged, and have more losses. Finally, the postmarket stock performance of hot and cold firms was compared with the benchmark indices for the first six months, the second six months, and the first year after going public. Results show that IPOs as a whole underperform their benchmark indices in the first year. However, if separated, cold firms actually significantly outperform the indices while hot IPOs are worse performers. In the first six months after trading, both hot and cold IPOs did not underperform the benchmark indices. The underperformance o f hot firms starts in the second six months while cold firms perform as well as the indices in this stage.
Conclusions The findings in this study are in line with the view that IPO markets are occasionally irrational and hot markets reflect greater investor optimism. When market
-107 conditions are favorable and the window of opportunity for IPOs is open, firms are more likely to complete their IPOs. Firms going public in the hot market are, on average, smaller in terms of revenue and total assets. They had higher losses in the year prior to their IPO, and their financial leverage is not lower than their counterparts in the cold market. However, due to investor overoptimism, their mean offer price and average firstday return are higher. This is in spite of the fact that they hire less prestigious investment bankers to underwrite their IPOs, and the fact that more firms intended to use IPO proceeds to repay their debt. It also takes less time to complete IPOs in the hot market. However, when market conditions deteriorated, more companies found it difficult to get sufficient investor interest in their shares and decided to withdraw their IPOs from the market. Only a small number of firms with strong financial characteristics managed to complete their IPOs when they hired prestigious investment bankers to help promote their shares. However, they have to spend more time selling their stocks and still receive less investor interests and relatively lower price. Due to overoptimism, hot IPOs are priced higher than they should be and generate higher first-day returns. However, the high valuation does not last for ever. Hot firms will generally underperform the benchmark indices in the long run and revert to their true value, while cold firms will have better stock performance. The findings in this research confirm the conventional wisdom that timing is everything for IPOs. Firms preparing to go public have to be aware of it and wait for an appropriate time to implement their plans. On the other hand, firms probably need to get into the process earlier enough and with adequate reserves so that the firm is prepared to
- 10 8 wait out a significant slowdown in the market for IPOs. Entrepreneurs also need to understand that issuing an IPO is a serious strategic challenge and requires significant preparation over a long period of time.
Limitations of This Research Findings in this study may not be generalized in the IPO market due to the sample period of 1999-2002, which covers the Internet bubble and subsequent market collapse. A number of unique characteristics are associated with the Internet bubble of 1999-2000. First, Ritter and Welch (2002) report that the percentage of technology firms increased from about 25 percent of the IPO market in the 1980s and early 1990s to 37 percent after 1995, followed by an amazing 72 percent during the Internet bubble, then returning to 29 percent in 200129. Second, Ljungqvist and Wilhelm (2003) and Ritter and Welch (2002) document that the percentage of IPOs with negative earnings in the 12 months prior to going public was abnormally high at around 80 percent. In the 1980s, only 19 percent of firms had negative earnings before going public. This gradually increased to 37 percent between 1995 and 1998. Third, Bartov et al. (2002) show that there are noticeable differences between valuations of Internet and non-Internet firms. The valuation of non-Internet firms generally follows the conventional wisdom regarding valuation while the valuation of Internet firms does not.
29 Tech stocks are defined as Internet stocks, computer software and hardware, communications equipment, electronics, navigation equipment, measuring and controlling devices, medical instruments, telephone equipment, and communications services, but tech stocks do not include biotechnology.
-109 Fourth, Ljungqvist and Wilhelm (2003) document that Internet IPOs averaged a stunning 89 percent o f first-day returns during 1999 and 2000. These average returns dwarf those from earlier periods, but they show that the astronomical level of IPO underpricing in the this period can be at least partially accounted for by market changes in pre-IPO ownership structure and insider selling behavior over the period, which reduced key decision makers incentives to control underpricing. It is still unclear what determines the Internet bubble. Many academics and practitioners attribute it to investor overoptimism, which was capitalized on by Internet firms. However, Schultz and Zaman (2001) find evidence that suggests Internet firms do not go public simply as a vehicle for founders to bail out. They find strong evidence that managers of Internet firms go public in order to grab market share.
- 110-
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APPENDIX A
ADDITIONAL RESULTS OF THE LOGISTIC ANALYSIS OF THE DECISION TO WITHDRAW AN IPO
118
- 119Table A Additional results of the logistic analysis of the decision to withdraw an IPO
Model 5
Model 5
Model 6
Model 7
Intercept (p-value) OPTIMISM LEINDXCHANGE UNDERPRICING RET30 Log( 1+REVENUE) Log(l +ASTTRNOVER) EPS ROA Lo g( 1+DEBTRATIO) BOOKVALUE RETENTION REPUTATION Log(FILESIZE) PRIUSE VENTURE
-1.3968 <0.0001 0.0131 <0.0001 0.6843 0.0001 0.5007 0.1143 2.8841 <0.0001
-0.3919 0.5170 0.0119 0.0153 0.6346 0.0537 0.7771 0.1588 1.8325 0.1431
1.0491 <0.0001
0.3781 0.5359
0.1015 0.1086 -0.5407 0.0148 0.0754 0.0892 0.0059 0.9638 0.2386 0.4550 -0.0393 0.0751 0.0078 0.9868 0.0027 0.9715 0.3554 0.0509 -1.4331 < 0.0001 0.2719 0.2187 1511 780 932 804
Number of Observations
-120 Table A ( C ontinued )
Model 5
Model 5
Model 6
Model 7
Testing Global Null Hypothesis: Beta=0 Likelihood Ratio <0.0001 Score <0.0001 Wald <0.0001
<0.0001 <0.0001 <0.0001
0.0823 0.0815 0.0908
<0.0001 <0.0001 <0.0001
Model Goodness-of-fit Generized R2 0.2194 0.1175 0.370 SomersD 0.475 Hosmer and Lemeshow Goodness-of-fit Test <0.0001 (p-value) <0.0001 Percent Correct Predictions
0.0174 0.122 0.1802
0.1019 0.364 0.2489
74.3
84.9
73.4
84.2
APPENDIX B.l ADDITIONAL RESULTS OF THE LOGISTIC ANALYSIS OF THE WINDOW OF OPPORTUNITY FOR INITIAL PUBLIC OFFERINGS ON SAMPLE OF COMPLETED IPOS
121
Table B.l Additional Results of the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on Sample of Completed IPOs Independent Variable Model 0 Intercept (p-value) OPTIMISM LEICHANGE UNDERPRICING RET30 -71.6097 <0.0001 0.4216 <0.0001 15.8851 <0.0001 17.7947 <0.0001 -1.6553 0.5400 Model 1 -13.5210 <0.0001 0.0949 0.0001 Model 2 0.2870 . <0.0001 Model 3 -3.9284 <0.0001 Model 4 0.1230 0.1064 Model 5 -6.9205 <0.0001 Model 6 -15.1061 <0.0001 0.0796 <0.0001 Model 7 -28.4014 <0.0001 0.1911 <0.0001 6.2464 <0.0001 Model 8 -69.5813 <0.0001 0.4104 <0.0001 15.8625 <0.0001 16.9956 <0.0001
1.2908 <0.0001 9.0926 <0.0001 10.0661 <0.0001 <0.0001 <0.0001 <0.0001 0.0726 0.371 <0.0001 60.4 <0.0001 <0.0001 <0.0001 0.6702 0.860 <0.0001 83.1 <0.0001 <0.0001 <0.0001 0.2644 0.528 <0.0001 74.3
5.0172 <0.0001 13.7892 <0.0001 -5.6702 <0.0001 <0.0001 <0.0001 <0.0001 0.7807 0.917 <0.0001 89.9
7.3441 <0.0001 0.5583 0.7245 <0.0001 <0.0001 <0.0001 0.7210 0.879 <0.0001 83.1
13.1597 <0.0001 <0.0001 <0.0001 <0.0001 0.7509 0.885 <0.0001 82.7 <0.0001 <0.0001 <0.0001 0.9087 0.972 <0.0001
-
Testing Global Null Hypothesis: Beta=0 Likelihood Ratio <0.0001 <0.0001 Score <0.0001 <0.0001 Wald <0.0001 <0.0001 Model Goodness-of-fit 2 Generized R 0.9089 0.5119 SomersD 0.972 0.698 Hosmer and Lemeshow Goodness-of-fit Test (p-value) <0.0001 <0.0001 Percent Correct Predictions 96.2 76.9
96.2
122-
APPENDIX B.2 ADDITIONAL RESULTS OF THE LOGISTIC ANALYSIS OF THE WINDOW OF OPPORTUNITY FOR INITIAL PUBLIC OFFERINGS ON THE WITHDRAWN SAMPLE
- 123 -
Table B.2 Additional Results of the Logistic Analysis of the Window of Opportunity for Initial Public Offerings on the Withdrawn Sample
Independent Variable Intercept (p-value) OPTIMISM LEICHANGE UNDERPRICING RET30
Model 0 -70.0389 0.0004 0.4104 0.0008 14.9345 <0.0001 16.0472 0.0006 -1.4879 0.7003
Model 1 -18.7624 <0.0001 0.1219 <0.0001
Model 2 -1.3134 <0.0001
Model 3 -5.6903 <0.0001
Model 4 -1.1854 <0.0001
Model 5 -8.2386 <0.0001
Model 6 -20.5299 <0.0001 0.1044 <0.0001
Model 7 -39.0131 <0.0001 0.2551 <0.0001 8.0402 <0.0001
Model 8 -66.5964 <0.0001 0.3902 0.0002 14.8442 <0.0001 15.0884 <0.0001
2.5884 <0.0001 10.5573 <0.0001 11.3172 <0.0001 <0.0001 <0.0001 <0.0001 0.2062 0.567 <0.0001 76.9 <0.0001 <0.0001 <0.0001 0.7448 0.926 <0.0001 92.1 <0.0001 <0.0001 <0.0001 0.3943 0.712 0.0010 80.2
4.7449 <0.0001 14.8463 <0.0001 -3.8198 0.0224 <0.0001 <0.0001 <0.0001 0.8199 0.947 0.9633 92.3
8.9327 <0.0001 -1.4013 0.5076 <0.0001 <0.0001 <0.0001 0.7912 0.919 0.5002 93.2
9.2522 0.0005 <0.0001 <0.0001 <0.0001 0.8188 0.946 <0.0001 93.2 <0.0001 <0.0001 <0.0001 0.9131 0.974 0.4464 - 124980
Testing Global Null Hypothesis: Beta=0 Likelihood Ratio <0.0001 <0.0001 Score <0.0001 <0.0001 Wald <0.0001 <0.0001 Model Goodness-of-fit j Generized R 0.9132 0.6071 SomersD 0.974 0.823 Hosmer and Lemeshow Goodness-of-fit Test (p-value) <0.0001 <0.0001 Percent Correct Predictions 98.0 79.6
APPENDIX C LONG-RUN STOCK RETURNS IN THE YEAR FOLLOWING THE IPO FOR HOT AND COLD MARKET IPOS AND THEIR BENCHMARKS WITHOUT DELISTED FIRMS
- 125 -
-126Table C Long-Run Stock Returns in the Year Following the IPO for Hot and Cold Market IPOs and Their Benchmarks Without Delisted Firms The sample consists of 941 completed IPOs in the first six months, and 907 in the second six months or in the first year as a whole, after excluding 16 IPO firms from 966 completed issues studied in this research due to the lack of trading information in CRSP tape, and 9 and 34 firms delisted in the first six months and in the second six months after trading, respectively. The abnormal buy-and-hold return (ABHR) is calculated as:
\ N T T
Itn O +
N
i'=l (=lo
r ) -
FI (1 + r" )] > where rit and rm t are the daily returns on stock i and the
l=lo
corresponding benchmark index, respectively, T=126 and 252 trading days for a sixmonth and one-year holding periods, and N is the sample size. The benchmark index is selected in the following way: if an IPO firm is traded in the NASDAQ, the NSADAQ Composite Index will be used as the benchmark. Otherwise, if an IPO firm is listed in New York Stock Exchange or American Stock Exchange, the S&P 500 index will be the benchmark. The daily returns are from the CRSP daily NASDAQ returns tape and the daily AMEX-NYSE tape. Column 4 lists the wealth relative, measured as:(l+average buy-and-hold return on IPOs)/(l+average bay-and-hold return on benchmark indices). Column 5 lists the cumulative abnormal return (CAR), which is calculated as:
1 NT
z ( n t ~ rmt).
N i=n = i
Buy-and-Hold Return Number o f Obs Panel A First six Months Whole Period Hot Cold 941 566 375 0.0905 0.2681 0.1775 0.0515 0.2260 -0.2120 0.0390 0.0421 0.0345 1.037 1.034 1.044 IPOs Benchmark ABHR WR
Cumulative Abnormal Return (CAR)
0.0057 -0.0460 0.0837***
Panel B Second six Months Whole Period Hot Cold 907 540 367 -0.1727 -0.1898 -0.1476 -0.0834 -0.0431 -0.1428 -0.0893*** -0.1467*** -0.0048 0.903 0.847 0.994 -0.0620*** -0.1340*** 0.0433
-127 Table C (Continued)
Panel C First Year Whole Period Hot Cold *, **, *** 907 540 367 -0.1013 0.0094 -0.2641 -0.0180 0.1845 -0.3160 -0.0833** -0.1751*** 0.0519* 0.915 0.852 1.076 -0.0570* -0.1840*** 0.1300***
Significant at the 10%, 5%, and 1% level

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WHAT CAUSES AN INITIAL PUBLIC OFFERING TO BE UNSUCCESSFUL?

Mississippi State, Mississippi May 2005

UMI Number: 3171424

Copyright by Xiaofeng Zhao

WHAT CAUSES AN INITIAL PUBLIC OFFERING TO BE UNSUCCESSFUL? AN EMPIRICAL ANALYSIS

Edwin H. Duett Professor o f Finance (Director o f Dissertation)

Kartono Liano Professor of Finance (Committee Member)

William G. Hardin III Associate Professor o f Real Estate (Committee Member)

Kevin E. Rogers Associate Professor of Economics (Committee Member)

Brian T. Engelland Professor o f Finance (Director o f Dissertation)

Sara Freedman Dean o f the College o f Business and Industry

I would like to dedicate this research to my parents.

Page DEDICATION ...................................................................................................... ii iii vi vii

Page 52 56 56 65 75 83 89 96 102 102 106 108 110

TABLE 1. 2. Number of Initial Public Offerings by Year .......................................

CHAPTER II LITERATURE REVIEW

Number o f Initial Public Offerings by Year

CHAPTER III DATA AND METHODOLOGY

Predicted Effect on Probability of Success of IPO

FILESIZE PRIUSE VENTURE

logit (p) = b0+ bi OPTIMISM + b2 CHANGE + b3 UNDERPRICING + b4RET30 (2)

N, - al0 + bj, OPTIMISM+ba CHANGE + bj3 UNDERPRICING + bi4RET J O (3)

CHAPTER IV EMPIRICAL RESULTS AND ANALYSIS

- 58Table 3 Sample Selection Process

I Number o f completed IPOs CZZI Number of W ithdrawn IPOs

NASDAQ Composite Index

-62Table 5 Industry Affiliation of Firms with New Issue Filings

3.73 4.97 3.62

3.12 4.77 1.65

36 38 40-49 50-59 60-67 70-72,75-89

10.46 3.93 10.35 5.90 7.14 8.39

6.97 4.22 10.46 9.54 6.61 9.72

40.18 0.20 100

36 40-49 70-72, 75-89 50-59

10.46% 10.35% 8.39% 10.46% 9.72% 9.54%

8.48% 9.18% 9.47% 12.57%

Descriptive Statistics on Sample Firms Conditional on Outcome of the Filings

178.00 1.30 1.1620 0.3402 85,010.30 26,532.00 12.96

30.46 0.39 0.3289 0.1128 3,840.73 1,159.98 0.94

119.07 -0.04 0.3322 -0.0526 114.54 104.04 0.87

132.00 0.00 0.2380 -0.0457 30.42 12.75 0.40

29.00 -0.70 0.00 -0.3242 0.35 0.00 0.00

178.00 1.30 1.1620 0.2949 5,226.00 5,402.00 12.69

38.21 0.37 0.2984 0.1443 383.51 397.69 1.34

<0.0001 <0.0001 <0.0001 <0.0001 0.060 0.312 0.132

Pearson Correlation Coefficient of Variables

OPTIMISM 0.3238 <0.0001 1.0000

LEICHANGE 0.2044 <0.0001 0.0472 0.0666 1.0000

UNDERPRICING 0.3294 <0.0001 0.7061 <0.0001 0.1354 <0.0001 1.0000

SUCCESS OPTIMISM LEICHANGE

UNDERPRICING RET30 REVENUE ASTTRNOVER EPS

ROA DEBRATIO BOOKVALUE RETENTION REPUTATION FILESIZE PRIUSE VENTURE

0.0369 0.2537 1.0000

0.2041 <0.0001 -0.1466 <0.0001 1.0000

0.0776 0.0270 0.0079 0.8239 -0.1179 0.0008 1.0000

0.1256 <0.0001 -0.0625 0.0528 -0.0056 0.8595 0.0253 0.4692 1.0000

-76Table 9 Logistic Analysis of the Decision to Withdraw an IPO

-2.6921 0.0055 0.0211 <0.0001 0.9085 0.0050

-2.5700 0.0059 0.0206 <0.0001 0.8592 0.0066

2.6841 0.0069 0.1645 0.0811 -0.6505 0.0447

REPUTATION Log(FILESIZE) PRIUSE VENTURE

0.0235 0.7884 0.3855 0.0847 -1.9361 <0.0001 0.0439 0.8646 780

0.0528 0.4822 0.2841 0.1523 -2.0486 <0.0001

0.3581 0.0323 -2.0540 <0.0001

Whole Period Hot Cold , ,