Does idiosyncratic risk matter in IPO long-run performance?

Abstract

This paper studies how firm-level idiosyncratic risk varies over time and affects both initial public offering (IPO) and matched non-IPO firms' long-run performance. It revisits the traditional approach to compute the long-run performance by conditioning aftermarket performance on idiosyncratic risk with a generalized autoregressive conditional heteroskedasticity GARCH-M extension of the standard three-factor Fama and French (3FF) model. Our findings show a positive long-run relationship between idiosyncratic risk and expected returns for almost all IPOs and matched non-IPO firms. We find that, in general, IPOs do not underperform their peers when we adjust long-run abnormal returns for firm-level idiosyncratic risk. We also note that the idiosyncratic risk exposure depends on the IPO profile; it is more important for firms going public in hot-issue markets, undervalued IPOs and high idiosyncratic-risk issues. Thus, this paper suggests that a part of abnormal returns in specific IPOs long-run performance is derived from firm idiosyncratic risk.

Performance and diversification benefits of IPO‐focused mutual funds

“…Hence, given the high level of idiosyncratic risk that negatively affects the long-run performance of IPOs, as demonstrated by Beaulieu and Mrissa Bouden (2020), we believe that investing in funds that include IPOs could be another way to invest in IPOs while benefiting from the high initial returns during the early aftermarket stage and avoiding the IPO long-run underperformance that occurs thereafter. Moreover, indirect investment in IPOs through mutual funds is a way to avoid the risk of new issues, as the funds allow for a diversification effect, which reduces the idiosyncratic risk of stocks.…”

“…They demonstrate that volatility varies with the complexity of the pricing problem over time. Following Campbell and Taksler (2003), who use idiosyncratic volatility to measure information asymmetry between a firm and its traders, Beaulieu and Mrissa Bouden (2020) discover that firms issuing IPOs have higher idiosyncratic risk than their non‐IPO‐issuing peers. Furthermore, they reveal that the difference in idiosyncratic risk between IPO‐issuing firms and their non‐IPO‐issuing peers is greater in the early aftermarket stage and tends to diminish by the end of the third year of IPO trading.…”

Modeling and Estimation of Cumulative Abnormal Return using VECM

“…The idiosyncratic risk was often used to measure information asymmetry (Campbell & Taksler, 2003). Some empirical studies (Beaulieu & Bouden, 2020;Fu, 2009) found a positive relationship between volatility and idiosyncratic risk. The authors argued that investors need high premiums to hold idiosyncratic risky stocks.…”

“…Therefore, they noted that more portfolios (especially in Spain and the Netherlands) contained positively idiosyncratic risks, whereas all portfolios were very damaging in the UK. Beaulieu and Bouden (2020) found that idiosyncratic risk at the firm level positively affected the IPO's return in the…”