Underpricing, share retention, and the IPO aftermarket liquidity

Abstract

Purpose -To test the effects of underpricing and share retention (i.e. the proportion of shares retained by the pre-initial-public-offering (IPO) owners) on IPO aftermarket liquidity. Design/methodology/approach -Uses both percentage spread and turnover ratio to measure liquidity. The percentage spread is the quoted bid-ask spread divided by the quoted midpoint and measures the trading cost relative to share price. Turnover ratio is the daily trading volume divided by the number of shares offered and measures the speed of transaction. Both non-parametric analyses and multiple regressions are conducted to investigate the effects of underpricing and share retention on liquidity. Findings -Results indicate that initial return is positively related to turnover ratio and negatively related to percentage spread. These relations are significant even after controlling for other factors. Also finds that the pre-IPO owners' retention rate is positively related to turnover ratio and negatively related to percentage spread. High retention rates attract more trades, provide quality assurance, and improve IPO aftermarket liquidity. Originality/value -This paper investigates the theoretical links between underpricing and liquidity and provides direct evidence on Booth and Chua's liquidity theory. In addition, this is one of the first empirical studies to analyze the effect of share retention on aftermarket liquidity.

Influence of IPO characteristics on liquidity

“…The ultimate relationship between share retention and liquidity will depend on whether the share-fl oating effect dominates the signalling effect or vice versa. Consistent with signalling theory, Li et al (2005) found pre-IPO owners' retention to be positively related to trading turnover and negatively related to bid-ask spread. They concluded that high retention rates attract more trades, provide quality assurance, and improve IPO aftermarket liquidity.…”

“…While most of the research on IPOs has focused on explaining the underpricing phenomenon, few studies have investigated the determinants of after-market liquidity (see Pham et al, 2003;Corwin et al, 2004;Li et al, 2005;Zheng et al, 2005;Ellul and Pagano, 2006;and Zheng and Li, 2008). For this reason we focus our attention on liquidity for the post-listing period.…”

“…This variable shows that the average size of IPOs is 41.157% of the shares outstanding with a variation ranging between 2.620% (European Aeronautic) and 100% (Dinamia and Parques Reunidos). Note that Zheng et al (2005) and Li et al (2005) label this variable «share retention», given that relative size of retention is the complement to unity of the relative size of the offering and represents the ratio of shares retained to shares outstanding. The third and last variable considered is the retail composition of the offering, which measures the ratio of shares offered in the retail tranche to the number of shares offered.…”

“…Thus, fi rms that use an IPO to obtain liquidity can be expected to underprice the share offering in order to attract small-scale uninformed investors. Pham, Kalev and Steen (2003) and Li, Zheng and Melancon (2005) conclude that greater underpricing not only increases trading turnover, but also reduces bid-ask spread. Pham et al (2003) claim that this relationship is due to the dispersion of the ownership structure brought about by the IPO.…”

Liquidity Benefits from IPO Underpricing: Ownership Dispersion or Information Effect

“…On average, underpriced IPOs exhibit higher aftermarket trading activity than overpriced IPOs (Miller and Reilly, 1987;Hanley, 1993;Schultz and Zaman, 1994;Reese, 1998;Hahn and Ligon, 2006;Li and Zheng, 2008). A higher level of underpricing leads not only to increased trading turnover but also to lower bid-ask spreads (Pham, Kalev, and Steen, 2003;Li, Zheng, and Melancon, 2005) and lower adverse selection costs (Li, McInish, and Wongchoti, 2005). 1 However, apart from Pham et al (2003), no literature exists on how this positive link between initial underpricing and liquidity actually is formed.…”