Fractional ownership and underpricing: signals of IPO firm value?

Pacific-Basin

Finance

Journal

1 (1993) 47-65.

North-Holland

Fractional ownership and underpricing: signals of IPO firm value? Janice C.Y. Howa and Joy G. Lowb aDepartment of Accounting and Finance, The University of Western Australia Crawley, Western Australia, Australia; bErnst & Young, Singapore

This paper examines whether fractional ownership and underpricing serve as signals of firm value in the Australian new issues market. While international studies have provided empirical support for the signalling hypothesis, there is a paucity of Australian evidence in this area. Instead, empirical tests of hypotheses proposed as explanations of the underpricing phenomenon have featured prominently in the Australian studies. This paper finds evidence of a positive relationship between firm value and fractional ownership. Our results also show that although the positive relationship between fractional ownership and firm value is robust, irrespective of whether market volatility and industry effects have been controlled for, the assumption of linearity of the relationship may not be appropriate. The relationship between underpricing and firm value is, however, ambiguous.

1. Introduction

The financial economics literature abounds with explanations for the observed underpricing of unseasoned new issues of equity (hereafter, IPOs)’ as an equilibrium phenomenon. They include the information asymmetry hypothesis [Baron (1982), Rock (1986) and Beatty and Ritter (1986)-J, the institutional framework hypothesis [Chalk and Peavy (1987) Finn and Higham (1988) and Taylor and Walter (1990)], the litigation hypothesis [Tinic (1988)], the reputation effects hypothesis [Titman and Trueman (1986), Beatty (1989), Balvers et al., (1988) and How (1990)] and the signalling hypothesis [Grinblatt and Hwang (1989), Welch (1989) and Allen and Faulhaber (1989)]. Correspondence to: Janice C.Y. How, Department of Accounting and Finance, The University of Western Australia, Crawley, Western Australia 6009, Australia. The authors would like to thank P. Brown, H.Y. Izan. and participants at the Fourth Annual PACAP Finance Conference, Hong Kong (1992) and the ESSEC-AFFI Conference in Finance, Paris (1992) for their insighful and heluful comments. Janice How would also like to aratefullv acknowledge the linanciaisupport from the U.W.A. Individual Research Grant. All remaining errors are the responsibility of the authors. ‘Refer to How (1990) for a summary of previous studies which have documented the IPO underpricing phenomenon. 0927-538X/93/$06.00

0

1993-Elsevier

Science Publishers

B.V. All rights reserved

48

J.C.Y. How and J.G. Low, Fractional ownership and underpricing

We examine the signalling hypothesis within the Australian IPO framework. We argue that, faced with asymmetric information in the new issues market, the issuer uses underpricing and his fractional ownership to signal firm value. While IPO underpricing has been discussed in the signalling literature only recently [Hwang (1988)], more than a decade has passed since fractional ownership was first suggested as a signal of firm value [Leland and Pyle (1977)] and empirically tested [Downes and Heinkel (1982)]. The remainder of this paper is as follows. A literature review is provided in section 2. Section 3 develops our hypotheses; section 4 discusses the data selection criteria and test variables; and our research methods are outlined in section 5. The empirical results are then discussed in section 6, while section 7 contains our conclusions.

2. Previous studies Leland and Pyle (1977) examine the signalling hypothesis within an IPO valuation framework. They argue that the fractional ownership retained by issuers is a key determinant of firm value, and it is used by issuers to convey their private knowledge as to the future cash flows of the firm. Such a signal is credible as the issuer forgoes the diversification of his personal portfolio in retaining a significant ownership interest in the firm. A positive relationship between fractional ownership and firm value is thus hypothesised. Their model is empirically supported by Downes and Heinkel (1982) using 297 firms which went public between 1965 and 1969. Ritter (1989) tests competing hypotheses on the relationship between fractional ownership and firm value the agency and wealth effect hypotheses2. Using a sample of 559 firms which went public during the period 1965 to 1973 in the US, he finds evidence which, while being consistent with the agency hypothesis, does not fully support the predictions of the other two hypotheses. His results, however, are not supported by Krinsky and Rotenberg (1989) whose sample consists of 115 IPOs listed on the Toronto Stock Exchange. Furthermore, their results show ownership retention to be of little statistical significance in explaining firm value. They suggest that factors such as differences in the sample size, research method,

*The agency hypothesis states that equity ownership is positively related to firm value because managerial shirking associated with lower equity ownership is expected to lead to lower cash flows. This, in turn, is reflected in a lower relative valuation of the firm’s equity. The wealth effect hypothesis predicts that the greater the market value of the firm, the higher the fractional ownership. This is attributed to the fact that to raise a given amount of money, the issuer will sell a smaller proportion of the firm’s shares if the firm value is high. See Ritter for the method of discriminating these hypotheses.

J.C.Y. How and J.G. Low, Fractional ownership and underpricing

49

omitted variables and institutional environments may explain the differences in the empirical results3. The aforementioned tests of Leland and Pyle’s hypothesis use a linear regression over the full range of possible levels of fractional ownership i.e. from 0% to 100%. This monotonic relationship between firm value and fractional ownership is recently questioned by Prasad and Merikas (1990). They suggest that the function relating this variable as a signal of project quality may not be continuous. In view of the regulatory provisions in the U.S.4, they hypothesise that the level of fractional ownership signals firm quality only at high levels of shareholding. They find empirical support for their hypothesis. A non monotonic relationship between firm value and the level of fractional ownership has in fact been previously documented by Merck, Shleifer and Vishney (1988) although their sample consists of seasoned firms. Their results suggest that there is a positive relationship in the 0% to 5% fractional ownership range, a negative relationship in the 5% to 25% range and a positive relationship beyond the 25% range. They argue that underlying the negative relationship is the entrenchment hypothesis, which suggests that market valuation may be adversely affected for some range of high ownership level. Within this range, the manager has a greater control of the firm; there are less checks on the manager’s activities’ and a greater potential for a conflict of interest between other shareholders and the manager. Consequently, the firm value is lower. Hwang (1988) develops a generalised version of Leland and Pyle’s model by relaxing the assumption that the variance of the firm’s future cash flows is known to outside investors. With both the expected value and the variance (project risk) of the firm’s future cash flows known only to issuers, Hwang argues that fractional ownership, by itself, will not be a sufficient signal of firm value as it will not allow outside investors to distinguish between firms of the same expected value but different variances of future cash flows. He proposes a bivariate signalling model which incorporates a second signal, ‘See also Hughes (1989). He provides a partial replication of Krinsky and Rote&erg’s analysis and, in contrast to the latter, finds a significantly positive relationship between fractional ownership and firm value. He also suggests that as his sample is larger, and drawn from a population of U.S. rather than Canadian data, the differing results may be attributable to statistical power or institutional factors. “Prasad and Merikas (1990) argue that certain observable corporate financing behaviour and federal and state legislation cast doubt on the proposed monotonic relationship between fractional ownership and firm value. An example of this is the merit statutes which allow administrators to judge the quality of the issue, as discussed in Brandi (1985). Merit standards are often imposed, requiring entrepreneurs to invest a minimum proportion of the total capital to be raised on the equity market. The implication is that Leland and Pyle’s hypothesised relationship may not hold at low levels of fractional holdings. 51n this setting, the manager is acting in the capacity of an agent. See Jensen and Meckling (1976) for a discussion of the agency relationship and how a potential conflict of interest arises between the agent and the principal in this relationship.

J.C. L How and J.G. Low, Fra~tio~l

50

ownership and a~er~ri~ing

underp~cing. It is argued that this variable will convey info~ation about the variance of the firm’s future cash flows, He finds empirical support for the two testable implications of his model: (i) for a given level of fractional ownership, there is a positive relationship between underpricing and firm value and (ii) for a given level of project risk, there is a positive relationship between fractional ownership and firm value. Allen and Faulhaber (1989) provide a direct link between underpricing and firm value. In their model, underpricing is a costly and credible signal and only good quality firms can be expected to recoup the cost of this signal from subsequent (seasoned) issues. High quality firms find it worthwhile to underprice their IPOs because by doing so they condition investors to more favourably interpret subsequent dividend results. The owners of low quality firms know their expected performance and subsequent market valuation. Since they know that they cannot recoup the initial loss from underpricing, they cannot afford to signal. The result is similar to Welch’s (1989) twoperiod model where only high quality firms can afford to underprice new issues. In investigating the seasoned offerings of 1,028 IPO firms over the 1977-1982 period, Weich finds that the mean ratio of seasoned offering proceeds to IPO proceeds for reissuing firms over the entire period is in excess of 3.0. He interprets these results as supporting the central argument of his model, that (high quality) firms choose to issue more than once so that the higher seasoned offering price eventually compensates them for the intentionally underpriced IPO. 3. Hypotheses According to Leland and Pyle’s signalling hypothesis, the level of fractional ownership serves as a signal of firm value to outside investors. The higher the level of fractional ownership retained by the issuer at the IPO, the higher will the market perceive his firm value to be. This is because from the issuer’s perspective, a higher personal interest in the issuing firm will be accompanied by a less diversified personal portfolio and thus a higher diversification cost. A rational issuer will thus only hold a larger ownership interest if he expects the firm’s future cash flows to be high relative to the current firm value. Our first hypothesis is therefore H,: Firm value is positively related to the level of the issuer’s fractional holding.

We propose two reasons why we expect a positive relationship between fractional ownership and firm value for the entire range of fractional ownership levels in our sample. Firstly, there is no regulatory requirement in Australia which mandates that issuers must invest a minimum proportion of

J.C.Z How and J.G. Low, Fractional ownership and underpricing

51

the total capital to be raised on the equity market. The required minimum investment may invalidate the signalling hypothesis over this ownership range, as previously documented by Prasad and Merikas. Secondly, the entrenchment hypothesis proposed by Merck et al. may not hold for IPO firms. Fractional ownership tends to be higher for IPO firms than for seasoned lirms6. Given the diversification cost involved, we argue that there is less incentive for the issuer to act opportunistically. The second hypothesis tests whether underpricing can signal firm value at the IPO. Consistent with Welch (1989) and Allen and Faulhaber (1989), a positive relationship between the degree of underpricing and firm value is hypothesised. This is based on the rationale that only good quality firms will be able to recoup this initial cost from the subsequent period’s cash flows. A poor quality firm will not only have to bear the imitation costs but also the signalling costs associated with underpricing so that it will voluntarily disclose its quality. Therefore, the greater degree of underpricing, the higher the firm quality (value). H,: Firm value is positively related to the degree of underpricing.

4. Data Our sample consists of 523 unseasoned issues of equity made over the ten year period, 1 July 1979 to 30 June 1989. To ensure that only ‘pure’ IPO firms are included in the sample, the following selection criteria are employed: (i) the sample firms must be independent of other listed and/or foreign companies; (ii) firms which are listed or registered in a foreign stock exchange before they are admitted to the Official List of the Australian Stock Exchange (ASX) are excluded; (iii) firms formed through a Scheme of Arrangement are excluded since this would normally result only in a change of name and/or capital structure of an existing listed company; and (iv) trust companies, which tend to have a unique institutional set-up, are also excluded. In addition, the companies are required to be traded on the twentieth trading day following listing on the ASX. For the purposes of testing the ‘% fact, we find that IPO firms tend to concentrate in the 50 to ~55% range of fractional ownership (refer to table 3 of this paper) while Merck et al. document that seasoned firms are concentrated in the 0 to <5% range. Furthermore, the average fractional ownership for IPO firms in our sample (44.8%) far exceeds the range seen to be supportive of the entrenchment hypothesis in Merck et al.

52

J.C.Y. How and J.G. Low, Fractional ownership and underpricing

hypotheses, information about the following variables, which are defined below, is obtained from the prospectus:

4.1. Fractional ownership Fractional ownership is one of the two signals of firm value tested in this paper. We denote this variable by ALPHA and it is measured by the percentage of the ordinary shares held by the issuer subsequent to the public offering’. Outstanding stock options are not included in the calculation of ALPHA as we do not know how many of these options will be exercised by the public. More often than not, these are not exercisable until after the completion date of offering. We also test the first hypothesis using Leland and Pyle’s signal, LP, defined as: LP=ALPHA

+ In (1 - ALPHA)

(1)

4.2. Underpricing Underpricing is the other signal of firm value examined in this paper. Previous studies on IPO underpricing have found that results using both risk adjusted and market adjusted measures of underpricing do not differ significantly’. This paper provides two measures of underpricing. The first measure is the natural logarithm of the unadjusted return (CUR) on the initial day of trading on the ASX and the second measure is the natural logarithm of the market-adjusted return (CMAR)‘.

4.3. Firm value

The value of the firm, denoted by VALUE, is firstly proxied by the natural logarithm of the firm’s post-offering market capitalisation, calculated as the product of the share price and the number of ordinary shares outstanding on ‘We encountered a problem in identifying who the ‘entrepreneurs’ in Leland and Pyle’s model are since for many of the firms in our sample, directors and their associates, employees, and other private investors already have a share of the company prior to it going public. As it is not possible to obtain information on the involvement of many of these investors in the issuance of the prospectus, all parties who owned the company’s shares prior to the IPO are assumed to be insiders or entrepreneurs. This paper uses the term ‘issuers’ to refer to these parties. ‘According to Finn and Higham’s (1988) results, the risk variable accounts for only 2.4% of the initial performance of IPOs. ‘Continuous returns are used since they have the effect of reducing the substantial departures from normality frequently observed with daily share returns [Fama (1965)].

J.C.l! How and J.G. Low, Fractional ownership and underpricing

53

the twentieth” day of public trading. We denote this variable by TEQ20. Since the underpricing measure and this proxy contain the same variable the post-offering share price - it is necessary for us to use an alternative measure of firm value. We choose the natural logarithm of the pro forma value of the issuing firm’s total assets, denoted by TASSET, as our second proxy for VALUE. This accounting variable can be found in the Investigating Accountant’s report in the prospectus. 4.4. Investment Leland and Pyle’s model assumes that the firm has a single project so that the value of the firm will be largely dependent on the size of the investment outlay. Given that the size of this outlay is not publicly known until after the investment is made at a later date, the issue size will be used as a proxy for this variable. The underlying assumption here is that the firm will fully invest the whole amount raised at the IPO and that the offer will be fully subscribed. We measure the issue size as the natural logarithm of the dollar amount of the public offering i.e. the product of the offer price and the number of shares offered to the public. We denote this variable by INVESTMENT”. 5. Research methods

To test the two hypotheses, we adopt the linear OLS equation from Leland and Pyle and modify it to include underpricing as the second signal. Formally, we regress the following equation: VALUEj=ao

+a,ALPHAj+a,CMARj+U,INVESTMENTj+&j,

(2)

where E is the error term. Support for Hypotheses 1 and 2 requires the coefficients a, and a2 to be positive. We also estimate eq. (2) using Leland and Pyle’s signal, LP, in place of ALPHA. Here, we expect the coefficients on LP to be negative if Hypothesis I holds. “‘We choose the twentieth day share price since previous event studies have documented that most of the effect of public announcements (that is, events) such as earnings and dividends announcements, is impounded into the share price within a 20 day period surrounding the announcement date [Aharony and Swary (1980), Divecha and Morse (1983), and Kane et al. (1984), amongst others]. Furthermore, we believe that this price is a better measure of the ‘true’ value of the share than the first day closing price given that IPOs are typically underpriced. We have also run the regressions using the firm value, calculated using the closing share price on the fifth day of public trading. In all cases, we find that the results are not significantly different from those reported here. The two measures of VALUE are highly correlated at 0.93. “Using issue size may understate the investment outlay of the firm as there exist other sources of funds such as debt or cash. As informztion on how the investment will be financed cannot be obtained from reading the prospectus, we assume that the amount of debt used by the issuing firm to finance the investment is small relative to the amount of equity to be raised at the IPO.

54

J.C.Y. How and J.G. Low, Fractional ownership and underpricing

To allow for the possibility of a non-monotonic relationship between fractional ownership and firm value, we adopt Merck et al.% method of piecewise regressions with 5% and 25% fractional ownership as the two turning points ’ 2. Two other combinations of turning points are also identified and tested. The first combination, 20% and SO%, is based on the quantitative guidelines on the concepts of ‘significant influence’ and ‘control’, as provided in the Australian Accounting Standards13. The second combination is 55% and 70%, identified from a scatterplot of fractional ownership and firm value which shows a concentration of firms within this range of fractional ownership. We will also include two industry dummy variables, HITECH and MINING, which refer to firms in the high technology and mining industries respectively, in the piecewise regressions I4 . The inclusion of these industry iZFollowing Merck et al., the definitions of the three regressors 25% combination. ALPHA1 is defined as follows: ALPHA1

= ALPHA

if ALPHA

= 5% if ALPHA

are provided

for the 5% and

< 5%

2 5%.

The coefficient on ALPHA1 measures the strength of the relationship between ALPHA for fractional ownership less than or equal to 5%. ALPHA2 is detined as: ALPHA2

= 0 if ALPHA

< 5%

= ALPHA

5% if 5% 5 ALPHA

-

= 20% if ALPHA

i

= 0 if ALPHA

< 25%

= ALPHA

25% if ALPHA

-

25%

= 5%

ALPHA2

= 20%

ALPHA3

= 50%.

for fractional

2 25%

and it measures the strength of the relationship between VALUE and ALPHA ownership greater than or equal to 25%. Therefore, if ALPHA = 75%, we have ALPHA1

and

2 25

and it measures the strength of the relationship between VALUE and ALPHA ownership greater than 5% but less than or equal to 25%. ALPHA3 is defined as: ALPHA3

VALUE

for fractional

If a non-monotonic relationship between fractional ownership and firm value exists, then one of these ALPHA regressors will have a different sign. i3The Australian Accounting Standards, AAS 22 ‘Related Party Disclosures’ and AAS 14 ‘Equity Method Accounting’ propose a 20% ownership level guideline in determining whether significant influence can be exercised. Significant influence is defined as ‘the capacity of an entity to affect substantially the financial and/or operating policies of another entity’ [AAS 14, para. 2(i)]. Control, on the other hand, is assumed to exist with a majority shareholding, that is, a shareholding of 50% or more. “‘These two industries are chosen as they are perceived to be riskier than other industries. How, Izan and Monroe (1991) document that IPOs made by these two industries are significantly more underpriced than those made by other industries. In their study, the average market adjusted underpricing for IPOs in the mining, high technology and other industries is 23.66x, 27.35% and 9.21x, respectively.

J.C. Y How and J.G. Low, Fractional ownership and underpricing

55

Table 1 Distribution of sample IPOs over the 10 year period, 1979-1989. Percent

Year

Number

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

4 6 11 3 15 28 65 123 214 32 22

0.76 1.15 2.10 0.57 2.87 5.35 12.43 23.52 40.92 6.12 4.21

Total

523

100.00

dummy variables is in line with Merck et al.% reasoning; namely, to control for any spurious correlation between fractional ownership and firm value which may operate through industry effects. If the coefficients on ALPHAl, ALPHA2 and ALPHA3 are found to be positive and significant even after controlling for the industry effects, this will provide further support for Hypothesis 1. If the linearity assumption of the relationship between fractional ownership and firm value is valid for all the IPO firms in the sample, the coefficients on these ALPHA’s are expected to be not significantly different from each other. In addition, OLS regressions are run on two subsamples of firms, segregated on the basis of their level of fractional ownership. Two cutoff points are used and they are 70% and 40%. The first cutoff point provides a means of comparison with Prasad and Merikas’ results, while the second cutoff point chosen corresponds with the average fractional ownership for the sample firms (44.8%). Subsample I represents IPOs with ‘low’ levels of fractional ownership (i.e. those with less than the cutoff point) and subsample II represents IPOs with ‘high’ levels of fractional ownership (i.e. those with more than or equal to the cutoff point). This approach provides an additional test of the monotonic relationship between fractional ownership and firm value. If the slope (coefficient) of ALPHA for the two subsamples is different, there is further evidence that a monotonic relationship does not hold.

6. Results Table 1 shows the distribution

of sample firms over the ten year period.

56

J.C.Y

How and J.G. Low, Fractional ownership and underpricing

The number of IPOs peaked in 1987 at 214 and fell dramatically in later years, coinciding with market conditions. Taken together, the number of new issues offered in the two years, 1986 and 1987, was almost two thirds of all new issues offered during the ten year period. To ensure that the results are not driven primarily by the ‘hot issue’ period [Ritter (1984)], we control for market conditions using dummy variables for the following states of the market: (i) pre-1985 boom period (MVl), and (ii) the boom period, from 1985 to just before the October 1987 market crash day (MV2). In our tests, the post-market crash day (MV3) is the base case. The descriptive statistics for the test variables are provided in table 2. Of particular interest are the fractional ownership and underpricing variables. Fractional ownership, as measured by ALPHA, ranges from 0% to 99.5%. Appropriate conclusions may thus be drawn as to the validity of the relationship between fractional ownership and firm value over the full range of fractional ownership levels. This variable has a mean of 44.8% with a standard deviation of 23.5%. The average unadjusted underpricing, CUR, is 16.4%. Consistent with previous studies, this value is not significantly different from the market-adjusted measure (CMAR) of 16.1% at conventional significance levels. Only 334 companies in the sample provided information on total assets in their prospectus. Consequently, regression tests using TASSET as the dependent variable are run on only 334 companies. Table 3 shows the summary statistics of firm value across different levels of fractional ownership. Merck et al. document that 46.1% of the seasoned companies in their sample fall within the 0 to <5% fractional ownership range. The table shows that this range of fractional ownership is the next most common one for our sample. In contrast, we find a concentration of IPO firms (15.2%) in the 50 to < 55% range, which is barely enough to retain majority ownership. Furthermore, the level of fractional ownership tends to be more evenly distributed across our sample of IPO firms. Table 4 provides a Pearson correlation matrix of the continuous variables. The matrix shows that ALPHA and LP are significantly related to the two measures of VALUE in the direction predicted. However, a significantly positive correlation between underpricing and firm value is found only when the latter is measured by TEQ20. This result is not surprising for the reason we gave earlier. Contrary to our second hypothesis, table 4 shows a negative although not signilicant relationship between the two measures of underpricing and TASSET. Table 5 provides the results of multivariate analyses with ALPHA as the measure of fractional ownership. Here, firm value is regressed on fractional ownership, underpricing, issue size (which proxies for Leland and Pyle’s investment outlay) and market volatility dummy variables. Firm value is

57

J.C.Y. How and J.G. Low, Fractional ownership and underpricing Table 2 Descriptive

ALPHA CUR CMAR Market capitalisation ($m) Total assets ($m) Issue size (%m)

statistics.

Mean

Std. dev.

Minimum

Maximum

Skewness

44.83% 16.36% 16.05%

23.46% 41.60% 46.88%

0.00% - 104.98% - 262.07%

99.50% 299.57% 157.78%

-0.38 1.85 - 1.37

11.66 11.98 6.41

25.21 50.34 12.47

0.20 0.75 0.12

405.90 830.56 150.00

9.18 13.257 5.856

Kurtosis

n

2.44 11.39 8.09

523 523 523

124.03 208.65 49.47

523 334 523

Table 3 Summary

statistics

of tirm’s total market capitalisation ($m) and grouped by fractional ownership.

Total assets (%m) ALPHA (%) &<5 1&<15 15-t20 2&<25 25- -=z30 3Gc35 35-140 WC45 45c50 SC10 5&<55 55-<60 6(rc65 65-~70 7&<75 755< 80 8&<85 8%<90 9(r<95 95100

total

assets

(Sm)

Firm’s total market capitalisation (%m)

n

Percent”

Mean

Std. dev.

Mean

Std. dev.

54 15 8 18 21 37 33 39 30 7 80 30 38 42 25 27 10 8

10.26 2.86 1.52 3.42 3.99 7.03 6.27 7.42 5.7 1.33 15.21 5.7 7.22 7.98 4.75 5.13 1.9 1.52 0.19 0.57

14.10 43.70 30.84 19.23 13.99 15.28 14.92 18.01 10.17 29.68 22.70 10.27 17.32 20.02 19.63 32.19 12.46 53.95 10.49 29.21

25.69 125.39 57.10 34.99 32.55 30.03 20.26 28.97 12.72 35.73 75.50 10.22 25.12 19.62 34.46 52.55 11.40 79.60 NA 38.52

14.47 7.73 17.24 26.34 7.03 9.48 7.86 6.06 10.00 29.68 12.26 9.38 20.05 17.21 20.63 19.34 12.81 174.41 10.49 5.45

23.58 8.89 12.49 28.93 7.14 12.14 9.47 5.60 12.43 35.73 34.91 9.48 24.24 17.40 31.24 34.13 9.66 366.85 NA 6.06

I 3

*Does not add up to 100.00% due to rounding

errors.

NA = not available.

measured by TEQ20 in regressions I and II, and TASSET in regressions III and IV, respectively.” When firm value is measured by TEQ20 in regressions I and II, the results provide strong empirical support for Hypothesis 1. Fractional ownership is significantly and positively related to VALUE at
to the INVESTMENT not a serious problem

variable. Our in our data.

residual

J.C.Y

58

How and J.G. Low, Fractional ownership and underpricing Table 4 A Pearson

LP LP ALPHA CMAR CUR TASSET TEQ20 INVESTMENT

correlation

ALPHA

1.00

-0.77* 1.00

matrix

CMAR

for continuous

CUR

- 0.02 0.04 1.00

variables.

TASSET

TEQZO

-0.02 -0.13tt 0.04 0.14* l.OO* -0.06 1.00 -0.07 1.00

-0.16* 0.18* 0.46* 0.46* 0.62* 1.00

INVESTMENT 0.11* -0.14** -0.10* - 0.07 0.75** 0.67** 1.00

TtThe coefficient is significantly different from zero at the 0.05 level; *the coefficient is significantly different from zero at the 0.01 level; **the coefficient is significantly different from zero at the 0.001 level. Table 5 Results

of multivariate

analyses

Dependent

of the relationship between for all companies.

Regression

ALPHA

1.71*** (0.11) 1.71*** (0.06) 0.95*** (0.02)

CMAR INVESTMENT MVl MV2 Constant Adj. R2 (Fisher)

0.60t (0.36) 0.82

and explanatory

variables

variable

TEQ20 Variable

VALUE

TASSET I

Regression 1.70*** (0.11) 1.69*** (0.06) 0.95*** (0.02) 0.01 (0.08) 0.07 (0.08) 0.60 (0.37) 0.82

II

Regression 1.70*** (0.18) -0.07 (0.09) 0.89*** (0.04)

1.57* (0.57) 0.65

III

Regression

IV

1.70*** (0.18) -0.07 (0.10) 0.88*** (KY (0.03) -0.01 (0.11) 1.73* (0.58) 0.65

Standard errors are in parentheses. tThe coefficient is significantly different from zero at the 0.1 level; *the coefficient is significantly different from zero at the 0.01 level; ***the coefficient is significantly different from zero at the
value and fractional ownership is also supported when the alternative measure of fractional ownership, LP, is used although the results are not reported here l6 . Given the results in Ritter (1989), it is diffkult to conclude unambiguously that the positive relationship between fractional ownership and firm value is exclusively supporting Leland and Pyle’ signalling hypothei6All the tests in this paper have been repeated using LP fractional ownership. In all cases, we find that the regression obtained using ALPHA.

as an alternative measure of results are similar to those

J.C.Y

59

How and J.G. Low, Fractional ownership and underpricing

sis. Ritter concludes that all the three hypotheses on the relationship between fractional ownership and firm value (the signalling, the wealth effect and the agency hypotheses) have merit and are not mutually exclusive. At best, we can conclude that higher fractional ownership is associated with higher firm value. Again, not surprisingly, a positive relationship between underpricing” and firm value is observed. We can interpret the latter findings as being consistent with the signalling hypothesis proposed by Welch (1989) and Allen and Faulhaber (1989) - only high quality (value) firms can afford to underprice their IPO. When TASSET is the dependent variable (regressions III and IV), fractional ownership is the only significant signal of firm value. As with the univariate results, there is a negative but not significant relationship between the degree of underpricing and firm value. Previous studies [Chalk and Peavy (1987) and Wolfe and Cooperman (1989)] found a negative relationship between firm size and underpricing. To the extent that TASSET may proxy for firm size (and not firm value), our results can be interpreted as being consistent with the existing empirical evidence. For all the regressions, firm value of IPOs issued during the MVl and MV2 (boom) periods is not significantly different from those issued during the MV3 (bearish) period. To test whether the relationship between firm value and fractional ownership is monotonic, we repeat the multivariate tests conducted above on subsamples of firms which have been categorised by fractional ownership, using two cutoff points, 70:/, and 40%. The results using these cutoff points are not significantly different so we will only discuss the results using the 70% cutoff point. These are provided in tables 6A and B. Using 70% as the cutoff point results in 452 IPOs (86%) in subsample I (i.e. those with fractional ownership less than 70%), and 71 IPOs (14%) in subsample II (i.e. those with fractional ownership of at least 70%). Table 6A provides the results of four OLS regressions for both subsamples when firm value is proxied by TEQ20. We find a significantly positive relationship between firm value and fractional ownership for both subsamples of firms, even after controlling for market volatility. However, the table shows that the size of the coefficient on ALPHA increases by more than twofolds as one moves from subsample I to subsample II. For every 1% increase in ownership, the firm’s total equity rises by an average of 1.40% (t= 10.77) for firms with fractional ownership ~70% and a higher rate of 4.12% (t=3.17) for firms with fractional ownership 270%. Fractional ownership therefore seems to be a more significant signal of firm value for firms with at least a

“We have also conducted the tests using CUR as a measure not signiticantly different to those obtained using CMAR.

of underpricing.

The results

are

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How and J.G. Low, Fractional ownership and underpricing Table

6A

Results of multivariate analyses of the relationship between VALUE and explanatory variables for subsamples of companies using 70% fractional ownership as a cutoff point (dependent variable: TEQ20). Subsample I ( < 70%, n = 452) Variable

Regression

ALPHA

1.42*** (0.13) 1.71*** (0.06) 0.956*** (0.02)

CMAR INVESTMENT

I

Regression

MV2

Adj. R2 (Fisher)

Regression

II

0.49 (0.37) 0.84

Regression

II

4.12** (0.28) 1.66*** (0.28) 0.89*** (0.08) 0.08 (0.03) 0.05 (0.23) -0.38 (1.63) 0.70

-0.38 (1.60) 0.71

Standard errors are in parentheses. **The coefficient is significantly different from zero significantly different from zero at the
Table

I

4.12** (1.27) 1.69*** (0.24) 0.89*** (0.08)

1.40*** (0.13) 1.69*** (0.06) 0.96*** (0.02) 0.02 (0.11) 0.11 (0.09) 0.48 (0.37) 0.84

MVl

Constant

Subsample II (270x, n=71)

at the 0.001 level; ***the

coefficient

is

6B

Results of multivariate analyses of the relationship between VALUE and explanatory variables for subsamples of companies using 70% fractional ownership as a cutoff point (dependent variable: TASSET). Subsample I (<70’/ n=452) Variable ALPHA CMAR INVESTMENT

Regression 1.71*** (0.16) -0.12 (0.07) 0.96*** (0.03)

MVl MV2 Constant Adj. RZ (Fisher)

0.52

I

Subsample II (270%, n=71) Regression 1.71*** (0.16) -0.12 (0.07) 0.95*** (0.03) 0.39 (0.19) 0.03 (0.10) 0.58 (0.48) 0.78

II

Regression 1.92 (2.96) 0.47 (0.60) 0.62*** (0.15)

5.37 (3.39) 0.23

I

Regression

II

0.79 (2.96) 0.12 (0.75) 0.49*** (0.17) 2.77 (1.75) -0.18 (0.49) -8.27t (3.65) 0.26

Standard errors are in parentheses. tThe coefficient is significantly different from zero at the 0.1 level; **the coefficient is significantly different from zero at the 0.001 level; ***the coefficient is significantly different from zero at the
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How and J.G. Low, Fractional ownership and underpricing

61

70% fractional holding level. Consequently, imposing a linear relationship between fractional ownership and firm value may not be appropriate. The degree of underpricing and firm value is also positive and significant, consistent with our second hypothesis. Market volatility has a positive but not significant impact on firm value in all cases. When firm value is proxied by TASSET, the relationship between firm value and fractional ownership is also positive and nonlinear, as shown in table 6B. Only for firms with fractional ownership less than 70% do we find a significant relationship. Our findings of a positive relationship between firm value and fractional ownership over the entire range of fractional ownership are therefore in contrast to Prasad and Merikas, who find that Leland and Pyle’s model does not hold for ‘low’ levels of fractional ownership. Although our results are consistent with our contention that, in the absence of regulatory provisions requiring a minimum level of investment by issuers, a positive relationship exists between firm value and fractional ownership across all levels of fractional ownership, they suggest that the relationship may be nonlinear. Using TASSET as a measure of firm value, table 6B shows the relationship between firm value and underpricing is negative for IPO firms with fractional ownership lower than 70%, and positive for those with fractional ownership of at least 70%. The relationship is not significant at conventional significance levels. As previously, underpricing is a significant signal of firm value only when it is measured by TEQ20. We can conclude that fractional ownership is a significant explanatory variable for firm value. The positive relationship between firm value and fractional ownership is also robust with respect to the use of alternative measures of fractional ownership and firm value. Furthermore, the relationship is not sensitive to the choice of the cutoff point. There is, however, evidence suggesting that the linearity assumption may not be appropriate for all companies. The results on the underpricing variable, on the other hand, are ambiguous as they are highly dependent on the measure of firm value used. Tables 7A and B provide the results of piecewise regressions which allow for the two changes in the slope coefficient on fractional ownership. In table 7A, TEQ20 proxies firm value while TASSET is the measure of firm value in table 7B. Only the results for the 55% and 70% combinations of turning points are reported since those using the other two combinations (5% and 25X, and 20% and 50%) are similar”. Furthermore, the 55% and 70% combination appears to be the ‘best’ choice of turning points based on the ‘sAlthough not reported here, we find that using Merck et al.‘s specification (that 25x), there is little evidence to support the entrenchment hypothesis which suggests relationship between fractional ownership and firm value. Most of the fractional variables have positive coefficients in our regressions.

is, 5% and a negative ownership

.I.C.Y How and J.G. Low, Fractional ownership and underpricing

62

Table 7A Piecewise regressions of the relationship between VALUE and explanatory variables for turning points: 55% and 70% (dependent variable: TEQZO). Variables

Regression

ALPHA1

0.51 (0.39) 3.06t (1.44) 1.oo (1.98)

1.13*** (0.16) 3.21*** (0.60) 3.46*** (0.83) 0.95*** (0.02) 1.72*** (0.06)

15.52*** (0.02) 0.03

0.74t (0.36) 0.83

ALPHA2 ALPHA3 INVESTMENT CMAR

I

Regression

HITECH MINING MVl MV2

Adj. R2 (Fisher)

II

Regression

III

1.06*** (0.17) 3.52*** (0.62) 3.35*** (0.83) 0.95*** (0.02) 1.68*** (0.06) 0.12 (0.11) 0.12t (0.06) 0.00 (0.10) 0.13 (0.08) 0.697 (0.36) 0.83

Standard errors are in parentheses. tThe coefficient is significantly different from zero at the 0.1 level; ***the coefficient is significantly different from zero at the
significance of ALPHAl, ALPHA2 and ALPHA3. This greater significance could be attributed to the greater concentration of firms within these ranges of fractional ownership. All the combinations of turning points, however, have adjusted R2 of around 0.83 for regression III. HITECH and MINING are industry dummy variables which take a value of one if the IPO is issued by lirms in those industries, and zero otherwise. Regression III of table 7A shows that even after controlling for the two industry effects, the coefficients on ALPHAl, ALPHA2 and ALPHA3 remain positive and significant. The positive relationship between firm value and fractional ownership for all ranges of fractional ownership levels is thus supported. However, the size of the coefficients on the ALPHAS suggests a nonlinearity in the relationship. For every 1% increase in fractional ownership between 0% and 55x, total equity rises by an average of 1.06% (t = 6.24), which increases sharply to an average of 3.52% (t= 5.68) for fractional ownership from 55% to 70%. For ownership rises beyond 70x, total equity rises but at a reduced rate of 3.35% (tz4.04) for every 1% increase in ownership.

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How and J.G. Low, Fractional ownership and underpricing

63

Table 7B Piecewise regressions of the relationship between VALUE and explanatory variables for turning points: 55% and 70% (dependent variable: TASSET). Variables ALPHA1 ALPHA2 ALPHA3

Regression -0.12 (0.43) 5.31*** (1.53) -2.13 (2.10)

INVESTMENT CMAR

I

Regression 1.23*** (0.27) 3.54*** (0.93) 1.34 (1.27) 0X?*** (0.04) - 0.05 (0.09)

HITECH MINING MVl MV2 Constant Adj. R2 (Fisher)

15.58*** (0.17) 0.04

1X1** (0.58) 0.65

II

Regression

III

1.35*** (0.26) 3.14*** (0.92) 1.48 (1.24) 0.87*** (0.04) 0.04 (0.10) -0.29 (0.20) -0.34*** (0.09) 0.57t (0.23) 0.01 (0.11) 2.00*** (0.57) 0.67

Standard errors are in parentheses. tThe coefficient is significantly different from zero at the 0.1 level; **the coefficient is significantly different from zero at the 0.001 level; ***the coefficient is significantly different from zero at the
As with fractional ownership, underpricing is found to be significantly and positively related to firm value even with the inclusion of industry variables. The MINING dummy variable is significantly and positively related to firm value in this piecewise regression. This implies that IPOs in the mining industry have a higher firm value relative to those in the non mining industry. The HITECH dummy variable also has a positive although not significant relationship with firm value. Table 7B provides the results for the 55% and 70% turning points when firm value is proxied by TASSET. The results of the three regressions on the relationship between fractional ownership and TASSET, over the three specified ranges, are somehow ‘mixed. In some cases, the relationship is positive whereas in other cases, the relationship is negative. In cases where fractional ownership is significant, it is more likely to have a positive relationship with firm value than a negative one. Focusing on regression III, the results show that the coefficients for the three ALPHAS are positive and only those for ALPHA1 and ALPHA2 are significant. Our results of piecewise regression therefore show that although the relationship between

64

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How and J.G. Low, Fractional ownership and underpricing

fractional ownership and firm value is positive throughout the three ranges of fractional ownership, it is not linear. The underpricing variable remains insignificant as a signal of firm value, measured by TASSET.

7. Summary and Conclusions This paper provides empirical tests of the signalling hypothesis within the IPO framework using 523 Australian unseasoned issues of equity made during the period 1979 to 1989. The results show that, although the relationship between firm value and fractional ownership is positive across all levels of fractional ownership and robust, irrespective of whether market volatility and industry effects have been controlled for, the non linearity assumption may not be appropriate. The relationship between underpricing and firm value is, however, ambiguous as it is highly dependent on the proxy used to measure firm value. Ritter (1991) shows that IPO firms tend to underperform in the long run and that firms which underprice the most tend to have the worst performance. His finding raises doubt about the validity of the signalling hypothesis of underpricing which implies a positive relationship between the degree of underpricing and firm value. Given that Ritter examines the three year anniversary performance in his paper, it is difficult to conclude that our findings on the negative relationship between underpricing and firm value (i.e. to the extent that TASSET is an adequate proxy for firm value) is relevant to Ritter’s findings since we examine the firm’s value at the twentieth trading day.

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