The pricing of equity offerings

Journal

of Financial

Economics

29 (1991)

35-57.

North-Holland

The pricing of equity offerings* Claudio Lhiiwsitiit

Dennis

F. Loderer Bern. Bern. Swir:erlund

P. Sheehan

and Gregory

B. Kadlec

Purdue L’niLeniry, Htst Lufuyettr,

IIV 47907, USA

Received

received

June

1990, hnal version

February

IYY

I

Examination of I.600 seasoned equity offerings reveals little evidence that underwriters systematically set other prices below the market price on the major exchanges. though they may do so for NASDAQ issues. Quick round-trip transactions in seasoned otferings are not prohtable. but subscribing to an offering and holding the stock for 30 days seems to be yen: profitable. especially in the NASDAQ market. In addition to seasoned offerings. we analyze 150 issues of new classes of preferred stock. These issues are not underpriced.

1. Introduction That initial public offerings of common stock (IPOs) are underpriced is well known. Smith (1986) summarizes a number of papers that investigate this underpricing and finds that investors in IPOs earn average excess returns of between 11% and 52%. Recent figures are reported in Ibbotson. Sindelar, and Ritter (1988). For 2,259 firms in the 1980-1984 period, the average

*This paper was started while the first author was at Purdue University and finished while the second author was visiting the.Graduate School of Business at the University of Chicago. The authors would like to thank Michael Barclay, LeRoy Brooks, Alex Fung, David Mauer. Mitchell Petersen, Jay Ritter, Claude Viallet, and M. Megan Partch (the referee) for helpful suggestions. and seminar participants at the University of Alberta. the University of Illinois. Penn State University, the University of Pittsburgh, the University of Utah’s Winter Finance Conference. and the University of Wisconsin for comments. Special thanks are due Clifford W. Smith. Jr. (the editor) for his many ideas and suggestions. The authors are indebted to Tina Blackwell for superb research assistance.

0304-105X/91/503.50

c l991-Elsevier

Science

Publishers

B.V. (North-Holland)

36

C. F. Lodrrer et al.. The pricmg of equity offerings

underpricing, calculated from offering price to first closing bid in the aftermarket, is 21%.’ That these are not annual returns makes the numbers even more striking. Financial economists have expended much effort in rationalizing these seemingly irrational results. With all the attention on IPOs, the pricing of seasoned public offerings has been neglected and that of new classes of preferred has been ignored. This paper investigates the pricing of such offerings by publicly traded firms. We focus on seasoned issues and new issues of preferred for two reasons. First, examination of these issues provides evidence on the robustness of models of IPO underpricing. Second, an analysis of seasoned offerings allows us to test an explicit model of underpricing in seasoned issues. the Parsons and Raviv (1985) model. Our findings should be helpful to firms in their funding choices, to investors in their portfolio allocation decisions, and to investment bankers in their pricing deliberations before the public offering of securities. The explanations for the underpricing observed in the IPO market include monopsony power of investment bankers [Ritter (198-t)]. insurance against legal liability [Ibbotson (19751, Tinic (198811, asymmetric information [Baron (19821, Rock (19861, Allen and Faulhaber (1989). Grinblatt and Hwang (19891. Welch (19891, Benveniste and Spindt (198911, and incomplete markets [Mauer and Senbet (198911. At least two of these rationales appear to have implications for the questions we examine. The first is the legal-liability hypothesis. According to Ibbotson and Tinic, IPO underpricing could provide insurance against legal liability and the associated damages to investment bankers’ reputations. Underwriters underprice new issues as a cheap way of lowering the probability that the price will fall after the issue, which in turn reduces the likelihood of legal action by disgruntled buyers. This insurance hypothesis would seem to predict some underpricing for both seasoned issues and new issues of preferred. The second is the asymmetric-information hypothesis which underlies several models of IPO underpricing. For instance, underpricing has been rationalized as a way to induce investors to reveal their reservation prices to underwriters (Benveniste and Spindt). The same argument could in principle be made of seasoned equity or new issues of preferred. Underwriters are likely to have incomplete knowledge of individual investors’ demand schedules for an equity issue, which is one reason seasoned offerings are actively promoted and prior indications of interest are solicited [Perez (1984)j. Hence, one would expect the issues we study to be underpriced, albeit not as underpriced as IPOs.

‘The median underpricing for IPOs is much smaller; modest 35 for issues between 1977 and 198-I.

Mauer

and Senbet

(1989) report

a more

C. F. Loderer er ~1.. The pncing of equity oflerings

37

Differences in information between the lirm and investors can also induce underpricing. Allen and Faulhaber and Grinblatt and Hwang argue that high-quality firms rely on IPO underpricing to signal their better quality. The same models should apply to seasoned equity issues. because market seasoning may reduce. but does not eliminate, information asymmetries between managers and capital markets. Indeed. much of the recent theoretical work in finance relies on these very asymmetries. Clearly, information asymmetries are likely to be smaller for mature firms; so, the underpricing of seasoned stock offerings should be correspondingly smaller than that reported for IPOS. Finally, Rock argues that IPOs are underpriced because of the winner’s curse faced by uninformed investors. If new shares were priced at their expected value, informed investors would submit bids when good issues were offered and withdraw from the market when bad issues were offered. In the absence of underpricing, uninformed investors would therefore face the prospect of systematic losses and pull out of the market. The same situation arises when firms issue additional common or new classes of preferred stock. Underpricing could be necessary to entice uninformed investors to subscribe to the new issues. Underpricing of seasoned offerings is also predicted by the Parsons and Raviv study, one of the few papers to address this topic directly. Parsons and Raviv assume the existence of two classes of investors with different reservation prices. The firm cannot identify the high-value investors to whom it wishes to sell: the result is a demand curve for the stock with finite price elasticity. Consequently, investors with high reservation prices, concerned about the probability of oversubscription, drive the pre-issue (and. by implication, the post-issue) price above the offer price. Our results contradict the predictions from all of these models. AIthough some issues are underpriced. notably in the NASDAQ market. the evidence is not pervasive. For exchange-listed issues, it does not appear that underwriters systematically set offer prices below previous market prices. Moreover, in neither the seasoned market for common stock nor the initial market for new issues of preferred stock can investors reliably earn abnormal returns by buying at the offer price and selling on the issue day. The overall lack of underpricing around the offer day masks two interesting features of the data. First, there is substantial dispersion in underpricing, which ranges from -25% to +33%. Second, the lack of sizable returns around the offer day is not matched by a similar pattern in the month following the issue. It appears to be possible to earn excess returns by holding seasoned issues for 30 days. Both of these results are difficult to explain with our current models of pricing. The next section discusses pricing models for seasoned issues. Section 3 details the characteristics of our offering sample. Underpricing of seasoned

issues is investigated in section 4 and that of new issues of preferred in section 5. In the concluding section, we summarize our results and their implications for our understanding of security issuance.

2. Pricing of seasoned

equity offerings

The literature on the pricing of IPOs is voluminous. Few results, in contrast, are available for seasoned offerings. Many empirical studies have investigated the market’s reaction to the announcement and distribution of seasoned stock offerings, but only Smith (19771 and Bhagat and Frost (1986) report data on the actual pricing of these issues. and only Parsons and Raviv (1985) and Giammarino and Lewis (1985) model a seasoned offer’s pricing explicitly.’ Smith briefly documents a small degree of underpricing for seasoned offerings. Analyzing 328 offerings for firms listed on the New York Stock Exchange (NYSE) or the American Stock Exchange (Amex) for the years 1971-1975, he finds that the average return from the close on the day before the offer to the offer price is -0.53% and the average return from the offer price to the close on the offer day is +0X5. These returns. although small, are statistically significant. Building on Smith’s results, Parsons and Raviv construct a model in which underwriters rationally underprice a seasoned offering. Their model predicts that the preoffer price will ‘always be higher than the price at which the new issue will be sold’ and that the expected price following the issue will be above the offer price. Although these predictions are not generated by market irrationality. the model does rely on short selling restrictions and information asymmetries between investors and underwriters. If trading were unrestricted and information were available on investors’ reservation prices, however, underwriters could simply set the offer price equal to the preoffer market price. Investors would be indifferent between buying from underwriters and buying in the market. In fact, offer prices can be set slightly above the preoffer price, since investors do not incur commissions when buying from the underwriter. To illustrate, let (Y be the one-way transaction costs. Then, assuming the offer is priced correctly, equilibrium requires that the investor be indifferent between buying in the open market and from the underwriter. The return from following either alternative should be equal to the opportunity rate of return,

‘Asquith and Mullins (1956). Barclay and Litzenberger (1988). Hess and Bhagat (19%). Masulis and Korwar (1986). and Mikkelson and Partch C1986) analyze the announcement effects of stock issues. Muscarella and Vetsuypens (1989) and Schipper and Smith (1986) also study underpricing in two special cases.

C. F. Loderer et ai.. 77~ pang

of

eqrrw oferings

39

R, namely:

PIB(1 -cX)

P,B(l -cX) = P_“,(l

PC,

+cu)

=(l

+R)‘,

where P,’ is the expected bid price t days after the issue, P,, is the offer price, and P?, is the ask price on the day before the issue. The expected return from buying at the preoffer ask and selling at the subsequent bid net of transaction costs has to be equal to the compounded opportunity rate of return. That return, however, also has to equal the expected return from buying at the offer and selling at the subsequent bid price net of transaction costs. Rearranging ( 1). we get P,, = Pf,(

1 + CX)

(2)

and P,“( 1 -a) p,, =

(l+R)’

*

(3)

These predictions are specified in terms of bid and ask prices. On the NYSE and Amex and for National Market System (NMS) stocks. we have closing prices only. We expect these closing prices to be, on average, at the midpoint of the bid and ask prices [see Phillips and Smith (1980) and Lease. Masulis. and Page (1990)]. If this is so. we can approximate the magnitude of any bias created by the use of closing prices. In section 4 of the paper we return to this issue; the conclusions in that section trtrn out to be unaffected by the use of closing prices.’ Eqs. (2) and (3) imply that offer prices are set higher than the preoffer ask (or close) by the amount of the one-way transaction costs and lower than the postoffer bid (or close) by the amount of the one-way transaction costs and the opportunity returns. These propositions constitute our null hypothesis. The alternative hypothesis is represented by the predictions of Parsons and Raviv. In their model, there are no transaction costs. no opportunity-rate-ofreturn considerations, and no assumptions that would justify the existence of a bid-ask spread. The underpricing predicted by Parsons and Raviv must be sufficient to overcome any savings in transaction costs or time-value-of-money “Eqs. (2) and (3) are also approximations because CI presumably depends on the stock-price level and the transaction size. An estimate for CTcan be obtained from Phillips and Smith (1980) and Smith (1986): including both the brokerage fee and the bid-ask spread. an estimate of the lower bound for a is 0.5%.

considerations; otherwise we would never observe the underpricing the model is designed to explain. Clearly, to test the model, we have to make some choice of prices. It seems most natural to use transaction prices to represent the price in Parsons and Raviv. Thus. closing prices on the NYSE and Amex are the obvious choice: the NASDAQ market is more problematic. If we argue as before that closing prices are expected to be in the middle of the bid-ask spread. then using the midpoint of the bid-ask spread in the NASDAQ market should make the results from all markets most comparable. For completeness, we also calculate our results using both bid and ask prices.

3. Data and descriptive

statistics

Our sample is taken from the Directon of Corporate Financir~g published by Investment Dealers’ Digest. We include all firm-commitment public offerings of stock for cash for the years 1980-1983. We exclude initial public offerings. unit offerings. and otferings without a primary component. The resulting sample consists of 1,608 seasoned common stock issues and 3-i 1 new issues of preferred stock. Thirteen percent of the common stock offerings are issued on the Amex. 15% on the NYSE. and 32% in the NASDAQ market. By comparison. only 5% of the preferred issues are distributed on the Ames. SlcE are distributed on the NYSE. and 11 Cc are in the NASDAQ market. This distribution reflects the dominance of NYSE-listed utilities in the preferred stock issues. Most offerings of common are issued by industrial firms (705). with utilities second (23%), and financials third (8%). Among the offerings of preferred, 10% are by utilities, 38% by industrials, and 12% by financials. As might be expected. the number of issues differs by year. The year with the most issues is 1953, with 36% of the common and 37°C of the preferred; the fewest issues occur in 19S-I for common (9% 1 and in 1981 for preferred (9%). We also investigate the distribution of offerings by month. There is no clustering of events in any month or any obvious time-series pattern. Information on prices before and after the offering is gathered from Standard and Poor’s Daily Stock Price Record. For listed firms, we take the closing prices. For NASDAQ firms. since the publication lists bid and ask prices, we take the ask prices before the issue and the bid prices aftenvard.” We make this choice because we want to compute the returns from buying in the market before the offer (at the ask) and selling afterward (at the bid). All prices are adjusted for splits and stock dividends. Holding-period returns are ‘In the third quarter of 1983. the National NASDAQ stocks switched to reporting high. prices are gathered.

Market System low. and closing

was inrtiated. FrequentI) prices. For these stocks.

traded closing

C. F. Lodrrrr er al., Thhepricing of equrr) offerings

41

computed inclusive of cash dividends. From the same source, we compile data on the number of shares outstanding before the issue. Information on offer prices and the number of shares issued is taken from the Director?, of Corporate Financing. There are few surprises in the descriptive statistics on offering size. Firms listed on the NYSE bring to market issues worth a median 94 of the common stock outstanding, with a minimum of 0.1% and a maximum of 63%. By comparison, the median Amex and NASDAQ firm sells an issue that is twice as large (18%), with a minimum of 1% and a maximum of 160%. The median NYSE firm, however, raises more than three times as many dollars as the median Amex or NASDAQ firm. For initial offerings of preferred, the median firm raises about 11% of the value of the common stock outstanding: this ranges from 97~ on the NYSE to 27% in the NXSDAQ market. with the Amex almost exactly in the middle. The 11% figure translates into an offering size of $50 million, more than seven times as large as the median S7 million for seasoned offerings. Most of the firms issuing additional classes of preferred stock are large (NYSE) firms: presumably this accounts for the large size of the offerings. 4. The pricing of seasoned

public offerings

To study how underwriters price new issues, we first compute the ratio of offer price to preoffer close (or ask) minus one. Since offer prices for listed firms are typically set after the market closes on the day before the offering, this return should be a small positive number under our null hypothesis and significantly negative under the alternative hypothesis of Parsons and Raviv. Next, we calculate the return from buying at the offer price and selling at the close (or bid) on the issue day. These returns are the relevant ones to compare seasoned issues with initial public offerings. Finally, we investigate returns from buying at the offer price and selling at the close (or bid) five and thirty trading days after the issue. Assuming market efficiency. these returns should not exceed the opportunity rates of return, adjusted for transaction costs. 1.1. Close-to-offer

retwns

A histogram of the full sample close-to-offer return, denoted R,. is shown in fig. 1. Normal probability plots and tests of normality indicate that the distribution of R, cannot be considered normal - it is plagued by both skewness and outliers. The actual values of R, for the full sample and by exchange are reported in table 1. Two perspectives require examination of both median and average returns as measures of central tendency. The first perspective is that of an issuing firm interested in the ability of investment

C. F. Loderer et al., The pricmg of rquuy offermgs

12 Nuntm

600

01 relums

-

.15

-12

-9

-6

-3

0

3

6

9

12

16

Close-to.ofler return (percent) Fig. 1. Close-to-offer percentage returns for the full sample of 1.606 seasoned otfsrings, 1980-1984. The return is computed as the ratio of offer price to closing (or ask) price on the day before the issue.

bankers to price issues correctly. In the presence of distribution skevvness, the median value is likely to be a better measure of what the firm could expect to happen in an offering. The second perspective is that of an investor interested in the profitability of investment strategies designed to exploit any systematic mispricing of seasoned offerings. The measure of central tendency most relevant to that point of view is the average return. The median R,, is -0.35% and the average is - 1.31%. Both parametric and nonparametric tests of the hypothesis that the center of location is zero reject the hypothesis. From these results. it is apparent that underwriters do not set the offer price systematically above the preoffer ask or close. Neither, however, do they always choose an offer price below the most recent ask or close. In fact, there is an approximately even split between offerings that are underpriced and offerings that are overpriced or have the same price as the previous day’s close. Despite the lack of systematic over- or underpricing, in a large number of cases underwriters price an issue at other than the most recently observed market price. About 70% of all issues are priced at other than the most recently observed closing price. This deviation from market prices ranges from - 22% to + 7%, with underwriters more likely to set a price lower than the market than higher. In about 10% of the issues the difference between the previous market price and the offer price is 5% or more. At an average

43

C. F. Loderer et al.. The pncing of equrn; offerings Table

1

Selected holding-period returns (in percentages) for seasoned common stock offerings. 1980-198-t. R,, is the ratio of the otfer price to a market price on the day before issue, minus one. R, is the ratio of a market price on the issue day to the offer price. minus one. For NYSE and Amex issues. we use closing prices as a market price; for NASDAQ issues. returns are calculated using either ask prices (for R,) or bid prices (for R,) and also with prices equal to the midpoint of the bid-ask spread. The t-statistic p-value is the probability value of the usual r-statistic for the hypothesis of zero mean: percent zero is the percentage of zero returns and percent negative is the percentage of negative returns. First quartile

Median

R,,

- 2.33

- 0.35

R,

-0.74

4,

- 1.39

R,

0.0

R,I

R,

0.0 - 0.67

R,, (ask) R,, (mid)

- 4.00 - 2.38

-2.13 - I.05

- 2.96 - 1.61

- 0.90 - 0.38

R, (bid) R, (mid)

- 1.16 0.0

0.0 0.94

0.67 I.94

1.51 2.88

Average

Third quartile

f-statistic p-value

Percent zero

Percent negative

(A) ,411offerings (sample size = 1.606.1 0.0

- 1.11 0.35

0.0

0.00

32

0.73

0.00

36

31 34

19 39

40 23

45 12

24 36

0.00 0.00

13 7

84 79

0.00 0.00

30 7

35 25

(B) Offerings on the American Erchunge (sample si:e = -7001 0.0 0.0

- 1.17 0.80

0.0 1.11

0.00 0.00

(C) Offerings on the New York Exchange (sample size = 726)

0.0 0.0

- 0.03 - 0.07

0.66 0.0

0.2 0.19

(D) Offerings in the IVASDAQ market (sample size = 6801

price of about $20, a difference of 5% is $1.00, a large deviation when the price is so easily observed. When the close-to-offer returns are broken down by exchange, substantial differences emerge. Using both parametric and nonparametric tests, the hypothesis of equality of R, across exchanges is strongly rejected by the data (p-values of 0.0001 for both tests). On the NYSE, only 24% of the issues are priced below the previous close; the figure rises to 40% on the Amex. Furthermore, in a substantial number of cases, 45% on the NYSE and 49% on the Amex, offer prices equal the preoffer close. Hence. there is little evidence of underpricing on the two exchanges that would be consistent with Parsons and Raviv. There is also no evidence to support our null hypothesis, since if offer prices are not higher than the previous close, they can hardly be higher than the previous ask, as predicted by eq. (2). The NASDAQ market shows a sharp contrast. Only 3% of the offers are priced above the previous ask, more than 80% are priced below the previous ask, and the median underpricing is more than 2%. This contrast between

C. F. Loderer et al.. The pncing of equtry oflerings wllmr 500

d

mtums

1

400 300

1

200

1

100 1

0

I -15

,

I -12

-9

, -3 0 3 6 -6 Cbse-to-offer return (perceti)

9

12

15

Fig. 2. Close-to-offer percentage returns for the sample of 716 seasoned offerings on the New Stock Exchange. 1980-1984. The return is computed as the ratio of offer price to closing price on the day before the issue.

York

Number 01 returns 250

-

-15

Fig. 3. Ask-to-otfer NASDAQ market,

-12

-9

-3 0 3 6 -6 Close-to-olier return (percent)

9

12

15

percentage returns for the sample of 680 seasoned offerings on the 19&W-19%. The return is computed as the ratio of offer price to ask price on the day before the issue.

C. F. Lodtwr et al.. The prrcing of equity offrrrngs

45

the exchanges and the NASDAQ market is clear when we plot the corresponding histograms (figs. 2 and 3). The distribution of f?,, seems fairly symmetrical around zero on the NYSE, but has a strong negative skew in the NASDAQ market. The findings for the NASDAQ market are the opposite of what the null hypothesis predicts. To decide whether they are consistent with the predic[ions of Parsons and Raviv, we recompute the NASDAQ results by replacing ask prices with the midpoints of the bid-ask spreads in the definition of R,,. The outcome of this analysis is shown in table 1 as R,, (mid). Computing R,, with the midpoint of the spread reduces both the median and the average underpricing for NASDAQ issues by almost half (from -2.lC; to - 1.1% for the median R,, and from -3.0% to - 1.6% for the average). In spite of this reduction, most of the NASDAQ offerings (79%) are underpriced.’ These findings make it clear that underwriters are not using eq. (31 to set offer prices in the NASDAQ market; the Parsons and Raviv prediction is much closer to what is happening. Examination of the National Market System (NMS) stocks in our NASDAQ sample provides a qualification to the data’s support of the Parsons and Raviv model. For 54 NMS issues, we have information on closing prices similar to that available for the exchanges. Close-to-offer returns for this subsample of NASDAQ stocks are very similar to those found on the Amex: the median R,, is zero. the average is about - 1%. and offer prices exceed previous closing prices in 60% of the cases. NhIS stocks are the most liquid stocks in the NASDAQ market: the Parsons and Rativ prediction seems to apply better to the less liquid NASDAQ segment. Overall, the data in all three markets easily reject our null hypothesis that underwriters set issue prices above the previous ask. At the same time, it is clear that seasoned stock issues are not always priced below the previous closing price, as suggested by Parsons and Raviv. For the NYSE and Amex offer prices are not usually set below the previous close. On NASDAQ, our results are more supportive of the Parsons and Raviv model except for the NMS stocks. 4.2. Ofler-to-close returns

Offer-to-close returns provide the relevant evidence to compare the underpricing of seasoned and initial offerings. The evidence from the aftermarket (table 1) does not suggest that offer prices are systematically set below ‘For completeness, we also computed returns using bid prices in the NASDAQ market. The median bid to offer return is zero, the average is -0.1, and onlv 235 of the offer prices are below the bid. These results are similar to those obtained for the GYSE. ConsIdered as a whole, the bid. ask. and midpoint calculations reveal that most offer prices are set between the bid and the midpoint of the bid-ask spread.

C.F. Loderer

16

1000

et al.. 77~ prtcmq of equttyofferings

1

15

-12

-9

-6 .3 0 3 6 Oner-to-close return (percent)

9

12

15

Fig. 1. Offer-to-tirst close percentage returns for the full sample of I.608 seasoned offerings. 1980-198-l. The return is computed as the ratio of closing (or bid) price on the issue day to the offer price.

market. The return from buying at the offer and selling at the close (or bid) of the offer day CR,) has a distribution that is fairly symmetrical around zero (fig. 4). The average is positive and significant (0.35%), but the median is zero and only 30% of the returns are positive. When we examine the aftermarket by exchange, no strong differences emerge. In each market, the median offer to close (or bid) is zero; averages are positive for Amex and NASDAQ issues, negative for the NYSE. Indeed, positive returns are quite scarce on the NYSE (22%‘c), and only slightly better odds are obtained in the NASDAQ market (35%) and on the Amex (38%). Most issues are simply not priced to yield positive returns on the issue day, in sharp contrast to the IPO market. As before, we investigate whether using midpoint prices for the NASDAQ issues has an effect on the results. Table 1 gives the issue-day returns, R, (mid), using the midpoint prices. Using midpoint prices, most issues have an issue-day price that is above the offer price.’ For NASDAQ issues, it appears that underwriters generally set the offer price to be on the low end of the bid-ask spread on the day before the issue; on the issue day, the spread does not move very much, with the result that returns are zero when calculated

‘The use of ask prices naturally results in an even larger issue-day return: mean 3.165 with 785 of the issues having an ask price above the offer.

median

1.96% and

C. F. Loderer et al.. 711eprrcing of equity offerings

17

Table Z Dollar returns from buying seasoned common stock offerings. 1980-1981. Dollar gains are calculated using two strategies for a round-lot transaction. The tirst is to short the stock on the day before the offering and buy at the offer price; the second is to buy at the offer price and sell on the day of the offer. Dollar returns are calculated assuming no transactions costs, 0.5% costs. and 1% costs. Dollar returns have been deflated by the Consumer Price Index (1967 = 100). Close-to-offer Median No transaction costs 0.5% transaction costs 1% transaction costs Dollar investment at offer price

return Average

Offer-to-close Median

return Average

SO -3 -7

$1 -3 -6

SO -1 -7

S1 -2 -6

669

768

669

768

from offer to bid, about l-2% when calculated from offer to midpoint, and about 2-3% from offer to ask. These results provide no support for our null hypothesis, as most issues have closing or bid prices at or below the offer price. The Parsons and Raviv model is also rejected by the NYSE and Amex data, but finds support in the NASDAQ data.’ Whether these differences by exchange can be explained by the models discussed in our introduction is a subject we return to in our conclusions. Even if underwriters don’t always set offer prices below market prices and even if average underpricing is small, it could still be possible to earn excess returns. If the large positive returns were concentrated in the higher-priced stocks, substantial dollar profits could result even with transaction costs. Table 2 shows the dollar returns available to an investor who undertakes a round-lot transaction in each issue: buying at the offer and selling on the issue day.” We use closing prices on the NYSE and Amex, bid prices for the NASDAQ issues. For completeness, we also show the profitability of shorting the stock before the offering at P_, (close or bid) and covering the short sale at the offer price. To employ constant dollars, we deflate by the Consumer Price Index (1967 = 100). Both strategies assume that issues are not rationed; if they were, profits would be smaller than shown in the table. As mentioned in section 2, investors can avoid transaction costs by buying the issue at the offer price, but they still face transaction costs when selling.

‘As before, however, the offer-to-close return for NMS issues looks much like the exchanges, with a median of zero and a mean of 1%: 60% of the issues have zero or negative returns on the issue day. “Investing table 2.

an equal dollar amount

in each issue ytelds qualitatively

the same results as those in

Table

3

Perccnrage excess returns on the issue day for 1.608 seasoned common stock otferings. Excess returns are calculated by subtractmg the return on the value--eIghted CRSP the offer to close (or bid) return on the issue day. Percent positive is the percentage returns. Sledian

Average

t p-value)

( p-value)

Percent positive

.Lledian

(p-value)

All offerings - 0.07 (OH)

0.27 (0.00)

-0.13 (0.02)

Percent Positive

‘Amex 17

0.2s: (0.00)

NYSE - 0.16 (0.00)

.Average

cp-value)

1980- 1981. Index from of positive

0.72 (0.00)

61

NASDAQ 43

- 0.09 (0.27)

0.57 (ll.00)

48

As table 2 reveals, dollar profits are small even without taking into account transaction costs. The median gross dollar profit, for instance, is always zero for either strategy. As it turns out, it is also zero for all markets (not shown). The average gross dollar profit is generally positive. Once we take transaction costs into account, these small profits disappear, Even transaction costs of 0.3% are sufficient to wipe out any profits, with both median and average dollar returns now negative. If we examine the sum of dollar returns from buying the full amount of every issue (not contained in the table), we find negative returns after transaction costs. Evidence on the possibility of excess returns is contained in table 3, which provides offer-to-close (or bid) returns net of the contemporaneous return on the value-weighted Center for Research in Security Prices (CRSP) index (we use one index for the NYSE and the Amex and another for NASDAQ). The table therefore compares investors’ returns with what they could earn by investing in the market index. Not surprisingly, the table confirms that there is little evidence of underpricing. From offer to first close (or bid) only 47% of the excess returns are positive. It is only for Amex issues that the first return is generally positive and significant. The returns in tables 2 and 3 depend on closing and bid prices; when we use midpoint prices for the NASDAQ issues. the findings, as expected, change. If we replicate table 2 with closing and midpoint prices, the numbers in the table generally increase. Transaction costs of 1% still yields negative profits: with 0.5% costs, the picture is somewhat mixed. For the NASDAQ issues alone, the use of midpoint prices produces positive profits even with 1% costs; this is not surprising because the average bid-ask spread is about 35, so the midpoint exceeds the transaction costs simulated. Turning to the market-adjusted returns using midpoint prices. the change for the NASDAQ issues is dramatic. Seventy percent of the issues earn a positive excess return

C. F. Loderer

et al.,

The pncing

of equity

offennqs

19

on the issue day. The median return is 0.85%; the mean is l.S%. When these NASDAQ results are combined with those for the NYSE and Amex issues, issue-day returns are positive and significant. In sum, the ability to earn positive returns on the issue day depends on where the issue is sold and what we use as a sale price. Exchange-listed issues are not underpriced using closing prices; obviously bid-price results would show even less underpricing. On the exchanges, the evidence does not support the claim that underwriters price offerings so as to leave substantial money on the table or to produce positive excess returns on the issue day. For NASDAQ issues, the same conclusion can be reached if shares are sold at the bid. When midpoint prices are used. however, these issues show evidence of underpricing. producing positive returns net of transaction costs .and market rates of return.’

4.3. Returm

following

the isme da):

Although neither our predictions nor Parsons and Raviv say anything about returns following the issue day, they are of interest nonetheless. Even if investors cannot earn substantial returns right around the issue day. longer holding periods may be profitable. Profitability in longer horizons would not be attributable to underpricin,, 0 however, because that should also be evident in shorter-holding-period returns. Excess returns could be a sign of market inefficiency. Table 1 contains returns calculated from the offer price to the close or bid price five and 30 trading days after the issue. We find that selling five days after the offer produces a median return of zero, with fewer than half of the returns positive. Once we go 30 days out, however, a majority of the offer-to-close returns are positive and both average and median are significantly larger than zero. When we examine the aftermarket by exchange, a pattern similar to that observed for the close-to-offer return emerges. Positive returns are scarce on the NYSE, and more frequent in the NASDAQ market, with the Amex occupying the middle ground. On both of the national exchanges, one must again go out 30 days before average and median returns are positive and the probability of a positive return exceeds 50%. In comparison. the aftermarket returns in the NASDAQ market are generally large and positive. ‘We also investigated whether there are differences in underpricing by industry. The strongest impression from the analysis is that utilities are different from other firms by virtue of being overpriced. confirming the contrast between the findings of Smith (19i7) and Bhagat and Frost (1986). We investigate the reasons for differences by industry in a related paper [Loderer and Sheehan (1990)]. Clearly, most of the theories discussed in this paper have a difficult time rationalizing overpricing.

C. F. Loder~r et al.. The

50

pncing ofrquity offrrrngs

Table -t Selected holding-period returns (in percentages) and market-adjusted returns for seasoned common stock offerings. 19YO-19Y-1. R, is the return from buying at the other price and selling at the closing (or bid) price on day r. where f = 1 is the issue day: RW, is the market-adjusted return, detined as R, minus the CRSP value-weighted index. The r-statistic p-value is the probability value of the usual r-statistic for the hypothesis of zero mean; percent positive is the percentage of positive returns and percent negative is the percentage of negative returns. First quartile

Median

(A) A-111 off%ngs -

2.61 4.61 2.132. 5.71

Third quartile

Average

0.0 2.96 0.0‘4

1..lY

(sumplr

1.19 4.71 O.Yl 1.86

six

0.0

0.56

3.54

5.02

-0.1-t 1.58 (C) Ofi,nngs

-

Z.-t9 -1.22 1.73 5.42

0.0 I.57 - 0.30 II.61 (D) O$rings

-

OIL rtrr NW

York Erchangr

0.1 1 2.73 -0.10 1.08 in rhr IWSDAQ

1.98 8.2s 2.tlY 6.71

~scrmplr six

18 59 50 56

43 38 50 44

47 61 1’) jj

17 3Y 51 -I5

1-A 58 47 51

IS 40 53 4s

= Mlt

0.73 0.00 0.4-t 0.00 isum&

size = 726) 0.53. 0.00 0.j-t 0.00

~nnrkrr fs~zntplr six

-7 -.__<> - 4.76

O.YY

2.53

5.30

6.75

15.9

0.00

- 1.75 - 5.87

0.52 3.18

3.17 4.61

5.26 17.8

0.00 O.00 -_

5X1

Percent negative

0.00 0.00 0.00 0.00

3.3 17.0 3.X 12.4

0.33 3.39

Percent positive

= 1.606t

3.52 12.7 3.63 Y.3,

(B) O_fir~tgv on the .-lmerrccm Excharlyr -3.16 - 7.39 - 3.52 - h.-t7

f-statistic p-value

0.00

= 680)

5’ 6; 55 5Y

38 35 -tj -I1

Positive returns in the aftermarket are not surprising. Whether investors buy at the offer price or in the open market, they expect to earn positive returns. The question is whether buying from underwriters offers the opportunity to earn excess returns. We address this question by calculating the return investors make over and above what they would make if they invested in the market index instead. Evidence on the possibility of excess returns is also contained in table 4, which provides offer-to-close returns net of the contemporaneous return on the value-weighted CRSP index (we use one index for the NYSE and the Amex and another for NASDAQ). The results are surprising. Five days out, the returns are mixed: 50% of the returns are positive, producing a very small median and a much larger average. As we lengthen the horizon, the proportion of positive market-adjusted returns increases, reaching 56% for a 30-day holding period and producing excess returns in the 1.5-3.0s range. This suggests that the post-issue market is inefficient.

C. F. Loderer et al.. The prrcing of equity offerings

51

When we take into account the exchange on which the offering is marketed, we find that the overall results are driven mainly by the NASDAQ market. For instance, on the NYSE the 30-day market-adjusted return has a median of 0.6% and an average of 1.1%; in the NASDAQ market the median is 3.1% and the average is 4.6%.‘” As usual, the results for the Amex fall in between those for the NYSE and the NASDAQ markets. These excess returns following the issue are consistent with earlier findings of Barclay and Litzenberger (1988). They examine 218 NYSE and Amex stock offerings and find a significant 1.5% average cumulative excess return from the issue day to for the existence twenty trading days later. ” There is no obvious explanation of these excess returns.

5. The pricing of preferred offerings Offerings of new classes of preferred stock have not previously been analyzed for evidence of underpricing. Predicting offer prices for these issues is problematic because the term ‘preferred stock’ encompasses several types of claims. Straight preferred, for instance, promises well-defined future cash flows and should therefore be as easy to price as coupon bonds. Weinstein (1975) studies 179 new debt issues and finds an average excess return of 0.38% in the first month after issue. On the basis of his results we expect small or no underpricing for our sample of straight preferred. Convertible preferred, however, has equity-like characteristics. It could therefore share the pricing patterns of common stock. Analysis of issues of new classes of preferred can tell us whether accurate pricing of new securities demands that underwriters observe previous prices on the security being issued or whether it is sufficient simply to have other traded claims against the firm. If no underpricing of new preferred issues is observed, especially for convertible preferred, it would seem that the information needed for accurate pricing can be inferred from observing the prices of other traded claims. In the context of IPOs, this would imply less underpricing when the firm going public has other financial claims outstanding and an associated credit history. In our sample of 251 new issues of preferred stock, most were listed on the exchange some time after the offer date. The median delay between offer and “‘It is unlikely that risk can account for such large excess returns. Assuming a risk-free rate of about 10% per year and an average annual NASDAQ market return of about 22% observed during this period implies an average beta of 1.6 to make the excess return zero. In this hypothetical market model. the average NASDAQ beta is 1.0. “One possible scenario is that the market for many of these stocks is illiquid and that it takes time for the issue to find ifs way to investors with higher reservation prices. The notion that the price elasticity of demand increases in time is well understood in nonspeculative markets, but our evidence seems to indicate traces of that phenomenon in highly organized markets such as the NYSE [see also Loderer, Cooney. and Van Drunen (199011.

first recorded price is 79 days, with a range of 1 to 133 days. Examination of the prospectuses for a dozen of the offerings uniformly revealed language such as: ‘Application has been made to the New York Stock Exchange for listing of this security, but there is no guarantee that a market will develop in the stock.’ Conversations with investment bankers and exchange officials confirm this story. Apparently, for these offerings of preferred stock, application for listing is often made too close to the offering to receive prior approval or is not made until after the offering. Investment Dealers’ Digest, which collects the data published in the Dad) Stock Price Guide, claims that it records the first publicly quoted price at which a transaction occurs. It seems likely, however, that. some trading occurs sooner, in view of the interval between the offer day and the start of official trading. To maintain good relations, for instance, underwriters probably feel obliged to repurchase shares that customers want to unload. Unfortunately, it does not appear possible to get any price information for the period between the offer date and the listing date. Thus we can only report the returns from offer to first and subsequent publicly observed closing prices. Clearly, this delay in observing prices diminishes our ability to detect underpricing, but unless prices first rise and then fall during the listing-delay period, it should still be possible to find evidence of underpricing. if there is any. To analyze the pricing of new preferred issues, we investigate the same aftermarket holding-period returns analyzed for seasoned offerings. The interpretation of these returns, however, is different. The offer-to-first-close return CR,) is now the geometric average daily return earned from buying at the offer price and selling at the first available closing (or bid) price (presumably the price on the listing day). The returns R5 and R,,, have a corresponding interpretation. Overall, the evidence in table 5, panel A, seems to be inconsistent with the prediction that new preferred stock issues are underpriced. With the exception of the 30-day holding-period return, average and median holding-period returns are not significantly different from zero. As with seasoned offerings, positive returns following the offer are anything but a sure thing. The possibility of earning a positive return by buying at the offer and selling at the first close is roughly 50%. When we divide the sample by exchange, we do not find the regularities observed for seasoned offerings. Offer-to-first-close returns are insignificantly different from zero regardless of exchange (panel B). Furthermore, when we compute market-adjusted returns, we find that neither average nor median excess returns are significantly different from zero regardless of holding period. As with seasoned, we also simulate the dollar returns investors could obtain by purchasing at the offer price and selling at the close on the listing day. As might be inferred from table 5, once transaction costs of 0.5% are

53

C. F. Loderer er al.. The pricing of equity offerings Table 5 Selected

holding-period

returns (in percentages)

for quasi-seasoned

stock offerings,

1980-1984.

R, is the geometric average daily return from buying at the otfer price and selling at the closing (or bid) price on day r, compounded for I days: t = 1 is the issue day: RWA, is the marketadjusted return, defined as R, minus the CRSP value-weighted index. The r-statistic p-value is the probability value of the usual r-statistic for the hypothesis of zero: percent zero is the percentage of zero returns and percent negative is the percentage of negative returns. First quartile

Median

Average

Third quartile

t-statistic p-value

Percent zero

Percent negative

11 6 6

37 38 38

(A) All offerings (sample si:e = 251)

R,

- 0.07

Rs R,,

- 0.34 - 1.58

0.02 0.15 0.86

0.09 0.19 1.55

0.1’ 0.65 3.77

0.28 0.17 0.03

(B) Offer to first close returns CR,) by e.rchange (sample size in parentheses)

Amex (13)

- 0.09

NYSE (203) NASDAQ (35)

- 0.05 - 0.37

RM.4, RMAj

- 0.67

Iw4

0.01 0.0’ 0.0 (0

30

- 0.03 0.03 0.5 1

0.06 0.13 0.21

0.64 0.11 0.40

8 8 29

39 37 37

Market-adjusted returns

- 1.80

-0.12 - 0.25

- 0.06 -0.09

- 7.43

- I.-t9

- 1.28

0.42

0.66

0

55

1.39 3.42

0.80 0.07

0 0

55 5Y

taken into account, both average and median dollar returns are negative; the sum of dollar returns from buying the whole amount of all 251 issues is also negative with 0.5% transaction costs. Consequently, and contrary to what researchers have documented for IPOs, quick round-trip transactions at the offer price of new preferred issues are not profitable, even ignoring opportunity rates of return. The negative excess returns could be a result of our overadjusting for risk by using the return from the CRSP market index rather than the return on a portfolio of financial assets in the same risk class as preferred stock. To address this issue, and to explore whether underpricing is correlated with security risk, we segment the preferred issues into those that are convertible to common stock and those that are not. Presumably, the convertibles should show pricing patterns similar to those observed for common stock, whereas nonconvertibles should be more like debt and therefore yield results similar to those reported in Weinstein (1978). As it turns out, there are differences in the magnitude of returns for convertibles and nonconvertibles, but they are not statistically significant except for the market-adjusted 30-day return (not reported in a separate table). The median excess returns for convertibles are always negative and never significant; thus, there is no evidence that the common stock-like preferreds are underpriced. The excess returns for the nonconvertibles are

5-t

C. F. Loderer et al.. Thhepncmg of equir) offrnngs

always negative and generally significant - this probably represents an overadjustment for risk. We also addressed the question of whether the convertible/nonconvertible split is an industrial/utility split. Industrials generally issue convertible and utilities nonconvertible preferred. There are, however. enough observations to conclude that industry affiliation does not explain a great deal. The offer-to-first-close returns are statistically indistinguishable from zero no matter who is issuing or what is being issued.

6. Conclusions We examine whether seasoned stock offerings and issues of new classes of preferred are underpriced. The pricin, 0 of seasoned offerings has been analyzed by Parsons and Raviv, who.predict that offer prices will always be set below the price prevailing the day before the formal issue, and that the price after the issue will be above the offer price. Alternatively, if markets are efficient and trading is unrestricted, there is no reason why offer prices should be systematically smaller than market prices. Neither of these stories seems to explain our results completely. Contrary to the Parsons and Raviv story, underwriters do not systematically set offer prices below previous transaction prices. except possibly in the NASDAQ market. Contrary to our null hypothesis, underwriters do not take into account the savings in transaction costs and price the issue above the previous ask price. More specifically, when we compare offer prices with the last closing price before the offering, we find little evidence of underpricing on the Amex and none on the NYSE. Using midpoint prices, there is evidence of underpricing in the NASDAQ market. The first aftermarket return ethos these results: zero median returns on the exchanges, significantly positive for NASDAQ using midpoint prices. Thus, our findings on all three markets reject our null hypothesis quite soundly. The evidence from the NYSE and Amex issues rejects Parsons and Raviv, but NASDAQ issues are consistent with their predictions. In contrast to the generally small returns around the issue day, buying at the offer price and holding for 30 days can be very profitable, even after transaction costs and opportunity rates of return are taken into account. Excess returns vary by exchange, with the largest returns available in the NASDAQ market, followed by smaller returns on the Amex. and still smaller returns on the NYSE. This suggests market inefficiency, especially in the NASDAQ market. Finally, initial offerings of new classes of preferred stock do not appear to be underpriced, regardless of exchange, length of holding period, or the type of preferred issued. It appears that underwriters are able to price new

C.F. Loderer et al.. The pncrny

of equq offrnngs

55

securities accurately even without the aid of previous prices on those securities. Having publicly traded claims outstanding seems to be what is needed to help price other claims with only small errors. In the introduction, we described a number of IPO models or explanations that we thought applied to seasoned issues as well. The legal liability hypothesis was one of those. It is possible to question the applicability of that hypothesis to seasoned offerings with the argument that the availability of market prices makes the pricing of issues a trivial matter. But market prices don’t reveal how deep and resilient the market would be in reaction to the issue of new securities. especially less liquid securities. Even in efficient markets, prices will provide an unbiased reflection of an upcoming stock issue only on average. The estimation error could be significant. In fact, the risk of underwriting seasoned issues is not zero. Thirteen percent of the sample has market prices that are 10% or more below the offer price within 30 days of the issue day. Investors subject to annualized returns of -70% or less may find an underwriter a convenient scapegoat. Thus it is not clear that underwriters are exposed to only very small risks when underwriting seasoned issues or new issues of preferred. As with the legal liability hypothesis, one could question the applicability of various asymmetric information models of IPOs. Certainly. much is known about publicly traded firms. but just as certainly information about such firms is not complete. That is precisely the basis for the extensive work going on with respect to. for instance, dividend policy and capital structure decisions. Indeed. it is the basis for the Parsons and Raviv model, which is explicitly a model of seasoned offerings. Instead of arguing that the IPO models don’t apply to seasoned issues, it could be claimed that our results actually support the models. Even though the current crop of asymmetric information models makes a binary assumption about asymmetric information (it either exists or it doesn’t), one could contend that the less asymmetry of information, the smaller the degree of IPO underpricing. By analogy, one would expect moderate underpricing of seasoned issues on the major exchanges (on the assumption that asymmetries of information are only moderate) and more underpricing in the NASDAQ market (on the assumption that asymmetries of information are more extensive). According to this logic, new issues of preferred should not be underpriced at all. The evidence, however, is only partly consistent with this thinking. First, contrary to the above line of reasoning, NYSE offerings are not underpriced at all (78% of the offer-to-close returns are nonpositive; the proportion would be even larger if we computed offer-to-bid returns). This occurs even though many NYSE firms are not household names and, by self-selection, issuing firms are probably the object of relatively large information asymmetries; firms are typically reluctant to issue stock, and those

56

C.F. Loderer rr al.. The prwng

of rquiryy offerings

that do must either be small [see Welch (198911 or in some financial difficulty. Second, even in the NASDAQ market, the first offer-to-close return has a median value of zero and short-term turnaround transactions are unprofitable. And third, there is little direct evidence that information asymmetries on the exchanges are significantly smaller than those in the NASDAQ market. On announcement day, stocks of NYSE and Amex industrials fall by 3% on average [Asquith and Mullins (198611, and the most frequently cited cause of this large announcement effect is asymmetric information. According to Korajczyk, Lucas, and McDonald (19901, the announcement effects for NASDAQ firms are smaller than those for NYSE and Amex firms. 2.9% versus 3%. If information asymmetries for NASDAQ firms are larger, why do these firms not have concomitantly larger issue-announcement effects than major-exchange firms? The alternative is to conclude that our results cannot be explained very easily by theories of IPO underpricing. The differences across exchanges and by industry cannot be readily reconciled with extant models or theories of equity pricing. Our results suggest that despite the volume of theoretical and empirical research on security issuance, there is still much we do not understand.

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C. F. Loderer et al.. The pricing of equity offerings

51

Lease. Ronald C.. Ronald W. Masulis, and John R. Page, 1990. An investigation of market microstructure impacts on event study returns. Working paper (University of Utah. Salt Lake City. UT). Loderer. Claudio F. and Dennis P. Sheehan. 1990. Investment bankers and the pricing of seasoned stock issues. Working paper (University of Chicago, Chicago, IL). Loderer, Claudio F., John W. Cooney, and Leonard D. Van Drunen. 1990, The price elasticity of demand for common stock, Journal of Finance. forthcoming. Masulis, Ronald W. and Ashok N. Korwar. 1986, Seasoned equity offerings: An empirical investigation, Journal of Financial Economics 15. 91-l 18. Mauer. David C. and Lemma W. Senbet, 1989, The effect of the secondary market on the pricing of initial public offerings: Theory and evidence. Working paper (University of Wisconsin. Madison, WI). Mikkelson. Wayne H. and M. Megan Partch, 1986, Valuation effects of security offerings and the issuance process. Journal of Financial Economics 15, 31-60. Muscarella, Chris and Michael Vetsuypens, 1989, The underpricing of ‘secondary’ initial public offerings: An empirical examination of information asymmetry, Journal of Financial Research 12, 183-192. Myers. Stewart C. and Nicholas S. Majluf, 1984, Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, 187-22 I. Parsons, John and Artur Raviv. 1985, Underpricing of seasoned issues, Journal of Financial Economics 14, 377-397. Perez, Robert C., 1984, Inside investment banking (Praeger, New York, NY). Phillips. Susan M. and Clifford W. Smith, 1980, Trading costs for listed options: The implications for market efficiency. Journal of Financial Economics 8, 179-201. Ritter, Jay. 1984, The ‘hot issue’ market of 1980, Journal of Business 57. 215-240. Rock, Kevin, 1986, Why new issues are underpriced. Journal of Financial Economics 15, 187-212. Schipper. Katherine and Abbie Smith, 1986, A comparison of equity came-outs and seasoned equity offerings: Share price effects and corporate restructuring, Journal of Financial Economics 15, 153-186. Smith, Clifford W., 1977, Alternative methods for raising capital: Rights versus underwritten offerings. Journal of Financial Economics 5, 273-307. Smith, Clifford W.. 1986. Investment banking and the capital acquisition process. Journal of Financial Economics IS, 3-29. Tinic. Seha M., 1988, Anatomy of initial public offerings of common stock, Journal of Finance 43, 789-822. Weinstein, Mark I., 1978, The seasoning process of new corporate bond issues, Journal of Finance 33, l343- 1354. Welch. Ivo. 1989, Seasoned offerings, imitation costs, and the underpricing of initial public offerings. Journal of Finance 44, 421-450.