Sharpening the IPO Double-Edged Sword

For a brief, giddy moment, it seemed like an IPO — any IPO — was a prepunched ticket to instant riches for companies and individual investors alike. But the technology- and Internet-stock tumble have made the risks of IPOs all too apparent. As companies sift through the wreckage, the question emerges: How can the risks of IPO stocks be predicted and managed?

Three new research studies explain why some IPO stocks plummet in price while others outperform the market. According to all three, information available prior to the opening trading day of an IPO company is critical. Executives and individual investors should consider the following factors in assessing risk and potential payoffs:

• Who is the underwriter? IPOs underwritten by top-tier investment banks turn in stronger performances after three to five years in the public marketplace.
• How much has the offering price changed? The greater the increase in price from the day the stock was announced until its offering day, the better the stock will do over the long term.
• Has the underwriter used pricing tactics such as the overallotment option? Use of tactics such as the overallotment option, which allows the investment banker to issue up to 15% more shares of the stock, indicates investor demand, which leads to better stock performance over the long haul.
• How much information about the IPO company is leaking out? The more information about a company that comes out before opening day, the more likely the price of the stock on opening day will be what the market will bear — and the more likely the stock will hold its price or increase in the future.
• How much cash and debt does the company have? Because IPO stocks typically have lower debt and higher liquidity, they are considered lower-risk investments, and that helps them outperform the stock of more seasoned companies.

Those factors work in a number of ways. According to a recent working paper, “Busted IPOs and Windows of Misopportunity,” top-tier underwriters qualify their public offerings through a stricter screening and certification process than do their lesser counterparts. (Unfortunately, hot markets are an exception to that rule, because IPO fever taxes the research resources of all levels of banks.)

The paper's authors traced 1,955 issuers that went public between 1988 and 1995. They also tracked investor enthusiasm by watching for price increases during the registration period and the use of pricing tactics such as the overallotment option. Both price increases and increases in the number of shares being offered correlated with future success.

The differences don't always show up right away, though. According to the study, most new offerings outperform comparable seasoned public companies for the first three to six months after the IPO. Poor performance, if it's going to occur, doesn't set in until the company has been public for about a year. “When a company first goes public, it raises a good chunk of capital. . . . It will take the company a while to burn through the capital — and for investors to see the real financials,” explains co-author Craig Lewis.

Biases can affect a stock's success, too. A second working paper, “Biases in the IPO Pricing Process,” investigated the pricing process for every company that went public between 1985 and 1999. The researchers found that IPOs from higher-rated banks enjoyed bigger price bumps during the registration period and continued to fare better over the long term. The study also found that new stocks listed on the NYSE and NASDAQ were less risky than those that debuted on AMEX.

Information that surfaces during the registration period also affects the offer price. Negative information and public data about a company are typically fully incorporated into the offer price, whereas private information is only partially accounted for. In general, the more information that is uncovered during the roadshow and built into the offering price, the more accurate that price will be. The more accurate the opening price, the more likely that the stock will be a good long-term investment.

A third working paper, “Leverage, Liquidity and Long-Run IPO Returns,” which examined 5,173 NASDAQ IPOs from 1973 through 1996, identifies two major factors that people typically overlook when they assess the risk and performance of IPOs. The paper argues that the lower leverage and the higher liquidity of IPO stocks make them technically less risky than non-IPO stocks of similar market capitalization. Burdened less by debt and its inherent risk, IPO stocks can be successful with lower returns and thus outperform more-seasoned stocks.

What should executives seeking a successful IPO and favorable long-term stock values conclude from the research? One answer is that they should hook up with a major investment banking firm (preferably one that will utilize the over-allotment option) and should widely publicize information about their company during the announcement and registration period.

And what is the message for investors, both corporate or individual? Namely, that before making an investment decision, people should weigh the reputation of the investment banking firm offering the stock, monitor changes in pricing between the stock's sale announcement and the first trading day, and select companies that have shared information widely. They also should keep in mind that IPOs' low debt structure often involves less risk. Overall, what is the message for assessing IPOs? It's simple: Knowledge is power.

“Busted IPOs and Windows of Misopportunity” is an April 2000 working paper by Vanderbilt University associate professor of finance Craig M. Lewis, University of Wisconsin-Madison associate professor James K. Seward and Lynn Foster-Johnson, a research statistical specialist at the Tuck School of Business, Dartmouth College. The February 2001 “Biases in the IPO Pricing Process” features the research of G. William Schwert, a professor of finance and statistics at the University of Rochester's William E. Simon Graduate School of Business Administration, and Michelle Lowry, assistant professor of finance at Pennsylvania State University's Smeal College of Business Administration. B. Espen Eckbo, a professor at the Tuck School of Business at Dartmouth, coauthored the February 2000 “Leverage, Liquidity and Long-Run IPO Returns” with University of Toronto Joseph L. Rotman School of Management assistant professor Oyvind Norli.