The pricing of equity IPOs that follow public debt offerings

Financial Management (Financial Management Association), Winter, 2004 by Nianyun Cai, Latha Ramchand, Arthur Warga

We examine the underpricing of initial public offerings (IPOs) of equity by firms that make prior public debt offerings. We find that subsequent IPOs are associated with significantly lower underpricing. Further, the price dispersion of the preliminary filing price range is smaller, as is the price revision subsequent to information gathering during the road show. The lower underpricing is confined to subsequent IPOs that are rated. Since rated IPOs tend to be financially stronger than non-rated IPOs, our results suggest that a longer history of information helps reduce the indirect cost of issue for good quality firms.

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Much research has been published on the behavior of initial public offerings (IPOs) by US firms. (1) A robust finding in these papers is the large one-day return observed on the offer date (price change measured from the offering price to the market price at the end of the first trading day) of the IPO. This phenomenon, known as "underpricing," has been a focal point of the IPO literature. One explanation for underpricing is the presence of asymmetric information.

For most firms, the initial public offer of equity is the first opportunity to become known to the investor community. There are exceptions however. For instance, as pointed out by Helwege and Packer (2001), firms such as Cargill and Mars are privately held although publicly known. (2) Along the same lines there are firms that are publicly known in that they have a public offer of debt prior to their equity IPO. Although most firms do an equity IPO prior to a public debt offer, there are firms that reverse the sequence, doing a public debt offer prior to their initial public offer of equity. By virtue of the public debt offer, this latter group is better known to capital markets at the time of their subsequent equity IPO. The information required at the time of the public debt offer, as well as the ongoing capital market scrutiny, also makes information on such firms more easily available to investors. To the extent that these firms are less unknown relative to the typical firm doing an equity IPO, information asymmetry, and hence underpricing, should be lower, ceteris paribus.

In this article, we examine the underpricing of equity IPOs by firms that have made a prior public debt offer. Using a sample of 91 equity IPOs during the period 1986-2000, each of which has a prior public debt offer (we refer to this group as "Subsequent IPOs," or SIPOs), we compare the underpricing of this group to that of equity IPOs by firms that do not have public debt outstanding at the time of the equity IPO. We also construct matched samples of IPOs in which we match each IPO in our Subsequent IPO sample to all equity IPO off similar size, offered around the same time, and from the same industry, but made by a firm that did not have a prior public debt offer.

In all cases we find that subsequent IPOs are associated with significantly lower underpricing. Lower underpricing for subsequent IPOs could be driven by the fact that they are larger, stronger and less risky firms to begin with. However, univariate and multivariate (regression) comparisons that control for size, industry, and risk do not change the result that there are significant differences in undepricing across the two groups.

The theoretical models used in the IPO literature explain underpricing as the result of information asymmetry. To determine if underpricing is driven by lower information asymmetry, we examine the extent of the price dispersion at the time the investment bank sets the initial price range. Ceteris paribus, if information is more easily available for these firms due to their prior public debt offer, there ought to be less uncertainty about the offer price. The lower uncertainty regarding the offer price would imply that the initial price range (a high and a low price within which the offer price should lie) set by the investment bank should be smaller. We examine the initial price range and find that it is significantly smaller for SIPOs. Additionally, if information asymmetry is lower to begin with, then offer price revisions (which we define as the deviation of the offer price from the initial price range set by the investment bank) are likely to be lower for subsequent IPOs. We find that offer price revisions are lower for SIPOs.

We examine the causes of lower information asymmetry and find that SIPOs are older firms that have a longer history of financial information. In general, firms must file annual financial reports with the SEC starting the year of their initial public offer of securities. However, at the time of their equity IPO, most firms make available the previous year's financial information. SIPOs are required to file financial information with the SEC starting the year of their initial public debt offer. On average there is little over a year's lag between the initial debt and subsequent equity offer. Hence, SIPOs have a two year filing history available at the time of their initial equity offer while the comparison group provides information going back one year on average.