Canadian real estate investment trusts: A review of the IPO literature and preliminary analysis of Canadian REIT IPO pricing

Canadian Journal of Administrative Sciences, Dec 2002 by Jane Londerville

There is also evidence that the returns on IPOs are cyclical; that is, there are "hot markets" for IPOs. Ritter (1984) concluded that the mean return for IPO stocks bought at the offering price and sold at the closing bid on the first day of trading, during the 15-month period starting January 1980, was 48%. This compared with a mean return for the same trading strategy of 16.3% for the remainder of his six-year trading period. Following Rock's model of investor uncertainty, he initially investigated whether these hot issues related to increased uncertainty about expected returns for the firms during this time period. He concluded that the significant underpricing could be traced to one industry, natural resources, and the uncertainty about results for this industry during the hot issue time frame. During the remainder of the six-year period, the returns for natural resources offerings were not significantly different from other industries. He concluded that there is supporting evidence for Rock's theory of uncertainty leading to greater underpricing. He argued that providing greater information to investors should lead to a lesser need to underprice the IPO.

Several other explanations for rational underpricing of IPOs have received less attention than Rock's model. One is outlined in Houge, Loughran, Suchanek, and Yan (2001). They based their model on a theory proposed by Miller (1977), that in markets with short selling restrictions, such as IPOs, prices are determined by "optimistic" investors. Those pessimistic about the prospects for the firm do not enter the market until they are allowed to short sell the shares, a rational activity given their view of the future. Tinic (1988) developed and tested a theory that underpricing is a form of insurance against law suits and damage to the reputation of the investment banker in situations where the firm does not perform well after the IPO.

Implicit in Rock's model is the assumption that investors who have done their homework know more about the prospects for the firm than either the firm itself or the underwriter. Allen and Faulhaber (1989) presented a slightly different model of uncertainty about the firm. They assumed that the firm itself has the greatest knowledge about its own prospects, but has no credible way to pass this information on to investors. It is rational for the firm to underprice its IPO as a signal to investors. Investors who experience good returns on the firm's IPO will be more likely to purchase shares in a secondary offering. Firms with good prospects are thus willing to underprice their IPOs because they can make up the loss on future share offerings. Firms with poor prospects are reluctant to underprice because they are not likely to have the opportunity to make this up on a second offering of equity. Allen and Faulhaber did not test their model but argued that Ritter's "hot issue" market findings were consistent with their model.

A similar hypothesis was put forward by Ibbotson (1975). He argued that it may be rational for a firm to underprice its IPO if it expects to be going back to the market shortly for a seasoned equity offering, in order to "leave a good taste in the investor's mouth." Welch (1989) developed a formal model to support this. Firms that expect to perform well are willing to underprice their IPOs in order to ensure that future stock offerings are well received. Firms that do not expect to do as well run the risk that this will be found out by investors prior to their secondary offerings and these firms will be unable to recoup what was left on the table by the initial underpricing. It then may become rational for the firms with poor prospects to correctly price their IPOs.