Do IPOs Under-Perform the Market because it’s a Rigged Game? Or is the Under-Performance the Triumph of Hope over Analysis?

• In Event: Financial Accounting and Reporting 2

Abstract

Do IPOs underperform the market because they are a rigged game? Or is underperformance the triumph of hope over analysis?

Who benefits from IPOs? Is it just insiders and investment banks that harvest profits and get out? Or, do company’s going public benefit the public by creating long-term value? Insiders, those who started and built the company and early investors often sell out at many times their invested capital. Investment bank fees can range from millions to hundreds of millions. Institutional investors purchase at the IPO price and harvest additional millions by flipping stock after the first day “pop.”

Work by Carter (1998), Ritter (1991) and Loughran (1995) documents the long term underperformance of companies’ post-IPO. These studies suggest that the game is somehow rigged because of the consistency of the underperformance. So, hypothesis one is that the IPO game is rigged. If IPOs are a fair game, one might expect returns to be normally distributed around market returns.

There is, however, an alternative hypothesis; and that is market underperformance represents the triumph of hope over analysis. As long as the public is willing to purchase inferior goods at above market prices someone will supply those goods. This leads to the question of whether there are clear indicators as to which companies are likely to outperform and those which are not. For the hypothesis that hope triumphs over analysis to be true, there would have to be a reliable, straight-forward way to separate winners and losers which is being ignored.


This study analyzes the long term performance of 820 companies that went public over the ten year period from 1998 to 2007. About 48.41% beat comparable period market returns defined as the Standard & Poor’s 500.

Underwriter reputation, industry, and selected financial indicators were found predictive of which companies would outperform. Since slightly more than half of IPOs underperformed the market at least some investors may be relying on hope more than analysis.

Authors

• David E. Vance, Rutgers, The State University of New Jersey, Camden

• Briance Mascarenhas, Rutgers, The State University of New Jersey, Camden