!! Determinants of IPO underpricing in New York and Hong Kong

Determinants of IPO underpricing in New York and Hong Kong

Is the underpricing an additional incentive for Chinese companies to go public on the New York Stock

exchange rather than the Hong Kong Stock Exchange, based on the underpricing in the period from

2005-‐2015?

Alex Moonen (10191836) Supervisor: Yumei Wang

June 2016

In this thesis, the IPO underpricing of the New York Stock Exchange and the Hong Kong Stock

exchange are examined in the period from 2005-2015. Institutional differences and restrictions of both

exchanges have been disclosed. A sample of 965 New York Stock Exchange and 1529 Hong Kong

Stock Exchange IPOs is used for this study. The underpricing in the period from 2005-2015 is 6,70%

point higher on the New York Stock Exchange and is tested by the Propensity Score Matching

method. The factors influencing the level of underpricing are still consistent with previous literature.

The book runner (indicating that the IPO is underwritten by a prestigious underwriter) has a positive

effect on underpricing. Also, the high-tech industry effect is positive and significant.

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Statement of Originality

This document is written by Alex Moonen who declares to take full responsibility for the contents of

this document. I declare that the text and the work presented in this document is original and that

no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the

work, not for the contents.

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Contents 1. Introduction ........................................................................................................................................ 3

2. Background information ..................................................................................................................... 5

2.1 Hong Kong stock market ............................................................................................................... 5

2.2 New York stock market ................................................................................................................. 5

2.3 Institutional differences ................................................................................................................ 6

2.3.1 Listing requirements .............................................................................................................. 6

2.3.2 Corporate governance requirements .................................................................................... 7

2.4 IPO process ................................................................................................................................... 9

3. Literature review .............................................................................................................................. 10

3.1 The definition of an IPO .............................................................................................................. 10

3.2 IPO underpricing determinants .................................................................................................. 11

3.3 IPO underpricing theories ........................................................................................................... 12

3.3.1 Underwriter theory .............................................................................................................. 12

3.3.2 Asymmetric information ...................................................................................................... 13

3.3.3 Symmetric information ........................................................................................................ 14

4. Data & methodology ........................................................................................................................ 15

4.1 Data ............................................................................................................................................ 15

4.2 Regression .................................................................................................................................. 15

4.2.1 Hypothesis ............................................................................................................................... 17

5. Results .............................................................................................................................................. 18

6. Conclusions ....................................................................................................................................... 24

7. Limitations ........................................................................................................................................ 25

8. Recommendations for future research ............................................................................................ 25

References ............................................................................................................................................ 26

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1. Introduction On the 19th of September 2014, the world’s largest-‐ever stock market flotation of Alibaba Group

took place on the New York Stock Exchange (NYSE) with an amount of $25 billion. The worldwide

enthusiasm had not only to do with the IPO value, but also because of the choice for listing on the

NYSE. This is because this company has its roots in China and the Hong Kong Stock Exchange (HKSE)

was the preferred listing venue. Regulations of the HKSE and operating characteristics of Alibaba

have ensured that Alibaba was forced to list on the NYSE (Huang, 2015). This specific example shows

how differences in regulation and legislation can ensure that certain companies are forced to choose

another stock exchange abroad.

Hong Kong is important for the Chinese economy and attracts a number of financial activities from

mainland China. It has established itself as a leading financial center. In 1993 the first mainland

Chinese company listed on the HKSE. At the end of 2013, out of the 1642 public listed companies,

797 companies were from mainland China (Yeung & Huang, 2015).

The number of Chinese companies listed on US stock exchanges has grown tremendously. The

number increased from 34 in 2001 to 294 Chinese companies listed in the US in 2011. This is due to

several factors. First, the growth of the Chinese economy resulting in the desire of public listing from

companies and secondly, the long and difficult regulatory process for listing on Chinese stock

exchanges (Ang, Jiang, & Wu, 2016).

According to Dreher & Hopp (2013) there exists a large fluctuation in the amount of underpricing.

The underpricing for 24 countries in the time period of 1988-‐2005 is to be seen. It appears that the

underpricing in this period for the US market varies between 21.73 and 72.98% and in Hong Kong

between 13.12 and 37.80%. Banerjee, Dai & Shrestha (2011), report an average underpricing of

5,26% in Hong Kong and 5 % in de US market between 2000-‐2006.

Due to large and diverse differences new research is required in the period after 2005. In this period

the financial recession had a major impact on the financial markets. The economic developments in

China in combination with the annual GDP growth of 10% have ensured China to become the second

largest economy and an influential player in the global economy.

Based on this, the main research question of this thesis is as followed:

Is the underpricing an additional incentive for Chinese companies to go public on the New York Stock

exchange rather than the Hong Kong Stock Exchange, based on the underpricing in the period from

2005-‐2015?

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This thesis describes the phenomenon of IPO underpricing and its theories. The institutional

differences and restrictions between the Hong Kong Stock Exchange and the New York Stock

Exchange will be discussed. The underpricing in the period from 2005-‐2015 will be examined.

The thesis is organized as follows. Chapter 2 provides background information about the features of

the NYSE and HKSE, chapter 3 contains literary reviews of classical IPO underpricing theories. The

methodology and regression are included in chapter 4. Chapter 5, 6, 7 and 8 contain the results,

conclusions, limitations and recommendations respectively.

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2. Background information This part provides background information of the stock markets of Hong Kong and New York. Section

3 discusses the institutional differences between the two exchanges and part 4 describes the IPO

process.

2.1 Hong Kong stock market In 1860 Hong Kong started trading in company shares, the Association of Stockbrokers in Hong Kong

was formed in 1891. Hong Kong has a service-‐oriented economy and 90% of Hong Kong’s GDP

depends on it (Yeung & Huang, 2015). When the British Empire colonized Hong Kong in 1842 it was a

small fishing village, but soon became one of the most affluent areas in the region with a gross

domestic product (GDP) per capita of $52.700 in 2013, the fifteenth highest in the world. The Hong

Kong Stock Exchange is the 3th largest stock market in Asia and the 6th largest in the world by market

capitalization.

Since the arrangement of 1983, the Hong Kong dollar is closely linked to the US dollar. The Hong

Kong stock market has developed itself as the most important stock market for mainland Chinese

firms who want to list abroad. 51% of the Hong Kong Stock Exchange consists of mainland Chinese

companies. These companies are responsible for 62.1% of the exchange's market capitalization

(Yeung & Huang, 2015).

The uncommon relationship between Hong Kong and China, also referred to as the ‘one country,

two systems’ formula, implies China’s socialist economic system would not be imposed on Hong

Kong. For this reason Hong Kong can maintain a high degree of autonomy and can protect its status

as a premier financial center (Yeung & Huang, 2015).

Due to the inflow of Chinese companies on the Hong Kong Stock Exchange, the number of Initial

Public Offerings (IPOs) increased significantly since the 1990s. Nowadays, the term ‘Nylonkong’ is

used to illustrate the created financial network between Hong Kong, London and New York by a

shared economic culture. The Hong Kong stock market was leading in attracting IPOs in the world in

the period from 2009-‐2011. In 2013, Hong Kong ranked second in terms of attracting IPO funds

worldwide after a performance drop after 2011 (Yeung & Huang, 2015).

2.2 New York stock market The New York Stock Exchange also known as ‘the Big Board’ is the largest stock exchange in the

world by market capitalization. Nearly 2800 companies are listed, of which 1500 are US companies.

The stock market found its origin from the Buttonwood Agreement in 1792. In 2007 the exchange

merged with the Euronext, to the current NYSE Euronext how the exchange is formally called.

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The US economy is marked as the most technologically powerful economy in the world, with a gross

domestic product (GDP) per capita of $54,800 in 2015. Individual freedom and free enterprises

characterizes the US market. The US market is featured with the lowest rates of unemployment and

inflation, making it one of the most efficient marketplaces in the world. A primary and secondary

market characterizes the stock market in the US. Companies’ initial public offerings are transacted in

the primary market. Investors trade shares of companies that are publicly held in the secondary

market. Compared to the secondary market, the primary market is less active.

2.3 Institutional differences The number of mainland Chinese companies listing on US stock exchanges has grown tremendously.

One of the reasons of this growth is the long and difficult regulatory processes for listing. This part

reveals the most important differences in listing and corporate governance requirements between

the New York Stock Exchange and the Hong Kong Stock Exchange.

2.3.1 Listing requirements The NYSE has two types of listing standards; the alternative, which is meant for non-‐US companies

and domestic standards for US companies. For the HKSE, there is only one listing standard (Huang,

2015). The two stock exchanges are characterized by different financial requirements.

-‐Financial requirements

The Hong Kong stock exchange requires a minimum trading record of three years, alongside the

company must undergo a profit test. This test implies the requirement that a company makes a

profit of $6.50 million in the preceding three years, including at least $2.60 million in the last year

(HKEX, 2016). If the company cannot meet the requirement, there are two alternatives to be

considered. The ‘market capitalization/revenue’ test, which requires a turnover of $64.50 million

and a market capitalization over $516 million. The second test that can be used is the ‘market-‐

capitalization/revenue/cash flow’ test, which requires a turnover of $64.50 million in the most

recent year, market capitalization over $257.80 million and a positive cash flow of $12.90 million

over the last three financial years (exchange rates June 2016) (HKEX, 2016).

Compared, the New York Stock Exchange knows more lenient requirements. This means if an

applicant meets the earnings test (EBIT of $100 million in the last 3 years and in the last 2 years a

minimum of $25 million) there is no required market capitalization. However, when the valuation is

based on ‘valuation/sales cash flow’ test or the ‘pure valuation/revenue’ test, the company must

have a minimum market capitalization of $500 million respectively $750 million (NYSE, 2016).

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-‐Shareholders and Free Float

A minimum of 300 shareholders is required on the HKSE, for the free-‐float (this percentage indicates

the minimum percentage of shares sold to the public) a percentage of 25% is required. When market

capitalization exceeds $1,3 billion this percentage declines to 15-‐25% (HKEX, 2016).

Unlike the Hong Kong Stock Exchange, the New York Stock Exchange has no requirement regarding a

minimum percentage of free-‐float. But for non-‐US issuers, it requires a minimum of 5000

shareholders worldwide with a minimum of 2.5 million shares with a value that exceeds $100 million

(NYSE, 2016).

-‐Working capital

Working capital is defined as the available money supply for day-‐to-‐day operations. This unit is used

to indicate whether the short-‐term obligations can be met. This requirement is made for the

protection of shareholders. To join the New York stock exchange there are no requirements for

working capital. However, the publication of these figures is required (NYSE, 2016). On the Hong

Kong stock exchange it is required to disclose in the prospectus that current obligations can be met.

In the case of Hong Kong this means 12 months after issuance of the prospectus (HKEX, 2016).

2.3.2 Corporate governance requirements Besides requirements within financials, corporate governance requirements differ between the two

exchanges.

-‐Board of directors’ requirements

The Board of Directors carries out the management of a company. They connect managers and

investors and determine the success of a company. The NYSE and the HKSE both have requirements

for board membership when listing at the stock exchange. Both exchanges require a board that

consists of external and internal members of the company. The NYSE requires that the board must

be composed of independent members within one year after entry. These members may not be

interested in the company in any way (section 3030A.02 of the NSE Listing Rules). According to the

listing rules of Hong Kong, the board must contain at least three independent members, of which at

least one member must meet the proper qualifications. It should have expertise in the area of

financial management and / or the field of accounting (section 3:20 of the HKSE Main Board Listing

Rules).

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-‐Audit committee requirements

The Audit Committee serves to protect shareholders against internal controls and financial reporting

independently. The committee assists the board of directors to fulfill these tasks (Huang, 2015). On

both the NYSE and the HKSE companies must have an audit committee. The requirements and

composition generally corresponding. For both exchanges, the audit committee must contain at

least 3 directors from which 1 must satisfy professional, accounting or related financial expertise and

the majority must be independent (Section3.21 of the HKSE Mainboard Listing Rules)(Section

303A.07 of the NYSE Listing Rules).

However, the NYSE the rules are more stringent in the situation of an IPO.

From the date of listing, at least one independent director must within the committee, after 90 days

the majority and by a year after the IPO all directors must be independent. Also on the NYSE an

‘audit committee financial expert’ is required to perform certain accounting actions to protect

shareholder interest (SOX Section 407).

In addition to these requirements and differences (in which the NYSE had clearly stricter rules), the

committee has received additional duties from the Sarbanes-‐Oxley act.

-‐ Sarbanes-‐ Oxley act of 2002 (SOX)

President Bush signed the Public Company Accounting Reform and Investor Protection Act (SOX) of

2002 in response to governance failures (Hostak, Lys, Yang, & Carr, 2013). SOX established more

stringent standards for auditing, internal control, disclosures, management conduct and

accountability to increase the accuracy and reliability of corporate disclosures to restore and

improve investors’ confidence in US capital markets (Hostak, Lys, Yang, & Carr, 2013). The Sarbanes-‐

Oxley act created additional requirements for listed firms in the United States. It imposes severe

costs and created significant legal exposure for companies as well as for executives, which makes US

listing less attractive to foreign companies (Doidge, Karolyi, & Stulz, 2007). The stricter regulations of

corporate governance requirements and the increased costs related to SOX resulted in

deregistration of firms from the NYSE.

Additional requirements for listing in the US are imposed by the Sarbanes-‐Oxley act. New York does

not have any requirements for companies to post profits before going public while in Hong Kong

firms need to post profits in three consecutive years before the IPO. Another potential advantage of

New York is that it provides a better visibility to gain international recognition for companies that

desire to acquire global market share.

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Whether to list in Hong Kong or New York is influenced by several characteristics of both cities,

exchanges and legislation. Some of these characteristics are in favor of Hong Kong whereas others

are in favor of New York. In the end, the decision of where to list will be determined by the norms

and values that the private firms value most.

2.4 IPO process Going public is one way for a company to acquire capital, to add liquidity to the investment for the

company or to improve brand awareness (Rock, 1986). After having chosen to go public, some steps

are involved.

At first, companies need to acquire an investment bank for the IPO process, this party is called the

underwriter and is obligated to several tasks. These tasks include the following; advising the issuing

company, looking for investors to buy the shares, and if unsuccessful, the underwriter should

purchase the shares himself. In many cases the IPO is managed by several banks, one bank is the

leading bank and indicated as the ‘lead underwriter’. The other investment banks are referred to as

‘sub-‐underwriters’ (Baron, 1982).

Once the underwriters are chosen, the manner in which shares are sold, prices are set and the

distribution of the stock is determined. Here are two possibilities that may arise when distributing

the stock: first the method of firm commitment. This is when the investment bank buys the shares at

an agreed price of the company and then sells them to the market. The discount at which the

underwriter buys the shares is usually around 7% (Chen & Ritter, 2000). This method has a high risk

for the investment bank. The other type of underwriting: ‘best effort offering’ means that the

underwriter will not buy the securities. The issuing firm and underwriter will agree on the offering

price, the minimum and maximum amount of shares to be sold. The underwriter basically performs

as an agent in this type of underwriting.

The next step involves the marketing of the offering (Road show process). The issuing firm has to

prepare an official registration statement and has to be filed to the Exchange Commission. Once the

exchange commission accepts the prospectus, a file including the IPO details, the marketing and

offering begins. Private and institutional investors receive the prospectus to create interest in the

stock and the underwriter then registers the placed orders. These are not legally binding before the

effective day (Ellis, Michaely, & O'Hara, 1999). The day before the IPO the underwriters and the

issuing firm will discuss the price and amount of securities that will be sold. These shares are often

underpriced. The phenomenon of underpricing is referred to as ‘leaving money on the table’ (Ritter,

1987).

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3. Literature review This chapter provides the IPO definition, a literary review and the determinants of IPO underpricing.

The most important theories of IPO underpricing are discussed.

3.1 The definition of an IPO Going public is an important turning point in the life of a young company. An IPO gives companies

easily access to capital by selling stock to investors, which gave them a way of investment

diversification. It provides a lot of benefits for the issuing company, such as providing access to

public capital for the firm what may lead to a lowering in the cost of funding (Ljungqvist, 2005). For

many decades IPOs have intrigued many economists. Important writers such as Logue and Ibbotson

documented the phenomenon of underpricing since the 1970s and showed that the share price

jumps substantially on the first day of trading (Ljungqvist, 2005). Since the 1960s a lot of research on

this subject has been done and from the 1980s it had been attempted to rationalize why IPOs are

underpriced. The best known theories about IPO underpricing are the underwriter, asymmetric

information and symmetric information theories. When a company goes public, investors purchase

stock from a firm and have to pay the offer price. From this point on investors can sell these to the

stock market, this is called the ‘aftermarket stage’ and prices are determined by supply and demand.

This price is not known beforehand because underwriters cannot predict the aftermarket price.

When, at the end of the first trading day, the stock price is above the offer price, the stock is

underpriced. There are two reasons that may play a possible role in this; underwriters misjudge the

share price or it is done consciously.

The main reason for a young and growing company to go public is the access to additional equity

capital to finance (future) projects (Ritter & Welch, 2002). Another reason of going public for private

companies is the awareness among investors. This can be created through listing on a large stock

exchange, this creates listing publicity around the firm. Ljungqvist (2005) and Pagano et al. (1998)

stated in their articles that IPOs are also followed by lower cost of credit and companies are able to

borrow more cheaply. Their study revealed that around the IPO date the interest rate on their short-‐

term credit falls and the number of banks willing to lend them rises.

Going public associates a large amount of costs. Ritter (1987) stated that direct costs and

underpricing together costs between the 21,25% and 31,87% of the realized market value of the

securities issued, depending on which offer is made. The most important costs of going public are

the indirect costs of underpricing. This amount a company does not receive with the offering.

Additional costs are present once a company is listed; for instance they include accountants to be

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hired to report mandatory financial statements, rewards for directors and costs to maintain

customer contacts (Ritter, 1987).

3.2 IPO underpricing determinants Past research showed that IPO underpricing occurs anywhere in the world and some important

factors must be taken into account in explaining IPO underpricing.

Ritter (2002) conducted a test to investigate the IPO underpricing in Hong Kong and found an initial

return of 15.9%. For the US market the initial return on IPOs was 15.8%. Wang (2012) reported in his

paper the IPO underpricing in Hong Kong of 102 GEM (growth enterprise market) in the period from

1999-‐2011 and explained that IPO size and the offer price are important determinants of IPO

underpricing.

The size of the IPO, measured as total IPO value (quantity of shares times the offer price) is an

important factor in explaining IPO underpricing. Wang (2012) found a negative relationship between

the size and IPO underpricing. A large IPO size indicates less speculation due to a smaller amount of

uncertainty. The higher the IPO value the more investors believe the firm is developed and will bring

more certainty. Therefore, a negative relationship with IPO underpricing is expected (Beatty & Ritter,

1986). McGuinness (1992) conducted an IPO underpricing test in Hong Kong in the period between

1980-‐1990, resulting in an underpricing level of 18% by calculating the initial excess market return.

Underpricing in the United States reported by Ljungqvist (2005) show the following results, since the

1960s underpricing of IPOs averaged around 19%. In the 1970s underpricing tends to be 12%, 16% in

the 80s and 21% in the 90s. Dreher & Hopp (2013) tested the underpricing in the period from 1988-‐

2005. For the US market the underpricing varies between 21.73 and 72.98% and in Hong Kong

market between 13.12 and 37.80%. Banerjee, Dai & Shrestha (2011), reported an average

underpricing of 5,26% in Hong Kong and 5 % in de US market between 2000-‐2006.

The time between the announcement and the issue date of the IPO, defined as lag, will influence the

underpricing (Tian, 2003). A larger time gap (lag) would lead to higher risks and therefore a greater

initial return. In China, after a company makes a public offering, the firm must wait until their shares

float. During this period investments are locked up and this illiquidity of equity shall be compensated

with discounts of share prices (Tian, 2003). The findings of Tian revealed an increase of initial returns

on IPOs increases by 0.4% per extra day of delay. We expect a positive relationship between lag and

underpricing.

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The reputation of the underwriter has an effect on the level of underpricing. In prior research Beatty

& Ritter (1986) and Carter et al. (1998) empirically showed that underwriters with a better

reputation decrease underpricing. Dewenter & Field (2001) investigated IPOs in relation to

underwriter reputation in Hong Kong. The investigation revealed that investment banks avoid issues

that could provide high speculation around the issue in order to maintain their reputation. This

tends towards a positive relationship with underpricing. The six biggest underwriters in China are

Huaxia Securities, Haitong Securities, Shenyin-‐Wanguo Securities, Junan Securities, Nanfang

Securities and Guotai Securities (Chen, Firth, & Kim, 2004). From the Statista database the largest

underwriters in the US market are Morgan Stanley, Goldman Sachs, Merrill Lynch, J.P. Morgan,

Credit Suisse and Citigroup. The direction of the relationship with underpricing is not clear ex-‐ante.

Technology companies have more ex ante uncertainty and higher risk, this is because these

companies are valued mainly from growth opportunities. For these reasons an IPO of a firm in the

high-‐tech industry are characterized by a higher level of underpricing. These firms are categorized by

the following SIC codes for high-‐tech firms: 2833, 2834, 2835, 2836, 3571, 3572, 3575, 3577, 3578,

3661, 3663, 3669, 3674, 3812, 3823, 3825, 3826, 3829, 3841, 3845, 4812, 4813, 4899, 7370, 7371,

7372, 7373, 7374, 7375, 7377, 7378 and 7379 (Loughran & Ritter, 2002).

In periods of recession there is a significant drop in economic activity and a decline is consumer

wealth. This caused a drop of IPO issued worldwide (Ritter, 1984). Chen et al. (2015) stated in their

research that Chinese IPO’s experience higher initial returns during periods of recession. ‘The great

recession’ indicates the time period between 2007-‐2009. This period indicates the recession period

in the United States, but for the Hong Kong market the recession had its impact since Q4 2008 and

recovered in Q4 2009, this period indicates the recession period for Hong Kong (Fung, 2014).

Uncertainty is higher during recessions and this causes a higher initial return of stock prices. A

positive relationship between recession and underpricingis expected.

3.3 IPO underpricing theories In the past, much has been written about underpricing and is a well-‐known phenomenon in the

financial literature. The main theories to explain IPO underpricing are asymmetric information,

symmetric information and the underwriter theory. This section will provide an overview of the

existing literature in connection with the US and Hong Kong stock markets.

3.3.1 Underwriter theory Ibbotson (1975) and Ritter (1984) provide evidence in their papers that IPOs on average are

underpriced. When a firm goes public, certain costs are involved. Besides the direct costs there are

also indirect costs. The main component of indirect costs include underpricing costs, also described

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by Ritter (1986) as ‘money left on the table’. Investors are willing to pay more than the offer price,

which is lower than the market value. The issuing firm cannot make a credible commitment about

the price, for this reason they must hire an investment bank (Beatty & Ritter, 1986). The reputation

of the underwriter has a major impact on the level of underpricing. Underwriters have an incentive

to underprice shares if the following three conditions are met. The first condition is that the

investment bank will lose customers if they deviate from the expected price. Another condition is

that the underwriter cannot predict the aftermarket share price and the last condition is that the

good reputation of the underwriter is at stake (Beatty & Ritter, 1986).

Underpricing levels tend to be lower when a well-‐known established broker underwrites the IPO.

There is less effect of reputation on underpricing in less mature stock markets. Therefore

underwriter performance is expected to have a greater influence on IPO underpricing in the US stock

market, because the stock market in Hong Kong is less mature.

3.3.2 Asymmetric information Companies work together with underwriters to determine the price that has to be paid for the

shares when issued. On the basis of the information supplied by the company, analysts calculate the

price at which the shares are offered.

Baron (1982) was one of the first who describes a model for the underpricing of shares as a result of

asymmetric information and explained the underpricing phenomenon by looking at how well the

market is informed. The underwriter has several roles in the IPO process, distribution of the shares

and advising the firms are just as important as the underwriting itself. If the issuer is poorly

informed, the demand for advice from the underwriter will be great and reflects a high discount on

the shares. In contrast, when the underwriter and issuer are equally informed, the only task for the

underwriter will be the distribution (Baron, 1982). The discount on the shares is important to the

underwriter. The relationship between the underwriter and the issuer and between the underwriter

and investor plays an important role. The underwriter and the issuer have a short-‐term relationship,

which only includes the sales process. A higher discount on the shares allows the underwriter to sell

them to investors more easily and this results in a better long-‐term relationship between the two

parties. The degree of underpricing is higher when the underwriter possesses superior information,

for this reason the underwriter requires a discount (Baron, 1982).

In contrast to Baron, Rock (1986) presented a model for underpricing of initial public offerings. His

model is based on the existence of a group of investors whose information is superior to that of the

company and other groups of investors. He named this the winner’s curse model. If the shares are

priced at the expected value, an offer of good issues will cause crowding out of the uninformed

14

investors from the market. The group that owns superior information, however, will leave the

market when the shares are offered at a price that deviates from the expected value price. This will

lead to a discount on the share price in order to guarantee a purchase from the uninformed

investors. The winner’s curse is the main reason for underpricing in China found by Ting and Tse

(2006), where the underpricing in China is tested in the period 1995-‐1998.

3.3.3 Symmetric information Other theories of underpricing that do rely on symmetric are declared by Tinic (1988). He argued

that the reason why issuers underprice their IPOs is because it would reduce their legal liability.

Inadequate information in the prospectus of an IPO requires commitment of considerable resources

for legal fees because issuing firms are often sued (Keloharju, 1993). Ibbotson (1975) and (Tinic,

1988) also argue the underpricing of shares can be a cause to avoid lawsuits. Tinic (1988), Ibbotson

(1975) and Beatty& Ritter (1986) all faced problems in testing their lawsuit-‐avoidance hypothesis. It

became clear that it is difficult to make a proper test of hypothesis to estimate the extent to which

legal liabilities affect the observed initial returns.

For the US market legal liability is not the primary determinant of underpricing (Keloharju, 1993). In

China lawsuits concerning IPOs have not occurred yet, making the symmetric information theory less

relevant (Hughes & Thakor, 1992).

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4. Data & methodology

4.1 Data In the period from 2005-‐2015 a sample of 965 IPO’s on the New York Stock exchange and a sample

of 1529 IPO’s on the Hong Kong Stock Exchange is used. From the Thomson One database the offer

price, closing price after the first day, deal value (total IPO size) and the book-‐runners are retrieved.

From the Zephyr database the announcement date was retrieved. Unfortunately, because of missing

announcement dates for the New York Stock Exchange, 384 observations were lost. This leaves us

with 581 observations for New York. From the Hong Kong Stock Exchange a lot more observations

were lost due to missing announcement dates, 620 observations remained.

This study uses two different stock markets with different companies. To combine these two existing

datasets and to answer the central research question of this paper, the method of ‘Propensity Score

Matching’ (PSM) is used. Propensity Score Matching is the most commonly used method of matching

data and is applied in many fields of research. Even when the datasets does not belong to the same

respondent, PSM can match without this requirement. This method transforms asymmetric

information into symmetric information. This property enables propensity score matching to be used

when overlap of respondents is little or non-‐existing and matches the observations by their degree

of similarity. Propensity score matching provides a means for adjusting for selection bias

(Rosenbaum & Rubin, 1983).

To use PSM, two groups with similar variables that affect outcome must be compared. The same

variables for both exchanges are used. The data is treated as an experiment with a treatment group

and non-‐treatment group. De NYSE data is used as the treatment group and the data of the HKSE is

used for the non-‐treatment group (Rosenbaum & Rubin, 1983).

4.2 Regression This study uses the market-‐adjusted rate of return to determine the extent of IPO underpricing. The

initial returns from the stocks are defined as follows:

ER!"# = [ P!,!/P!,!!! − H!,!/H!,!!! ]

• ER!"# = Market adjusted rate of return on stock j at period t,

• P!,!=Closing price of stock j, t days from initial trading (t=1 refers to the end of first day

of trading),

• P!,!!!=Closing price of stock j one day before day t of trading (when t=1, t-‐1 refers to the

offering price of the IPO shares),

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• H!,! = Index at the close of trading on day t for stock j,

• H!,!!! = Index at the close of trading for stock j one day before day t.

The equation measures the initial trading returns in excess market returns form. Empirical research

deducted by Beatty and Ritter (1986) and Ibbotson (1975) support this measure as a useful ‘risk-‐

adjusted’ measure for IPO returns.

For P!,! and P!,!!! the offering and closing prices of trading day 1 are used to measure the IPO

underpricing in the excess market return form. For the market returns, the Hang Seng Index is used

for Hong Kong IPOs and the S&P500 Index for IPOs on the NYSE.

The empirical research in this study was conducted by Propensity Score Matching to match two

different stock markets with different companies. Ordinary least squares (OLS) was used to test

hypothesis 2 and 3.

Regression equation:

𝐸𝑅!"# = 𝛽! + 𝛽!𝑀𝑎𝑟𝑘𝑒𝑡 + 𝛽!𝐿𝑎𝑔 + 𝛽! ln 𝑆𝑖𝑧𝑒 + 𝛽!𝐵𝑜𝑜𝑘𝑅𝑢𝑛𝑛𝑒𝑟 + 𝛽!𝐻𝑖𝑔ℎ𝑇𝑒𝑐ℎ+ 𝛽!𝑅𝑒𝑐𝑒𝑠𝑠𝑖𝑜𝑛 + 𝜀

In this study the model including the following variables is used: lag, deal size and three dummy

variables: book-‐runner, high-‐tech and recession. The time between the announcement date and

issue date of the IPO is defined as the lag variable. The IPO value is the total deal size and defined as

total shares times the offer price, this variable is indicated by Ln(Size). If the IPO occurred between

2007 and 2009 (financial recession period) the dummy variable for recession in the United States

takes the value 1 and 0 otherwise. However the recession had its impact since Q4 2008 and

recovered in Q4 2009 in China (Fung, 2014). The dummy variable book-‐runner takes the value 1 if

the book-‐runner is prestigious and 0 otherwise. When the book-‐runners are part of the top six

underwriters in the United States or China the underwriter is indicated as ‘prestigious’. The

distinction is made between high-‐tech and non-‐high-‐tech firms following SIC (Standard Industrial

Classification) codes followed by (Loughran & Ritter, 2002).

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4.2.1 Hypothesis Hypothesis 1:

This hypothesis is related to the research question of this thesis, which is whether the underpricing in New York is lower than the underpricing in Hong Kong. This hypothesis will be tested by the method of ‘Propensity Score Matching’.

H0: β! = 0

H1: β! < 0

Hypothesis 2 and 3 will be tested by running an ordinary least squares (OLS) regression.

Hypothesis 2:

The second hypothesis will test if the IPO of high-‐tech firms will result in a higher level of

underpricing. Loughran & Ritter (2002) argue high-‐tech firms will result in a positive relationship

with underpricing.

H0: β! = 0

H1: β! > 0

Hypothesis 3:

The third hypothesis will test if the IPO underpricing is higher when underwritten by a prestigious

book-‐runner. Beatty & Ritter (1986) and Carter et al. (1986) have shown with empirical research that

book-‐runners with a better reputation decrease underpricing. Dewenter & Field (2010) investigated

IPOs in relation to underwriter reputation in Hong Kong. The investigation revealed that investment

banks avoid issues that could provide high speculation around the issue in order to maintain their

reputation. This tends more towards a positive relationship with underpricing in Hong Kong. The

direction of the relationship is not clear ex-‐ante.

H0: β! = 0

H1: β! ≠ 0

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5. Results The descriptive statistics of the sample are presented in table 1. From the Thomson One database

the offer price, closing price after the first day, deal value (total IPO size) and the book-‐runners are

retrieved. From the Zephyr database the announcement date was retrieved.

Table 1: Descriptive statistics variables Variable Mean Std.Dev Min Max

IPO return 6.24% 18.10% -‐28.96% 192.97% Market return -‐0.03% 0.58% -‐4.58% 27.55% Market 0.484 0.499 0 1 Lag 31.579 52.193 0 355 IPO size 292.677 1021.486 0.32 21767.22 LN(size) 4.573 1.579 -‐1.139 9.988 Book-‐runner 0.506 0.500 0 1 High-‐tech 0.165 0.371 0 1 Recession 0.143 0.350 0 1

From the regression conducted by the method of Propensity Score Matching, the results are

presented in table 2 and 3. With this test the data is treated as an experiment with a treatment

group and non-‐treatment group, de NYSE is used as the treatment group.

Table 2: Regression results PSM Variables

-‐0.051

MarketReturn (.086)

0.001 Lag (.001)

0.533*** LN(size) (.039)

1.796*** Book-‐runner (.101)

0.447** High-‐tech (.136)

0.253* Recession (.149)

-‐3.596*** Constant (.210) Pseudo R2 0.5099 N 1201

* significant at 10% level ** significant at 5% level *** significant at 1% level

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Table 3: Propensity Score Matching Variable Sample Treated Controls Difference S.E. T-‐stat

Excess return Unmatched 12,8286311 0,114493482 12,7141377 0,980561477 12,97 ATE 6,70376862 . .

Within the used sample, prestigious underwriters on the NYSE execute IPOs more often. This can be

deduced from the table because New York is used as the treatment group, and has a coefficient of

1.79. Furthermore, more high-‐tech companies are contained in the sample of New York (indicated

by the high-‐tech coefficient). The total size of IPOs is larger on the NYSE. The variable lag does not

have a significant effect on the probability being in one of the two markets so it looks like there is no

significant difference in lag between the two markets. From the regression results in Table 3, the

conclusion can be made that the underpricing in New York is 6,70 percentage point higher that the

underpricing in Hong Kong. This leads to the result of hypothesis 1:

H0: β! = 0

H1: β! < 0

H0 is rejected, however the alternative hypothesis cannot be accepted since β! is significantly larger than 0. This means there is more underpricing in New York than in the Hong Kong exchange.

To test the second and third hypothesis an OLS regression is done. The total dataset is used.

Hypothesis 2 tests the effect on underpricing of the market sector high-‐tech. The influence of the

book-‐runner on the IPO underpricing is tested with hypothesis 3. The dummy variable market is used

to indicate the exchange, and take the value 1 if the IPO took place in New York and 0 otherwise.

Results are showed in Table 4.

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Table 4: Regression results OLS Variables

10.310***

Market -‐1.240

-‐0.000 Lag (.010)

0.010 LN(size) (.210)

1.520 Bookrunner -‐1.050

11.350*** High-‐tech -‐2.060

-‐1.130 Recession -‐1.430

-‐1.120 Constant (.940) R-‐squared 0.180 N 1201 * significant at 10% level ** significant at 5% level *** significant at 1% level

From the results, the variable high-‐tech is significant and positive. This is consistent with the

expectation stated in hypothesis 2. Therefore hypothesis 2 is consistent with (Loughran & Ritter,

2002). The third hypothesis, the direction of the relationship was not clear ex-‐ante because of

divergent and contradictory literature. As table 4 shows, the variable book-‐runner is positive but not

significant, for this reason a valid assumption cannot be made about the influence of the book-‐

runner. However from the 95% confidence interval [-‐0.62 and 3.53] it tends to be positive.

To see if the book-‐runner has an effect on the excess return, the insignificant variables are deducted

from the model and results are showed in table 5. By leaving the inconsistent variables out, almost

the same results and R-‐squared are obtained. The results show that the variable book-‐runner has no

significant effect on the excess return of IPOs.

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11.260***

Market

(.900)

11.440*** High-‐tech

(2.050)

-‐1.070*** Constant (.230) R-‐squared

0.1762

N

1201 * significant at 10% level ** significant at 5% level *** significant at 1% level

From the analysis above, the variable LAG is not relevant in the regression. Table 4 shows no

significant effect on excess return. Due to this conclusion the variable LAG can be omitted. As

mentioned before, the variable LAG was limiting our number of observations due to missing

announcement dates.

In the next section the variable LAG is excluded and the same regression is done. The number of

observations increases to 2177.

New Regression equation:

𝐸𝑅!"# = 𝛽! + 𝛽!𝑀𝑎𝑟𝑘𝑒𝑡 + 𝛽! ln 𝑆𝑖𝑧𝑒 + 𝛽!𝐵𝑜𝑜𝑘𝑅𝑢𝑛𝑛𝑒𝑟 + 𝛽!𝐻𝑖𝑔ℎ𝑇𝑒𝑐ℎ + 𝛽!𝑟𝑒𝑐𝑒𝑠𝑠𝑖𝑜𝑛 + 𝜀

Table 6: Descriptive statistics variables Variable Mean Std.Dev Min Max

IPO return 3.99% 14.66% -‐28.96% 192.97% Market return -‐0,02% 0.52% -‐4.58% 3.82% Market 0.397 0.489 0 1 IPO size 260259 822.365 0.182 21767.22 LN(size) 4.391 1.674 -‐1.704 9.988 Book-‐runner 0.438 0.496 0 1 High-‐tech 0.130 0.336 0 1 Recession 0.124 0.330 0 1

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Table 7 & 8 show the results obtained from the PSM test.

Table 7: Regression results PSM Variables

0.572***

LN(size) (.031)

1.910*** Book-‐runner (.078)

0.393** High-‐tech (.114)

0.482*** Recession (.118)

-‐3.991*** Constant (.169) Pseudo R2 0.5099 N 1201 * significant at 10% level ** significant at 5% level *** significant at 1% level

Table 8: Propensity Score Matching

Variable Sample Treated Controls Difference S.E. T-‐stat

Excess return Unmatched 9,92524421 0,100216238 9,82502797 0,607610169 16,17 ATE 3,29033514 . .

Again, the US market is used as the treatment group. By leaving out the variable lag, it becomes

clear that the difference in excess return is smaller. The difference in the excess return is now 3.29

percentage points. In the new dataset, again in New York prestigious book runners execute more

IPOs. Also more high-‐tech firms are included in the US dataset and the US dataset contains more

IPOs during recession. The total IPO value of IPOs on the NYSE is higher than on the HKSE.

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8.507***

Market (.875)

-‐0.121 LN(size) (.120)

1.460** Book-‐runner (0.640)

8.730*** High-‐tech -‐1.500

-‐1.520 Recession (0.980)

-‐0.450 Constant (.500) R-‐squared 0.15 N 2177 * significant at 10% level ** significant at 5% level *** significant at 1% level

The variable book-‐runner is positive and significant. This is consistent with literature by Dewenter &

Field (2001). The variable High-‐tech is just as in the first regression positive and significant. This is

consistent with the expectation made in hypothesis 2 and also by the literature written by (Loughran

& Ritter, 2002).

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6. Conclusions This thesis compares the underpricing on the Hong Kong Stock Exchange in relation to the

underpricing on the New York Stock Exchange in the period from 2005-‐2015. The study is done with

a sample of 965 Hong Kong IPOs and 1529 IPOs on the New York Stock Exchange. Several theories

that explain underpricing are; the underwriter theory, asymmetric information theory and the

symmetric information theory and they are discussed in part 3.

The main research question of this paper is: Is the underpricing an additional incentive for Chinese

companies to go public on the New York Stock exchange rather than the Hong Kong Stock Exchange,

based on the underpricing in the period from 2005-‐2015?

In the period from 2005-‐2015, the underpricing found on the New York Stock Exchange was 6,70

percentage point higher than the underpricing in Hong Kong.

This result is consistent with findings by Dreher & Hopp (2013), in their research the underpricing

levels in the US exceeds the underpricing in Hong Kong. But inconsistent with results found by

Banerjee, Dai & Shrestha (2011). Several drivers for the underpricing are found. First, the market

sector high-‐tech showed a positive relationship with underpricing and consistent with hypothesis 2.

When the number of IPOs marked by the high-‐tech industry increases, the IPO underpricing

increases. These companies have more ex ante uncertainty and higher risk, this is because these

firms are valued mainly from growth opportunities. In contrast, determinant LAG is not significant,

contradicting literature by Tian (2003). For this reason this variable is dropped out in the second

regression. By leaving out this limiting variable, the second (positive) relationship with underpricing

was found. This Second relationship with underpricing, consistent with hypothesis 3, was the factor

book-‐runner. This relationship is consistent with the findings by Dewenter & Field (2001).

Summarizing, the IPO underpricing is not an additional incentive for Chinese companies to list on the

New York Stock Exchange rather than the Hong Kong Stock Exchange. However from the literature

we can identify possible explanations for Chinese companies to list on the NYSE instead of the HKSE.

First, the additional requirements for listing in the US by the Sarbanes-‐Oxley act. Besides financial

requirement are stricter on the HKSE than on the NYSE. Another potential advantage for Chinese

companies to list in New York is the international recognition and better global visibility by listing

abroad.

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7. Limitations Unfortunately for the first regressions, a lot of announcement dates were missing. Due to these

missing dates a lot of observations were lost because this information was needed to conduct the

variable lag. In the second regression, a lot more observations were used. By this changing number

of observations, a smaller difference in underpricing between the two exchanges was found. Due to

missing observations, an unrepresentative image of the IPO excess returns can be the result.

The effect of the recession period can give a unrepresentative image of IPO underpricing, first the

time of influence of the recession period is not equal on both stock markets. Second there is a

significant drop in economic activity during periods of recession and IPO activity decreases.

8. Recommendations for future research Despite the large amount of underpricing literature regarding IPO underpricing, there is still room for

future research. Because of changing regulations on the both stock markets, for instance the

implications of the Sarbanes-‐Oxley act in the United States. Deregistration of firms from the NYSE

were seen as a result from the Sarbanes-‐Oxley act. New research can be done on the implications of

this act of listing of Chinese companies on the US stock market.

These issues, related to corporate governance and IPO underpricing are relatively new in the Chinese

stock market. And due the growing economy and its role in the global interconnected economy this

subject become more and more interesting.

Furthermore, an interesting issue may be the ‘one country, two systems’ formula between China

and Hong Kong. What are the future implications of this relationship and China’s socialist economic

system in relationship with Hong Kong?

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