Advances in Investment Analysis and Portfolio Management, Volume 9

THE LONG-RUN PERFORMANCE AND

PRE-SELLING INFORMATION OF

INITIAL PUBLIC OFFERINGS

Anlin Chen and James F. Cotter

ABSTRACT

We show that private information as well as public information is

important in revising the terms of the offer during the pre-selling period

(or the waiting period) and that when the revealed private information is

positive, the underwriter compensates the investors for this information by

underpricing the issue more than when the information is negative. Even

though the cost of compensating positive information is quite high, the

issuer still benefits from the positive information in that the wealth

transferred to the investors is smaller under underwriter’s information

acquisition activities. Furthermore, IPO long-run performance is neg-

atively related to the positive information revealed during the waiting

period and the underwriter prestige. Finally, IPO firms without receiving

significant information during the waiting period survive longer after

issuance.

1. INTRODUCTION

Theoretical models by Benveniste and Spindt (1989) and Benveniste, Busaba

and Wilhelm (1996) examine the initial public offering (IPO) process when the

underwriter plays an active role in marketing the offer to investors and setting

Advances in Investment Analysis and Portfolio Management, Volume 9, pages 203–232.

Copyright © 2002 by Elsevier Science Ltd.

All rights of reproduction in any form reserved.

ISBN: 0-7623-0887-7

203

the parameters of the offering. A growing body of empirical literature analyzes

the observable activities of the underwriter and documents the factors that

affect the relationship between the issuer and investors in an IPO. This paper

examines the competing objectives of each party in the IPO process and

empirically documents the role the underwriter plays in balancing the differing

financial objectives of issuer, and investors. Specifically, we examine the costs

and benefits of the underwriter’s attempts to gather information to help issue a

successful offering. Further, we show how the financial incentives of each

participant are satisfied, either wholly or in part, given the other parties to the

transaction. Finally, we also show the effects of market fads on the adjustment

of pricing terms and on the short-run and long-run performance.

When a private firm is considering an equity offering, it must first interview

underwriting firms and select the appropriate investment bank to provide

advising and underwriting services. Once selected, the underwriter, in

conjunction with other advisers (accounting, legal, etc.), formulates a strategy

for the issuer to offer equity securities to the market. The first administrative

step in the process involves preparing and filing a registration statement. In

addition to detailed discussion of the issuer’s business operations and financial

condition, the underwriter and the issuer must agree on their first estimate of

the offering terms, including the offer price range and number of shares that the

issuer plans to offer. The period of time between filing of the registration

statement and the actual offering of securities is called “waiting period”.

During the waiting period, the underwriter assumes a special responsibility

to market the offer to the investment community and attempt to determine the

demand for the securities offered. Especially, for firm commitment offerings,

the underwriters bear the proceeds risk in case the issuance may fail.

Interestingly, the information the underwriter is seeking both from the market

and from the investors will lead to changes in the terms of the offer that

potentially may have an adverse affect on the investors’ financial situation. For

example, assume that the terms of the offer filed in the registration statement

are attractive to the investors considering the offer. If the investors

communicate their strong intent to purchase the offering, the underwriter then

knows that the terms of the offer can be adjusted to increase the price and/or

the number of shares offered.

In this paper, we examine the benefit of the issuer, and investors in an

attempt to document the role of information acquisition activities prior to

issuance and IPO long-run performance with respect to the information

received during the waiting period. We find that issuers benefit from the

underwriter’s activities because the benefits of higher proceeds when demand

is strong (positive information) are larger than when demand is weak (negative

204 ANLIN CHEN AND JAMES F. COTTER