Institut numerique

I-2-1\\ Informational Asymmetry Theory:

* The theory of signalling: Firm quality

The issuer is the most and best informed party about the issuing firm quality. There are many
proxies of firm quality that can be employed . I introduce the most important ones often used
by researchers:

 The Overhang ratio = Pre-IPO shares retained by insiders/Public Float
The percentage ownership retained by insiders serves as a signal for firm quality, and two
different relations are observed between firm quality and underpricing with two different
explanations. The first relation is that, for high overhang ratio and so for high quality issues,
the issue price is lower a mean to demonstrate their quality and to distinguish themselves
from the pool of low quality issuers, then a higher level of underpricing is observed. In the
same direction, we can justify the use of overhang ratio and its importance to underpricing
phenomenon by the fact that only the shares sold to the public in the IPO are undervalued.

The shares retained by insiders are valued at market. Thus, for a given degree of underpricing,
the economic cost per retained share (the dilution) declines as overhang rises. Because the
cost of underpricing to the issuer declines as overhang rises, it is natural to conjecture that
firms with greater overhang will have greater underpricing and we find the same positive
relation between overhang ratio and underpricing.

The second relation is completely different in that issuing firm quality is negatively correlated
with underpricing. Issuers with high quality firms bargain for higher offer prices for their
IPOs and then a lower degree of underpricing is observed at the first day of trading.

 The R&D intensity = Pre-IPO R&D expenditures/expected market value after IPO
R&D expenditures are the intangible investment most extensively researched in economics,
accounting and finance, they have to be disclosed in the corporate financial reports. R&D
contributes to information asymmetry and Guo, Lev and Shi (2006) consider R&D activities
as the major source of asymmetry. Pre-IPO R&D intensity of the issuer is strongly and
positively related to the first day underpricing. R&D-intensive firms are often undervalued by
investors. That is why R&D intensive issuers can not set a high offer price for their IPO.

Besides, they are more willing to forgo money on the IPO table than are no R&D issuers,
because they expect to recoup money left on the table by subsequent issues of seasoned stocks
when the market realizes over time the positive outcomes of their R&D. So the relation
between R&D intensity and underpricing is positive but many studies find no relation
between underpricing and SEO, which refute the last point of recouping money left on the
table by SEO in the future.

Another relation can be found between R&D intensity and underpricing, mainly since no
relation between underpricing and SEO: R&D intensive issuers believing in the high quality
of their firms and in the importance of their R&D and its positive outcomes in the recent
future require high offer prices for their IPOs which induces a negative relation between R&D
intensity and underpricing.

 Venture Capital backed: a dummy variable taking the value of one if the issue firm is
backed by a venture capital and zero otherwise.

Since venture capitalists have expertise in particular industries, they are expected to make
superior investments relative to other investors. In essence, VCs certify the quality of an IPO
and their presence signals that asymmetric information is relatively low for this issue and that
the issuing firm quality is high. So, issuers can bargain for a high offer price which declines
underpricing. Another explanation is found, that VC backed firms face larger underpricing,
since high quality issuers will continue demonstrating the firm quality by throwing money on
the IPO table and not requiring high issue prices. However, in many studies using the venture
capital as a determinant of firm quality, this variable is found insignificant. A question may
arise: “Is Venture Capital backing really a signal of firm quality and an explanatory variable
to underpricing anomaly?”. I introduce this variable in the model to verify these results.

 Underwriter Reputation: a dummy variable taking the value of one if the lead
underwriter has a rank ≥ 8 (zero otherwise).

Some issuers use it as a signal of high quality and want to hire a prestigious underwriter, since
by agreeing to be associated with an offering, prestigious intermediaries “certify” the quality
of the issue. When an issuer chooses a prestigious underwriter for the book-building
mechanism, he sets a low offer price conducting a high underpricing on one hand, as
compensation to the underwriter and on the other hand, he is sure about full subscription, he is
concerned by quantity rather than price and a lower offering price increases the probability of
full subscription. Then, there is a positive relation between underwriter reputation and
underpricing.

But, there is another explanation completely different: when an issuer chooses a prestigious
underwriter who certifies the high quality of the issue, he can bargain for a higher offer price
and then a lower level of underpricing is observed: A negative relation between underwriter
reputation and underpricing.

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