Academic journal article Financial Management

Characterizing the Risk of IPO Long-Run Returns: The Impact of Momentum, Liquidity, Skewness, and Investment

Academic journal article Financial Management

Characterizing the Risk of IPO Long-Run Returns: The Impact of Momentum, Liquidity, Skewness, and Investment

Article excerpt

We study 6, 686 initial public offerings (IPOs) spanning the period 1981-2005 and find that the new issues puzzle disappears in a Fama-French three-factor framework. IPOs do not underperform in the aftermarket on a risk-adjusted basis and do not underperform a matched sample of nonissuers. IPO underperformance is concentrated in the 1980s and early 1990s, and IPOs either perform the same as the market or outperform on a risk-adjusted basis from 1998 to 2005. We find that outperformance in the later period is driven by large firms. Factors for momentum, investment, liquidity, and skewness help to explain aftermarket returns, although size and book-to-market tend to proxy for skewness. IPO investors receive smaller expected returns due to negative momentum and investment exposure and in exchange for higher liquidity.

Prior research indicates that new issues of equity and debt underperform benchmarks and matched samples of nonissuers (Ritter, 1991; Loughran, 1993; Loughran and Ritter, 1995). This result has been dubbed the "new issues puzzle." We revisit this finding using a sample of more recent data encompassing some fundamental changes in the going public landscape. We also examine the impact of several factors known to help price securities in the literature on initial public offering (IPO) returns including stock return momentum, share liquidity, return skewness, and investment.

Momentum has been shown to be a significant and robust factor in pricing securities by Carhart (1997). Brav, Geczy, and Gompers (2000) find that momentum helps to explain the returns of IPO firms. Eckbo and Norli (2005) find that share liquidity, defined as trading volume divided by the number of shares outstanding, is significant in explaining IPO returns. Harvey and Siddique (2000), Smith (2007), and Nguyen et al. (2007) find that return skewness is significant in explaining security returns, in general. Lyandres, Sun, and Zhang (2008) find that firm investment is significant in explaining IPO returns. However, until now, no test has been conducted that brings all of these factors together at once. In this paper, we explore the explanatory power of each of these four factors in accounting for the aftermarket performance of new equity issues.

While momentum, liquidity, and investment have each been introduced into IPO pricing models by prior work, skewness has not been examined in this context. Early work by Rubinstein (1973) and Kraus and Litzenberger (1976) shows that if asset returns are nonnormal, investors will have a preference for assets exhibiting positive skewness. The intuition is the same as the standard capital asset pricing model in that only the systematic or undiversifiable component of skewness should be priced. This systematic skewness is referred to as coskewness. Harvey and Siddique (2000) test whether stocks with negative coskewness with the market earn higher risk premia and find that negative coskewness is a priced factor in the cross section of stock returns. Since stock returns have been shown to exhibit market coskewness in general, we posit that controlling for coskewness should be important when benchmarking IPO returns. Harvey and Siddique (2000) and Chung, Johnson, and Schill (2006) also find evidence that the Fama-French (1993) size and value factors proxy for return coskewness. Including all factors simultaneously allows us to revisit the longstanding empirical regularity of IPO underperformance and examine which factors matter most.

Using a sample of 6,686 IPOs spanning the period 1981-2005, we implement three tests of long-horizon abnormal performance. We measure abnormal performance using buy-and-hold IPO returns versus an attribute-based control sample, factor regressions, and cumulative abnormal returns (CARs). When comparing the three-year post-IPO performance with that of a market index, there is some evidence of underperformance. However, we find that this underperformance is concentrated in the early part of the sample and disappears from 1998 to 2005. …

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