A Simultaneous Equation Approach to
IPO Underpricing and Oversubscription in China
(An early draft, please do not cite or distribute)
Helen Lu
*Paul Geertsema
Department of Accounting and Finance University of Auckland
(This version: 22nd October 2015)
* Corresponding Author. Department of Accounting and Finance, the University of Auckland, Private Bag 92019, Auckland 1142, New Zealand
e-mail address: [email protected]
2 Abstract
Using oversubscription ratios as a proxy for un-met demand to explain IPO
underpricing in China can lead to biased statistical inference, particularly before the major reform towards a more market-driven IPO pricing system in 2005. We find that prior to 2005 (when IPO prices were heavily regulated in the A-share market) public demand and underpricing were simultaneously determined. In contrast to the earlier literature, we do not find that un-met public demand leads to higher initial return after addressing endogeneity in the sample prior to 2005. After 2005 un-met demand for IPO shares leads to higher initial returns and this effect is robust to endogeneity.
JEL classifications: G23, G28
Keywords: Initial Public Offering, IPO underpricing, IPO oversubscription, Endogeneity, Simultaneous equations
Page 3 of 17 1. Introduction
Since the inception of PRC’s stock market in 1990, investors in the People’s Republic of China (PRC) have shown extraordinarily strong demand for initial public offerings (IPO).
In the period from 1990 to 2013, oversubscription ratios in IPOs average over 300 times in A-share IPOs2. Lucky investors who get IPO allocations through a lottery-like system often see share prices more than double on the first trading day. Many investors flip IPO shares and take profit on the first day, resulting an average turnover ratio of in excess of 60%. Because China’s Securities Regulatory Commission (CSRC), the regulator of securities market in the PRC, controls the number and timing of IPOs and regulate prices of IPO shares, recent studies point toward shortage of supply of (or, un-met demand for) IPO shares as a factor in the excessive initial returns in IPOs in the A-share markets (for example, see (Chan, Wang, &
Wei, 2004; Guo & Brooks, 2008; Mok & Hui, 1998; Tian, 2011; Ting & Tse, 2006)). This un-met demand at IPO can induce more trading activity and a higher first-day return (Tian 2011). We refer to this effect from oversubscription in IPOs to IPO underpricing as the demand effect. Taking the perspective of applicants for IPO shares, regulated and artificially-
low IPO prices equate to large initial returns. Large initial returns make participating in IPO lucrative and induce more demand for IPO shares – we refer to this effect as the price effect.
Considering the institutional background in PRC’s stock market, our study considers the possible simultaneity between IPO underpricing and oversubscription and investigates the relation between the extremely high oversubscription ratios and initial returns in depth. We
2 A-shares are denominated in RMB and can be traded by domestic investors and qualified foreign institutional investors (QFII). The total quotas for QFIIs are set by China Securities Regulatory Commission (CSRC).As of 15th Oct, 2015, the total quota for all QFIIs is eight billion U.S. dollars, a small fraction of the six-trillion market capitalisation. By contrast, B-shares, which are denominated in foreign currencies, can be trade by both
domestic and foreign investors. We study IPOs of A-shares because the B-share market is a small and illiquid market with only 90 listed stocks as of 15th Oct, 2015.
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address two questions. First, does demand for IPO shares increase initial returns? Second, does regulated IPO underpricing generate investor demand?
Results from simple ordinary least square (OLS) regressions are biased due to the presence of endogeneity. Nevertheless, we show that high demand for IPO shares from the public (as proxied for by online oversubscription ratios) “leads” to a large amount of
underpricing (or, a high level of initial return), as shown by many previous papers. Similarly, high initial returns also seem to “attract” more public demand for IPO shares. These results show up in both the pre-reform period (before 2005) and post-reform period (2005 and onward).
Once we account for simultaneity in the relations between demand and underpricing, the picture changes. In the pre-reform period, a large amount of underpricing strongly leads to a strong demand for IPO shares, but a strong demand does not further push up initial returns. This finding stands in contrast to the existing literature that routinely employs the oversubscription ratios to explain IPO underpricing. By contrast, in the post-reform period, endogeneity is not economically significant from initial returns to demand, perhaps because IPO prices have been set by the market instead of being regulated to be artificially low. In the post-reform period, we find some evidence that a high level of public demand for IPO shares further pushes up the initial return.
2. IPO Pricing and Allocation in China
Since its inception in 1990, the stock market in the People’s Republic of China (PRC) has grown exponentially and become the second largest stock market in the world in 2015.
The total market capitalisation of these two stock exchanges stands at over six trillion U.S.
dollars as of 31, January 2015.3 Despite its size, IPOs in the PRC are distinctively different
3 World Federation of Exchanges.
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from those in developed financial markets in terms of government’s control over supply of IPO shares, IPO pricing and allocation.
The CSRC exercises tight control over the size of total issues of new shares. Initially, the CSRC decided a quota of number of IPOs to be approved on an annual basis. This quota system was replaced by an authorisation system in 2001 but a tight control over the supply of IPO shares remains effectively in place. The CSRC has unilaterally closed the IPO market for nine times in the history for periods ranging between a few months and more than a year.
During a closure period, the CSRC suspended its approval process for all IPOs. The closures of primary market have been aimed at supporting stock prices in the secondary market in face of a market turmoil or allowing government time to decide and implement new rules that affect all listed companies.
IPO pricing in the PRC has gradually transited from regulated pricing to market- pricing over the last two decades. The CSRC rule on pricing IPOs through a tender offering process has become effected in 1st January, 2005, marking the turning point in this transition.
Before 1st Jan 2005, IPO prices for essentially all companies were determined by price-to- earnings (PE) multiples negotiated between the CSRC and the issuer.4 After 1st January, 2005, the CSRC requires that IPO prices be determined through a tender offering process participated by institutional investors, resembling the bookbuilding process in developed markets. This change from regulated IPO pricing to market-pricing is evident in Table 1. The PE multiples at the time of IPOs average around 18.98 times before 2005 and the average increases to 43.73 times after 2005.
The bulk of IPO shares are allocated online through a lottery-like system in the A- share market, instead of being allocated by investment banks at their discretion in developed
4 The CSRC tested pricing mechanisms resembling auctions in 1994 and in 2001 without success – these IPOs make up about 4% of all IPOs during the regulated-pricing period.
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capital markets (Cornelli & Goldreich, 2001). This online allocation system was first introduced in 1994.After the IPO price is determined, all interested investors need to deposit cash to a designated account that covers 100% of the value of shares applied to validate their
applications. Each application is in the unit of 500 or 1,000 shares. After the online
application closes, winning applications are randomly drawn from all applications. Winning applications obtain IPO shares for cash. Cash with interest earned is refunded to all losing applications. Since 2005, IPO prices have been determined through tender offering processes where an average of approximately 20% of shares issued has been placed offline to
institutional investors. The remainder the IPO shares, averaging at approximately 80% of total issue size, is placed online to all domestic investors at the same price through a “lottery”
system like before 2005. Shares allocated online become immediately tradable at listing, thus the online demand directly relate to the initial returns. By contrast, shares subscribed offline cannot be sold immediately after listing because they are subject to a three-month or longer lock-up period from the listing date. Our sample includes all IPOs that have allocated shares online between 1994 and 2013.5
3. Methods
As discussed earlier, in the A-share market, both the supply of IPO shares and the pricing of IPOs are regulated. The number and timing of IPOs are controlled by regulators and limited alternative investment products exist. Thus, part of the un-met demand for IPO shares flow to secondary market and push up the first-day closing price (Tian, 2011). We refer to this effect as the demand effect. The initial return is a function of un-met demand, as well as a function of the amount of uncertainties (Beatty & Ritter, 1986). At the same time, the demand for IPO shares through the online allocation system is extraordinarily strong
5 In early 2000s, the CSRC also temporarily used a secondary-market placement method. Our analysis exclude these IPOs because investors are not required to deposit cash to validate their IPO applications, thus, valid online subscription ratios do not exist for these IPOs.
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perhaps because the IPO price is regulated and well below the share’s necessary IPO price – this is the price effect. Therefore, we expect to see that a larger regulatory underpricing attracts more demand. These bi-directional relation between price and demand is modelled by the following equations:
Demand effect: initial return = 𝛼1+ 𝛽1𝑑𝑒𝑚𝑎𝑛𝑑 + 𝛾1𝑿 + 𝜃1𝑋1+ 𝜀1 (1) Price effect: demand = 𝛼2+ 𝛽2𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝛾2𝑿 + 𝜃2𝑋2+ 𝜀2 (2) where initial return is the amount of underpricing in the IPO for 𝑖; demand is the online oversubscription ratio in the IPO for firm 𝑖; 𝑿 is a vector of control variables that are common to both initial return and demand; 𝑋1 is the identifying variable that is uniquely related to the degree of IPO underpricing but not demand; 𝑋2 is the identifying variable that is uniquely related to the online oversubscription ratio of an IPO but not initial return.
The objective of this system of equations is to investigate whether the initial return of A-share IPOs is a result of shortage of supply of IPO shares, after considering the price impact on demand. Many studies on IPO underpricing in the A-share market have routinely included the over-subscription ratio as a proxy for demand in explaining the size of
underpricing. We aim at addressing this endogeneity issue and investigate whether the extremely high initial return is a result of shortage of supply of IPO shares or regulated IPO pricing. At the same time, we examine whether the strong demand for IPO shares is from regulated IPO pricing or regulated supply of IPO shares. We separately estimate this system of equations for the regulated-pricing period (1994-2004) and the market-pricing period (2005-2013).
Equation (1) examines whether and how un-met demand for IPO shares affects a firm’s underpricing. Note because the demand for an IPO firm’s shares is not exogenous.
Instead, it depends partially on the amount of underpricing. A lower IPO price (i.e. higher
Page 8 of 17
initial return or higher underpricing) induces more demand for IPO shares. For example, a firm to issue shares at an artificially low price will have a high error term, 𝜀1, and it is also likely to attract a large number of IPO applications. Thus, the error term and demand are not independent. This violates a basic assumption of OLS and inferences from an OLS regression will be inappropriate.
Equation (2) tests whether underpricing attracts more investor demand. It is inappropriate to estimate this equation using OLS, for reasons similar to those discussed above. We account for the interdependency between initial return and oversubscription ratios by treating equation (1) and (2) as simultaneous equations.
The common control variables (𝑋) that affect both underpricng and oversubscription ratios include firm age (AGE), the natural logarithm of total assets (SIZE), IPO proceeds (IPO price multiply by the number of shares issued) and the gap in days between IPO pricing and listing (GAP). Because IPO proceeds and firm size are strongly correlated, we regress the natural logarithm of IPO proceeds on SIZE and use the regression residuals (PRCDS_R) to capture the effect from issue size, in addition to the effect from firm size, on IPO
underpricing and oversubscription ratios. AGE, SIZE and PRCDS_R proxy for the uncertainties in valuation of IPO shares. We expect that initial returns increase in
uncertainties. These control variables are motivated by information asymmetry and other factors that affect IPO underpricing.
The identifying variable for Equation (1), the demand effect on initial return, is the turnover ratio in the first listing day (TURNOVER). Turnover on the first trading day is strongly and positively related to the amount of uncertainties in IPO valuation and thus initial returns. However, it is very unlikely that this turnover ratio affects the oversubscription ratio that occurs before the firm is listed. To identify the price effect on demand in Equation (2), we use the number of competing IPOs (CMPTIPO). Because applying for A-share IPOs uses
Page 9 of 17
up cash, we choose the number of competing IPOs to identify the level of demand for IPO shares. Cash amount equivalent to the value of shares applied has to be deposited no later than the closing date of an offering. Then, the cash for losing applications is only returned in four trading days after an IPO closes. During this window, the cash cannot be used to apply for other IPOs. Because all investors have limited funding source, competing IPOs divert investor demand. However, it is not likely that the number of competing IPOs has any direct effect on the first-day return. The number of IPOs during a period and their timing are also highly regulated. The CSRC has unilaterally closed the IPO market for 9 times in the history – either because the government is concerned that new issues will induce sell-down of shares of listed companies and trigger a more severe market turmoil or as a cautious measure when the government needs time to decide and implement reforms of rules that affect all listed companies.6
4. Data
Our sample includes A-share IPOs between 1994 and 2013 that allocate IPO shares online (or, with online oversubscription ratios). Oversubscription ratios are multiples of number of shares in valid online applications allocation to the number of shares allocated online. We do not consider offline oversubscription multiples because shares allocated offline are subject to a lock-up period of three months or longer thus they cannot be sold on the first trading day – or, initial returns do not necessary attract more offline applications. Thus, offline oversubscription ratios are not closely related to our objective of investigating the potential endogenous relations between first-day returns and demand.
6 For example, the IPO market was closed in 2004 before the introduction of the new IPO pricing and allocation mechanism and between 2002 and 2003 when designing and implementing the rule on sell-down and float non- tradable shares that are primarily owned by the state.
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Table 1 summarises main variables before and after 1st January of 2005, the turning point of transiting from regulated IPO pricing to market pricing of IPOs. As expected, when issuers and underwriters can consider demand and have more say in determining IPO prices, initial returns drop and prior-IPO PE ratios increase. The first stage of stock market has served primarily as a channel for privatisation of state-owned enterprise and the issuers tend to be new firms established shortly before IPOs. Thus, the state owns an average of 76% of interest in the firm before listing in the regulated pricing period but only 15% in the second period and the average age of firms at IPO also increases from 2 years to 8 years. As the economy grows, the size of issuer and proceeds increase by more than 15 times and three times, respectively in the second period. In the second half, the average of online
oversubscription ratios exceeds that in the first half by 123 times, primarily because the oversubscription ratios in 2007 and 2008 before financial crisis were extraordinarily high – over 1,000 times on average in each of these two year. Similarly, because since [2001], firms do not need to obtain a separate approval for listing after raising IPO proceeds, the gap between IPO and listing has significantly decreased from 32 days before 2005 to 12 days after 2005.
[Insert Table 1 about here.]
5. Results
To provide a benchmark for our simultaneous-equation approach, we first present results from simple OLS regressions without controlling for the endogeneity between initial returns and un-met demand. The first column and the third column of Table 2 test the demand effect before and after 2005, respectively. This OLS regression is similar to the analysis conducted in Tian (2011) and Cheung, Ouyang, and Weiqiang (2009). However, as discussed, the OLS coefficient may be biased because demand is affected by the potential profit from flipping shares on the first trading day. The result is presented in column (1) of
Page 11 of 17
Table 2. Similarly, column (2) and column (4) of Table 2 test the price effect before and after 2005 by using initial returns to explain online oversubscription ratios. Like prior studies, this paper also show that, without controlling for endogeneity between initial returns and demand, high oversubscription ratios seem to “lead” to large amounts of underpricing and vice versa, in both the regulated IPO pricing period and the market pricing period. We refrain from making further inference from the results in Table 2 because the potential endogeneity problem.
[Insert Table 2 about here.]
To account for the endogeneity of initial returns and demand for IPO shares, we estimate Equation (1) and (2) using a simultaneous-equation approach. As a first step, we regress oversubscription ratios (OVSUB) and underpricing (UNDERPRC) on all exogenous variables and present the results on Columns 1 and 3 (before 2005) and Columns 5 and 7 (after 2005) in Table 3. In the second stage regressions, we substitute oversubscription ratios (OVSUB) and underpricing (UNDERPRC) in Table 2 with two instruments, which are the fitted values from the two first-stage regressions. Column (2) and (6) present results of the second stage regressions for the demand effect before and after 2005. Column (3) and (7) include results for the price effect in these two periods. The significant and strong coefficient on OVSUB_PRED on column (4) in Table 3 suggest a strong price effect in the regulated IPO pricing period (before 2005) – underpriced IPOs attract investor’s demand before 2005 and an increase of 1% in underpricing translates to an increase of 1.74 time oversubscription.
This price effect turns insignificant after 2005 (column (8) in Table 3). In the period of market pricing of IPOs, un-met demand for IPO shares further drives up initial returns but demand is not a result of underpricing anymore. The demand effect in the period after 2005 is statistically significant but economically marginal because an increase of 100 times
Page 12 of 17
oversubscription only leads to an additional return of 5% (not annualized) on the first trading day – an economically insignificant return compared with the average initial return of 60%
during the second period.
Standard errors are adjusted for the fact that we use estimated values in the second stage of regressions.
Contrary to common belief, we do not find evidence for the demand effect before 2005 – shortage of supply of IPO shares (or un-met demand) is not the reason for
extraordinarily high initial returns in the A-share market before 2005. Prior to the IPO pricing reform in 2005, the regulated IPO price makes investing in IPOs a free lunch and attracts an astronomical number of applications of IPO shares – without the low IPO price (or, after controlling for underpricing), demand itself does not lead to high first-day return. Instead, we show that, after the impact from low price on demand is accounted for, a strong expected demand for IPO shares in the period before 2005 leads to a smaller amount of IPO
underpricing – the coefficient on estimated oversubscription ratios is −0.06 and significant at a 5% level. This result is consistent with the further econometric tests that show the online oversubscription ratio is endogenous to IPO underpricing in the sample between 1994 and 2004.
After the IPO pricing reform in 2005, the demand effect becomes the more important effect of these two effects because firms are allowed to consider institutional demand and price their shares offline before offering the bulk of shares online. Thus, after 2005, a “normal” amount of IPO underpricing does not attract additional online demand. By contrast, initial returns increases as the “estimated” level of oversubscription increases.
6. Conclusion
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Regulators in the PRC, through their approval processes, have exercised tight control over the number of IPOs and their timing, as well as the prices of new shares. Recent studies have attributed extraordinarily high initial IPO returns to the shortage of IPO shares and regulated prices. We find that the regulated price before 2005 plays the main role in generating an excessively high level of oversubscription and that un-met demand itself does not further inflate initial returns. We also find that the reform of the IPO pricing mechanism has mitigated this underpricing-induced demand. In the post-reform period between 2005 and 2013, a high level of public demand for shares in an IPO is still associated with high initial returns. This finding in the post-reform period is consistent with the un-met demand hypothesis but it can also be explained by the possibility that initial returns are associated with retail investors’ sentiment.
Page 14 of 17 Reference
Beatty, R. P., & Ritter, J. R. (1986). Investment banking, reputation, and the underpricing of initial public offerings. Journal of Financial Economics, 15(1), 213-232.
Chan, K., Wang, J., & Wei, K. J. (2004). Underpricing and long-term performance of IPOs in China.
Journal of Corporate Finance, 10(3), 409-430.
Cheung, Y.-l., Ouyang, Z., & Weiqiang, T. (2009). How regulatory changes affect IPO underpricing in China. China Economic Review, 20(4), 692-702.
Cornelli, F., & Goldreich, D. (2001). Bookbuilding and Strategic Allocation. The Journal of Finance, 56(6), 2337-2369. doi:10.1111/0022-1082.00407
Guo, H., & Brooks, R. (2008). Underpricing of Chinese A-share IPOs and short-run
underperformance under the approval system from 2001 to 2005. International Review of Financial Analysis, 17(5), 984-997.
Mok, H. M., & Hui, Y. (1998). Underpricing and aftermarket performance of IPOs in Shanghai, China. Pacific-Basin Finance Journal, 6(5), 453-474.
Tian, L. (2011). Regulatory underpricing: Determinants of Chinese extreme IPO returns. Journal of Empirical Finance, 18(1), 78-90.
Ting, Y., & Tse, Y. K. (2006). An empirical examination of IPO underpricing in the Chinese A-share market. China Economic Review, 17(4), 363-382.
Page 15 of 17 Table 1 Summary statistics
Before 2005 After 2005 Difference
Average Average
UNDERPRC 131.49 60.17 -71.32***
OVSUB 257.22 380.94 123.72***
PE 15.55 33.35 17.79***
AGE 2.43 8.09 5.66***
TA 2,177.19 32,070.69 29,893.50**
GRSPRCD 449.71 1,564.12 1114.41***
SIZE 6.15 6.53 0.38***
PRCDS_R -0.35 0.29 0.64***
GAP 32.33 11.75 -20.59***
STATE 0.76 0.15 -0.61***
CMPTIPO 4.73 6.38 1.65***
TURNOVER 0.62 0.70 0.08***
Page 16 of 17 Table 2 Simple OLS regressions
Before 2005 After 2005
(1) (2) (3) (4)
UNDERPRC OVSUB UNDERPRC OVSUB
OVSUB 0.09*** 0.04***
UNDERPRC 1.22*** 3.59***
AGE 2.68** 14.30*** -1.24*** -15.76***
SIZE -19.11*** -17.22*** -2.42* -73.95***
PRCDS_R -17.21*** 59.07*** -33.41*** -192.31***
GAP 0.33 -0.37 1.85*** -0.36
TURNOVER 148.35*** 64.59***
CMPTIPO -29.78*** -42.47***
CONST 110.48*** 341.66*** 13.47 1105.99***
ADJ R-SQR 29.37 32.11 38.22 35.2
N 746 746 1,101 1,101
Page 17 of 17 Table 3 Simultaneous equation approach before and after 2005
Before 2005 After 2005
(1) (2) (3) (4) (5) (6) (7) (8)
Demand-effect STG1
Demand-effect STG2
Price-effect STG1
Price-effect STG2
Demand-effect STG1
Demand-effect STG2
Price-effect STG1
Price-effect STG2
OVSUB UNDERPRC UNDERPRC OVSUB OVSUB UNDERPRC UNDERPRC OVSUB
OVSUB_PRED -0.06** 0.07***
UNDER_PRED 1.61*** 3.30***
AGE 17.76*** 6.16*** 5.10*** 9.54** -21.15*** -0.23 -1.78*** -15.27***
SIZE -31.17*** -22.55*** -20.69*** 2.21 -88.36*** -0.28 -6.77*** -66.02***
PRCDS_R -0.02 0.00 0.00 -0.02 0.00 0.00 0.00* 0.00
GAP 0.26 0.42*** 0.40 -0.39 14.16*** 2.01*** 3.05*** 4.10
TURNOVER 308.11*** 209.40*** 191.02*** 317.83*** 72.93*** 96.25***
CMPTIPO -27.60*** 1.65* -30.26*** -73.01*** -5.36*** -55.32***
CONST 343.56*** 127.17*** 106.68*** 171.48* 1203.59*** -40.22** 48.09** 1044.78***
Adj. R-sqr 21.04 21.66 21.66 21.04 17.17 17.44 17.44 17.17
N 746 746 746 746 1,101 1,101 1,101 1,101
