Information content of lock-up provisions in initial
public offerings
Nancy J. Mohan*, Carl R. Chen
Department of Economics and Finance, University of Dayton, 300 College Park Drive, Dayton, OH 45469-2251, USA
Received 30 December 1999; revised 30 April 2000; accepted 10 July 2000
Abstract
An overwhelmingly large proportion of initial public offerings (IPOs) report lock-up provisions that prohibit existing stockholders from selling their shares within a specified period after the offering date. These lock-up periods may last as long as 3 years. Because influential buyers request the lock-up, we conjecture that the length conveys credible information pertinent to the risk of the IPO. Analyzing 729 IPOs from January 1990 to December 1992, we found that the lock-up period signals the issuer's riskiness and that a 180-day lock-up period seems to be the norm. Any departure from the norm suggests more uncertainty about a firm's value and thus results in deeper IPO underpricing as well as a larger underwriter spread. We also found that thin-trading activity occurring shortly after the expiration of the lock-up period is perceived by the market as good news, while heavy trading is regarded as bad news.D 2001 Elsevier Science Inc. All rights reserved.
JEL classification:G24; G30
Keywords:Initial public offerings; Lock-up period
1. Introduction
There are various restrictions on the sale of a company's shares around the initial public offering (IPO) date. For example, NASD limits sales by venture capitalists who have made a private investment in the issuer (90 days) and underwriters who receive shares of the issuer as
* Corresponding author. Tel.: +1-937-229-2458; fax: +1-937-229-2477. E-mail address: [email protected] (N.J. Mohan).
10 (2001) 41 ± 59
1059-0560/01/$ ± see front matterD2001 Elsevier Science Inc. All rights reserved.
compensation (1 year).1In general, prospectuses also mention the limitation on stock sales imposed by Rule 144 on securities not registered with the SEC. This rule prohibits sales during the first 2 years of ownership and allows limited quantities to be sold in ordinary brokerage transactions after the 2-year holding period.2 Finally, SEC Rule 10b-6 (concerned with conditioning of the market at the time of the distribution) prohibits any person with a material interest in the success of the offering from bidding for or purchasing securities during the distribution (with the exception of the syndicate). These restrictions no longer apply when the distribution is complete.3
For almost all IPOs, however, existing stockholders agree not to sell shares within a specified period after the offering date. This agreement is termed a ``lock-up provision,'' and actual range for the lock-up time varies considerably.4For example, the existing shareholders of Abbey Healthcare agreed not to sell shares for the first 180 days after going public. Although the 180-day period is quite common, staggered lock-up provisions also occur. Consider the lock-up provision listed in the prospectus for Arch Communication. All stockholders, option holders, officers, and directors of the company agreed with the under-writers not to sell any shares during the 120-day period following the offering and to sell no more than two-thirds within the next 120 days.
Although IPO issuers generally agree to a lock-up period, the existing literature is silent on this topic. Why do IPO issuers agree to the lock-up? Why do lock-up periods vary among IPO firms? Is there any relationship between the lock-up term and underpricing of IPOs? How does the market react to the trading activities after the expiration of the lock-up restriction? This paper seeks to address these unexplored questions.
We provide several explanations to the existence of the lock-up provision. First, it may be argued that a lock-up agreement is helpful to underwriters in that it prevents the sale of large blocks of securities during the early trading period. Underwriters often engage in price stabilization during the distribution (SEC Rule 10b-7). Aggarwal (1998), Asquith, Jones, and Kieschnick (1998), Benveniste, Erdal, and Wilhelm (1998), Chowdhry and Nanda (1994), Hanley, Kumar, and Seguin (1993), Prabhala and Puri (1998), Rudd (1993), and Schultz and Zaman (1994) all report evidence consistent with underwriter stabilizing. Any agreement that reduces sales of the security during distribution reduces the potential capital commitment and
1
A listing of NASD rules appears in the NASD manual. A discussion of rule changes appears in Securities and Exchange Commission Release No. 34-30587 at 57 FR 14597.
2
The amount of the sale by an affiliate of the issuer under Rule 144 ``during any three-month period may not exceed the greater of (a) 1% of the total number of units of the security outstanding and (b) the average weekly trading volume for the preceding four weeks''. See Ratner, D. L. (1990).Securities regulation(3rded.). West Publishing (pp. 72 ± 74). The rules differ for a nonaffiliated shareholder. If the shareholder has not been an affiliate for the company for 3 months prior to the sales and 3 years have elapsed since the time the shares are acquired from the issuer, then he/she may sell free of Rule 144 volume limitations. There is also a registration exemption for shares acquired through employee benefit plans (Rule 701). Ninety days after a firm goes public, nonaffiliates may sell shares obtained pursuant to Rule 144.
3
See Johnson (1990) for examples of the time to complete a successful offering, pp. 184 ± 185. A thorough discussion of antimanipulation regulation of securities offerings appears in SEC Release Nos. 33-7057 and 34-33924 as printed in 17 CFR part 240.
4
risk assumption of underwriters. Aggarwal (1998) reports that underwriters rarely post stabilizing bids. Underwriters routinely sell more shares to the public than the initial allotment, creating a short position. This short position, in addition to creating more liquidity for the new issue, allows the underwriter to buy shares in the market place to cover the short position if the price falls or exercise the over allotment option if the share price increases. The second scenario is more profitable for the underwriting, thus restricting insider selling is consistent with the preferred underwriter approach to price stabilization. Lock-up features, therefore, potentially reduce the risk of price stabilization.
Second, Teoh, Welch, and Wong (1998a), and Teoh, Wong, and Rao (1994) suggest that an IPO firm may manage earnings, accruals, and cash flows before going public in an attempt to mold investor expectations. In effect, Teoh et al. (1998a) find that IPO issuers in the most aggressive quartile of earnings managers have 3-year aftermarket returns of about 20% less than the IPO issuers in the most conservative quartile. They also suggest that incentives to manage earnings are likely to persist in the months after the offering. Earnings management to exploit market credulity is also found in the seasoned equity offerings (Rangan, 1998; Teoh et al., 1998b). In light of this research, we argue that the lock-up provision reduces the chance of insiders taking advantage of earnings management, allowing more time for investors to resolve uncertainty in firm value without the adverse effect of insider selling. Lock-up provisions, therefore, can be viewed as a bonding mechanism that bonds the issuer against overstatement of the issuing firm's future outlook.5
Finally, Carter, Dark, and Singh (1998) find that the 3-year underperformance is less severe for IPOs handled by more prestigious underwriters. They suggest that by marketing higher-quality IPOs, investment bankers protect their reputation. Therefore, investment bankers care not only about initial mispricing, but also about the IPO firm's longer-run performance because both impact investment bankers' nonsalvageable reputation. Lock-up provisions delay the adverse effect caused by insider selling. Therefore, it is reasonable to argue that both price stabilization and lock-up provisions lessen the chance of IPO under-performance in the short-run and in the longer-run. Both underwriters and investors, therefore, benefit from the lock-up provision.
Lock-up provisions, nevertheless, may be costly to insiders in light of Ritter (1991) and Loughran and Ritter's (1995) studies showing that IPOs are overpriced in the long run. Evidence also shows that there is some tendency for the companies with the highest initial returns to perform the worst in the long run. Other research suggests that companies go public during periods of favorable market sentiments. For example, Aggarwal and Rivoli (1990) report that IPOs issued during periods of high volume earn negative market-adjusted returns for the first year after going public. Thus, not being able to sell within the early period after the offering has the same effect as a penalty bid to investors, which may be costly to corporate insiders, especially when a large percentage of the insider's wealth consists of the company's stock. The issue then, is why insiders agree to lock-up provisions of various lengths.
5 For a theoretical argument of price stabilization as a bonding mechanism, see Benveniste, Busaba, and
Discussions with some underwriters indicate that influential investors request the lock-up. The length and number of shares subject to the agreement are determined during informal discussions with these buyers during the book-building process. Therefore, we conjecture that better-informed investors and the underwriters require insiders to hold shares as a form of insurance Ð insiders will be unable to sell overpriced IPOs.6In effect, influential investors are better informed, and are reported to have access to ``cheat sheets'' that contain pages not found in the prospectus, such as earnings projections (Wall Street Journal, 1997).7 Our argument that lock-up period allows better informed investors to mitigate uncertainty is, therefore, consistent with the aforementioned earning management hypothesis, bonding mechanism hypothesis, and underwriter reputation hypothesis.
Because lock-ups mitigate uncertainty about the IPO value, the agreements convey important information about the ex ante risk of an IPO. This conjecture may provide an alternative approach to test Baron's (1982) asymmetric information theory, which predicts a deeper underpricing for IPOs that are subject to greater pricing uncertainty. Furthermore, through conversations with underwriters, we learned that some security analysts do follow closely the expiration of lock-up periods. Trading surrounding the expiration of lock-up periods, therefore, could convey information pertinent to the firm's true value.
Although underpricing of IPOs has attracted much academic research, disagreement persists.8 Our research documents an unexplored issue of going public: the information content of lock-up provisions found in IPO prospectuses. The existence of various lock-up provisions could reveal information that is related to the initial pricing of IPOs. Otherwise, the length of the lock-up period contains no information and it is a redundant provision. In this paper, we study the following two issues pertinent to the IPO pricing.
1. Since various forms of lock-up provisions are requested by influential investors, and consented to by the issuer and underwriters, they reveal information about the price uncertainty of an IPO. If the lock-up provision is a credible source of signaling regarding the risk of an issuer, underpricing of IPOs should be related to the lock-up provisions. On the other hand, if the lock-up provision contains no useful information about the IPOs, there will be no relationship between the provision and the IPO pricing.
2. Because corporate insiders possess information pertinent to the future cash flows of the business, abnormal trading activities occurring immediately after the expiration of the lock-up provision reflects the market's perception of the IPO's true value.
6 Ling and Ryngaert (1997) document the relationship between IPO underpricing and the institutional buyers'
(informed investors) influence. Specifically, they find that the existence of institutional investors has made the REIT IPO market more susceptible to the winner's curse.
7
SeeWall Street Journal, December 31, 1997, page C-1.
8
Our results show that the length of the lock-up reveals credible information pertinent to the IPO's riskiness. Sample partitioning suggests that departure from 180 days (a period that may be regarded as a norm) signals a more uncertain IPO. Both longer and shorter lock-up periods result in deeper underpricing and a larger underwriter spread. Various regression analyses also indicate that the lock-up period is a more consistent and powerful ex ante risk measurement than gross proceeds, a variable widely accepted in the IPO literature.9 Furthermore, trading activities occurring shortly after the expiration of the lock-up periods reflect the market's perception of the firm's true value. Our results indicate that the market interprets thin trading as good news and heavy trading as bad news. The remainder of the paper is organized as follows. Section 2 describes our hypotheses, the data source, and the collection procedure. The information content of lock-up periods is discussed and empirically analyzed in Section 3. Section 4 examines the relationship between trading activities after the expiration of the lock-up period and performance of IPOs. Finally, our conclusions are presented in Section 5.
2. Hypotheses and data
In this section of the paper, we propose two hypotheses and describe the sources of the data employed for empirical testing. Our first hypothesis is to study whether the lock-up provisions contain information regarding price uncertainty, and thus the initial pricing of the IPOs.
Hypothesis 1:Null: The length of the lock-up period contains information regarding the risk of the IPO firms, therefore, it is related to the initial pricing of the IPOs.Alternative: Lock-up provision contains no useful information on the IPO firms and it bears no relationship with the pricing of the IPOs.
Our second hypothesis examines the price discovery process when the lock-up periods expire. Because corporate insiders often possess information pertinent to the future cash flows, trading activity surrounding the lock-up period expiration date may signal the firm's true value. Our second hypothesis is stated as:
Hypothesis 2:Null: Abnormal trading activity after the expiration of the lock-up period signals a company's true value, therefore, it is related to the IPO's aftermarket performance.Alternative: Trading activity after the expiration of the lock-up period is unrelated to the IPOs aftermarket performance.
To test these two hypotheses, we used a database prepared by Disclosure (Compact D'33) that summarizes all registrations filed by companies for securities registered for sale to the public as required by the Securities Act of 1933. A search of this database for firm-commitment, common stock IPOs provided a preliminary sample size of 806 offerings for the
9 The importance of using offering size to determine firm value diminishes in a two-period model, i.e., in a
period January 1990 through December 1992. (Unit offerings are excluded from our sample.) From this database we collected information on the company and the offering (total assets, offering price, gross proceeds, number of securities offered, and underwriter discount) and the lock-up provisions. For each lock-up provision, we manually recorded the time limit and number of shares covered from the section in the prospectus labeled Shares Eligible for Future Sale. We contacted the company and requested a copy of the prospectus for those cases where this section was missing from the Compact Disclosure database. We collected lock-up information for 729 companies.
Daily stock returns and respective market index values starting on the date the firm went public and continuing for a maximum of 250 trading days (1 calendar year) after the expiration of the lock-up are taken from the CRSP tapes (Center for Research in Security Prices at the University of Chicago). Initial underpricing is defined as the percentage price change from the offering price to the closing price of the first trading day adjusted for the corresponding return on the CRSP equally weighted index for the same period. Daily excess returns (after the initial underpricing) are computed by subtracting the CRSP equally weighted return from each IPO stock return. Since all IPOs do not have complete price
Table 1
Distribution of longest lock-up period for 729 IPOs over the period 1990 ± 1992
Lock-up period in days Frequency
0 5
90 9
120 31
135 2
150 26
180 481
181 1
198 1
210 2
214 1
240 16
243 1
270 20
272 1
274 5
300 1
360 11
365 56
395 2
396 4
426 1
487 1
548 20
730 23
data, depending on their IPO date and price information available to us, the sample used for testing the second hypothesis varies with a full sample size of 682.
Some descriptive data for the lock-up period appears in Table 1. The most common lock-up period is 180 days; 481 companies reported this length as their restrictive period.10 The range, however, is quite wide. For example, five prospectuses do not include a lock-up while 8, 23, and 56 companies have lock-lock-up periods of 3, 2, and 1 years, respectively. A lock-up period of 6 months is the most popular one and can thus be regarded as the norm. The number of shares subject to a lock-up also varies. The last line of Table 2 reports the average number of shares subject to restrictions is 1.96 times the amount offered to the public.
Table 2 also presents descriptive statistics for the sample IPOs. The initial returns and average offering price for our sample appear similar to those in prior studies. Our sample's initial return of 11.0% is somewhat lower than the 16.4% reported by Ibbotson and Ritter (1992) for the period 1960±1987 but it exceeds the 6.35% found in Barry, Muscarella, and Vetsuypens (1991) for offerings without warrants for the period 1983±1987. In addition, the average offering price of US$11.43 is close to that reported by BMV (US$12.76). However, the average gross proceeds are larger than those reported in prior studies due to the number of leveraged buyouts returning to public status and large international offerings during this time.11
Table 2
Descriptive statistics for 729 IPOs over the period 1990 ± 1992
Variable Sample size Mean Minimum Maximum
Offering price 729 US$11.43 US$1.00 US$27.00
Gross proceeds in millionsa 729 US$49.17 US$1.90 US$861.63
Total assets in millionsb 684 US$154.62 US$ 0.00 US$6291.28
Average initial return 729 11.0% ÿ16.56% 99.01%
Lock-up shares/shares offered to publicc 555 1.96 0.015 9.12
a
Gross proceeds before over allotment.
b
Total assets at the time of going public.
c
Lock-up shares are the numbers of shares subject to the longest lock-up period reported by the company in the registration statement.
10
As disclosed in the Introduction, some companies have more than one lock-up period. For our sample, 188 IPOs have two. We focus our analyses on the longest period for a few reasons. First, a majority of the IPOs reports just one restricted period. Second, for IPOs that do have two, the average number of shares subject to the longer period is larger. Our statistics show that if IPOs have two lock-up periods, the mean value of shares subject to shorter lock-up is 1,283,467 shares, while the mean value of shares subject to the longer lock-up is 4,736,293 shares. Finally, intuitively we suspect that a longer lock-up period represents more risk to the consenting insider and, therefore, the longer period provides more information to the market place.
11
3. Information content of lock-up periods: initial returns
3.1. Univariate analysis
Discussions with underwriters reveal that influential buyers request lock-up periods during which insiders are prohibited from selling their holdings. Although it can be understood why influential buyers request such a provision, it is interesting that lock-up periods vary from 90 days to as long as 3 years, as reported in Table 1. If, as we have argued, influential buyers are the better-informed investors in the sense that they possess better information about the IPO's risk, then the length should convey information pertinent to the issuer's risk. If we assume that better-informed investors and underwriters are the makers and issuers are the price-takers,12a longer lock-up period allows time for the IPO firms to reveal their true value and for the investors to resolve uncertainty without the adverse effect of insider selling. Then the length of the lock-up period will be unambiguously and positively related to the issuer's risk. However, if some issuers are not pure price-takers, then the relationship between lock-up periods and perceived risk may contain noise. We discuss the noise issue in the latter part of this section.
To examine the information content of the lock-up period, Table 3 reports simple correlations between some variables employed in the study. The first row of the table presents simple correlation between initial underpricing (R1) and a group of risk proxies:
standard deviation of 19-day returns excluding the first trading day (s2,20), gross proceeds of
the offerings (GP), total assets of the issuer (TA), and underwriter reputation ranks (UNDWR) that we took from Carter and Manaster (1990). (Sample sizes vary because of the lack of information for some variables.) All of the risk proxies carry the expected sign and are significant at a minimum level of 1.4%. Lock-up period (LU) is positively related to the initial returns (r= 11.8%), which is consistent with our contention that informed investors request a
longer lock-up period for more risky issues. Furthermore, lock-up period is negatively correlated with the underwriter reputation rank (r=ÿ29.77%), which is also consistent with
the argument that more reputable underwriters are more likely to underwrite less risky issues. Simple correlation analysis, however, oversimplify the rather complex nature of the lock-up period provisions. Based lock-upon Table 1, we know that although the lock-lock-up period varies across IPOs, the most common one is 180 days. Therefore, it is interesting to examine if a ``group effect'' exists. To examine this possible effect, we partition the sample by the length of lock-up period into three groups: high, more than 180 days; medium, 180 days; low, less than 180 days. The sample sizes for the high, medium, and low groups are 175, 481, and 73, respectively. The partitioning is not entirely arbitrary if we consider the findings reported in Table 1. We then compare the values for a group of relevant variables (e.g., returns and risk measures) according to lock-up period partitioning.
Table 4 provides the following descriptive statistics for high vs. medium lock-up periods: initial returns (R1), standard deviation of 19-day returns excluding the first trading day (s2,20),
12 For an interesting example of how an investment banker sets the IPO price for the AST Research, see
gross proceeds of the offerings (GP), offering price (OP), total assets of the issuer (TA), underwriter spread (US), and underwriter reputation rank (UNDWR). The initial return is more than 2.7 percentage points larger for the high lock-up portfolio. Although thet test is significant at the 10% level, we also report the Wilcoxon nonparametric statistic, which is significant at the 5% level, because the data may not be normally distributed. Deeper
Table 4
Characteristics of variables based upon lock-up periods `high' vs. `medium' subsamples
High lock-up Medium lock-up Difference in means
More than 180 days 180 days Studentt Wilcoxon
Variable
Total assets of the issuing firm (TA, in thousands)
Underwriter reputation rank (UNDWR) 102 7.147 (2.31)
439 7.447 (1.64)
ÿ1.53 0.326
Standard deviations are in parentheses.
ttests are adjusted for unequal variances when necessary. * Denotes significance at the 1% level.
** Denotes significance at the 5% level. *** Denotes significance at the 10% level. Table 3
Simple correlation matrix for initial returns and risk proxies
underpricing is thus associated with the high lock-up IPOs. If the 180-day lock-up is regarded as the `benchmark,' deeper underpricing for the longer lock-up IPOs is consistent with our hypothesis that better-informed investors request longer lock-up periods because the issues are perceived as more risky. Gross proceeds, offering price, and total assets, three variables that are commonly used as proxies of ex ante risk, have statistically different mean values between these two portfolios. The high lock-up portfolio exhibits a lower offering price, smaller gross proceeds, and smaller total assets. Prior research generally found that smaller IPOs, characterized by lower gross proceeds and/or smaller total assets, are deeper under-priced to compensate for more uncertainty about the true firm value. Therefore, results based upon these three ex ante measurements of risk are consistent with that found in the difference in underpricing between the two groups. Furthermore, the difference between the underwriter spread for the high and benchmark portfolios (8.146% vs. 6.91%) is statistically significant at the 1% level for both the t test and the nonparametric test, a finding consistent with the argument that underwriter spread is larger for firms whose values are more uncertain. Ex post measurement of risk, s2,20, however, is not significantly different between these two
portfolios. If price support is popular, the standard deviation of the aftermarket stock returns may not be a powerful risk measure. Underwriter reputation rank is higher for the medium lock-up sample than the high lock-up sample, although neither the t statistic nor the nonparametric test show statistical significance. One should note, however, that there are many missing observations for the underwriter reputation variable, especially for the high lock-up sample. Because those underwriters not ranked by Carter and Manaster (1990) are mostly the lesser-known ones, it seems safe to argue that they are less prestigious. Our test of the underwriter reputation differences is thus biased in favor of finding no differences.
While the majority of the lock-up periods are 180 days, there are 73 IPOs with shorter time restrictions. Some, though representing a small portion of the IPOs, have no lock-up provisions at all.13 Because of the lack of literature in this area, we provide two possible explanations to this apparent departure from the norm. First, the IPO issuer could be a low risk such that informed investors and underwriters require minimal lock-up provisions. If this is the case, we would expect the evidence found in Table 4 to prevail; that is, we would observe a positive relationship between the length of the lock-up period and degree of underpricing. The second explanation rests upon the assumption that not all issuers are pure price-takers and/or that contract design allows for substitutes for the lock-up period. Some issuers prefer a shorter or no lock-up period over the norm.14Indeed, one issuer that we talked to commented that it was not easy to have every insider agree to the requested lock-up period. However, because the issuer's risk perceived by the better-informed investors and under-writers remains unchanged, the shorter lock-up period must be compensated for by alternative
13
All the statistical tests were repeated excluding the five companies not reporting a lock-up in the section Shares Eligible for Future Sale. The results were not materially different from those reported.
14
measures. One way to compensate for a shorter lock-up period is to underprice the issue to the extent that it is comparable to an otherwise similar issue. This kind of compensatory provision is not unusual in the IPO markets. For example, Barry et al. (1991) find that underwriter warrants allow the issuers to offer extra compensation to underwriters marketing especially risky offerings. If this notion is correct, then we can expect a shorter lock-up period (shorter than the norm) to result in deeper underpricing. Whether the first or the second explanation is true is thus an empirical issue.15
In Table 5 we report results from comparing the medium to the low lock-up portfolio. Initial returns and the underwriter spread are higher for the low lock-up portfolio. First-day returns are 4.3 percentage points higher for the low vs. the medium lock-up portfolio (which we regard as the norm). Thetstatistic is significant at the 10% level, and Wilcoxonzstatistic is significant at the 5% level. This evidence is consistent with the second explanation that for a given risk, a shorter lock-up period must be compensated for by deeper underpricing. This conjecture is further supported by the difference in underwriter spread. The average under-writer spread is 7.3% for the low lock-up portfolio and 6.9% for the benchmark portfolio. The difference is statistically significant based ont test results.
Table 5
Characteristics of variables based upon lock-up periods `low' vs. `medium' subsamples
Low lock-up Medium lock-up Difference in means
Less than 180 days 180 days Studentt Wilcoxon
Variable
Total assets of the issuing firm (TA, in thousands)
Underwriter reputation rank (UNDWR) 66 7.0833 (2.003)
439 7.4476 (1.64)
ÿ1.63*** ÿ1.28
Standard deviations are in parentheses.
ttests are adjusted for unequal variances when necessary. * Denotes significance at the 1% level.
** Denotes significance at the 5% level. *** Denotes significance at the 10% level.
15 We also examine whether any departure from the benchmark lock-up period is industry specific. However,
The 4.3 percentage-point difference in underpricing, however, may not be regarded as a pure compensation for the shorter lock-up periods. The lower gross proceeds, offering price, total assets, and underwriter reputation are characteristics suggesting that the low lock-up portfolio consists of more uncertain issuers. Both Student t and Wilcoxon statistical tests reveal that the benchmark portfolio has significantly larger proceeds than the low lock-up portfolio. Also, total assets for the benchmark group is approximately two-and-half times larger than the assets of the low lock-up issuers.16 While we do not have information to answer the question as to why some of the more risky IPOs fail to accept a longer lock-up period, one may speculate that the informed insiders do not wish to forfeit the opportunity of selling overvalued shares. Furthermore, although we do not know why low lock-up firms accept deeper underpricing in exchange for a shorter lock-up period, we do know that departure from the norm is consistent with a more uncertain issuer and results in deeper underpricing.17 The inability of the issuer to commit to a longer lock-up period constitutes uncertainty. If we assume that the low lock-up IPOs are about equally risky as the high lock-up period IPOs, then the difference in the initial returns of 1.68 percentage points (0.14267±0.12587) represents the implicit IPO costs of failing to agree to a longer lock-up period. To summarize, we find a U-shaped relationship between the lock-up periods and the risk of an IPO Ð both low and high lock-up periods IPOs are more risky and are more deeply underpriced.
3.2. Regression analysis
Our preliminary results based upon univariate analyses (Tables 4 and 5) are reinforced in this section by using regression analysis. Following Beatty and Ritter (1986), Miller and Reilly (1987), Ritter (1984), and Rock (1986), the underpricing of an IPO is related to uncertainty that is measured ex ante by the amount of gross proceeds and/or ex post by the standard deviation of after market returns. We argue, however, that lock-up periods convey information pertinent to the uncertainty of the firm value. Therefore, lock-up duration serves as a reliable proxy of ex ante risk measure. We conduct our analysis using OLS regressions and the results are reported in Table 6.
The first four equations are univariate analyses using gross proceeds (GP), standard deviation (s2,20), underwriter reputation rank (UNDWR), and lock-up period length (LU) as
independent variables. All four variables are statistically significant with the expected sign direction.18 The impact of lock-up periods on the initial returns, however, could be
16
Statistical tests yield inconsistent results for the variable total assets. Whiletstatistics show that low lock-up IPOs have significantly smaller total assets and higher underwriting discounts, Wilcoxon tests fail to confirm it.
17
Although not reported in a separate table, it is clear from Tables 4 and 5 that issuers with shorter lock-up periods more resemble issuers with longer lock-up periods. For example, gross proceeds, standard deviations, and total assets are quite comparable between these two issuers. This evidence seems to be more supportive of our second reasoning. That is, low lock-up period IPOs are not necessary low risk firms, and shorter lock-up periods must be compensated for by deeper underpricing.
18
Table 6
OLS regression results of initial returns
Equations
Gross proceeds scaled by 10,000,000 (GP) ÿ0.00163
(ÿ2.26)**
ÿ0.00012
(ÿ0.17)
0.0034 (2.77)* Standard deviation of 19 after-market returns
following the initial return (s2,20)
1.42899
Underwriter reputation rank (UNDWR) ÿ0.0095
(ÿ3.25)*
ÿ0.0072
(ÿ2.22)**
0.0024 (0.60)
Lock-up period in days, scaled by 100 (LU) 0.012329
(3.20)*
Square of lock-up period in days, scaled by 100 (LU2) 0.00325
(2.49)**
R2 0.007 0.019 0.015 0.014 0.022 0.043 0.077
Tstatistics are in parentheses.
* Denotes significance at the 1% level. ** Denotes significance at the 5% level. *** Denotes significance at the 10% level.
nonlinear. Although a priori we do not have information regarding the exact functional form, we speculate the existence of a U-shaped relationship between initial returns and lock-up periods based upon the analyses presented in Tables 4 and 5, i.e., a normal 180-day lock-up period is associated with the least underpricing, and underpricing intensifies as the lock-up period increases or decreases. Eq. (5) tests this conjecture using the length of the lock-up period and the square of the length as explanatory variables.19 Although the t
statistic is not significant (P value = 13%) for the length of the lock-up period, the squared length is significant at the 5% level (two-tailed test). Because the F statistic indicates that both variables are jointly significant at the 1% level, multicollinearity most likely contributes to the lower t statistics of the variable LU. In Eq. (6), we test a multivariate model that includes all aforementioned variables. Gross proceeds, although still possessing the correct sign, is no longer statistically significant.20 Both standard deviation and underwriter reputation rank remain significant at the 1% and 5% levels, respectively. Interestingly, lock-up period and lock-up period squared are now statistically significant at the 10% and 5% levels, respectively, with the right signs, reinforcing our argument of a U-shaped relationship between initial underpricing and lock-up periods. Finally, in Eq. (7) we consider two additional proxies for the risk of an IPO. Underwriter spread (US) usually is higher for IPOs that are harder to price (Bloch, 1989). Total assets of IPO firms is a measurement of firm size, and large firms are presumably less risky than smaller firms. Underwriter spread is positive and significant at the 1% level, and total assets carries the expected negative sign and is significant at the 10% level. Interestingly, gross proceeds (GP) now carries a wrong sign. Lock-up period (LU) and its squared term (LU2) continue to carry the expected signs and are statistically significant at the 5% level. We conclude, therefore, that lock-up period is a reliable measurement of IPO risk, and is related to the initial underpricing of the IPOs.
4. Information content of trading after the expiration of lock-up period
As we have discussed earlier, trading that occurs after the expiration of the lock-up period is often watched by Wall Street. And we suspect that the amount of activity contains information pertinent to the true firm value. To test Hypothesis 2, we argue that abnormal trading (e.g., unusually thin or heavy) after the expiration of the lock-up period signals the extent of insider confidence. Trading volume signals the level of insider confidence because insiders have unrestricted opportunity to buy, but not sell, stock before the lock-up period expiration. Heavy volume right after the lock-up expiration may be perceived and interpreted by market participants as insider selling, and therefore, signal a lower quality firm. On the other hand, very light trading after the expiration of the lock-up period may signal insider confidence and market participants may interpret this as good news.
19 The nonlinear model specified here is considered as `intrinsically linear,' thus an OLS model is appropriate. 20
To examine our hypothesis, we set the lock-up period expiration date as Day 0, and examine daily excess returns for each company for a maximum of 250 trading days.21 Fig. 1 shows a plot of the average cumulative excess returns for the entire IPO sample over the 250-day interval surrounding the lock-up expiration date. Two notable patterns emerge. First, average cumulative excess returns decrease monotonically from Days ÿ250 to 250 (2 trading years). This observation is consistent with other findings that, on average, IPO stocks performed poorly over longer time periods. Second, for the IPO firms as a group, there is no notable change in the average cumulative excess returns for the period immediately surrounding the lock-up period expiration date.
To better examine our argument that trading conducted shortly after the expiration of the lock-up period is interpreted by the market participants as signals of the true firm quality, we partition the sample according to thin or heavy trading after the expiration date. We first compute the average daily trading volumes (Vp) for each IPO firm using the entire sample
period. We then compute the same statistic (Vs) using only daily volume from Days 0 to 30. Average daily trading volume of the 31 day window immediately after the lock-up period expiration date is then compared with the average daily trading volume for the entire sampling period for each IPOs, that is,
TAIj VsjÿVpj=Vpj; 3
where TAIjstands for trading activity index for firmj,j= 1. . .682. TAIjfor all firms then are
ranked based on magnitude. The bottom 20th percentile, which consists of 137 IPOs, is considered as the thin-trading portfolio, while the top 20th percentile, which also consists of 137 IPOs, is regarded as the heavy-trading portfolio.22
Daily average cumulative excess returns for each portfolio are computed and plotted in Fig. 1. For the thin-trading portfolio, average cumulative excess returns before the lock-up period expiration date follow the same pattern that was observed for the entire sample in Fig. 1. Average cumulative excess returns after the expiration date, however, begin to increase approximately 30 days after Day 0 and continue to increase through Day 250. This pattern of average cumulative excess returns generally conforms to our contention that thin-trading activities right after the expiration date of the lock-up period signal a high-quality firm and the markets respond positively to this signal. The approximately 30 days delayed response can be interpreted in two ways. First, all insiders need not rush to sell their holdings the day or the week immediately after the expiration of the lock-up period. In effect, a delay in releasing bad news is documented in the finance literature. The 1 month delayed response coincides with the time window we used to measure the trading activity index (TAI). Furthermore, according to Section 16a of the 1934 Securities Exchange Act,
21
In this section the sample size varies. First, not all of the IPO firms have 250 days of trading after the lock-up expiration date. The maximum sample sizes after time 0 is 682. Second, the number of trading days before the expiration depends on the length of the lock up. As shown in Table 1, the most popular length is 180 days. Thus, the sample size varies before expiration date.
22
insiders of a public company are required to file a Form 4 statement with the SEC within 10 days after each month in which there is a change in ownership. Taking this filing lag into account, market participants can verify insiders' selling only 25 days (on average) after the transactions are done. This is not, however, a necessary condition for the market to react positively with a time lag. Presumably, the market participants can easily infer light trading as no evidence of insiders' selling and react positively. Furthermore, we are not testing the ex post relationship between actual insider buying/selling and market reactions; instead, we test if the markets respond to the trading activities in general, and in which way the market interprets and responds to thin/heavy trading.
The more striking results are also reported in Fig. 1 for the heavy-trading portfolio. The average cumulative excess returns decrease dramatically after Day 25
mately) for the heavy-trading portfolio. In effect, the portfolio value decreases more than 23% during the 90-day period after Day 25. The market reacts negatively to the heavy trading conducted shortly after the expiration date because heavy trading may be perceived by market participants as informed insiders having lost their confidence in the IPO firm. Therefore, heavy trading immediately after the expiration date of the lock-up period signals a poor-quality IPO firm. We repeat the process for the bottom 10th percentile IPOs (68 firms) and the top 10th percentile IPOs (69 firms). Our inference does not change. Results based upon the 10th and the 90th percentile portfolios are even stronger than that of the 20th and 80th percentile.23 We conclude, therefore, that trading activities conducted shortly after the lock-up period expiration date signal the true value of the IPO firms.24
5. Conclusions
Examining the IPO prospectuses, we found that an overwhelmingly large proportion of IPOs report various lock-up provisions that prohibit insiders from selling their stock within a certain period after going public. Discussions with underwriters suggest that influential buyers, presumably better-informed investors, request the lock-up. It is interesting, however, that lock-up periods vary across IPOs. We conjecture, therefore, that the length of lock-up periods conveys credible information pertinent to the issuers' risk. Analyzing 729 IPOs from January 1990 to December 1992, we found that the lock-up period signals issuer's risk and that a 180-day lock-up period seems to be the norm. Departure from the norm (longer or shorter) suggests more uncertainty about the firm value, and thus results in deeper under-pricing of the IPO as well as larger underwriter spread. Group analyses confirm our conjecture that lock-up length is a reliable ex ante measurement of IPO risk. Both univariate and multivariate regression analyses reinforce the contention that lock-up period is robust in explaining the IPO underpricing.
The lock-up variable seems to convey information beyond the IPO period. Our results are consistent with the suggestion that Wall Street pays special attention to the expiration of the lock-up period. We conjecture that trading activities conducted shortly after the expiration of the lock-up period signal the true firm value. Our empirical findings support our contention that thin-trading activities are perceived by the market as good news, while heavy trading is regarded as bad news.
23
We also investigate if there is any relationship between the length of the lock-up provision and the trading activity after the expiration of the provision that may be caused by the asymmetric information existing between the old and the new shareholders. For the thin-trading portfolio, the mean lock-up period is 226 days with a standard deviation of 113 days, and the same statistics for the heavy-trading portfolio are 225 and 143 days, respectively. Attest of unequal means is not statistically significant.
24
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