IPO UNDERPRICING, INSIDER SELLING AND SUBSEQUENT EQUITY OFFERINGS - IS UNDERPRICING A SIGNAL OF QUALITY

Recent papers posit that a firm may deliberately underprice its IPO in order to inform the market that the firm is of high quality. These pa pers argue that underpricing is a vehicle whereby firms can signal the ir favorable private information and thereby increase the price receiv ed in subsequent securities offerings. Similarly, insiders may also re coup the costs of underpricing through subsequent open market sales of their shares at a more favorable price. I test the implications of th ese models and find evidence generally inconsistent with their predict ions. Specifically, I examine the relationship between IPO underpricin g and the likelihood of returning to the market with a seasoned equity offer or an open market insider sale. Overall, I find no significant relation between IPO underpricing and the probability of reissue, afte r controlling for factors that may affect both underpricing and the pr obability of reissue. In addition, I find no relationship between unde rpricing and the probability of an open market insider sale. Thus, it appears that firms are not underpricing in a deliberate effort to info rm the market of their quality. This paper builds on previous research that tests the implication of signalling by underpricing theories, th at underpricing is positively related to the probability of the firm s elling additional equity in the future. In particular, this is the fir st paper that recognizes the importance of open market insider sales a s a means for recouping the losses due to underpricing. It is also the first paper that controls for the partial adjustment phenomenon in un derpricing as well as other factors that may affect both underpricing and reissue activity, in the tests of the signalling theory implicatio ns. Specifically, prior research has noted the possibility that factor s affecting underpricing may also affect the likelihood that a firm wi ll reissue equity. For example, proxies for growth opportunities may a ffect underpricing since growth opportunities are more difficult to ev aluate than tangible assets, causing greater uncertainty about the val ue of the firm. Moreover, firms with many growth opportunities are mor e likely to require additional outside financing in the future, implyi ng a greater probability of returning to the equity market with a seas oned equity issue. However, other research has shown that underpricing is also related to the partial adjustment phenomenon. Briefly, partia l adjustment occurs when investment bankers partially adjust the share price and number of shares issued in response to strong demand for an IPO during the pre-offer period (the time when underwriters gather in formation on demand for the issue). Since this adjustment is partial b y design, the share price will rise in the secondary market once tradi ng begins. Thus, underpricing is greater for issues where the price ha s been adjusted during the pre-offer period than for issues that have not. Moreover, upward adjustment in price and shares offered leads to greater proceeds at the IPO, perhaps mitigating the need to reissue eq uity. As a result, this partial adjustment phenomenon must be controll ed for when testing for a relation between underpricing and the likeli hood of a seasoned equity offer. I find that underpricing does not mat erially affect the likelihood of reissuing equity for a sample of 494 IPOs issued between 1981 and 1983 inclusive, after controlling for pro xies for ex-ante uncertainty and the partial adjustment phenomenon. Sp ecifically, my measure of the sensitivity of the probability of reissu ing equity to underpricing is statistically indistinguishable from zer o when I include proxies for ex-ante uncertainty and partial adjustmen t variables in my analysis. I find the same lack of a relationship whe n I examine the effect of underpricing on the probability that an insi der will sell shams in the open market within two years of the IPO. My findings have implications for both investors and entrepreneurs of fi rms preparing to ''go public.'' Investors should recognize that observ ed underpricing of the IPO does not guaranty high quality of the firm. Entrepreneurs can better understand the factors affecting underpricin g and the importance of it (or lack thereof) in influencing investors' beliefs about firm quality.