Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance

Zachary A. Smith, Ph.D.

An Empirical Analysis of Initial Public Offering (IPO) Performance

Zachary A. Smith, Ph.D.

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 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Abstract: For decades, researchers have disagreed about the magnitude and predictability of
abnormal securities’ price performance generated by initial public offerings (IPOs). The purpose
of this study was to identify the best specified and most powerful method of abnormal
performance detection and to apply this method to examine the price performance of IPOs.
Matched by size, industry, and book-to-market ratios this study explored which of the resulting
seven portfolios and matched-firm methods of abnormal performance detection produced the
best specified and most powerful test statistics. Additionally, this study analyzes IPO price
performance to determine if IPOs generate abnormal performance. This analysis was conducted
using the event study approach for the research design along with the buy and hold abnormal
return (BHAR) method of calculating abnormal returns. The findings were that (a) all of the
matched-firm methods of abnormal performance detection were well specified and powerful
(matching by industry affiliation generated the best power and specification results) and (b) that
the IPOs generated statistically significant abnormal price performances occurring in: (a) short-
term analyses, (b) longer-term analyses, and (c) analyses of the lockup and quiet periods.

Key words: Event study, IPO performance, Quiet period, Lockup period, Specification and
power analysis, Short- and long-term abnormal performance, Initial public offering, Price
performance
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

An Empirical Analysis of Initial Public Offering (IPO) Performance

This research project will provide the reader with thorough understanding of the
anomalies related to IPO price performance, by canvassing the population of IPOs that went
public on U.S. financial exchanges from 1985-2002. There were four test of abnormal IPO
performance carried out in this research project, test for: (a) abnormally positive pre-market and
initial day of trade performance, (b) abnormally negative longer-term performance, (c)
abnormally negative performance occurring around the expiration of the lockup period, and (d)
abnormally positive performance occurring during the expiration of the quiet period. In addition
to the preceding tests, this study seeks to determine which of seven portfolio-matching (PM) and
matched firm (MF) strategies are the best-specified and most powerful estimators of normal
performance. The matching strategies evaluated in this analysis were PM techniques by market
capitalization, industry affiliation, and market capitalization and book-to-market ratios and MF
techniques by market capitalization, industry affiliation, industry affiliation and market
capitalization, and market capitalization and book-to-market ratios. This study relied on the use
of the event study methodology throughout the analysis and the calculation of abnormal returns
by the buy and hold abnormal return (BHAR) method.
The main results and conclusions reached in this analysis were as follows. First, this
paper illustrates how poor, in regards to specification and power, PM techniques performed; on a
positive note, all of the MF strategies used to estimate abnormal performance performed
remarkably well—interestingly enough, the MF approach by industry affiliation outperformed
the more popular approach—matching by market capitalization and book-to-market ratios.
Second, it is apparent that initial abnormal performance, between the offer and initial trading of
shares, is substantial—the current study estimates this abnormal performance at 11.74%—
however, abnormal performance is not constrained to pre-market inefficiencies. During the
initial trading day, IPOs in this sample generated abnormally positive performance of 3.44%.
Third, this analysis illustrates that IPOs experience substantial long-term underperformance three
years after their initial unseasoned equity offering, when compared against firms matched based
upon industry affiliation. Finally, IPOs experience significant abnormally positive performance
in the five-day period surrounding the expiration of the quiet period of 1.64% and a significantly
negative abnormal performance of 1.00% around the expiration of the lockup period.
This paper continues as follows. Section I introduces the theory, empirical work, and
conceptual framework of the hypotheses related to IPO performance. Section II presents the
proposed methodology. Section III presents the results of the current analysis. Section IV
provides a summary of the work and concludes.

Literary Review

Studies of IPO performance have concentrated in two general veins of inquiry: (a) why
do IPOs generate abnormal performance and (b) to what extent is this performance abnormal.
This project focus on addressing the second of the two preceding questions, namely how
significant this abnormal IPO performance. Many researchers have attempted to answer this
question (e.g. Affleck-Graves, Hedge, & Miller, 1996; Ibbotson, 1975; Loughran & Ritter, 2004;
Reilly & Hatfield, 1969), but questions regarding their methods used to identify abnormal
performance have arisen (e.g. Brav, Geczy, & Gompers, 2000; Brown & Weinstein, 1985;
Cheng, Chueng, & Po, 2004; Schultz, 2003). This list of relevant research is only an introduction
to a vibrant debate that has been brewing, and is as complicated as it is interesting and
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

invigorating. The question that this project seeks to illuminate is as follows: If IPOs generate
abnormal performance, when is this abnormal IPO performance significant and how should
academics measure this performance?

Method

Traditionally, researchers attempt to measure abnormal performance in research

conducted on financial data sets using the event study methodology. This method seems to have
been pioneered by Ball and Brown (1968) and Fama, Fisher, Jensen, and Roll (1969), in which
the researchers analyze the impact of information on the performance of a publicly traded
security; however, according to Campbell, Lo, and MacKinlay (1997) the first published event
study was conducted 1933. When we refer to traditional event study designs, like those
mentioned in Campbell et al. (1997), normally the researcher has the luxury of (a) an estimation
window, (b) event window, and (c) post-event. However, when dealing with IPOs, we lack this
estimation period, which is suppose to provide the researcher with normalized expectations of
return behavior. Therefore, researchers have to find other means of estimating normal return
behavior.
Researchers have used various methods to accomplish this task. In current and recent
research, these methods normally fall into one of two categories: matched firm (MF) approaches
or portfolio matching strategies (PM). PM matching strategies have been carried out by Brav and
Gompers (1997), Carter, Dark, and Singh (1998), Gompers and Lerner (2005); contrarily,
Bhabra and Pettway (2003) and Perfect and Peterson (1997) focused solely on the MF approach;
Finally, Ritter, J. (1991) used both MF and PM strategies. Attempts have been made by Barber
and Lyon (1997), Mitchell and Stafford (2000), and others to generate tests of different methods
analyzing the ability of different methods to detect abnormal performance—the two general
approaches are categorized as event and calendar time analyses.
There are good arguments for and against using various methods; researchers typically
prefer one method to the other. This project is interested in evaluating the investor’s buy and
hold investment experience; therefore, because the buy-and-hold investor’s returns are most
appropriately modeled in event time the method used to analyze the investment performance in
the current analysis was the buy and hold abnormal return (BHAR) method. The question that is
inherently difficult to answer is that if we were interested in analyzing the buy and hold
investor’s experience, in terms of abnormal performance, what would the best-suited method
look like? Mitchell and Stafford (2000) picked apart the BHAR method in their analysis, but they
focus their critiques on portfolio-matching techniques and using bootstrapping procedures or
bootstrapped t-statistics and stated that “BHARS have poor statistical properties, producing
biased test statistics in random samples” (p.302). Portfolio-matching techniques produce
misspecified test statistics in random samples; however, the method ignored in the Mitchell and
Stafford (2000) analysis is the matched-firm approach to benchmarking, which will produce
well-specified test statistics in the present analysis. Barber and Lyon (1997) concluded that the
matched firm approach, relying on a firm’s market capitalization and book-to-market ratios to
evaluate firm performance, generated well-specified test statistics throughout their analysis. This
project focuses on measuring the buy-and-hold investor’s investment experience; therefore, the
researcher applied the BHAR method throughout this analysis.
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Research Questions

This analysis focuses on four different research sections; this section develops these
questions and this paragraph identifies them. The first question that this research project
endeavors to answer is which general method, matched-firm or portfolio-matching technique,
paired with firm-specific information (i.e. market capitalization, industry affiliation, and book-to-
market ratios) provides the best proxy for expected return. The next topic that this project seeks
to address is when short-term abnormal performance occurs, in the process of issuing unseasoned
equity shares; the researcher analyzes the specific time horizons in segments, studied by pre-
trade and initial trading day results. Lengthening this analysis the project will then seek to
determine whether IPOs underperform the market in longer-term analyses. Finally, the analysis
will evaluate whether IPOs generate significant abnormal performance in the five-day period
surrounding the expiration of the quiet and lockup periods.

Specification and Power Analyses

The first portion of the hypothesis testing section will evaluate the performance of
potential methods used to identify abnormal performance in similar studies. There has been
significant debate regarding whether researchers should use the CAR or BHAR method of
calculating abnormal returns when conducting event studies, in the previous subsection, this
debate was already articulate. In this section, the discussion centers around which method of
estimating expected return should be use to conduct event studies, given that the BHAR method
is the appropriate method used to estimate the extent of abnormal performance.
In the majority of research projects attempting to determine which method of abnormal
performance detection, portfolio matching or matched-firm, to use when conducting event
studies conclude that the matched firm approach works quite well (Ang and Zhang, 2004; Barber
and Lyon, 1997). However, researchers continuously revert to their quest to identify a method of
abnormal performance detection that relies on the construction of portfolio benchmarks. In Lyon,
Barber, and Tsai (1999) the researchers used skewness adjusted t statistics and empirically
generated distributions of mean long-term stock returns generated from pseudo portfolios, to
compensate for the following biases: (a) the new listing bias, (b) the rebalancing bias, (c)
skewness bias, (d) cross-sectional dependence, and/or (e) a bad model problem (p. 197).
However, after these efforts are undertaken, the control-firm approach used to detect abnormal
performance, using market capitalization and book-to-market ratio data to match, generated
better-specified test statistic than either adjusted portfolio technique.
This analysis will illustrate that the entire set of matched firm approaches used to detect
abnormal performance generated well-specified and relatively powerful test statistics, prior to
making additional changes to the models of abnormal performance detection. We can easily
avoid exposing the matched firm approach to the new listing, rebalancing, and skewness biases.
Cross-sectional dependence may pose some threat to the conclusions and results reached in this
analysis; however, it is apparent that markets run in cycles—whether we are discussing industry
correlations, correlations of market returns by size and/ or market-to-book ratios—this problem
is evident in the majority of analyses conducted on event studies. This study assumes that the
sample sizes used to implement the analyses and the 18-year period that the study was ran will
minimize the impact of this bias on the results obtain. Finally, this research project provides
evidence that when researchers use the match firm approach to detect abnormal performance,
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

combined with an independent sampling technique, the model performs very well regardless of
the techniques researchers use to match the event firms. In summary, first, there are many biases
that researchers can fall prey to when attempting to conduct event studies, second, when
researchers use portfolio-matching techniques instead of matched firm approaches these biases
are accentuated, and , third, the biases affect the results of the portfolio-matching techniques
more than the matched-firm approaches used to detect abnormal performance.

Short-Term Abnormally Positive Performance

The most visible abnormality that currently exists in studies of IPO performance is that
IPOs tend to produce extremely abnormally positive performance results a short duration after
going public. This excess abnormal return occurs either in the preissuance period or in the one-
day performance of the post-offering period (see Krigman, Shaw, & Womack, 1999; Loughran
& Ritter, 2004; McDonald & Fisher, 1972; Reily & Hatfield, 1969). Miller and Reilly (1987)
found that the extent of this underperformance was approximately 9.87% (p. 34) and Ibbotson,
Sindelar, and Ritter (1994) reiterated this sentiment by concluding that “first–day returns average
10-15%” (p. 66). Cheng, Cheung, and Po (2004) found, while studying IPO price performance
on the Hong Kong financial market, that no trading profits were obtainable once IPOs began
trading publicly (p. 853), this finding contrasts those reached in Miller and Reilly (1987), an
analysis of IPOs listed in the U.S. markets. Historically, researchers seem to have assumed that
IPOs obtained profits in the first trading day. Perhaps, they have ignored the negative social and
process implications attached to an empirical finding that the positive IPO performance is
constrained to the pretrading period. If the abnormal performance is constrained between the
offer and issuance, then the distributions of shares, and whom the shares are distributed, become
a more fundamental question, in regards to affording investors with equal opportunities to profit.
This question is relevant because the underwriting syndicate holds an unfair informational
advantage over the majority of the investing public.
The pertinent questions are does the underwriting syndicate exploit the informational
advantage, and is the initial abnormally positive performance a result of an under pricing /
rebating scheme (see Ritter & Welch, 2002)? There are alternative arguments for what occurs
here, for example, the investing public may create abnormal performance because they are acting
irrationally when attempting to value these IPOs. This irrational analysis may occur because the
investors know about the historical pricing anomaly (short-term abnormally positive
performance), and in turn demand for new issues are exacerbated and unwarranted optimism, in
the post-issuance performance capability of these securities, increases, thus pushes the share
price away from its fundamental value in the aftermarket (see Garfinkle, Malkiel, & Bontas,
2002). Case in point, Purnanandam and Swaminathan (2004) found in a study of 2,000 IPOs that
went public from 1980 to 1997 that investors overvalued the median IPO, when compared
against firms matched by operating characteristics—they approximate the overvaluation at
approximately 14% to 50% (p. 812). Since the investment bankers, who are underwriting these
offerings, are considered market experts, it seems that the market would consider a systematic
underpricing a disadvantageous finding for the EMH. If investors are responsible for this
abnormal performance, then researchers should seriously question market efficiency because the
markets are irrationally pricing individual securities in a reaction to systematic events related to
the process of issuing unseasoned equity shares.
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Long-term Underperformance

Researchers have also provided evidence in support of the theory that IPOs suffer from
long-term price underperformance when measured against standard benchmarks (see Affleck-
Graves, Hedge, & Miller, 1996; Ibbotson, 1975; Loughran, & Ritter, 1995; Ritter, 1991). Ritter
(1989) found that, in his sample of IPOs issued from 1975-84, IPO’s 3-year holding period
returns (HPR) underperformed portfolios matched based upon market capitalization and industry
characteristics by 27.39% (p. 4); Ibbotson, Sindelar, and Ritter (1994) found similar results
analyzing IPO data from 1970-1990. Ritter (1989) and Ibbotson (1994) suggested that on
average IPOs underperform standard benchmarks from the end of the initial trading day to at
least the firm’s five-year publicly traded anniversary.

Event-specific Abnormal Performance

Two events in occur systematically after a company issues unseasoned equity to the
public are the expiration of the quiet period and the lockup period. Researchers have illustrated
that these two events produce abnormal performances in empirical analyses of event studies.
However, the directions of the abnormal performances that the two events generate are
divergent, and researchers have questioned the magnitude and causes of these abnormal
performances. The following two sections will define and review the literature related to the
abnormal performance, which that purportedly occurs during the expiration of the quiet and
lockup periods.

The Quiet Period. The quiet period is the market’s terminology for SEC regulation
#5180, enacted in 1971; it states that companies are not to issue forecasts or predictions related
to revenues, income, and earnings per share, or publish “opinions concerning values” (see
Bradley, Jordan, & Ritter, 2003, p. 5). The rationale behind the enactment of the quiet period is
that, according to Bradley, Jordan, Ritter, and Wolf (2004), it provides investors with the
necessary time to value the company without insider interference or influence. The quiet period
provides a time period that allows investors to search for a fair value of the underlying assets
owned by the company without external, expert, influence on their opinions.
At the conclusion of the quiet period, the SEC allows investment firms to initiate
coverage of a security. The reason why this period is so interesting is that Bradley, Jordan, and
Ritter (2003) have found that from 1996-2000, for all IPOs issued, analysts initiated coverage on
76% of the newly issued IPOs, and of these 76%, analysts initiated coverage on 96% of these
issues as a strong buy or a buy (p. 33). This is not what the researcher expected; structurally, I
would prefer to see a distribution that, from a probabilistic standpoint, firms rated would just as
likely receive a positive rating as a negative rating. According to Bradley et al. (2003), when
analysts initiate coverage immediately after the quiet period, the IPOs affected by this event
experienced a significantly positive abnormal return of 4.1% in a five-day window surrounding
the quiet period (p. 33). If analysts left the newly issued IPOs uncovered at the conclusion of
their quiet period, firms experienced an insignificant abnormal return of 0.1% (see Bradley et al.,
2003, p. 33). In 2004, Bradley, Jordan, Ritter, and Wolf (2004) attempted to expand this study to
include IPOs that went public from January 2001 through July 2002; the impact of the expiration
of the quiet period during this time horizon was insignificant (p. 11). In this study, the researcher
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

endeavored to answer why the two research projects differed in regards to their results and
analyze whether abnormal performance is significant during the expiration of the quiet period.

Lockup Expiration. Researchers, in the past, have not built a solid case to declare that
abnormal performance occurs as the lockup period expires. However, Field, and Hanka (2001)
found that from 1988 to 1997, during the expiration of the lockup period, investors experienced a
three-day abnormally negative performance of 1.5% (p. 471). The results from Garfinkle,
Malkiel, and Bontas (2002) were in agreement with Field et al. (2001), although the Garfinkle et
al. (2002) found that negative performance experienced during the expiration of the lockup
period was to 4.47%. The two different percentages vary remarkably and the methods that the
researchers used to calculate abnormal returns are quite different. It is my goal to add clarity and
specificity to this potential anomaly.

Summary

From a methodological perspective, according to Lyon, Barber, and Tsai (1999), “the
analysis of long-run abnormal performance is treacherous” (p. 198); therefore, it is beneficial for
any analysis attempting to identify long-term abnormal performance to be paired with a
specification and power analysis of the metric used to identify this abnormal performance. This
empirical study will combine the majority of the different tests of abnormal performance that
occur because of unseasoned equity issuance with a test of the metric used to identify abnormal
performance. Many researchers have conducted analyses on IPO performance, both short- and
long-term, and, in general, what prompts researchers to doubt the outcome of an analysis is the
metrics they use to calculate expected returns and aggregate abnormal returns. Thus, researchers
should include a specification and power analysis of the metric used to estimate expected return
within their analyses of abnormal performance, to avoid undue criticism and dissention in
regards to the interpretation of the conclusions generated in the analysis.
This analysis tests the models of expected return to find the best-specified and most
powerful method to use to detect abnormal performance so that we use the best the metric to
detect abnormal IPO performance. This study tested five conjectures related to IPO
performance—they were as follows: (a) abnormally positive performance occurring in pre-
issuance trading, on the initial day of trade, around the expiration of the quiet period, and (a)
abnormally negative performance occurring at the conclusion of the lockup period and in long-
term analyses. Researchers have run analyses related to these aforementioned abnormalities in
preceding studies, however, for whatever reason, as outlined in this section other scholars have
questioned the results of these analyses. This analysis aims to reconcile tests of abnormal IPO
performance using large sample sizes and well-specified and powerful method used to estimate
expected return as well as detect abnormal performance.

Methodology

A discussion of the rationale behind the decisions to use the BHAR method to calculate
abnormal returns over the choice of the CAR method was address earlier in this document; this
section will describe how the researcher will implement the method and run the power and
specification analyses. Furthermore, the sample sizes are different in many of the analyses, even
though the study canvassed the entire time horizon, from January 1985 to December 2002;
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

because of incomplete records, the researcher conducted some of the analyses with much smaller
sample sizes than originally anticipated. This section will review the methodological procedures
applied to conduct the power and specification analyses as well as the test of abnormal
performance and the samples sizes of each test.

Power and Specification Analyses

In this analysis, the researcher conducted the power and specification analyses based
partially on the methodology described in Ang and Zhang (2004). The following paragraphs
describe the adjustments made to the Ang et al. (2004) methodology. It is appropriate to note
here that two different power and specification analyses were run to determine how increases in
sample sizes would influence the metrics ability two identify abnormal performance. In the first
analysis, we took 10 non-repeating samples of 50 companies taken from the list of Russell 3000
constituents each year of our analysis. Next, the researcher combined these 10 yearly samples of
50 companies were combined to produce larger samples (n – 500).

Specification Analysis

To evaluate which of the seven different benchmarking techniques generated the best
specified test statistics, the project needs a pool of random companies to evaluate, the metric
used as a proxy for normal performance, a method used to calculate abnormal performance, and
a method to aggregate abnormal performances a cross the sample. This analysis uses the BHAR
methodology to calculate abnormal performance and seven different methods based upon either
portfolio matching or matched-firm methods used to proxy for expected returns; however, now
the project’s pool and the method used to aggregate returns a cross samples will be specified.
This project used two different procedures to obtain proxies for expected returns: (a)
portfolio-matching and (b) matched-firm. For the match-firm approach, the researcher extracted
the sample firms used in this analysis from a list of the components of the Russell 3000 Index
each year. If a company was included in the Russell 3000 list of companies, the company was
eligible to be a matched firm in this analysis—each year, the list was updated, from 1985-2002,
due to the addition and deletion of firms from the list of constituents each year. If a firm is
matched based upon any singular firm characteristic (i.e. market capitalization or industry
affiliation), the pool of potential matched firms are sorted and the closet match is selected;
furthermore, if there are multiple firms that meet the matching requirements, a number is
assigned to each potential match and a firm is randomly selected from the potential matches. If
two factors are included in the matching procedure (i.e. industry and market capitalization and
market capitalization and book-to-market ratios), the firms are sorted by the most appropriate
factor (i.e. industry affiliation for the industry/market capitalization sort and market
capitalization for the market capitalization and book-to-market sort) first, and then the second
factor.
When this research project used the portfolio-matching technique, it relied on external
portfolios to match the firm to a similar portfolio with a similar likeness. The procedure for
matching was simple: the researcher paired the event firm with a portfolio grouping compiled
and maintained on Dr. Kenneth French’s website (URL:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). The researcher then
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

carried out this matching procedure for portfolio-matching approaches based upon industry
affiliation, market capitalization, and market capitalization and book-to-market ratios.
After the pairings were made, the performance of the simulated event firm (randomly
drawn from the Russell 3000 list each year) and the matched firm or portfolio match were
compared, in terms of specification, for 1, 2, 3, and 4-year time horizons. The researcher then ran
the specification analysis to determine if a metric would conclude that abnormal performance
had occurred when in actuality it had not—throughout this analysis the level of significance was
set at 5%. Therefore, on for each pairing the following Buy and Hold Abnormal Return (BHAR)
was calculated:

τ τ
BHARi , t = ∏ [1 + Ri , t ] − ∏ [1 + E ( Ri , t )] (1)
t =1 t =1

The researcher then pooled the result of this formula for each sample taken for this analysis and
then compiled the following summary statistics: (a) sample size, (b) sample average, (c) sample
standard deviation.
After the researcher compiled these statistics for each sample taken, he calculated the
following statistic, Barber and Lyon (1997):

t BHAR = BHARi ,t /(σ ( BHARi , t ) / n ) (2)

The researcher then took the t statistics and grouped them based upon their respective sample to
generate the empirical size (ES) statistic. The following calculation will provide us with the ES
statistic; again, we are comparing this statistic against our theoretical 5% level of significance to
determine if our metric can perform properly if abnormal performance does not exist. The
researcher calculated this statistic by taking each sample of 50 or 500 observations contained in
the yearly cohorts, summing the number of times that the given metric identified abnormal
performance, and dividing this sum by total number of observations contained in the cohort.

Power Analysis

The power analysis uses the results of the specification analysis as a base to continue the
evaluation of the given method of abnormal performance detection. All models that the
researcher has properly constructed should identify no abnormal performance. From this base of
zero abnormal performance, abnormal performance is simulated across the entire sample by
taking the average performance add adding either positive or negative percentage movements of
1, 5, 10, 15, 20, 30, 50, and 75%.
Using the outcome from these simulations, this project then calculates the tBHAR for each
level of simulated abnormal performance. We expect abnormal performance to be negligible
where we simulate zero abnormal performance and increase as both positive and negative
abnormal performances are simulated; therefore, when charting the results of this analysis we are
looking to obtain a v or u-shaped power curve, centered on zero abnormal performance and
increasing substantially as we simulate abnormal performance. After simulating abnormal
performance, for each simulation and each metric, the Empirical Power (EP) statistic was
calculated. The EP statistic is similar to the ES statistic, but when we calculate the EP statistic
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

we are analyzing how well a metric identifies the researcher’s simulation of abnormal
performance and when it does not. Thinking back to our u or v-shaped curve, at zero percent
simulated abnormal performance we want to see that the metric does not identify abnormal
performance, therefore, our ES statistic would be zero, but at each increment (positive and
negative) from 1% to ∞, we want to see that the metric’s ability to detect abnormal performance
increases.

Short-term Abnormal Performance

The time horizon used to evaluate short-term abnormal performance shrank significantly
when compared to the other studies in this analysis. Using the sources that were available
(Hoovers IPO Central, Edgar IPO), this study was able to obtain premarket offering prices for
the IPOs included in this analysis. The researcher used the following time horizon, January 1,
1997 to December 22, 2005, for tests conducted on the performance of the initial day of public
trading and April 12, 1996 to January 28, 2008 for tests conducted on pre-trade performance.
Although, this is a substantial reduction in the intended sample, there were still a significant
number of observations in each sample—the researcher identified 1,876 observations for
premarket performance and 2,143 observations for the initial day of trading. Even if it was
possible to obtain performance data prior to January 1, 1997 for the initial day of trading in IPOs,
the CRSP database, which was used to obtain daily pricing data in this analysis, did not have
initial day trading data for IPOs listed prior to January 1997.
It is important to note, when we analyze pre-trade performance, the public does not
openly share their return expectations and we lack a specific time horizons (e.g. does the offering
to issue period last 12 hours, 24 hours, 36 hours, or more) to match the return of the event firm
against. Therefore, the researcher compared the aggregate returns obtained in the pre-public
trading period with the returns obtained by investor’s investing in a market proxy—the
researcher uses standard market indices to obtain this performance (e.g. Russell 3000, S & P 500,
NASDAQ Index, etc.). Therefore, when the researcher evaluated abnormal performances
occurring in pre-public trading he started with the assumption that the aggregate IPO will
produce a return of 0%, and compared this return against the return of the DJIA, Russell 3000,
and NASDAQ indices, to gain some insight on how substantial premarket IPO performance is.
The researcher will revert to using the best-specified and most powerful method used to detect
abnormal performance in the remainder of the analyses, because he has public trading data that
can be compared our event firm’s performance. Therefore, in our initial day of trading, the
researcher will take the returns obtained in from the sample of IPOs and, using the BHAR
method to detect abnormal performance, and match these firm’s to the best-specified and most
powerful metric identified in the preceding power and simulation analysis explained in the
preceding section.

Long-term Abnormal Performance

To obtain a general sample to run tests for longer-term abnormal IPO performance, the
researcher used the Field-Ritter dataset of founding dates, identified in Loughran and Ritter
(2004; as noted in http://bear.cba.ufl.edu/ritter/foundingdates.htm) for companies that went
public from 1985 to 1996. Additionally, the researcher obtained information pertaining to IPO
issuance from 1996 to 2002 from on-line IPO databases (e.g. Hoovers IPO Central, Edgar IPO).
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

The total sample of IPOs used in this analysis was 5,883. Any company that had an offer price of
less than $5 or were foreign offerings were removed from this list—this is the base IPO list used
for both the analysis of longer-term abnormal IPO performance and event specific abnormal IPO
performance. Using the best-specified and most power method of abnormal performance
detection, the researcher paired the IPOs in this sample with the benchmark to determine whether
abnormal performance is evident using time horizons ranging from day 2 to trading day 750.

Event-Specific Abnormal IPO Performance

For tests of abnormal performance occurring during the expiration of the quiet and
lockup periods, the sample size shrunk to 5,529 due to firm attrition. In this analysis, the event
horizon was the five-day period surrounding the day of the specific event—either the expiration
of the lockup period or the conclusion of the quiet period. The researcher compared the BHAR
obtained from the IPO experiencing the event against the benchmark and the results of these
individual analyses were aggregate to give an average BHAR for the entire sample of IPOs
issuing shares over this period.

Results

This section provides the results of test that the researcher conducted to indentify
abnormal price performance related to the issuance of unseasoned IPO issuance. The first section
provides the results of the specification and power tests the researcher conducted on seven
metrics used to identify abnormal performance. Sections 2 through 4 will display the results of
tests that the researcher conducted to identify abnormal performance, using the best-specified
and most power testing procedure.

Specification and Power

The purpose of this section was to determine, which method of benchmarking was more
effective testing for abnormal performance of the IPOs. Based upon the review of literature, the
researcher employed two broad methodological strategies to conduct the specification and power
analyses--the portfolio matching and the matched-firm approaches. The first subsection will
present the specification results and the second subsection will present the results of the power
analysis.

Tests for Specification

The first question that this analysis answered is as follows: in samples of 50 and 500
companies, how often did the randomly drawn event firm (i.e. drawn from the list of Russell
3000 constituents each year) generate statistically significant abnormal performance. The
hypothesis test run on each of the 180 samples of 50 and 18 samples of 500 companies was as
follows:
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Hypothesis 1:

H o : BHAR = 0
H 1 : BHAR ≠ 0

After the researcher conducted the hypothesis test for each sample, he added the number of
rejections together and divided by the number of observations, thus resulting in the ES statistics.
The researcher displayed the results of the specification analysis Table 1.

Insert Table 1 Here

The researcher found that all of the approaches using the matched-firm technique (i.e.
matching based upon market capitalization, industry affiliation, industry affiliation and market
capitalization, market capitalization and book-to-market ratios) were generally well specified,
using a level of significance of 5%. The matched-firm approach by market capitalization, alone,
did identify abnormal performance in 5.56% of its samples, using sample sizes of 50 and 11.11%
with sample size of 500. However, the researcher conducted an additional test to determine
whether the ES was significantly different from the theoretical 5% level of significance—where
α was the level of significance and n was the sample size.

α (1 − α )
α ± 1.96
n

The ES interval ranges from 1.82% to 8.18% for the 180 samples of 50 companies and
from negative 5.07% to 15.069% to the 18 samples of 500 companies. Matched firm approaches,
matched based upon Market Capitalization, Industry Affiliation and Market Capitalization, and
Market Capitalization and Book-to-Market Ratios Companies, generated spurious rejections;
however, these rejections where not statistically different than our theoretical level of
significance. Even though they were not statistically different from the theoretical level of
significance used in this analysis, they were different. The best-specified matched-firm approach
used in this analysis and the approach that did not identify abnormal performance greater than
the theoretical level of significance in any of the analysis, which the researcher used in this
analysis, was the matched firm technique based solely upon industry affiliation.
Each of the portfolio-matching strategies (i.e. matched by market capitalization, industry
affiliation, and market capitalization and book-to-market ratios) rejected the null hypothesis; this
indicates an identification of abnormal performance even though, the researcher had not
simulated abnormal performance. Every specification test, using the portfolio-matching
techniques, regardless of how it was matched to the event firm, generated misspecified test
statistics in all cases that were significantly different from our theoretical level of significance.
As illustrated in Tale 1, as the sample size increases from 50 to 500, the observed
percentage of spurious rejections decreased using the matched firm approach. This occurs
because, without simulating abnormal performance, researchers would expect to detect no
abnormal performance. Given the preceding results, I found I believe it is evident that the
matched-firm approach is a better-specified method of abnormal performance detection than the
methods using portfolio-matching strategies. The researcher concluded that the best-specified
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

matched firm approach is implemented using matched-firm strategy, matching by industry

affiliation.

Tests of Power

The purpose of power analysis was to determine what test method had the least type II
error, and which methodology had the highest power. This research project relied on running the
power analysis by simulating abnormal performance in +/- .01, .05, .10, .15, .20, .30, .50, and .75
intervals to the individual BHARs derived from the results of the specification analysis. In
essence, to calculate the EP statistic this analysis forced the average abnormal performance away
from zero and imposed abnormal performance on the BHAR. The researcher calculated the EP
statistic by adding each of the sample average BHARs, for each level of simulated abnormal
performance, and dividing this sample average by the size of each sample. Again, the researcher
abstracted 180 samples of 50 observations in the first round of the analysis and 18 samples of
500 companies in the second round of the analysis. The specific hypothesis tested in this analysis
is the same as that tested in Hypothesis 1; however, the researcher conducted this hypothesis test
for each level of simulated abnormal performance.

Insert Figure 1 Here

In Figure 1, all of the matched-firm approaches have defined power curves—the

traditional U or V shaped—the power curve are centered approximately centered on zero, the
point where no abnormal performance is simulated. In comparison, the portfolio-matched
benchmarks had no defined structure or at least not the structure needed to make credible
inferences pertaining to the power of the benchmark. Again, the portfolio benchmarks failed to
approach acceptable standards that are necessary to judge the benchmarks ability to detect
abnormal performance; in the remaining analyses, the portfolio techniques were not included in
the analyses because the researcher did not considered them to be meaningful alternatives to the
matched-firm approach.
Figure 1, illustrates that if the event firm generates abnormal returns of 15%, the
competing matched-firm approaches only rejected the null hypothesis (identifying abnormal
performance) in approximately 30% of samples. This seems rather low; researchers would
identify simulated abnormal performances of greater than 30% in 70% of the analyses. After
comparing these numbers with the results found in Figure 2 where the researcher expanded the
number of firms per sample to 500 from 50, the matched-firm approach rejected 80% of the
samples, if the simulated level of abnormal performance is 10% points of abnormal performance,
compared with approximately a 17% identification using the smaller sample sizes. Therefore, as
the sample size increases, the power curve narrows making the employed methodology
appropriate.

Insert Figure 2 Here

There is still no statistically significant difference between the different matched firm
approaches to benchmarking. When conducting the remainder of the tests the research project
was concerned with the speed at which the metric deteriorates. As the event horizon increased
the method’s ability to detect abnormal performance decreases. Comparing the event horizons of
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

one-, two-, three-, and four-years using sample sizes of 50, this study found that a simulated
abnormal performance of +/- 10% will be detected in 17%, 10%, 6%, and 6% of the samples; in
samples of 500 observations the percentage of detection are 80%, 55%, and 25%, and 11%,
respectively. To analyze the general ability of each of the matched-firm approaches to detect
abnormal performance, this project now will identify when the metrics identify abnormal
performance in 95% of the analyses. The EP reached 95% at 15%, 15%, 30%, and ~40%
simulated abnormal performance using an event horizon of one-, two-, three-, and four-years,
respectively, and sample sizes of 500 observations. Therefore, if researchers intend on using the
matched firm approaches identified in this analysis their sample sizes and predicted level of
abnormal performance should be significantly large.
The purpose of the power and specification analysis was to determine which of the seven
benchmarking methods selected in the literature review would provide the best balance between
specification and power or which method most appropriately balanced Type I and II errors. As in
most analyses this project was more concerned with type I errors than type II--more succinctly it
is better to err on the side of caution, not to conclude that abnormal performance occurs when in
actuality it had occurred, than to conclude that abnormal performance occurred when in reality it
did not. In the specification analysis, the only benchmarking method that generated well
specified test statistics, over all time horizons and using sample sizes of both 50 and 500
observations, was the matched-firm approach based upon industry affiliation. There were
substantial differences between the results of the power analysis run on the portfolio-matching
and matched-firm approaches; the match-firm approaches performed significantly better in the
power and specification analyses and there was no significant difference between the power
results of the matched-firm approaches.

Section 2: Initial Performance

The following section focuses on the detection of abnormal performance during the initial
trading period. The main questions posited in the following section were whether unseasoned
IPOs produced abnormal performances in the time proceeding public trading and if this
abnormal performance continued into the first day of public trading. The results of the analysis
conducted prior to public trading are reported first and then and an analysis of whether IPOs
produce abnormal performance on their first day of trade is reported.

IPO Performance (Pre-issuance)

Using standard indexed benchmarks to gauge normal performance—the company issues

its shares on the night preceding its initial day of trade, the following hypothesis is tested:

Hypothesis 3:

H0 : R ≤ 0
H1 : R > 0

This project uses the average returns in this round of the analysis; there is no way to pair event
firms with another firm base upon firm specific criteria, because this performance occurs prior to
public trading. The average return that IPOs generated prior to public trading or from their
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

offering to their issuance to the public was 11.74%, with a sample standard deviation of 31.16%,
and 1876 observations taken from April 12, 1996 to January 29, 2008. The researcher applied the
following formula to determine if the 11.74% performance was statistically different from zero.

X −0
t=
S
n

The resulting t statistic was 16.32, which was outside the critical value of 1.645 for a one-tailed
statistical test, given a 5% level of significance.
The preceding analysis illustrated the difference between the performance obtained by
IPOs pre-public trading and an expectation of zero abnormal performance, because this is the
pre-public trading period, there is no specific way to pair the individual IPO performance with a
benchmark. Therefore, the researcher aggregated the returns into monthly IPO cohorts, these
performances assume the investor obtains shares of the IPO in the offering and sells them at the
initial trade on the first day of public trading. In Table 2, I have illustrated how abnormal IPOs
perform in pre-public trading.

Insert Table 2 Here

To make this analysis comparable to the results obtained in the remainder of these
analyses contained in this project, the researcher paired these returns with the performances of
standard benchmarks over this time horizon. The researcher displayed the results of these
comparisons in Table 3. Table 3 shows the average monthly performance of IPO cohort versus
those of DJIA, Russell 3000, and the NASDAQ Composite Indices over the period analyzed.

Insert Table 3 Here

As the numbers in Table 3 indicate, at 5% level of significance for a one-tail t test (t critical of
1.66), the researcher rejected the null hypothesis for only the IPO sample, implying that the
IPO group experienced significant abnormally positive returns. None of the benchmark indices
produced abnormal returns.
The DJIA was the best performing benchmark out of the three potential benchmarks
chosen for this analysis; the project continues to analyze whether the IPO cohort significantly
outperformed the best performing index, which was the DJIA in this period.

Hypothesis 2:

H 0 :R IPO ≤ R DJIA
H 1 : R IPO > R DJIA

The average difference between the IPO cohort and the DJIA’s yearly average return was
8.41%, with a sample standard deviation of 13.86%, and observations’ occurring over 139
months--the computed t statistics was 7.15. Again, with a 95% level of significance for a one-
tailed test the critical value of t is 1.66; therefore, this research project rejects the null hypothesis
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

and determines that significant abnormal performance occurred during the pre-public trading
period when compared against standard indices.

Initial Day of Public Trading

This round of the analysis attempts to determine whether IPOs generate abnormal
performance on the first day of public trading. To answer the question, the analysis evaluates the
returns of IPOs issued to the public from January 1, 1997 to December 22, 2005, the sample
contains 2,143 observations, and the researcher evaluated the following hypothesis test.

Hypothesis 3:

H 0 :R IPO ≤ R MF − IND
H 1 : R IPO > R MF − IND

Using a standard t test, this analysis uncovered the following: the average return across the IPOs
was 3.44%, and the average performance of the matched-firm benchmark was 0.13%. The
sample standard deviation was 16.27%; resulting in a t value of 9.423, which when compared to
a critical value of 1.645, at a 95% level of significance, indicated that the IPOs abnormal returns
on the first day of trade are statistically significant. The returns of IPOs on the first day of trade
are significantly different from the returns obtained for the matched-firm benchmark.

Section 3: Long-term Abnormal Performance

This round of the analysis turns to evaluating whether significant abnormal performances
occur after the short-term abnormal performances. This project accomplished its longer-term
analysis by canvassing the population of IPOs issued in the U.S. from January 1, 1985 to
December 31, 2002. The study identified 5,583 IPOs to use in this analysis; the researcher
matched these IPO upon industry affiliation to a benchmark firm. The BHAR was calculated and
the research identified the sample average and standard deviation given the individual BHARs.
The output, which encompasses trading day 2 through 750, is the averaged BHAR across the
entire sample over the specified time horizon. The researcher evaluated the data and generated a
two-tailed t test for all 749 time-horizons.

Hypothesis 4:

H 0 :BHARIPO = RMF − IND

H 1 : BHARIPO ≠ R MF − IND

Insert Figure 3 Here

Analysis of the data provided in Figure 3 shows that, during trading days 5 through 12
IPOs significantly underperformed the matched-firm benchmark, at day 17 the trend changed
positive, and it was significantly positive until trading day number 120 (with one insignificant
reading on day 33)--at day 120 the BHAR is 1.934%. The averaged BHAR continued along
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

insignificantly, but positive, until reaching trading day 161. However, the BHAR did not
generate a significantly negative BHAR until it reached 201 trading day. The BHAR remained
significantly negative through the remainder of the analysis. In Figure 4, this project provides the
t values calculated in comparing IPO performance to the matched-firm returns. Figure 4 shows
that the trend of the BHAR was unmistakably negative. Overall, there is an abnormally positive
performance of approximately 3 % occurring within the first year and at the end of year three,
the highest abnormally negative performance occurred, which was -22.41%.

Insert Figure 4 Here

Section 4: Quiet and Lockup Expiration

To construct a test for abnormal performance at the expiration of the lockup and quiet
periods this project canvasses the same population of IPOs used in the longer-term analysis. The
number of observations for the quiet and lockup period analyses was 5529. To carry out these
analyses this section calculates the 5-day BHAR surrounding the date in which the quiet period
ended and the lockup period expired.

Hypothesis 5:

H 0 :BHARIPO ≤ R MF − IND
H 1 : BHARIPO > R MF − IND

For the analysis of performance surrounding the expiration of the quiet period, the sample
average BHAR was 1.64%, for the five-day period surrounding the event and the sample
standard deviation was 13.9%. The resulting t statistic was 8.75, using a 95% level of
significance the critical value was 1.645; the null hypothesis is rejected—at the conclusion of the
quiet period IPOs produce a significantly positive abnormal performance.

Hypothesis 6:

H 0 :BHARIPO ≥ RMF − IND

H 1 : BHARIPO < R MF − IND

In the analysis of the performance resulting from the expiration of the lockup period, the
researcher found significantly negative performance of 1.00%. In addition, the sample standard
deviation was 13.74%, therefore, the resulting t test produced a test statistic of –5.41, and with a
5% level of significance the critical t value is, again, -1.645. Therefore, again, the researcher
rejected the null hypothesis and concluded that significant negative abnormal performance of
1.00% occurred at the expiration of the lockup period.
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Conclusions

In the preceding section, the researchers has (a) presented a well specified and powerful
method used to identify abnormal performance when conducting event studies, (b) shown that
short-term abnormal IPO performance is positive, (c) illustrated that events occurring throughout
the IPO process instigate abnormal performances, and (d) provided a description of IPO
performance over the initial three years of seasoning. The results of the analyses related to event
specific performances--abnormal performances occurring at the expiration of the quiet and
lockup periods--generated significant, but not substantial abnormal performance. However, the
pre-public trade abnormal performance of 11% and 3% abnormal performance in the initial
trading day, together with long-term underperformance of IPOs in excess of 30%, seem to
suggest that substantial performance abnormalities occur when companies issue unseasoned
equity shares to the public.
Researchers focus the majority of their explanations that attempt to explain why short-
term abnormal performance occurs on the asymmetric information hypothesis. To summarize,
according to Ritter and Welch (2002), either investors are more informed than the issuer about
the market demand for the company’s shares or the investor believes that the issuer knows more
about the firm’s prospects and need protection against potential market lemons (IPOs that
underperform). Recently, Purnanandam and Swaminathan (2004) questioned the conventional
wisdom that companies initially discount their shares when they offer them to the public, for
whatever reason. Purnanandam et al. (2004) found that, in a sample of over 2,000 IPOs issued
from 1980 to 1997, companies typically overpriced IPOs, when the researchers compared these
IPOs to their non-IPO counterparts the over pricing ranged from 15% to 50%, depending on the
matching criteria. Puranandam et al. provide the first real critique of what has become general
knowledge in the academic community: Companies typically under price their shares when they
issue unseasoned equity. If IPOs are initially overpriced and this overpricing increases—not only
in the period prior to public trading, but IPOs continue to generate significantly positive
abnormal performance in their first day of trading—does this signal market inefficiency?
It would be a mistake to conclude that empirical evidence supports the conjecture that
markets are inefficient. However, this initial over-pricing, followed by substantial short-term
abnormally positive performance, which is followed by—over a period of three years—a
reversal to longer-term underperformance could at least hint at market inefficiency. Efficient
market theory concedes that short-term departures from fundamental or intrinsic will exist in the
marketplace; however, prices will rapidly adjust and the market will eliminate pricing
discrepancies. In Figure 4, this research project illustrates that when the IPOs are trading under
their lockup provision, the returns are generally positive—of course discounting the significantly
negative movement lasting through trading day two through seven, presumably a reaction to the
initial positive movement prior to issuance and on the initial day of public trading. However, as
the IPOs approach the expiration of the lockup period the performances generated by the IPOs
evaluated in this analysis is resoundingly negative.
The expiration of the lockup period occurs at approximately trading day number 128 (i.e.
180 calendar day lockup period is equivalent to ~26 weeks, subtracting the weekends equals 128
trading days). In this research project’s ex post analysis, after testing all ex ante hypotheses, it
became apparent that the downward trend in IPO prices, following the expiration of the lockup
period, was remarkable. In figure 5, the chart focuses in on what occurs from trading day 128 to
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

350, which the researcher has approximated at 241 calendar days—one-year, is a decline of
.05% every trading day when compared against a firm matched based upon industry affiliation.

Insert Figure 5 Here

The regression summary is appealing, the R-Squared and Adjusted R-Squared values are in
excess of 98%, and a relationship that is very significant (p - .001). The trend is undeniable and
significant, after IPOs reach their lockup expiration, they are likley to experience negative
performance of approximately .05% points in value each day for approximately one-year.
The general conclusion that the researcher has reached in this analysis is as follows,
when it comes to participating in the IPO market, buyer beware. First, and foresmost, the process
of issuance is not fair, there are not fair opportunities for economic profit. A class of
sophisticated investors reap the benefits of the 11.74% of performance occuring prior to public
trading and in the initial trading day investors may be able to obtain approximately 3 percentage
points of positive performance, however, the investors have to buy at the market open and sell at
the closing price on the security’s initial trading day. If the average investor does not sell at the
market close, holding onto the newly issued security will generate a negative 3% price
movement from trading day 2 through trading day 7. This is then followed by a substantial
upswing in performance and, ofcourse, eventually if held long enough investors will feel the
sting of longer-term negative abnormal performance of 22.41% after approximately three years.
The researcher has provided investors an overview of the patterns that IPOs seem to have exhibit
from 1985 to 2002; hopefully, the average investor finds a meaningful way to put this
infomration to use.
 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

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 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Tables & Figures

Table 1. The results of the specification analysis conducted on 180 samples of 50 companies and
18 samples of 500 companies.

Figure 1. One-year power curve (n = 50).

Figure 2. One-year power curve (n = 500).

 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Table 2. Pre-public trading IPO returns.

Table 3, Sample Return, Yearly Cohorts-Pre-Public Trading

Figure 3. Long-term abnormal IPO performance

 Working Paper: An Empirical Investigation of Initial Public Offering (IPO) Performance
Zachary A. Smith, Ph.D.

Figure 4. BHAR for IPOs from the initial trading day to trading day 755

Figure 5. Illustration of the BHAR after IPOs reach their lockup period.