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Review of Quantitative Finance and Accounting

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17-10-2017 | Original Research

The efficiency of IPO issuing mechanisms and market conditions: evidence in China

Author: Chen Su

Published in: Review of Quantitative Finance and Accounting | Issue 2/2018

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Abstract

This study conducts a comparison analysis on the efficiency of bookbuilding and secondary market proportional offering (hereafter, SMP offering) in the China stock market. SMP offering as described in this paper is not a follow-on offering, but an initial offering applicable to investors in the secondary market. Specifically, as a unique type of fixed price offering, SMP offering only allows the existing investors who are holding shares (of any listed firms) in the secondary market to subscribe to IPO shares. The amount of IPO shares available to be subscribed by the existing investors is proportional to market value of shares held by them in the secondary market. We find some interesting evidence showing that, compared with bookbuilding, SMP offering is more efficient for pricing IPOs, particularly, in a volatile market. SMP offering leads to lower underpricing and lower cross-sectional variation of short-run returns of IPOs. Also, SMP offering is better able to counteract adverse market conditions in the form of low market return and/or high market volatility. Our results are robust to various alternative tests, e.g., the Heckman (Econometrica 47:153–161, 1979) two-stage procedure and an out-of-sample test, after controlling for the problem of endogeneity and for the influence of the exchange of listing, respectively.

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A routinely updated Table 1 in Loughran et al. (1994) presents comprehensive evidence on the level of IPO underpricing worldwide (Available at: https://site.warrington.ufl.edu/ritter/files/2017/05/IPOs2016Underpricing.pdf).

Jagannathan et al. (2015) conduct a comparative review of the three most common types of IPO issuing mechanisms in 47 international markets and provide potential explanations on why auction is unpopular in most markets. We note, but do not explore, the existence of numerous studies on the efficiency of auction-related issuing mechanisms (see Biais and Faugeron-Crouzet 2002; Derrien and Womack 2003; Sherman 2005; Lowry et al. 2010).

In a follow-on offering, the listed firm itself issues additional shares on the primary market after the initial offering, thus diluting the existing shares.

As required by the CSRC, the offering price is based on the price-to-earnings (P/E) ratio and the forecasted earnings per share (EPS): the offering price = P/E × the forecasted EPS, where the P/E ratio was initially fixed at 15. There were substantial changes in the measurements of EPS. For example, on December 26th, 1996, the CSRC changed the measurement of EPS based on the realized arithmetic average EPS in the past 3 years: EPS _t = (the realized EPS _t−3 + the realized EPS _t−2 + the realized EPS _t−1)/3. The CSRC adjusted the measurement of EPS again on September 10th, 1997, based on the weighted average of the realized EPS in the year before the IPO and the forecasted EPS during the IPO year: EPS _t = 0.7 × the realized EPS _t−1 + 0.3 × the forecasted EPS _t. On March 17th, 1998, the CSRC again changed the measurement of EPS back to the forecasted EPS: EPS = forecasted earnings/[the total number of shares before IPO + the number of IPO shares × (12 − M)/12], where M is the month when the IPO is issued.

The ownership structure of firms listed in the China stock market has some unique features. For example, most listed firms are state-owned enterprises (SOEs) and a majority of shares are non-tradable shares, owned by the government and/or other legal entities. Specifically, the ordinary shares of a typical listed firm in the China stock market can be classified into two categories: tradable shares and non-tradable shares, which is also referred to as the split-share structure. Tradable shares include A-shares and B-shares traded either on the SHSE or on the SZSE, while non-tradable shares include: (1) state-owned shares held by state authorized investment departments or institutions with state assets; (2) state-owned legal person shares held by other state-owned enterprises; (3) legal person shares held by corporate enterprises or public institutions and social bodies; and (4) employee shares held by employees and initially prohibited from trading for a certain time period until they become tradable.

The CSRC released Circular on Issues Relating to the Pilot Reform of Listed Companies Split Share on April 29, 2005 (No. 32 [2005]), marking the launch of the first phase of its split-share structure reform by inviting four listed firms to convert their non-tradable shares into tradable shares. On September 5, 2005, the CSRC issued the first official document––Administrative Measures on the Split Share Structure Reform of Listed Companies (No. 86 [2005]), providing guidelines on the implementation of the split-share structure reform.

As the China stock market was at an early development stage, neither institutional nor individual investors were able to determine the value of an issuer, resulting in some overheated IPOs with very high offering P/E ratios in 2000. For example, Fujian Mindong Electric Power Co., Ltd. (000993) went public on the SZSE with a record high P/E ratio of 88.69 on July 31st, 2000. To cool down the overheated IPOs with excessively high P/E ratios, on July 1st, 2001, the CSRC introduced an upper limit on the P/E ratio of 20, which was lifted in 2005, though, in practice, the CSRC did not approve IPOs with a P/E ratio of greater than 30.

Several experimental auction mechanisms were implemented in 1994 and 1995. Specifically, issuers and underwriters set an initial price and investors were required to bid for both price and quantity. The final offering price was set at the level where the accumulative quantities demanded by investors were equal to the total number of new shares available. However, only four IPOs issued between June 1994 and January 1995 employed this auction mechanism. Furthermore, two pro rata mechanisms were introduced by the CSRC on December 16th, 1996. Investors were required to save enough money to subscribe to IPO shares in special accounts, and IPO shares were allocated pro rata in case of over-subscription. The two pro rata mechanisms were widely adopted in 1996 and 1997, but were never used after 1998. A summary description of relevant issuing mechanisms employed in the China stock market over the period from 1994 to 2003 is presented in Ma and Faff (2007).

Lowry et al. (2010) argue that, in a volatile market, a higher level of underpricing is expected to compensate investors for their greater costs of becoming informed and a higher variance of initial returns is expected because it is difficult for investors to estimate the value of the issuer.

Loughran et al. (1994) argue that, under information asymmetry, the existing shareholders and managers have information advantages over prospective investors in regard to the issuer, as prospective investors rely primarily on financial statements in the prospectuses, which are supposed to be presented in a favorable manner. That is, issuers might boost earnings relative to cash flows before the IPO and the profitability declines after the IPO. Therefore, prospective investors cannot effectively identify the quality of issuers, leading to an adverse selection problem, and eventually a lemon market (Beatty and Ritter 1986; Rock 1986; Balvers et al. 1993; Mantell 2016).

Under the old quota system, the quantity of IPOs to be issued each year was determined by the central government and then allocated among regional governments and ministries. The CSRC, the regulatory authority of the China securities market acting on behalf of the central government (rather than underwriters) was in charge of pricing and timing of IPOs. As a response to the extreme government intervention and to promote a more market-oriented and internationalized IPO allocation system, the quota system was replaced by an approval system in April 2001. Since then, underwriters have been taking more responsibility to evaluate issuers’ credit standing as well as risk, and been able to recommend qualified firms to the CSRC for the final verification as long as the recommended firms meet all relevant standards and requirements (see Su 2015). Therefore, in order to ensure more accurate estimation, this study confines the sample to IPOs issued exclusively during the approval system period as this helps reduce the possibility that other factors, such as the changing role of underwriters, might affect our results.

The SHSE operates only a Main Board, while the SZSE operates a Main Board as well as the SMEs Board and the Growth Enterprise Board (also known as the ChiNext Board), launched on June 24th, 2004 and on October 30th, 2009, respectively.

The Kruskal–Wallis nonparametric test does not require equal sample sizes and is robust to departures from normality.

We test the potential influence of multicollinearity in the regression analyses by calculating the variance inflation factors (VIFs). VIF is defined as 1/(1 − R ²), where R ² is obtained from the regression of one variable on all other regressors specified in the regression model. All of multiple regressions yield a value of VIF of less than 2.5, much smaller than the commonly accepted threshold of 10, indicating no evidence of multicollinearity in the regression analyses.

Given the limited sample of 18 BS offerings and the fact that over 70% of IPO shares of BS offerings are actually allocated using SMP offering, we replicate all regression analyses either excluding all BS offerings in our sample or combining BS and SMP offerings in a single category. Our results are qualitatively the same, which are not reported for the sake of brevity, but available on request.

Following Clogg et al. (1995), we employ z-statistics to test the statistical difference between the two interaction coefficients: \( z = \left( {\beta_{a} - \beta_{b} } \right)/\left( {SE \times \beta_{a}^{2} + SE \times \beta_{b}^{2} } \right)^{1/2} \)

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Title: The efficiency of IPO issuing mechanisms and market conditions: evidence in China
Author: Chen Su
Publication date: 17-10-2017
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 2/2018
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-017-0677-2

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