Monday, March 21, 2005

A look at IPO price stabilization by Lewellen

Katharina Lewellen provides is an interesting look at price stabilization in the IPO market.

Price stabilization is the practice of investment bankers going into the secondary market to support the price of newly issued shares. There has been much debate in the academic literature as to the rationale and the extent of this practice. For instance, is it a reward to institutional investors as some previous researchers (e.g. Chowdry and Nanda 1996) suggest? Or a means of helping the syndicate sell shares? Or some combo of each? One problem with these studies is that there is little publicly available data on the stabilization activities.

In her forthcoming JF article, Lewellen sheds light on this practice using a proprietary data set from the NASDAQ. She finds
"that underwriters accumulate large inventories of cold IPOs on the first day of trading, consistent with price support. Stock prices are extremely rigid at and below the offer price, in the sense that it requires large selling pressure to induce a price decline. For example, if a stock opens the first day at the offer price, marketmakers repurchase, on average, 6.0% of shares offered before they allow the bid to drop. The corresponding number is 2.1% for IPOs that open below the offer price, and only 0.4% for stocks that open above the offer price.
What is weird however is that once stabilization ends, the stock prices do not seem to fall. This suggests that, as investment bankers claim, stabilization is only a temporary support to allow the market to develop. (or as the author points out, it cold also be that the investment bankers have inside information and only support those stocks that in fact are not overpriced.)

Previous papers have suggested that stabilization is partially a substitute for underpricing as a means of handling information asymmetries. It is somewhat surprising therefore when Lewellen finds little support for this:
"A natural empirical implication is that, other things equal, stocks with more information asymmetries should exhibit more underpricing or stronger price support. I do not find support for this hypothesis. Instead, price support appears strongest for IPOs that are less risky,... and for IPOs underwritten by larger, more
reputable underwriters. A story that is consistent with these findings is that while underwriters avoid stabilizing risky IPOs, large underwriters absorb inventory risk better and, hence, stabilize more strongly. However, Aggarwal (2000) finds that underwriters usually oversell the issue and begin the first day of trading with a short position.....Alternatively, large underwriters may be more willing to support overpriced IPOs to protect their reputation with investors.

Consistent with the reputation hypothesis, I find that underwriters stabilize less
extensively on days when the stock market is doing poorly, that is, when the weak IPO performance can be attributed to market-wide events outside the underwriter’s control."
Another surprising finding is that investment banks with large retail operations tend to engage in more stabilization. This runs counter to previous papers. Lewellen offers several explanations:
"First, retail banks might value price support because it allows them to discriminate among investors: A promise to repurchase weak IPOs can be targeted to specific investors. Second, Hanley, Kumar, and Seguin (1993) suggest that underwriters
support prices to disguise weak offerings from initial investors. If such tactics indeed take place, they are probably targeted at unsophisticated investors, and therefore may be favored by retail banks. Third, it is possible that retail banks suffer larger reputational damage from ex post overpriced IPOs."
Definitely an interesting and important paper!

The forthcoming JF version of the paper is available for a short time. A previous version is available from SSRN.

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