* I would like to thank Frank Dobbin, Christopher Marquis, Peter ...
underperformance (Ljungqvist, Nanda and Singh 2006) and why underwriters induce sentiment investors into the market (Cook, Kieschnick and Van Ness 2006). Corroborating behavioral price theories, little evidence exists that institutional investors make better IPO investments than retail investors due to superior monitoring or private information; instead, better use of publicly available fundamental information explains almost all of their outperformance relative to retail investors (Field and Lowry 2009). Since sentiment investors underweight public information, fundamental information about issuers (e.g., offering size, revenues, earnings, etc.) could predict pricing. Given non-Bayesian investor models of pricing, we should also include appropriate measures of investor sentiment. Baker and Stein initially recommended market liquidity (NYSE share turnover) as a suitable proxy for investor sentiment, but have since developed improved composite indices of sentiment (Baker and Wurgler 2006, 2007). Derrien (2005) recommends “market conditions” (defined as the three- month moving average return on industry sector indices) as a suitable proxy for sector-specific sentiment. I will address endogeniety and other concerns when regressing pricing above the range on these sentiment proxies in the “Data and Methods” section. Less problematic are investor surveys that attempt to measure sentiment levels directly by sampling both institutional (rational) and retail (sentiment) investors, such as those conducted by Robert Shiller since 1989. While Shiller did not formalize how investor sentiment impacts IPO first-day returns as later analysts did, he demonstrated how excess volatility in stock prices relative to dividends directly implies the predictability of long-run returns, contradicting EMH. 8 More importantly for IPO first-stage return outcomes (pricing above the range) are non- rational issuer models within behavioral finance. These models generally relax the assumption of rational SEU preferences, hypothesizing that issuers either accept or seek underpricing. For 10
instance, professional managers with lower share ownership versus owner-managers may be less vigilant against higher first-day returns (Ljungqvist and Wilhelm 2003): higher management ownership should thus predict lower underpricing. Prospect theory remains the dominant non- SEU theory of preferences within behavioral finance (Kahneman and Tversky 1979; Barberis and Thaler 2003). Instead of normative preferences, prospect theory utilizes cognitive psychology to argue that utility is defined relative to an arbitrary reference level, with actors being risk-averse when above such a level but risk-seeking when below. Given these empirical preferences, framing and mental accounting effects matter since the utility of actors are reference-level dependent and non-linear. 9 Applied to IPO pricing, prospect theory predicts that issuers integrate wealth gain from first-day returns with the loss of underpricing (Habib and Ljungqvist 2001; Loughran and Ritter 2002). The portion of the offering consisting of secondary (existing shares sold by pre-IPO shareholders) rather than primary shares (new shares issued by the company for the IPO) should thus impact first-day returns. A high secondary portion reduces the mental integration effects of prospect theory since issuers have already sold their shares at the offer price and do not benefit from the wealth gain created by first-day returns. Given non- SEU issuer models of pricing, we should include management ownership and secondary portion in our analyses. As I will elaborate in the next section, both non-Bayesian investors and non- SEU issuers should impact first-day returns, but only non-SEU issuers could theoretically impact pricing above the range. Underwriting Returns When a company wants to access the U.S. equity capital markets for the first time, they must engage an investment bank to underwrite the new issuance of stock. In the United States, 11
! ! 13! (0.436) (0.433) Positive Ea
! ! 15! Table 9: Venture Capital-co