hypothesis( Grinblatt and Hwang 1989, Welch 1989, Allen and Faulhaber 1989 and How and Low 1993) The phenomenon of underpricing has not received as much attention in an Australian setting by researchers when compared to the significant literature that has emerged in the US Lee, Taylor and Walter(1996a)find that Australian IPO underpricing varies in a manner consistent with the model of Rock(1986), and the extension of this by beatty and Ritter(1986) In contrast to Lee, Taylor and Walter(1996a), How(2000)documents that the degree of underpricing is not systematically related to long run returns for mining companies. The underpricing literature in Australia has also examined the robustness of the predictions generated by the signalling model of Datar, Feltham and Hughes(1991). To this end, Lee, Stokes, Taylor and Walter(1999)report a significant positive relation between ex ante proxies for an IPO candidate's firm-specific risk and the selection of a high quality auditor as an indication to the market of the underlying quality of the IPO candidate 2.2 Underpricing and stock Hype Lang and Lundholm(2000)suggest that increasing disclosure can be used to hype the stock and thereby reduce the firms' cost of equity. Lang and Lundholm(2000)examined the disclosure practices and associated stock market responses of 4 1 small companies in the US around the time of seasoned equity offerings The authors report significant results in support of their hypothesis that a higher level of disclosure during the period leading up to a stock-offering announcement is associated with higher stock returns. On announcement date, however, Lang and Lundholm found that the market penalises firms that achieved higher levels of disclosure by altering their previous disclosure patterns and they interpret this as evidence that firms hyped their stock However, the full penalty is not imposed on the announcement date for those firms that actively inflated their stock prices without an economic basis. The stock prices of these companies continue to decline for a period up to 390 days after the equity offering is announced
5 hypothesis (Grinblatt and Hwang 1989, Welch 1989, Allen and Faulhaber 1989 and How and Low 1993). The phenomenon of underpricing has not received as much attention in an Australian setting by researchers when compared to the significant literature that has emerged in the US. Lee, Taylor and Walter (1996a) find that Australian IPO underpricing varies in a manner consistent with the model of Rock (1986), and the extension of this by Beatty and Ritter (1986). In contrast to Lee, Taylor and Walter (1996a), How (2000) documents that the degree of underpricing is not systematically related to long run returns for mining companies. The underpricing literature in Australia has also examined the robustness of the predictions generated by the signalling model of Datar, Feltham and Hughes (1991). To this end, Lee, Stokes, Taylor and Walter (1999) report a significant positive relation between ex ante proxies for an IPO candidate’s firm-specific risk and the selection of a high quality auditor as an indication to the market of the underlying quality of the IPO candidate. 2.2 Underpricing and Stock Hype Lang and Lundholm (2000) suggest that increasing disclosure can be used to ‘hype the stock’ and thereby reduce the firms’ cost of equity. Lang and Lundholm (2000) examined the disclosure practices and associated stock market responses of 41 small companies in the US around the time of seasoned equity offerings. The authors report significant results in support of their hypothesis that a higher level of disclosure during the period leading up to a stock-offering announcement is associated with higher stock returns. On announcement date, however, Lang and Lundholm found that the market penalises firms that achieved higher levels of disclosure by altering their previous disclosure patterns and they interpret this as evidence that firms ‘hyped’ their stock4 . 4 However, the full penalty is not imposed on the announcement date for those firms that actively inflated their stock prices without an economic basis. The stock prices of these companies continue to decline for a period up to 390 days after the equity offering is announced
DuCharme et al. (2001)find that the extent of underpricing for US-based Internet ompanies is systematically related to greater levels of news exposure for the IPO candidate in a seven-day period prior to the IPO. Bhartov, Mohanram and Seethamraju(2001) find that, even for non-Internet firms, earnings were significant for valuation prior to 1999 but lost their significance as the market turned a blind eye toward financial statement information in 1999 Further, Loughran and Ritter(2000) found that the higher the expected demand for stock prior to listing, the more likely it is that issuers will accept a lower offer price because of the expected appreciation in share price once the stock is listed. When coupled with the unprecedented first day returns achieved in recent years by firms with Internet-focused business models, the findings of Loughran and ritter(2000)and DuCharme et al. (2001)suggest that stock hype may potentially be playing a significant role in explaining the underpricing in technology IPOs In this paper we argue that the concept of hype is related to the phenomenon of hot IPO markets. It has been well documented that there are pronounced cycles in the number of new issues per month and in the average initial returns per month(e.g. Ibbotson and Jaffe 1975, Ritter 1984, Ibbotson, Ritter and Sinclair 1988, Lowery and Schwert 2001). We use the word hype to capture information effects reflecting market sentiment, whether rational or irrational, in the pre IPO period. We examine the extent to which this sentiment influences underpricing during a hot IPO period Another aspect of media coverage and underpricing is the recent evidence by Demers and Lewellen(2001)that underpricing is associated with post-IPO advertising benefits. That is, the underpricing leads to increased exposure and increased website traffic. While we focus on the period prior to the IPO, Demers and Lewellen suggest that any observed underpricing in the finance market can also provide future benefits from increased exposure in the post-IPO period 2.3 CLERP, Increased Going Concern risk and Underpricing Substantial reforms to the ASX Listing Rules and the Corporations Law through the Corporations Law Economic Reform Act("CLERP Act )were implemented on September 1 1999 and have significantly improved the regulatory environment for small con raise capital from the public equity market in Australia. The prerequisite of profitability that had traditionally prevented loss-making or marginally profitable operations from accessing the asx Lower and Schwert(2001)find that the cycles in initial returns and high volumes in IPOs are predominantly driven by information learned during the registration period and argue that this is more consistent with equential learning. Lower and Schwert measure information content with reference to returns to recent similar IPO firms and the market in general, with the potential that these returns reflect a bubble rather than explain information about future prospects. In this study we consider hype'to include all potential"information'from both news sources and recent market returns. We do not attempt to distinguish between rational or irrational expectations of high future growth
6 DuCharme et al. (2001) find that the extent of underpricing for US-based Internet companies is systematically related to greater levels of news exposure for the IPO candidate in a seven-day period prior to the IPO. Bhartov, Mohanram and Seethamraju (2001) find that, even for non-Internet firms, earnings were significant for valuation prior to 1999 but lost their significance as the market turned a blind eye toward financial statement information in 1999. Further, Loughran and Ritter (2000) found that the higher the expected demand for stock prior to listing, the more likely it is that issuers will accept a lower offer price because of the expected appreciation in share price once the stock is listed. When coupled with the unprecedented first day returns achieved in recent years by firms with Internet-focused business models, the findings of Loughran and Ritter (2000) and DuCharme et al. (2001) suggest that stock hype may potentially be playing a significant role in explaining the underpricing in technology IPOs. In this paper we argue that the concept of hype is related to the phenomenon of ‘hot IPO’ markets. It has been well documented that there are pronounced cycles in the number of new issues per month and in the average initial returns per month (e.g. Ibbotson and Jaffe 1975, Ritter 1984, Ibbotson, Ritter and Sinclair 1988, Lowery and Schwert 2001). We use the word ‘hype’ to capture information effects reflecting market sentiment, whether rational or irrational, in the preIPO period.5 We examine the extent to which this sentiment influences underpricing during a ‘hot IPO’ period. Another aspect of media coverage and underpricing is the recent evidence by Demers and Lewellen (2001) that underpricing is associated with post-IPO advertising benefits. That is, the underpricing leads to increased exposure and increased website traffic. While we focus on the period prior to the IPO, Demers and Lewellen suggest that any observed underpricing in the finance market can also provide future benefits from increased exposure in the post-IPO period. 2.3 CLERP, Increased Going Concern Risk and Underpricing Substantial reforms to the ASX Listing Rules and the Corporations Law through the Corporations Law Economic Reform Act (“CLERP Act”) were implemented on September 1, 1999 and have significantly improved the regulatory environment for small companies seeking to raise capital from the public equity market in Australia. The prerequisite of profitability that had traditionally prevented loss-making or marginally profitable operations from accessing the ASX 5 Lower and Schwert (2001) find that the cycles in initial returns and high volumes in IPO’s are predominantly driven by information learned during the registration period and argue that this is more consistent with sequential learning. Lower and Schwert measure ‘information’ content with reference to returns to recent similar IPO firms and the market in general, with the potential that these returns reflect a bubble rather than explain information about future prospects. In this study we consider ‘hype’ to include all potential ‘information’ from both news sources and recent market returns. We do not attempt to distinguish between rational or irrational expectations of high future growth
Official Listing has been replaced by a broader series of tests designed to evaluate an entity's ability to operate as a going concern. An analysis of AsX listings during the 1999 and 2000 hot IPO market reveals that the regulatory amendments did, in fact, facilitate improved access to public equity capital than what was available for SMEs under the earlier listing framework. A total of 69 technology firms secured an official listing on the AsX during 1999. However, 42 firms from this sub-sample(60.9 per cent) secured their listing in the four months following September 1, 1999 when the amended AsX Listing Rules came into effect. A further 87 technology firms were listed on the ASX during 2000. With profitability no longer a disqualifying factor for the achievement of a listing, we anticipate that the average risk profile and level of ex ante uncertainty associated with technology firm IPO candidates since September 1, 1999 particularly high. This provides a valuable setting in which to examine the effectiveness with which the investigating accountants, auditors and management are able to communicate the nherent risk associated with investing in a technology offering to potential investors One mechanism for increasing the credibility of management statements regarding performance is the independent accountant s report contained in the prospectus documents Willenborg and McKeown(2000) find that for a sample of small U.S. offerings, offering firms with pre-issue going-concern opinions suffer less first-day underpricing than similar securities without going-concern opinions. The Australian Corporations Law effectively prevents companies with a going concern qualification from going public. We therefore consider a broader definition of warnings contained in the prospectus that indicate some need for an investor to specifically consider going concern risk for the IPO candidate firm 3. DEVELOPMENT OF HYPOTHESES 3.1 Underpricing and stock hype One of the objectives of our research is to investigate whether market sentiment surrounding the listing of IPO candidates is a possible explanation of the extent of observed underpricing. As noted above, previous research suggests hype as a measure of the market sentiment and excitement surrounding a pending issue. The interest in an IPO is fostered by investment bankers, managers and potential investors. Hype surrounding an IPO candidate in the period immediately prior to listing assists in fostering a market for the firms shares We consider two types of measures of hype that reflect the level of interest surrounding a pending issue. We consider hype as reflected by exposure in the media and hype as reflected the market for similar issues The exposure in the print and electronic media generates awareness among potential investors, which results in an increase in demand for the newly listed stock. This provides
7 Official Listing has been replaced by a broader series of tests designed to evaluate an entity’s ability to operate as a going concern. An analysis of ASX listings during the 1999 and 2000 hot IPO market reveals that the regulatory amendments did, in fact, facilitate improved access to public equity capital than what was available for SMEs under the earlier listing framework. A total of 69 technology firms secured an official listing on the ASX during 1999. However, 42 firms from this sub-sample (60.9 per cent) secured their listing in the four months following September 1, 1999 when the amended ASX Listing Rules came into effect. A further 87 technology firms were listed on the ASX during 2000. With profitability no longer a disqualifying factor for the achievement of a listing, we anticipate that the average risk profile and level of ex ante uncertainty associated with technology firm IPO candidates since September 1, 1999 is particularly high. This provides a valuable setting in which to examine the effectiveness with which the investigating accountants, auditors and management are able to communicate the inherent risk associated with investing in a technology offering to potential investors. One mechanism for increasing the credibility of management statements regarding performance is the independent accountant’s report contained in the prospectus documents. Willenborg and McKeown (2000) find that for a sample of small U.S. offerings, offering firms with pre-issue going-concern opinions suffer less first-day underpricing than similar securities without going-concern opinions. The Australian Corporations Law effectively prevents companies with a going concern qualification from going public. We therefore consider a broader definition of warnings contained in the prospectus that indicate some need for an investor to specifically consider going concern risk for the IPO candidate firm. 3. DEVELOPMENT OF HYPOTHESES 3.1 Underpricing and Stock Hype One of the objectives of our research is to investigate whether market sentiment surrounding the listing of IPO candidates is a possible explanation of the extent of observed underpricing. As noted above, previous research suggests hype as a measure of the market sentiment and excitement surrounding a pending issue. The interest in an IPO is fostered by investment bankers, managers and potential investors. Hype surrounding an IPO candidate in the period immediately prior to listing assists in fostering a market for the firm’s shares. We consider two types of measures of hype that reflect the level of interest surrounding a pending issue. We consider hype as reflected by exposure in the media and hype as reflected in the market for similar issues. The exposure in the print and electronic media generates awareness among potential investors, which results in an increase in demand for the newly listed stock. This provides
relatively more price ramp up on the actual day of offer, which, in turn, induces more underpricing High underpricing in recent similar offerings can indicate that during the period between the registration of the offer and the initial trading of the issue, investors' perceptions of the prospects for the firm have changed. If these improved perceptions are maintained then high underpricing will result. Such underpricing is consistent with rational revelation of"information about industry prospects"(Lowry and Schwert 2001), or because the underpricing reflects excess demand for these type of stocks(Loughran and Ritter 2000) Our hypothesis that stock hype created by both the media and underlying market sentiment fuels momentum trading in the stock of an IPO candidate on listing date has received support in the prior literature. DuCharme et al. (2001)find that the extent of underpricing for US-based Internet companies is systematically related to greater levels of news exposure for the IPO candidate in a seven-day period prior to the IPO. Further, Loughran and Ritter(2000) found that the higher the expected demand for stock prior to listing, the more likely it is that issuers will accept a lower offer price because of the expected appreciation in share price once the stock is listed. When coupled with the unprecedented first day returns achieved in recent years by firms with Internet-focused business models, the findings of Loughran and Ritter(2000)and DuCharme et al. (2001)suggest that stock hype may potentially be playing a significant role in explaining the underpricing in technology IPOs This study extends the findings of duCharme et al. (2001)in an Australian context where domestic corporate law imposes a seven-day media black-out period pre-listing which prevents systematic attempts by issuers to enhance publicity about a prospective offering by publishing media releases. There are possible real economic actions, other than the IPO, that would reasonably be expected to affect firm value. Therefore we have chosen a 10-day window preceding the 'media black-out period to reduce the likelihood of picking up corporate announcements of economic substance. We expand the notion of hype as it was operationalised by DuCharme et al. (2001)to include hype derived from the australian public equity markets sentiment towards public offerings by technology firms. This dimension is motivated by ritter (2001) who suggests that the secondary market performance of comparable firms is likely to influence investor reaction to the present offering To summarise, we posit that, at least in the period examined (1999 and 2000), the level of stock hype is positively associated with stock returns. We examine the first day of trade for initial public offerings by technology firms and predict that
8 relatively more price ramp up on the actual day of offer, which, in turn, induces more underpricing. High underpricing in recent similar offerings can indicate that during the period between the registration of the offer and the initial trading of the issue, investors’ perceptions of the prospects for the firm have changed. If these improved perceptions are maintained then high underpricing will result. Such underpricing is consistent with rational revelation of “information about industry prospects” (Lowry and Schwert 2001), or because the underpricing reflects excess demand for these type of stocks (Loughran and Ritter 2000). Our hypothesis that stock hype created by both the media and underlying market sentiment fuels momentum trading in the stock of an IPO candidate on listing date has received support in the prior literature. DuCharme et al. (2001) find that the extent of underpricing for US-based Internet companies is systematically related to greater levels of news exposure for the IPO candidate in a seven-day period prior to the IPO. Further, Loughran and Ritter (2000) found that the higher the expected demand for stock prior to listing, the more likely it is that issuers will accept a lower offer price because of the expected appreciation in share price once the stock is listed. When coupled with the unprecedented first day returns achieved in recent years by firms with Internet-focused business models, the findings of Loughran and Ritter (2000) and DuCharme et al. (2001) suggest that stock hype may potentially be playing a significant role in explaining the underpricing in technology IPOs. This study extends the findings of DuCharme et al. (2001) in an Australian context where domestic corporate law imposes a seven-day media black-out period pre-listing which prevents systematic attempts by issuers to enhance publicity about a prospective offering by publishing media releases. There are possible real economic actions, other than the IPO, that would reasonably be expected to affect firm value. Therefore we have chosen a 10-day window preceding the ‘media black-out’ period to reduce the likelihood of picking up corporate announcements of economic substance. We expand the notion of hype as it was operationalised by DuCharme et al. (2001) to include hype derived from the Australian public equity market’s sentiment towards public offerings by technology firms. This dimension is motivated by Ritter (2001) who suggests that the secondary market performance of comparable firms is likely to influence investor reaction to the present offering. To summarise, we posit that, at least in the period examined (1999 and 2000), the level of stock hype is positively associated with stock returns. We examine the first day of trade for initial public offerings by technology firms and predict that:
H1: The extent of first day underpricing of Australian technology IPOs is positively correlated with the degree of stock hype about an IPO candidate prior to listi We measure hype along two dimensions. First, we focus on the reflection of hype in the media as measured by the number of mentions a particular IPO candidate receives in the press and electronic media. Secondly, we measure the underlying sentiment of the market as reflected in recent underpricing of similar IPOs 3.2 Underpricing and the rate of Cash burn DuCharme et al. (2001)observe that the establishment of a systematic relationship between stock hype and the underpricing of technology offerings is valuable in its own right, however it does not explain why an issuing firm would leave potential IPO proceeds on the table. To this end, we examine a second hypothesis, consistent with DuCharme et al. (2001), whereby firms anticipating the need for considerable additional financing in the future to fund growth opportunities have an incentive to tolerate IPO underpricing The decision to go public typically reflects the need for additional equity capital to finance expenditures associated with future growth. Business models in the technology sector during the period we examine were frequently only sustainable to the extent that entrepreneurs were able to return to the capital markets for a follow-on offering as IPO proceeds were consumed (or burnt) This suggests that entrepreneurs, anticipating the need for considerable additional financing in the uture to fund growth opportunities, have an incentive to tolerate greater underpricing so as to leave investors with a sound impression of the firm at the time of going public. We hypothesise that the desire to return to the capital markets, proxied by the rate at which the firm burns through its IPO proceeds on operating activities, is systematically related to the extent of underpricing This suggests the second hypothesis to be examined H2: The extent of underpricing of Australian technology IPOs is positively correlated with the rate at which an IPO candidate is expected to burn cash Explanations of the cross-sectional variation in stock prices for technology firms were prevalent in the literature during the bull market of the late 1990s(e.g. Cohen 1999, Hand 2000a, Hand 2000b). Demers and lev (2001)find that an Internet firms rate of cash burn was a value driver that differed in its pervasiveness as the sector matured and shifted focus towards sustainable business models and bottom(as opposed to top) line financial statement analysis. In 1999, capital markets encouraged aggressive spending behaviour by technology firms to develop the
9 H1: The extent of first day underpricing of Australian technology IPOs is positively correlated with the degree of stock hype about an IPO candidate prior to listing. We measure hype along two dimensions. First, we focus on the reflection of hype in the media as measured by the number of mentions a particular IPO candidate receives in the press and electronic media. Secondly, we measure the underlying sentiment of the market as reflected in recent underpricing of similar IPOs. 3.2 Underpricing and the Rate of Cash Burn DuCharme et al. (2001) observe that the establishment of a systematic relationship between stock hype and the underpricing of technology offerings is valuable in its own right, however it does not explain why an issuing firm would leave potential IPO proceeds on the table. To this end, we examine a second hypothesis, consistent with DuCharme et al. (2001), whereby firms anticipating the need for considerable additional financing in the future to fund growth opportunities have an incentive to tolerate IPO underpricing. The decision to go public typically reflects the need for additional equity capital to finance expenditures associated with future growth. Business models in the technology sector during the period we examine were frequently only sustainable to the extent that entrepreneurs were able to return to the capital markets for a follow-on offering as IPO proceeds were consumed (or ‘burnt’). This suggests that entrepreneurs, anticipating the need for considerable additional financing in the future to fund growth opportunities, have an incentive to tolerate greater underpricing so as to leave investors with a sound impression of the firm at the time of going public. We hypothesise that the desire to return to the capital markets, proxied by the rate at which the firm burns through its IPO proceeds on operating activities, is systematically related to the extent of underpricing. This suggests the second hypothesis to be examined. H2: The extent of underpricing of Australian technology IPOs is positively correlated with the rate at which an IPO candidate is expected to burn cash. Explanations of the cross-sectional variation in stock prices for technology firms were prevalent in the literature during the bull market of the late 1990s (e.g. Cohen 1999, Hand 2000a, Hand 2000b). Demers and Lev (2001) find that an Internet firm’s rate of cash burn was a value driver that differed in its pervasiveness as the sector matured and shifted focus towards sustainable business models and bottom (as opposed to top) line financial statement analysis. In 1999, capital markets encouraged aggressive spending behaviour by technology firms to develop the