Beatrice Presentation March 2, 2004 Robert M. Hull, a, b Robert Kerchner, a Sungkyu Kwak, a Rosemary Walker a a School of Business, Washburn University, 1700 SW College Avenue, Topeka, KS b Corresponding author. Tel.: ‑ 231 ‑ 1010; fax: ‑ 231 ‑ E ‑ mail address: (R. Hull) Earlier Version Published in Proceedings of: American Financial Services, October 8, 2003 Final Version Published in: Investment Management and Financial Innovation, 2005

We examine the market’s response to IPOs surrounding the last quarter of the year During this quarter, the financial press began reporting insider accusations that investment bankers had colluded with preferred clients to create profits in the IPO aftermarket. We find that the underpricing associated with extreme IPO aftermarket profits was sharply curtailed during this quarter. Underpricing ceased altogether for the following quarter before subsequently picking up. These findings become even more pronounced after we compare IPO underpricing with that found for firms undergoing seasoned offerings. We conclude that investment bankers, for up to a six-month period, either ceased their alleged aftermarket practices or drastically reduced their IPO profits to pacify public sentiment. Abstract JEL classifications: D82; G14; G32; G34 Key Words: Initial public offerings; Underpricing; IPO Bubble; Underwriter compensation; Collusion; Seasoned Offerings

 Underpricing refers to selling shares below their fair value. Underpricing for IPOs, as measured by first-day returns, is cyclical reaching heights of 60% to 80% during the buoyant markets of 1961, , 1980, and In the United States, first-day returns for IPOs averaged around 15% prior to  The unprecedented level of IPO underpricing for is the most widely recognized feature of what is now referred to as the “IPO bubble”. This bubble can be likened to earlier bubbles such as the 17th century tulip craze in Holland. At the core of these bubbles is a compulsive demand by zealous investors who often become subject to price exploitation by opportunistic suppliers.  The end result for each bubble is absurdity. Can we imagine how it would feel to save every penny of earnings for seven years to buy a tulip bulb that later would sell for less than one day’s wage?

I P O I N F O Underpricing refers to selling shares below their fair or true value. Underpricing can be defined as the true price minus the offer price. Underpricing refers to selling shares below their fair or true value. Underpricing can be defined as the true price minus the offer price. For SEOs, underpricing is measured ex-ante based on stock price data prior to the offering, e.g., the closing market price the day before the offer date For SEOs, underpricing is measured ex-ante based on stock price data prior to the offering, e.g., the closing market price the day before the offer date For IPOs, underpricing is measured ex-post based on the closing market price at some designated time after the offering For IPOs, underpricing is measured ex-post based on the closing market price at some designated time after the offering Underpricing for IPOs, as measured by first-day returns, averaged 15% prior to Underpricing for IPOs, as measured by first-day returns, averaged 15% prior to Peaks for IPOs reach 60%-80% during 1961, , 1980, and Peaks for IPOs reach 60%-80% during 1961, , 1980, and The IPO bubble, like the 17th century tulip bubble or any bubble, has at the core a compulsive demand by zealous investors who can become subject to price manipulation by opportunistic suppliers. The IPO bubble, like the 17th century tulip bubble or any bubble, has at the core a compulsive demand by zealous investors who can become subject to price manipulation by opportunistic suppliers.

Motivation for Research During the last quarter of the year 2000, the financial press reported allegations that investment bankers operated kickback schemes with preferred IPO clients when shares were bought and sold in the IPO aftermarket. Allegedly, both the company (who raised less money) and individual investors (who were not preferred clients and consequently paid too much in the aftermarket) lost when exorbitant profits were made through the manipulation of stock prices. According to a complaint filed January 22, 2002 by the SEC, underwriters extracted from clients (through excessive fees) a large portion of the underpricing profits that those clients made in the IPO aftermarket.

Purpose We seek to empirically explore whether the allegations of excessive IPO profits are rooted in factual underpricing numbers during this period. We do this by analyzing IPOs surrounding the last quarter of 2000 when the serious allegations began to surface. If these allegations are true (or at least changed investment bankers behavior to significantly lessen underpricing) then the profits resulting from underpricing should begin subsiding during the last quarter of the year 2000 when the allegations began hitting the financial press.

Environmental Changes  First, the internal environment within a company changed in the late 1990s. Wilhelm and Ljungqvist (2003) suggest that the extreme underpricing in the late 1990s can be least partially accounted for by a variety of marked changes in pre-IPO ownership structure and insider selling behavior over the period.  Second, the external environment affecting management changed as investors clamored for more IPOs. This demand created a situation where underwriters could more easily dictate the terms of the IPO and collude with preferred customers to jointly capitalize on the anticipated stock price run-up in the IPO aftermarket.

Economic Justification  In a red-hot IPO market, it becomes more imperative to gather truthful input from investors. Price support can overcome the fact investment bankers in the countries like the U.S. cannot price discriminate.  Greater IPO underpricing leads to a less favorable market reaction for subsequent offerings.  U.S. underwriters behave strategically in the allocation of IPOs allocating favorable IPOs to customers who partake in unfavorable IPOs.

Prior Research  Underpricing for IPOs has been well documented and is more extreme than that found for SEOs. There is overwhelming international evidence of underpricing in IPOs. As measured by the difference between the offer price and the first day of trading, underpricing averages about 15% in industrialized countries and about 60% in emerging markets.  SEOs have not always focused on underpricing. One exception is Hull and Kerchner (1996) who find that underpricing is 2.97% of offer value (for example, for every $100 of equity raised, the companies lose $2.97 due to underpricing). However, when just small OTC firms (which are more similar in size to IPO firms) are examined, they find that underpricing is 4.26% of the value of the new offering. The findings of Hull and Kerchner (2000) suggest underpricing should be greater for small IPO companies.

Underpricing Measures Initial Public Offerings (IPOs) Initial Public Offerings (IPOs) Ex-Ante Measure: Offer Price Minus Average Price File Range Ex-Post Measure: Offer Price Minus Closing Price One Week After the Offer Date Seasoned Public Offerings (SEOs) Seasoned Public Offerings (SEOs) Ex-Ante Measure: Offer Price Minus Closing Price the Day Before Offer Date Ex-Post Measure: Offer Price Minus Closing Price One Week After the Offer Date Two Underpricing Computations Two Underpricing Computations We will compute both dollar underpricing and percentage underpricing

Testable Hypotheses We hypothesize that there should be a drastic reduction in IPO underpricing during the last quarter of To determine the extent of the reduction, we shall compare the last quarter of 2000 with the two previous quarters and the two following quarters. To help accurately weigh any excessive profits, we will contrast IPOs with SEOs. What happens in the SEO aftermarket serves as a benchmark when conducting tests.

Table 1: Descriptive statistics for total period Key Variable IPOs (n=246) SEOs (n=351) Offer Price $14.85 ($14.00) $35.73 ($28.50) Ex-Ante Price $15.24 ($14.00) $37.13 ($29.56) Ex-Post Price $20.55 ($15.63) $36.96 ($29.38) New Shares 16.52M (6.00M) 12.43M (4.50M) Offer Value $256M ($83M) $407M ($137M) Stock Value $770M ($195M) $5264M ($1168M) $1058M ($241M) $8048M ($1591M) Firm Value $1058M ($241M) $8048M ($1591M) Offer Value as a Offer Value as a % of Firm Value 49.31% (32.92%) 9.09% (7.01%) % of Firm Value 49.31% (32.92%) 9.09% (7.01%)

Quarter Offering Type (n) Type (n) Offer Price Mean (Median) Ex-Ante Price Mean (Median) Ex-Post Price Mean (Median) 4/1/00- IPOs (n=85) 6/30/00 SEOs (n=70) $13.97 $13.00 $35.43 $30.50 $15.21 $15.00 $37.21 $32.04 $20.44 ($15.50) $36.35 ($32.72) 7/1/00 IPOs (n=63) -9/30/00 SEOs (n=52) $16.38 $15.00 $44.06 $35.00 $15.13 $13.00 $45.30 $37.19 $27.15 ($21.25) $45.45 ($36.69) 10/1/00- IPOs (n=52) 12/31/00 SEOs (n=72) $14.03 $13.25 $39.65 $30.41 $15.16 $14.00 $41.95 $32.57 $15.82 ($14.60) $41.39 ($33.34) 1/1/01- IPOs (n=20) 3/31/01 SEOs (n=68) $11.40 $11.50 $33.97 $26.09 $13.56 $13.50 $34.90 $26.88 $12.29 ($11.90) $34.97 ($28.01) 4/1/01- IPOs (n=26) 6/30/01 SEOs (n=89) $18.32 $15.50 $29.28 $23.68 $17.09 $15.00 $30.09 $23.81 $20.69 ($17.56) $30.41 ($24.60) Table 2: Descriptive Statistics for Quarters

Table 3: Underpricing results for total period Key Variable IPOs (n=246) SEOs (n=351). mean (median) mean (median). Ex-Ante Underpricing  – $28.3 ($0.0) – $13.4 ( – $3.5) (Offer Price – Ex-Ante Price)(New Shares). Ex-Ante Underpr. %age  – 1.2 % (0.0 % ) – 3.5 % ( – 3.0 % ) (Offer Price – Adjusted Ex-Ante Price)(Adjusted Ex-Ante Price). Adj. Ex-Post Underpr.  – $40.1 ( – $13.5) – $11.1 ( – $3.4) (Offer Price – Adjusted Ex-Post Price)(New Shares). Adj. Ex-Post Und. %age  – 34.8 % ( – 13.0 % ) – 4.9 % ( – 3.1 % ) (Offer Price – Adjusted Ex-Post Price)(Offer Price). Adj. Ex-Post Underpr. *  – $11.8 ( – $4.0) – $2.4 ( – $0.2) (Ex-Ante Price * – Adjusted Ex-Post Price)(New Shares). Adj. Ex-Post Und. %age *  – 42.5 % ( – 4.5 % ) – 1.2 % ( – 0.3 % ) (Ex-Ante Price * – Adjusted Ex-Post Price)(Offer Price).

Quarter Offering Type (n) Type (n) Ex-Ante Underpricing AdjustedEx-PostUnderpricing Adjusted Ex-Post Underpricing if Offer Price Set at Ex-Ante Price 4/1/00- IPOs (n=85) 6/30/00 SEOs (n=70) -$7.3M; -$4.0M -$13.9M; -$5.1M -$46.6M; -$13.6M -$4.0M; -$1.2M -$39.9M; -$2.0M +$15.5M; -$0.0M 7/1/00 IPOs (n=63) -9/30/00 SEOs (n=52) +$11.7M; +$7.8M -$5.9M; -$2.1M -$73.0M; -$33.2M -$13.6M; -$1.8M -$82.7M; -$46.3M -$10.6M; +$1.6M 10/1/00- IPOs (n=52) 12/31/00 SEOs (n=72) -$39.2M; -$6.9M -$31.7M; -$5.0M -$10.1M; -$7.2M -$13.4M; -$5.4M +$29.6M; -$0.0M +$18.1M; -$3.1M 1/1/01- IPOs (n=20) 3/31/01 SEOs (n=68) -$337M; -$8.8M -$7.4M; -$3.6M +$4.4M; -$3.3M -$13.5M; -$6.2M +$338M; +$7.3M +$0.0M; +$2.0M 4/1/01- IPOs (n=26) 6/30/01 SEOs (n=89) +$65.8M; +$7.4M -$7.3M; -$2.6M -$33.2M; -$13.0M -$11.5M; -$2.5M -$91.1M; -$21.1M -$5.0M; -$0.6M Table 4: Underpricing by quarters: dollar change results

Quarter Offering Type (n) Type (n)Ex-AnteUnderpricingPercentage Adjusted Ex-Post UnderpricingPercentage Adjusted Ex-Post Underpricing if Offer Price Set at Ex-Ante Price 4/1/00- IPOs (n=85) 6/30/00 SEOs (n=70) -7.42%; -7.69% -5.13%; -4.80% %; % -3.23%; -1.72% %; +1.50% +2.13%; +1.15% 7/1/00 IPOs (n=63) -9/30/00 SEOs (n=52) %; +8.33% -2.72%; -2.76% %: % -4.16%; -1.54% %; % -1.38%: +2.39% 10/1/00- IPOs (n=52) 12/31/00 SEOs (n=72) -5.97%; -7.69% -3.39%; -3.27% %; -6.86% -6.37%; -4.24% -9.51%; +1.60% -2.90%; -1.19% 1/1/01- IPOs (n=20) 3/31/01 SEOs (n=68) %; % -3.41%; -2.50% -3.41%; -2.50% -8.13%; -4.65% -6.14%; -5.26% +1.97%; +4.47% -2.49%; -1.53% 4/1/01- IPOs (n=26) 6/30/01 SEOs (n=89) +6.57%; +4.37% -3.00%; -2.79% %; -8.38% -4.39%; -3.22% %; -9.75% -1.23%; -0.29% Table 5: Underpricing by quarters: percentage change results

Exhibit 2. Mean Difference Results for Adjusted Ex-Post Underpricing Q1Q2Q3Q4Q5 Total Period IPO Mean  $46.62M (n = 85)  $73.14M (n = 63)  $10.10M (n = 52) +$4.36M (n = 20)  $33.16M (n = 26)  $40.12M (n = 246) SEO Mean  $3.95M (n = 70)  $13.56M (n = 52)  $13.36M (n = 72)  $13.53M (n = 68)  $11.58M (n = 89)  $11.10M (n = 351) MeanDifference  $42.67M  $59.58M +3.26M+17.89M  $21.58M  $29.02M t statistic  2.33   2.10  3.25 SignificantLevel

Exhibit 3. Mean Difference Results for Adjusted Ex-Post Underpricing Percentage Q1Q2Q3Q4Q5 Total Period IPO Mean 37.65% (n = 85) 64.26% (n = 63) 14.95% (n = 52) 8.13% (n = 20) 14.52% (n = 26) 34.82% (n = 246) SEO Mean 3.23% (n = 70) 4.16% (n = 52) 6.37% (n = 72) 6.14% (n = 68) 4.39% (n = 89) 4.87% (n = 351) MeanDifference 34.42% 60.10% 8.58% 1.99% 10.13% 29.95% t statistic 4.49 5.05 2.05 0.51 2.03 6.95 SignificantLevel<0.001< <0.001

Exhibit 4. Mean Difference Results When IPO Adjusted Ex- Post Underpricing Tested Against SEO Ex-Ante Underpricing Q1Q2Q3Q4Q5 Total Period IPO Mean  $46.62M (n = 85)  $73.14M (n = 63)  $10.10M (n = 52) +$4.36M (n = 20)  $33.16M (n = 26)  $40.12M (n = 246) SEO Mean  $13.92M (n = 70)  $5.90M (n = 52)  $31.72M (n = 72)  $7.35M (n = 68)  $7.34M (n = 89)  $13.44M (n = 351) MeanDifference  $42.67M  $67.24M M+11.71M  $25.82M  $26.68M t statistic  2.56   2.64  3.14 SignificantLevel

Exhibit 5. Mean Difference Results When Non-Technology IPO Adjusted Ex- Post Underpricing Tested Against SEO Ex-Ante Underpricing Q1Q2Q3Q4Q5 Total Period IPO Mean  $48.21M (n = 29)  $110.38M (n = 25)  $5.13M (n = 26) -$11.36M (n = 16)  $34.58M (n = 22)  $44.35M (n = 118) SEO Mean  $10.05M (n = 37)  $5.23M (n = 35)  $26.79M (n = 54)  $6.52M (n = 50)  $6.13M (n = 71)  $11.19M (n = 247) Mean Difference  $38.16M  $105.15M M-4.84M  $28.45M  $33.16M t statistic  1.47   2.54  2.79 Significant Level

Exhibit 6. Quarterly Results for Adjusted Ex-Post Underpricing (upper hand) and Adjusted Ex-Post Underpricing Percentage (lower hand) with t statistic followed by significant level in first row and turnaround in second row (M = million) Q1Q2Q3Q4Q5 Q1  1.16;  $26.52M +2.49; $36.52M +0.98; $50.98M +0.87; $13.46M Q2  1.92;  26.61% +3.01; $63.04M +1.43; $77.50M +1.85; $39.98M Q3+2.71; % +4.00; < % +0.28; $14.46M  1.84;  $23.06M Q4+3.53; % +4.56; < % +1.27; %  0.73;  $37.52M Q5+2.59; % +3.92; < % +0.07; %  1.03;  6.39%

6.3.4 Evidence from statistical tests summarized We have attempted to look at and analyze the hard numbers to get to the root of any excessive profit taking in the IPO aftermarket. While evidence from our many tests is not always in agreement as pertains to all details, our tests do point toward several general findings. These findings are summarized below. First, we find that Q1 and Q2 manifest bubble-like underpricing that surpasses historical norms of  15% and are statistically significant from SEO ex-ante and ex-post underpricing values. Profit taking possibilities for Q2 indicate the investment bankers and preferred clients could have made over half as much money as raised by IPOs. Second, we find that the allegations occurring in Q3 do not fully impact ex-post underpricing until Q4. Heavy losses in the IPO aftermarket are avoided by judiciously setting the offer price below ex-ante levels especially for larger offering. Some of our tests even indicate there is overpricing especially for Q4. Third, we find that underpricing returns to its historical average of  15% by Q5. This is achieved by a huge turnaround in mean difference when IPO ex-post underpricing is compared to SEO underpricing. The sharpness of the turnaround indicates that the allegations had an effect that did not last more than six months. The underpricing could have returned to bubble levels experienced earlier if offer prices had been set nearer to ex-ante prices. Thus, conditions appear to have changed such that underwriters can no longer get their bubble profits. Fourth, we find no consistent evidence that high-tech firms are driving the profit taking even though they may be energizing it. For the dollar underpricing tests, our conclusions are actually strengthened if we delete high-tech observations. For percentage tests, conclusions are weakened. Fifth, we conclude that our evidence supports our research hypothesis: underpricing for IPOs fell due to the allegations of misconduct. However, the fall was from bubble levels with a return to normal historical levels.

Summary & Conclusion We examine stock offerings for the two quarter prior to and after the quarter (10/1/00 to 12/31/00) during which allegation are made that investment bankers and preferred clients made exorbitant profits through manipulating stock prices in the IPO aftermarket. We find that IPO profits disappeared. In some case, investment bankers probably even sustained losses. However, any total industry losses were minimized because the number of IPOs fell dramatically. Any fall in underwriting profits were short-lived because the potential for profits in the aftermarket began surfacing within six months of the accusations. We can attribute the resurfacing of profits to several factors. First, no one really knows or can prove if stock prices were manipulated. After things quieted down, investment bankers returned to work in an attempt to restore profits. Second, the markets realize that investment bankers must make profits to stay in business. The market only requires that investment bankers police themselves so that the companies they serve and potential investors (other than preferred clients) are not taken to the “cleaners” on a regular basis.

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