Two essays on the role of institutional investors in IPO

Abstract

My thesis consists of two essays that investigate the roles of institutional investors in Initial Public Offerings (IPO). By adopting a "two-stage" framework that considers the pre-market (bookbuilding) and aftermarket (trading) stages, I aim to provide explanations to how investor sentiment and total allocation to institutional investors influence IPO pricing and price discovery. My first essay examines how underwriters price an IPO in the presence of investor sentiment especially when pre-market sentiment may deteriorate in aftermarket stage. Ljungqvist et al. (2006) show that underwriters cooperate with institutional investors in adopting a "staggered sale" strategy to exploit sentiment investors who arrive to the IPO market over time. Their study predicts that underwriters leave money on the table to compensate institutional investors for bearing the risk of sentiment deterioration. However, their prediction has not been empirically examined. My study fills such a void by utilizing a unique IPO mechanism in Hong Kong: The separate retail tranche where pre-market sentiment can be directly measured by retail oversubscription. I find that underwriters adjust offer price to take advantage of pre-market investor sentiment but the adjustment is only partially done. More importantly, the money left on the table is positively related to the deterioration of investor sentiment in the aftermarket. Overall, my result is consistent with the re-distributing role of institutional investors in the aftermarket and establishes a relation between their compensation and the reversal of investor sentiment. My second essay investigates how total allocation for institutional investors affects their choice of aftermarket trading as an alternative to participating in pre-market bookbuilding. Busaba and Chang (2010) show that if institutional investors anticipate unfavorable allocation, they may strategically choose to withhold their private information in the bookbuilding and trade on it subsequently in the aftermarket. However, little research so far has explored informed aftermarket trading by institutional investors. My study fills this gap by taking advantage of the "Clawback" arrangement in Hong Kong, which exogenously generates a wide but anticipated variation in the total institutional allocation by linking share allocation to pre-market retail demand. I find that insufficient allocation encourages institutional investors to choose strategic aftermarket trading, resulting in less (more) private information being incorporated into share price during the pre-market bookbuilding (the aftermarket trading). I document that aftermarket trading by institutional investors earns excess returns in both short and long horizons. Overall, my findings confirm the prediction by Busaba and Chang (2010) and suggest that institutional investors can enhance price efficiency through either their participation in pre-market bookbuilding or aftermarket trading.