Short covering and price stabilization of IPOs

Abstract

Underwriters underprice Initial Public Offerings (IPOs) and often, immediately after, repurchase shares in an attempt to stabilize the price. This ancillary service is not mandatory and can be provided by underwriters in the first month of trading. Using a sample of Italian IPOs, we investigate whether the price stabilization activity is carried out when actually needed. We document that only half of the IPOs that require this service are actually stabilized after going public. The fees charged by underwriters are not informative about the provision of this ancillary activity. Rather, the underwriter's reputation is negatively associated with the stabilization activity. Negative price revisions and negative (or low) underpricing also drive the provision of price stabilization.

Keywords:

• IPOs
• underwriters
• gross spread
• price stabilization
• investment banks

JEL Classification:

• G15
• G24

Notes

¹ Data are from the EURIPO database. See Vismara et al. (2012) for a description of the database. We are grateful to Fabio Braga, Enrico Pellizzoni and Borsa Italiana for providing proprietary data on stabilization and useful insights.

² Overallotment occurs when the underwriter sells more shares than the issuer made available, by borrowing them from pre-IPO shareholders. The balance can be covered by giving back the corresponding amount of money (greenshoe) and/or shares (stabilization) to the lenders. In the first case, the underwriter can exercise the greenshoe option up to 30 days after the listing and pay for shares at the offer price independently from the current market valuation. In the second case, the underwriter buys shares from the aftermarket and gives them back to the lenders. A naked short position occurs when overallotment is greater than 15% of the offer volume. The presence of a naked short position implies stabilization, since the greenshoe option is limited to 15% of offer volume. The greenshoe option and stabilization are not mutually exclusive. The choice of which strategy to adopt is determined by the aftermarket stock price: if it rises, buying shares would be more costly than exercising the greenshoe. Hence, stabilization is typically associated with poorly performing IPOs and is aimed at preventing price drops.

³ Stabilization data are disclosed in a report transmitted to Borsa Italiana by the underwriter at the end of the first trading month.

⁴ Endogeneity of the 1-month BHAR is verified through Hausman (1978) test. Valid instruments must explain both stock performance and be uncorrelated with the second-stage regression residuals. Once tested their validity, we checked exogeneity with respect to the dependent variable in the main equation and excludability from the regression through Hansens's J-test.

⁵ Claw-back clauses are provisions allowing the underwriter to shift shares from one investor category to another, in order to manage different levels of oversubscription. Bertoni et al. (2008) find that underwriters in Italy increase the fraction of the shares allotted to the public when the first day return is negative.

⁶ We checked the validity of these variables by testing relevance (correlation with the endogenous explanatory variable) and exogeneity (no correlation with the error terms).

⁷ We also defined underwriter's reputation with reference to the number of IPOs managed instead of capital raised, finding similar results. These models are not reported in this article.

⁸ As reported in Table 1, the median gross spread in Italy is 4%, lower than the traditional 7% solution of the United States, but in line with the previous studies in Europe (Chen and Ritter, 2000; Ljungqvist et al., 2003).

⁹ To be precise, if a stock trades sufficiently below the offer price, at a discount larger than the gross spread, the underwriter would prefer to cover the short position by repurchasing shares in the aftermarket instead of exercising the greenshoe option.