The Specific Underpricing of IPOs in U.S. Stock Markets

CONTENTS

1 INTRODUCTION

2 INITIAL PUBLIC OFFERINGS AND THEIR UNDERPRICING
2.1 THE IPO
2.2 GOING PUBLIC IN THE U.S
2.2.1 THE IPO PROCESS - PREPARATION AND FACTORS OF SUCCESS
2.2.2 PARTICIPANTS AND THEIR ROLES
2.3 IPO UNDERPRICING
2.3.1 DEFINITION
2.3.2 WHO BENEFITS FROM IPO UNDERPRICING?
2.3.3 EVIDENCE ON UNDERPRICING

3 THE REPUTATION OF MARKET SEGMENTS IN THE CONTEXT OF IPO UNDERPRICING
3.1 MARKET SEGMENTATION IN THE UNITED STATES
3.2 THE REPUTATION OF MARKET SEGMENTS

4 LISTING REQUIREMENTS IN THE U.S. AND THEIR POTENTIAL IMPACT ON MARKET REPUTATION
4.1 THE SEC AND ITS REQUIREMENTS
4.1.1 INITIAL REGISTRATION
4.1.2 PERIODICAL REQUIREMENTS
4.2 LISTING REQUIREMENTS AT NYSE EURONEXT MARKETS
4.2.1 INTRODUCTION TO NYSE EURONEXT
4.2.2 CORPORATE GOVERNANCE
4.2.3 NEW YORK STOCK EXCHANGE
4.2.4 ARCA
4.2.5 AMEX
4.3 LISTING REQUIREMENTS AT NASDAQ OMX MARKETS
4.3.1 INTRODUCTION TO THE NASDAQ OMX GROUP
4.3.2 CORPORATE GOVERNANCE
4.3.3 THE GLOBAL SELECT MARKET
4.3.4 THE GLOBAL MARKET
4.3.5 THE CAPITAL MARKET
4.4 COMPARISON AND POSSIBLE IMPLICATIONS ON THE UNDERPRICING

5 EMPIRICAL ANALYSIS
5.1 DATA BASE AND METHODOLOGY
5.2 SAMPLE DESCRIPTION
5.3 THE SPECIFIC UNDERPRICING IN EACH MARKET SEGMENT
5.4 THE UNDERPRICING AT NYSE EURONEXT AND NASDAQ OMX MARKET SEGMENTS - AN AGGREGATED COMPARISON
5.5 REGRESSION ANALYSIS
5.4.1 THE REGRESSION MODELS
5.4.2 RESULTS AND DISCUSSION
5.6 SUMMARY OF THE EMPIRICAL ANALYSIS

6 CONCLUSION

Illustrations

Illustration 1: Percental Change in GDP for 10 Years

Illustration 2: The Computation ofIPO Underpricing

Illustration 3: The Impact ofUnderpricing on the Wealth of Pre-Issue Shareholders

Illustration 4: The Reputation Building Process for Stock Market Segments

Illustration 5: Critical Periods during the SEC Registration21

Illustration 6: Number of examined IPOs in Particular Market Segments

Illustration 7: Number ofIPOs in the Time Course

Illustration 8: Mean Underpricing in Particular Market Segments54 Illustration 9: Regression Model Underpricing/CAGR Revenues64

Tables

Table 1: Recommendations for Companies planning to offer Securities initially

Table 2: Deadlines for the Filing ofPeriodic Reports

Table 3: Distribution and Size Criteria at NYSE

Table 4: Financial Criteria at NYSE

Table 5: Continued Distribution Criteria at NYSE

Table 6: Continued Listing Requirements for the Pure Valuation Standard at NYSE

Table 7: Initial Listing Standards at NYSE Arca

Table 8: Continued Listing Standards at NYSE Arca

Table 9:Initial Listing Standards at NYSE Amex

Table 10:Continued Distribution Criteria at NYSE Amex

Table 11:Continued Financial Requirements at NYSE Amex

Table 12: Initial Financial and Qualitative Requirements at Nasdaq GSM

Table 13: Liquidity Requirements for IPOs at Nasdaq GSM

Table 14: Continued Listing Requirements at Nasdaq GSM

Table 15: Initial Listing Requirements at Nasdaq GM

Table 16: Continued Listing Requirements at Nasdaq GM

Table 17: Initial Listing Requirements at Nasdaq CM

Table 18: Continued Listing Requirements at Nasdaq CM

Table 19: A Comparison of the Listing Requirements in the United States44 Table 20: Comparison of Initial Size Requirements

Table 21: Ranking of Size Groups defined by Market Segment's Size Minimums

Table 22: Effective Size of Issuing Firms based on Total Assets and Revenues

Table 23: Ranking ofMinimum Size Requirements and Effective Company Size ofIssuers - An Assumption-Based Expectation

Table 24: The Specific Underpricing in the Examined Market Segments

Table 25: The Specific Underpricing in the Examined Market Segments (outlier adjusted)/Issue Intensity

Table 26: Tests of Equality

Table 27: Comparison of the Underpricing in NYSE Euronext and Nasdaq OMX Segments

Table 28: Tests of Equality

Table 29: Explanations on Exogenous Variables for the Regression Model (Panel A)

Table 30: Explanations on Added Exogenous Variables for the Regression Model (Panel B)

Table 31: Regression Results Panel A61

Table 32: Regression Results Panel B63

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1 INTRODUCTION

The economical development is improving and world trade volumes are expected to recover. The recovery process is developing constantly but slowly: Share prices have rebounded within 2009, worldwide trade volumes have recovered slightly and are expected to catch up with values from the end of 2008 during the next year (cf. OECD 2009).

The world is recovering from one of the most severe economic downturns since The Great Depression. Comparing GDP volumes from the previous period at the same time, OECD countries lost up to 2%.

Illustration 1: Percental Change in GDP for 10 Years (OECD 2010)

Abbildung in dieser Leseprobe nicht enthalten

As a logical consequence the U.S. IPO market has been affected by the economic meltdown as well. "IPO activity tends to cluster in certain time periods, thus it appears in waves, so-called hot IPO markets" (Hamer 2007, 9). From 2007 to 2008 the number of IPOs decreased. The U.S. market broke down by more than 85% in one year. In 2007 there were 160 IPOs whereas in 2008 21 securities went public for the first time (cf. Ritter 2010, 2). After the slowest year for IPOs since the 1970s, the market began to show signs of life again in 2009. The number of offerings increased by 21 % although the offering value decreased by almost 15 % (cf. PWC 2010).

"IPO market conditions can change rapidly. Many factors influence the market, political developments, interest rates, inflation, economic forecasts, and sundry other matters that seem unrelated to the quality of a company's stock. The market is admittedly emotional" (Kleeburg 2005, 53).

To get a deeper understanding of how IPO activity is influenced one has to dispute with further analysis. One of the main drivers that have an impact on the IPO market is the venture capital market. According to Ritter, 35% of the IPOs from 1980 - 2009 were related to venture-capital-backed firms while 57% of all technology IPOs during the same period were VC-backed. The analysis counted for 7,456 IPOs including 2,706 technology IPOs (cf. Ritter 2010, 7). Evidently, the number is highly dependent on the development of venture capital markets, which also started to revive at the end of 2009 (cf. NVCA 2010).

Regarding the IPO procedure itself there are inefficiencies. If going public was fully efficient, an initial public offering should maximize the issuer's proceeds, the investors who most value the shares should receive them, and in the absence of news or private information there should be little trade after the shares are allocated (cf. Pritsker 2006, 1). But several empirical studies documented the existence of the underpricing-phenomenon for newly listed firms during the early days of trading across many countries and capital markets (cf. Boudriga/Slama 2009, 2). The underpricing is the effect of a significant shift in wealth that is related to an initial public offering. It occurs in the form of an increase of the stock price right after the offering.

By intuition it seems to be highly rational for an issuer to choose the market segment with the highest reputation to maximize his proceeds. But if the issuer does not meet the requirements he will run the risk of losing value. Hunger states that IPO underpricing is attributed to the scarcity of suitable market segments, suitable in terms of the specific issuer risk. In recent literature there are assumptions, proclaiming a connection between the reputation of stock market segments and the level of underpricing. The main implication: The lower the reputation which coheres with listing requirements, the marketing of the stock exchange or presence in the media, the higher the underpricing-effect seems to be (cf. Hunger 2009).

Furthermore, he assumes that it is a necessary consequence of the respective market segment whose reputation is due to qualitative attributions, not to the specific risk an issuer is bringing along (cf. Hunger, 2009).

The empirical investigation Hunger conducted, confirms a specific underpricing in vertical stock market segments in Europe. He constructs the thesis that if rationales, concerning the emergence of corporate reputation, were transmitted to stock market segments, a consistent explanation for underpricing, specific to market segments, could be found. The author's analysis samples 809 IPOs in Germany, France, Italy, Austria, and Switzerland (cf. 2004, 22).

A differentiated understanding of the terms "vertical market segment" and "underpricing" will be given in the following chapters.

The Market Reputation Thesis delivers a consistent explanation for the empirical results Hunger obtained.

Therefore, this thesis pursues two main objectives:

1) Confirmation for The Market Reputation Thesis should be found.
2) Concerning economic recovery and the expected increase in IPO activity, the understanding ofhow capital markets gather new issuers should be facilitated.

To achieve these goals this thesis will be structured as follows: First of all an overview and an universal understanding of IPOs and their underpricing should be given. Secondly, in chapter 3, the segmentation of stock markets in the United States will be outlined, followed by the presentation of The Market Reputation Thesis. Likewise the term "reputation" and its adaptability to stock markets will be discussed while a theoretical model of the reputation building process is presented.

In Chapter 4, taking potential reputational effects into account, the only objectively assessable and measurable influence factor for the reputation of a stock market (segment) will be discussed critically - the listing requirements. Based on this assessment and in respect of the underpricing, an assumption-based expectation will be derived.

The empirical analysis, underlying this thesis, encompasses stock market segments of NYSE Euronext (NYSE, AMEX and ARCA) and NASDAQ OMX (The Capital Market, The Global Market, and The Global Select Market). Therefore, almost sixty parameters, attributable to more than 200 IPOs, were gathered. The fifth part will use this data (i) to compare the deducted expectation with the underpricing of approximately 200 IPOs (ii) to conduct further analysis that confirms The Market Reputation Thesis and (iii) to test different, scientifically discussed, variables that could influence the IPO underpricing.

2 INITIAL PUBLIC OFFERINGS AND THEIR UNDERPRICING 2.1 THE IPO

"An initial public offering can be defined as the first public offer of shares on the primary market and the introduction of these shares to a security market" (Carls 2007, 359). IPOs are performed in the primary market which is known as the market for the first sale of issuers to investors, even if a bank or a syndicate intermediates (cf. Carls, 2007, 415).

Concerning macroeconomics, IPOs accomplish two very important functions within economies. First of all, they enable the supply of risk capital for companies. This can be seen as a crucial factor to maintain the ability of economies to grow and innovate (Hunger 2004,17). Secondly, they allocate some of the issuing firm's risk amongst the wider investing public (cf. Pritsker 2006,1).

The proceeds of an IPO improve a company' s financial situation remarkably. In terms of accounting the company will improve the debt-to-equity ratio what upgrades the debt financing situation. On the other hand the cash, raised through the offering, could be captured and used for innovation and expansion financing or debt reduction what implicates lower financing costs (cf. Perridon/Steiner 2007, 362) . Furthermore, the shareholder value can be increased, current shareholders will be able to diversify their portfolio, growth can be financed, and the potential for mergers and acquisitions will be greater (cf. Kleeburg 2005, 22/23).

But there are also indirect, less obvious advantages an offering can bring along. "An accompanying offer of a stock-option plan for the management or employees can have a motivating effect and the public perception of the company can be extended, respectively, improved" (Geddes 2003, 24). However, empirical studies have shown that the main financial reason to go public is to strengthen the equity base with the purpose of financing company growth. In many cases, this is a prerequisite for higher future leverage (cf. Hamer 2007, 3).

Knaus/Jakob argue that managements often only focus on the net proceeds and the IPO-related valuation results. By doing this, companies put themselves insofar in danger as the IPO will shift, from being a mean to an end, the end itself. However, the authors also conclude that the main IPO-related objective is the financing of future growth (cf. 2001,1).

To gain the benefits outlined above, a company also has to take the costs of an IPO into account. Buermeyer splits them into direct and indirect costs (cf. 2000, 125­129). "Direct costs generally amount to 6-8 % of the issue volume" (Buermeyer 2000, 127), while in the U.S. a general price of 7% of the gross issue volume for issues up to $ 80 million evolved (cf. Carls 2007, 363). Furthermore, Buermeyer mentions the costs of publicity and the underpricing as indirect costs (cf. 2000, 128/129).

"In going public an issuing firm undergoes a rather complex process which must meet the requirements and expectancies of the capital markets, and at the same time maximize the desired benefits for the issuer. However, the listing process is associated with several risk factors, which must be evaluated before the IPO initialization" (Hamer 2007, 2).

In the following, briefly, the milestones of going public in the United States, factors of success, and the role of main participants is described.

2.2 GOING PUBLIC IN THE U.S.

2.2.1 THE IPO PROCESS - PREPARATION AND FACTORS OF SUCCESS

This thesis examines the IPO underpricing in U.S. stock markets. Explaining the IPO process broadly would not be useful concerning the topic. However, it is meaningful to get a superficial understanding of the complexity, the process inheres, what should be considered before an IPO and what are the main country specific regulation requirements.

Before outlining the process in general, an understanding of the necessary- maturity a company should exhibit is given.

"Some rules of thumb for a firm considering an IPO are that the company is growing, that it has a definite need for much larger funding, that it has a "good story", and that it is a good time in the market for this type of company" (Ghosh 2006,21).

To get a more precisely idea of how minimum requirements could look like, consider the following table:

Table 1: Recommendations for Companies planning to offer Securities initially (Own illustration based on Petersen 2001, 57/58)

Abbildung in dieser Leseprobe nicht enthalten

However, these recommendations should be considered as very flexible and highly depending on the individual situation of the firm and actual market conditions. Based on own research, there is empirical evidence for three of four quantitative parameters. Every company, except those that have been incepted right away or were only researching without generating turnover, had revenues of more than $ 100 million in the last fiscal year before the IPO event. Revenues grew within the last three fiscal years before going public at an arithmetic average rate of 63,24 %. Only in one out of 202 cases the gross IPO volume was lower than $ 5 million. Merely in terms of profitability, evidence on the recommendations cannot be proved. The growth rate's arithmetic average of the gross operating margin was 7,14 % (Own Research 2010).

"Selling a company's shares and maintaining the interest of potential investors in the aftermarket is much like a selling product or a service to customers. Both are enhanced by name recognition, advertising and publicity, a product support system, and good distribution channels. The company's underwriter and the underwriting syndicate constitute the distribution channel, but the company itself will need to create a recognizable corporate image and build the foundation for a strong investor relations program" (Kleeburg 2005, 59).

Klausner highlights several sensitive organizational and preliminary topics concerning the IPO process. The author claims the credibility of the earnings projection that details future growth, the existence of a plan for the usage of the proceeds, a strong management team with sufficient skills, a solid historical financial performance, and the execution of a business plan that facilitates the understanding ofthe company's vision (cf. 2008,16/17).

"After the establishment of the business plan and the undertaking of necessary strategic transactions the fundament for the IPO is to be set up. During the months before an IPO event, successful companies consider questions regarding the operating, personnel, and transactional milestones, the usage of the proceeds and the market's readiness for the IPO" (Kleeburg 2005, 97/98). "The most important and time-consuming task facing the team is the development of the prospectus, a document that basically serves as a brochure for the company" (Ghosh 2006, 22).

The entire process could be understood as a multidimensional and collateral ongoing procedure throughout several months. It integrates aspects concerning the organizational structure, the registration with SEC and the security market with its pursuant requirements, and the valuation of the company (cf. Petersen 2001, 57-76). The SEC registration will also be presented in the following chapters.

Ghosh states, an analysis of initial public offerings indicates that the IPO process constitutes five distinct phases: (i) the preparation of the IPO prospectus and submission to the SEC approval; (ii) selecting the lead underwriter to form the syndicate and sell the stock to the public; (iii) organizing the "road show" to present the IPO's appeals and prospects to the investors, mainly the institutional investors; (iv) setting the offer price and the number of shares to be offered to the public, either through the organized exchanges or through the over-the-counter market; (v) and finally, developing the aftermarket position, after observing the "quiet period" (cf. 2006, 22).

Though, since the underpricing scales differently in various market segments (cf. Hunger 2004, 126), the choice of an adequate segment should be integrated into the IPO process. This decision, depending on when it is made, can influence the downstream stages of the process significantly. Even Carls recognizes the stock exchange application, i.e. the choice of the market segment, as the second step of an IPO process (before iii-v) (cf. Carls 2007, 367).

Generally, depending on the market segment, there are different requirements which force a company to set up appropriate organizational measures to meet those criteria. This, obviously, has an impact on the IPO process.

Concerning the choice of the market segment, a company can also be influenced by the investor's reaction on the IPO project. If the market is not in a shape to gather the new security in a way, the company and the underwriter is hoping and planning to, it is possible that the stock is going to be under-allotted and will consequently sell at a high discount in the aftermarket. Indirectly this could lead to an adaption of the offer price.

Now, after the introduction of necessary considerations and the IPO process, participants and their roles will be presented.

2.2.2 PARTICIPANTS AND THEIR ROLES

There are several institutions and individuals that play a role in the offering process. Beside the issuing company there are investment banks, the SEC, accountants, lawyers, investors, and the exchanges.

The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital information. (cf. SEC 2010) Accountants and lawyers generally consult issuing companies in terms of accounting and legal questions while the security exchange companies set up listing and transparency requirements that issuers have to meet. "The main task of an investment bank in an IPO transaction is the development and execution of the issuing strategy" (Hamer 2007, 3).

"When a company decides to make a public equity offering using bookbuilding, it first selects one or more investment banks that will be managing underwriters. One or more managers are selected as the lead underwriters" (Hu/Ritter 2007, 3). The initial agreement between the underwriter and the issuing company is called "The Letter of Intent" that prospects the underwriter against any uncovered expenses in the event that the offer is withdrawn (cf. Ghosh 2006, 23).

"In most cases lead underwriters are also bookrunners. They take on most of the responsibilities of the managing underwriters, which might include due diligence, marketing of the issue, pricing, price stabilization, market making, and analyst research coverage of the stock" (Hu/Ritter 2007, 3).

As the crucial institution regarding the offering's success, the lead underwriter plays a significant intermediary role. He is counterpart for the syndicate, the exchange, advisors, the issuer, selling stockholders, and investors. While he is coordinating the offering process he involves several departments. Concerning the internal bank structure mainly the divisions Equity Capital Markets, Research, and Sales and Trading perform the offering process (cf. Carls 2007, 361).

2.3 IPO UNDERPRICING

2.3.1 DEFINITION

In literature there are several understandings of the underpricing of IPOs.

Ideally, stock prices should match the per share present value of the discounted future earnings of the company, theoretically paid out as dividends. (cf. Karlis 2000, 82) "Most literature describes underpricing as the difference between the fair value of the company and the offer price, making the price movements on the first trading day the adaption process to the fair valuation. The term "underpricing" originates from U.S. academic literature dating back to the 70s and basically describes the phenomenon of a price movement of newly issued shares after the offering" (Hamer 2007, 8). Usually this price movement manifests itself in an increase of the stock price right after the sale and thus involves a positive effect for the investor. (Own research) Illustration 3 will clarify this effect.

"Underpricing is estimated as the percentage difference between the price at which the IPO shares were sold to investors (the offer price) and the price at which the shares subsequently trade in the market. Most studies use the first-day closing price when computing initial underpricing returns" (Ljungqvist 2006, 6).

However, Hunger uses the first day opening price:

"The term underpricing implies that the issue price, compared with the (first) secondary price, is too low" (Hunger 2004, 43). "The Underpricing-Phenomenon examines the price difference between primary and secondary market trading. Thus, ideally the first secondary market price is used for the computation, because with its finding the secondary market trading begins. Albeit, because of missing availability, often the first day closing price is used to determine the underpricing" (Hunger 2004, 41).

"Scientific literature distinguishes between the ex-ante and the ex-post underpricing. While the ex-ante underpricing is the difference between the expected price on the secondary market and the issue price, the ex-post UP means the difference between the realized first trading price and the issue price" (Hunger 2010).

For the presentation of own empirical study results, exposed in the following, IPO underpricing is considered ex-post and defined as

Illustration 2: The Computation of IPO Underpricing (cf. Hunger 2010)

Abbildung in dieser Leseprobe nicht enthalten

UPi = UP of share i

Pit = first day opening price of share i

Ei = issue price of share i

Mt = price of the market portfolio on the first trading day of share i

Mt,o = price of the market portfolio at the end of the subscription period of share i

First, a comparable initial return is to be calculated. Therefore, the discreet difference between the first trading price and the issue price is quoted in relation to the issue price. Secondly, to determine if the underpricing is in excess of the market, the calculated relation is reduced by the market's performance. This computation is also described as ex-post underpricing, because it refers to the (market-adjusted) difference between the issue price and the effectively realized first secondary market price (cf. Hunger 2010).

The consequence of underpricing is a significant shift in wealth. Obviously, there is an issuer's willingness to "leave money on the table".

"The amount of "money left on the table" is defined as the offer price to closing market price on the first-day of trading, multiplied by the number of shares offered (excluding over-allotment options) on a global basis" (Ritter 2010, 1). Adapting this to the above outlined computation, the first market price would be considered. For clarification of the impact of underpricing on the wealth and ownership of pre­issue shareholders consider the following two issuing strategies:

Illustration 3: The Impact of Underpricing on the Wealth ofPre-lssue Shareholders (Own illustration based on Ritter 2002)

Abbildung in dieser Leseprobe nicht enthalten

If a company plans to gain $ 78 million by offering common stock, the effect of an underpriced offering manifests itself in a loss of almost 6 % in ownership. The collected dataset, underlying this thesis, counts 135 underpriced IPOs with $ 3,41 bn "left on the table", representing a nominal issue volume of $ 24,13 bn. This means that on average 14 % of the nominal issue volume is lost due to the underpricing effect.

2.3.2 WHO BENEFITS FROM IPO UNDERPRICING?

As substantial amounts of money are "left on the table" when shares are sold too low and the prices for retained shares are diluted, underpricing is costly to firm owners (cf. Hopp/Dreher 2007, 3). But if companies accept these amounts, there also seems to be someone who picks them up. To find out who benefits from IPO underpricing, it has to be figured out which group of investors (institutional / retail) generally receives the highest portion of allocated shares.

"Hanley and Wilhelm (1995) gather distribution data for a sample of 38 IPOs managed and (co-managed) by a single underwriter during the period 1983-1988. The authors find that around 70⁰ % of shares in both underpriced and overpriced issues are allocated to institutional investors. In a more recent study, Aggrawal et al. (2002), using a sample of 164 companies going public between May 1997 and June 1998, find that institutions dominate IPO allocations, accounting for a median of about three-quarters of shares offered. The authors document that institutions earn greater profits on their IPO investments than retail investors. Leaving the U.S. issue market, the authors Ljungqvist and Wilhelm found out that, for 1,031 IPOs in 37 countries and between 1990 and 2000, share allocations to institutional investors are virtually double those received by retail investors" (Pons-Sanz 2005, 11).

By getting the highest portion when new shares are allocated, apparently, institutional investors that initially invest into the offered stocks mainly benefit from the Underpricing-Phenomenon. Generalizing Ljungqvist's and Wilhelm's findings, institutional investors participate twice as often than retail investors do.

2.3.3 EVIDENCE ON UNDERPRICING

"The first ones who related IPO waves to underpricing were Ibbotson/Jaffe (1975), detecting certain years in the 60s and 70s where IPOs generated very high initial returns. They conclude that underpricing follows a distinct pattern. Based on their discovery, Ritter (1984) advances with this finding and applies it to the year 1980 in his article "The "Hot Issue" Market of 1980", which gives ground-braking insights and is still referenced to in recent works. Ritter points out that underpricing is not solely a function of risk, but it depends on the time frame chosen, in which one industry type strongly participates in the IPO market" (Hamer 2007, 9).

For the U.S. primary market, Loughran/Ritter (2002) examined the underpricing based on a sample of 6.169 firms for different time frames and find average initial returns of 7% between 1980 and 1989,15% for 1990-1998 and up to 65% (1999) for the following years during The Dot-Com Period. For the U.S. market, they conclude that underpricing has continuously increased over time, contradicting to Ritter (1984) stating that underpricing comes in waves. For 1999, Ljungqvist/Wilhelm (2003), estimate initial returns of 73,3% with a standard deviation of 96,3% and a median of 39,5% (cf. Hamer 2007, 10). The difference might be explainable by the usage of different computation methods.

Furthermore, Loughran/Ritter (2003) state that the change in underpricing refers to three circumstances: (i) the change in the risk composition of companies, (ii) the realignment of incentives, and (iii) a changing in issuers objective function. "The realignment of incentives hypothesis and the change in issuers objective function hypothesis both assert that the willingness of issuing firms to accept UP has changed overtime" (cf. 2003,1/2).

Using the computation method outlined in Chapter 2.3.1, Hunger finds that it ranges, depending on sample period, sampling method, and capital market, averagely between 2 and 167% (cf. Hunger 2004, 41).

3 THE REPUTATION OF MARKET SEGMENTS IN THE CONTEXT OF IPO UNDERPRICING

3.1 MARKET SEGMENTATION IN THE UNITED STATES

Hunger's empirical investigations confirm a specific UP for vertical stock market segments in Europe. (cf. 2004, 143). The author's analysis samples 809 IPOs in Germany, France, Italy, Austria, and Switzerland (cf. Hunger 2004, 22).

Ghosh intensifies Hunger's findings for U.S. markets: "In the estimates of Thomson Financial, NASDAQ-listed IPOs had gained an average of 18.5 percent on their first days of trading, and 40.5 percent over their offering during the first three-quarters of 2003. By contrast, new stocks on the New York Stock Exchange had 8.7 percent, and were up 18 percent overall during the same period" (2006, 25/26). Generally, this comparison of initial returns implies a difference in the amount of UP in various stock markets. In chapter 5, as part of the empirical analysis, the UP, referring to specific market segments, will be presented.

"Vertical market segmentation means the existence of several market segments and the possibility of a security being traded in only one of them. In contradiction, there is horizontal segmentation which exists when a security is traded in several market segments simultaneously...However, in respect of IPOs, horizontal segmentation does not play a significant role since initial publicly offered securities are supposed be traded at one exchange" (Hunger 2004, 23).

"American stock exchanges are independent and self-regulative. Although, they are not segmented vertically, they have different admission criteria, which can be transferred to the quality of the offered securities" (Wolff 1994, 164) Concerning those criteria and other requirements, they can be regarded hierarchically. This means that IPOs in different market segments have to fulfill different admission criteria, i.e. listing requirements, corporate governance standards, and liquidity- requirements.

Actually, U.S. stock markets are segmented on a commercial basis by national security exchanges like the empirically investigated NASDAQ OMX Group or NYSE Euronext. By the establishment of particular listing requirements for corresponding markets like Arca, Amex, The Global Select Market or The Capital Market, exchanges try to attract certain issuers.

"Several regulatory functions of exchanges have been delegated and contracted to third party non-governmental regulators (i.e. FINRA), while others, notably in the area of listing, have been retained by exchanges themselves. In Europe, in most cases, it is the capital market regulators, not exchanges, who have an upper hand in issuer regulation according to national and, in many cases, EU legislation" (Christiansen/Koldertsova 2009, 4).

According to Wolff the exchange's admission criteria can be transferred to the quality of offered securities. Contrarily, Hunger finds that a company listed in a certain market segment is not necessarily worse than a company listed in a segment with higher reputation (2010). This comparison, concerning both Wolff's and Hunger's statement, is based on the assumption that admission criteria influence reputation and that there is a link between the terms quality and reputation. Barnett/Jermier/Jafferty deliver it by stating that corporate reputation includes basic components, such as the image and quality (cf. Ljubojevic 2008, 222). This link could possibly be adapted to the reputation of a stock market segment. However, in the following chapter the term "reputation" and its adaptability to market segments will be analyzed more detailed.

A reduction or elimination of UP can only be achieved if there are enough market segments available for companies with different risk profiles. The underpricing of IPOs is a consequence of the market segment's reputation. The reputation arises due to qualitative factors that do not reflect the issuer's risk profile. The author, explicitly, names publicity, disclosure, and listing requirements as a determinant of a market segment's reputation (cf. Hunger 2010).

In the United States, these requirements are manifold and will be presented in chapter four.

3.2 THE REPUTATION OF MARKET SEGMENTS

Hunger assumes, summarizing his statement under The Market Reputation Thesis, that each stock exchange and its market segments possess a certain reputation due to the respective listing requirements, the marketing of the stock exchange, its presence in the media, and the historical or jurisdictional arrangement in capital markets. The lower the reputation of a market segment is the higher is the level of underpricing. This could be understood as a compensation for investors that accept minor market liquidity and a higher risk. (2010) Before further analysis can be conducted, the term "reputation" and its adaptability to stock markets and their segments needs to be examined.

"Reputation" originates from the Latin and means "consideration" or "reckoning". Wiedmann finds in his studies that it is optimally defined as "distinction". Furthermore, the American Heritage Dictionary determines reputation as "...the estimation in which one is generally or publicly held"" (Seemann 2008, 37). "Depending on the context in which the term "reputation" is used, there is different emphasis. For marketing experts it is the "corporate analogue to brand equity", economists understand the term as a signal for future behaviour, strategists recognize it as a market entry barrier i.e. a competitive advantage, and accountants might refer to it as a kind of goodwill" (Seemann 2008, 37). There is no common definition for the term. However, in literature, there is agreement on the emergence of corporate reputation (cf. Hunger 2004,154).

So, who could be the one that perceives the reputation of a stock market segment? The computation of IPO underpricing refers to the first secondary market price, i.e. the first trading price. This price is determined by (i) the results of the book­building process, i.e. the investor's bids and (ii) the general receptiveness of the market, i.e. the potential secondary market investors (cf. Ghosh 2006, 25). Consequently, investors are supposed to be the party that perceives the reputation (the cause) of a market segment and impacts the pricing process, i.e. the underpricing (the consequence). Seemann finds the reputation is not a result of facts but rather of the perception of these facts by the particular group of people (cf. 2008, 39), i.e. investors. Since perception is highly subjective, each investor will establish an individual view of the market segment's reputation. That makes it very difficult to measure reputation in an objective way.

"Concerning corporate reputation, Fombrun defines it as the overall estimation in which a company is held by its constituents. A corporate reputation represents the "net" affective or emotional reaction - good-bad, weak or strong - of customers, investors, employees, and general public to the company's name" (2007, 44). It is highly related to experiences that have been made, to communicated experiences of third parties, and to trust in the consistency of the corporation's behaviour (cf. Hunger 2004, 154). Schwalbach states, citing Wilson (1985), that "...in common usage, reputation is a characteristic or attribute ascribed to one person (firm, industry, etc.) by another..." (Schwalbach 2004, 1). Furthermore, he assumes that reputation is relevant when reality is perceived imperfectly and can only hardly be evaluated, e.g. product sales are impeded due to asymmetric allocation of information in respect of a product's quality (cf. Schwalbach 2004,1).

A summary of these definitions implies that (corporate) reputation could be perceived by several groups of people, is not only attributable to a person, and that it is highly related to experience and trust. Hence, the adaptability to market segments is given.

"Another interesting and for the topic highly relevant definition is stated by Nerb: Corporate reputation is firstly shaped by subordinated reputations of particular persons and secondly by superior, especially the country's and the industry's reputation" (Hunger 2004, 157). Hunger assumes that this perspective is particularly relevant for the adaption of the term to stock market segments. He concludes that the market segment's reputation can be assembled by subordinated and superior reputations, i.e. by subordinated listed company's reputations or superior organizational reputation of the market segment (cf. 2004, 157). On the one hand, if a company has a high reputation, for example in terms of product reliability, this reputation could be transmitted to the compliance with listing requirements that have to be met.

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