This study investigates a well-documented enigma in the finance literature, the aftermarket behavior of closed-end fund initial public offerings (IPOs). Many models with rational agents attribute the underpricing of industrial IPOs to information asymmetry between the IPO issues and the investing public. Since closed-end funds typically do not have pre-existing assets or proprietary rights, there is little information asymmetry about their asset valuation. Consequently, these models suggest that closed-end funds should exhibit less underpricing than industrial IPOs. However, information asymmetry theories cannot explain why closed-end funds are successfully brought to market overpriced. Specifically, closed-end funds are overpriced at issue relative to their net asset values (NAVs) due to substantial underwriting fees that average approximately 8% of total issue size.
The study investigates these anomalies and describes regulatory and institutional mechanisms that contribute to the pattern of aftermarket returns. The authors perform an intraday analysis of aftermarket trades and quotes in the first 100 days of trading. They find that underwriting arrangements, identified during discussions with underwriters, help to explain not only the their primary observations, but also several unusual patterns in the transactions data.
The authors show that the vast majority of volume in the first four weeks of trading is seller-initiated. Since short selling is not possible during this time period, the selling imbalance confirms the presence of flippers. However, these imbalances do not immediately translate into price declines. As the number of issues that are stabilized declines over time, the proportion of issues trading at unencumbered, market-determined prices increases.
The authors also provide evidence that underwriters manage the cost of stabilizing by creating a net short position in the number of shares issued during the pre-market. Selling imbalance in the first few trading days has predictive power for the timing of subsequent price decline: the faster the short position is covered through stabilizing purchases, the sooner the price drops. Funds that exercise the over-allotment option experience longer stabilization periods.
The authors document that seller-initiated trades are both larger and more profitable than buyer-initiated trades in the after market period. Small investors who buy shares in the aftermarket engage in open market transactions that they believe are at unencumbered prices.
The authors believe that their findings support a marketing hypothesis for closed-end fund IPOs. To protect their reputation and improve the likelihood of a successful offer, lead underwriters promise to stabilize prices in the aftermarket, essentially granting free put options with a strike price equal to the offer price. The stabilization bid provides the opportunity for some syndicate members to sell large blocks to flippers during the pre-issue period.
The number and size of sell orders in the first few days of trading show that a sizable number of these traders exercise this options and flip their shares back to the syndicate. The size of the trades suggest that they are small, retail customers.
The legality of this scenario appears to be within the guidelines of current securities regulation The authors speculate that flippers are wiling to participate because of other inducements they receive through their ongoing relationships with underwriters.
On the cost side, underwriters may incur significant costs from flipping and protracted stabilization. However, the cost of stabilization may well be offset by the benefits of assuring a successful initial distribution.
Small investors face substantial information processing costs and may be highly susceptible to "marketing" tactics.
The authors believe their findings raise questions about the adequacy of current disclosure rules for IPOs, and the propriety of securities regulation that permit short term stabilization in closed-end fund IPO aftermarkets. They also suggest that similar patterns of selling pressure, price stabilization, and asymmetric behavior between large and small trades may be found in two other securities - master limited partnerships and real estate investment trusts.
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De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990.
"Noise Trader Risk in Financial Markets,"
Journal of Political Economy,
University of Chicago Press, vol. 98(4), pages 703-38, August.
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