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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 66621 b Corresponding author. Tel.: + 1-785 231 1010; fax: + 785 231 1063. E mail address: rob.hull@washburn.edu (R. Hull) Earlier Version Published in Proceedings of: American Financial Services, October 8, 2003 Final Version Published in: Investment Management and Financial Innovation, 2005

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We examine the markets response to IPOs surrounding the last quarter of the year 2000. 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

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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, 1967-1968, 1980, and 1999-2000. In the United States, first-day returns for IPOs averaged around 15% prior to 1999. The unprecedented level of IPO underpricing for 1999-2000 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 days wage?

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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 1999. Underpricing for IPOs, as measured by first-day returns, averaged 15% prior to 1999. Peaks for IPOs reach 60%-80% during 1961, 1967-1968, 1980, and 1999- 2000. Peaks for IPOs reach 60%-80% during 1961, 1967-1968, 1980, and 1999- 2000. 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.

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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.

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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.

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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.

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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.

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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.

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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

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Testable Hypotheses We hypothesize that there should be a drastic reduction in IPO underpricing during the last quarter of 2000. 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.

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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%)

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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

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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).

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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

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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% -37.65%; -12.87% -3.23%; -1.72% -37.37%; +1.50% +2.13%; +1.15% 7/1/00 IPOs (n=63) -9/30/00 SEOs (n=52) +11.10%; +8.33% -2.72%; -2.76% -64.26%: -32.39% -4.16%; -1.54% -96.87%; -51.02% -1.38%: +2.39% 10/1/00- IPOs (n=52) 12/31/00 SEOs (n=72) -5.97%; -7.69% -3.39%; -3.27% -14.95%; -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) -11.52%; -10.42% -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% -14.52%; -8.38% -4.39%; -3.22% -23.23%; -9.75% -1.23%; -0.29% Table 5: Underpricing by quarters: percentage change results

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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 2.70 +0.25+0.35 2.10 3.25 SignificantLevel0.0210.0080.8040.7290.0430.001

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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