Does idiosyncratic risk matter in IPO long-run performance?

Marie-Claude Beaulieu,Habiba Mrissa Bouden

doi:10.1007/s11156-019-00864-x

Marie-Claude Beaulieu, Habiba Mrissa Bouden

Open Access

https://doi.org/10.1007/s11156-019-00864-x

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Abstract

This paper studies how firm-level idiosyncratic risk varies over time and affects both initial public offering (IPO) and matched non-IPO firms’ long-run performance. It revisits the traditional approach to compute the long-run performance by conditioning aftermarket performance on idiosyncratic risk with a generalized autoregressive conditional heteroskedasticity GARCH-M extension of the standard three-factor Fama and French (3FF) model. Our findings show a positive long-run relationship between idiosyncratic risk and expected returns for almost all IPOs and matched non-IPO firms. We find that, in general, IPOs do not underperform their peers when we adjust long-run abnormal returns for firm-level idiosyncratic risk. We also note that the idiosyncratic risk exposure depends on the IPO profile; it is more important for firms going public in hot-issue markets, undervalued IPOs and high idiosyncratic-risk issues. Thus, this paper suggests that a part of abnormal returns in specific IPOs long-run performance is derived from firm idiosyncratic risk.

Highlights

The pricing of initial public offerings (IPOs) has attracted the attention of researchers in finance for decades
This paper improves upon traditional approaches used in the previous literature to measure abnormal returns and presents a new approach that accounts for firm-specific risk to elucidate the variation in IPO performance in the long run
As the firm-specific risk varies over time, we add a generalized ARCH (GARCH)-M extension to the standard 3FF model to account for the conditional idiosyncratic volatility in the individual returns’ equation through the IPO event-time method

Summary

Introduction

The pricing of initial public offerings (IPOs) has attracted the attention of researchers in finance for decades. The literature identifies three anomalies in the IPO process. The first two anomalies observed in the short-run are, namely, the hot-issue market for IPOs (Ritter 1984) and IPO underpricing (Ritter and Welch 2002). Ritter (1991) and Loughran and Ritter (1995) report that IPOs underperform the market in the long run when they compare IPO stock returns to common market index returns.. Other empirical studies on IPO long-run performance present mixed results. Brav and Gompers (1997) and Gompers and Lerner (2003) do not find evidence of long-run IPO underperformance. Barber and Lyon (1997), Kothari and Warner (1997), and Gompers and Lerner (2003) document that IPO long-run performance depends on the methodology used to measure abnormal returns, which could explain the mixed evidence in the behavior of IPO performance

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