Information Asymmetries and IPO Underpricing: The Role of Voluntary Disclosure of Forward-Looking Information in the Prospectus

Abstract

When a firm files to go public it faces the risk of underpricing. Within the agency theory framework, models of underpricing are based on adverse selection and rely on the ways in which the different parties, involved in the IPO process, are asymmetrically informed as managers and internal subjects posses private information about the firm's future prospects which may be not completely known to external investors. The underpricing phenomenon, measured by the difference between the closing price and the opening price on the first day of trading, represents the cost paid by the issuer for the ex-ante uncertainty perceived by external investors. Thus, underpricing is often used as a proxy of the ex-ante uncertainty. Theoretical and empirical studies have evidenced that an issuing firm can reduce ex-ante uncertainty both by signalling the quality of the IPO through various mechanisms (e.g. a larger retention of ownership by the insiders, an appointment of high quality auditors, and highly reputable investment bankers as underwriters) and by disclosing information before the IPO deadline in the hope of decreasing the money left on the table. There are different ways and prospects through which a firm can disclose information before the IPO date. Among them, the most comprehensive document is the IPO prospectus. The EEC Directive n. 2003/71 regulates the contents of the prospectus by defining information that must be disclosed and information that can be voluntary disclosed: an issuer exercises considerable subjectivity in disclosing voluntary information such as projected financial statements, indication on future and planned investments, information on strategies - projected and implemented, EPS estimates, etc. to external investors. In this paper we contend that a higher level of voluntary disclosure leads to a lower level of underpricing, after having controlled for the mechanisms used for signalling the quality of the IPO. As the evaluation of IPOs is strictly linked with the value that external investors attribute to the perspective of new listed firms, and there is no information about past share price, risk and forward-looking information (FLI) in IPO prospectus play a crucial role in supporting financial analysts in their earnings forecasts. We analyse 85 IPOs issued between 1999 and 2005 on the Italian Stock Exchange by applying content analysis to the IPO prospectuses. The Italian set is very distinctive because, although in presence of low litigation costs, only few firms disclose earnings forecasts and prospective financial information even if law allows their inclusion in the IPO prospectus. We focus on the role played by narrative FLI contained in the IPO prospectus and by its attributes in relation with underpricing. Following previous literature, we study also the relation between underpricing and the extent of risk factors included in the prospectuses. We find a negative association between the level of underpricing and the extent of FLI in the IPO prospectus and a positive association between the level of underpricing and the number of risk factors disclosed.