trading volume and share retention (1)

8/6/2019 Trading Volume and Share Retention (1)

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Review of Quantitative Finance and Accounting, 25: 293312, 2005c 2005 Springer Science + Business Media, Inc. Manufactured in The Netherlands.

Pursuing Value Through Liquidity in IPOs:Underpricing, Share Retention, Lockup, and TradingVolume RelationshipsSTEVEN X. ZHENG Departmentof Accountingand Finance,Asper Schoolof Business, Universityof Manitoba, Winnipeg, MB, Canada,Tel: 204-474-7933; Fax: 204-474-7545 E-mail: [email protected]

JOSEPH P. OGDEN

FRANK C. JEN Department of Finance and Managerial Economics, School of Management, University at Buffalo, SUNY, Buffalo, NY 14260, Tel: 716-645-3270; Fax: 716-645-2131 E-mail: [email protected] E-mail: [email protected]

Abstract. We argue that in an initial public offering (IPO), pre-IPO owners make decisions regarding underpric-ing, share retention, and share lockup simultaneously and optimally to maximize aftermarket liquidity. We predictthat underpricing fosters higher trading volume in both the short run and the long run. Also, liquidity is negativelyrelated to the proportion of shares retained by pre-IPO owners, ceteris paribus , so IPO underpricing should bepositively related to the proportion of shares retained, as an offset. We document evidence consistent with thesepredictions. In addition, we nd that, for IPOs with a lockup restriction, underpricing is more substantial and the

positive relation between share retention and underpricing is much stronger. We also nd that the relationshipbetween underpricing and trading volume is stronger for IPOs with lockup. IPOs with lockup have higher tradingvolume, and a signicant portion of this difference is associated with the effect of underpricing.

Key words: IPO, underpricing, share retention, liquidity, lockup, trading volume

JEL Classication: G10, G14, G24

1. Introduction

As a rm prepares for its initial public offering (IPO) of stock, three decision variables areprominent: (1) the extent to which the rms stock will be underpriced at the offering; (2)

the percent of the rms shares that pre-IPO owners retain after the IPO; and (3) whether toinclude a lockup provision, whereby pre-IPO shareholders temporarily refrain from sellingtheir stock in the aftermarket. Thenance literature provides several explanations for rmsdecisions regarding each of these variables. In this paper, we take the stance that an IPOrm makes these decisions simultaneously and optimally with the goal of maximizing theliquidity of its stock.

Corresponding author.


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294 ZHENG, OGDEN AND JEN

We argue that pre-IPO shareholders are pressured to retain shares due to the informationasymmetry problem. This problem, and thus share retention ratios, likely vary across IPOrms. However, as share retention rises, liquidity is reduced because thermwill oat fewershares, ceteris paribus . To offset the negative liquidity effect of share retention, an IPO rmcandeliberately underpriceits shares at theoffering,which will increaseliquidityby enticingmore investors to own the stock. The cost of underpricing is the partial loss of the value of shares that pre-IPO owners sell at the offering. However, the cost of underpricing decreasesas share retention increases. We assume that share retention is relatively more important interms of the ultimate goal of maximizing pre-IPO owners wealth. This assumption leadsto our prediction that IPO underpricing is positively related to the proportion of sharesretained. We present evidence consistent with this prediction.

We also predict that underpricing fosters higher trading volume in both the short run

and the long run. We present evidence consistent with this prediction. In addition, wend that for IPOs with a lockup restriction (vs. IPOs with no lockup): (1) underpricing ismore substantial; and (2) the positive relation between share retention and underpricing ismuch stronger. We also compare the relation between underpricing and aftermarket tradingvolume for IPO rms with and without lockup. We nd that the relationship betweenunderpricing and trading volume is stronger for IPOs with lockup. IPOs with lockup alsohave higher trading volume, and a signicant portion of this difference is associated withthe effect of underpricing. The evidence supports the argument that for IPOs with lockup,underpricing improves liquidity more effectively; thus its use is more closely associatedwith share retention.

The remainder of the paper is organized as follows. In Section 2 we review the literatureand develop our hypotheses. In Section 3 we discuss our dataset and present empiricalresults. Section 4 concludes.

2. Literature review and hypothesis development

In this section, we review the IPO literature and discuss hypotheses about the separateand interactive effects of underpricing, share retention, and the lockup restriction on theaftermarket liquidity of an IPO stock.

2.1. Why focus on liquidity?

In going public, the ultimate objective of pre-IPO owners is to maximize their wealth(Aggarwal et al., 2002; Ang and Brau, 2003). In this paper, we focus on a secondary

objective: to establish a liquid market for the rms stock. While wealth maximization andaftermarket liquidity aredistinct objectives, they areclosely related. For instance,Ritter andWelch (2002) argue: Public trading. . . can, in itself, add value to the rm, as it may inspiremore faith in the rm from other investors, customers, creditors, and suppliers (p. 1978).In addition, liquidity reduces the cost capital for rms in general (Amihud and Mendleson,1986; Butler, Grullon and Weston, 2005), and IPO rms in particular (Booth and Chua,1996). Also, Demers and Lewellen (2003) nd that underpricing of internet IPO stocks ispositively related to subsequent web trafc growth. For these reasons, we posit that pre-IPO


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PURSUING VALUE THROUGH LIQUIDITY IN IPOS 295

owners decisions regarding underpricing, share retention, and lockup are important andare likely made simultaneously and optimally to maximize the aftermarket liquidity of theirstock, which in turn serves the primary goal of wealth maximization.

2.2. IPO underpricing and liquidity

Numerous articles in the nance literature document evidence of substantial underpricingin IPOs. (See Ibbotson, Sindelar and Ritter (1994) and Ritter and Welch (2002) for sum-mariesof theevidence.) Themost commonexplanation for IPO underpricing focuses on theinformation asymmetry problem (e.g., Rock, 1986; Allen and Faulhaber, 1989; Grinblattand Huang, 1989; Welch, 1989; Balvers et al., 1993; Booth and Chua, 1996; Jenkinsonand Ljungqvist, 1996; Aggarwal, Krigman and Womack, 2002; Ellul and Pagano, 2004).Ritter and Welch (2002) summarize the asymmetric information problem in IPOs, and itsresolution via underpricing, as follows: If the issuer is more informed than investors, ra-tional investors fear a lemons problem : Only issuers with worse-than-average quality arewilling to sell their shares at the average price. To distinguish themselves from the pool of low-quality issuers, high-quality issuers mayattempt to signal their quality. In these models,better quality issuers deliberately sell their shares at a lower price than the market believesthey are worth, which deters lower quality issuers from imitating. (p. 1803)

Among the studies cited above, Booth and Chua (1996) relates most closely to our anal-ysis. They argue that IPOs must be underpriced to induce potential investors and others toproduce information on the issuer. Specically, underpricing is likely to lead to oversub-scription to the offering, which in turn tends to result in broad initial ownership, which inturn increases aftermarket liquidity. Broad initial ownership, however, requires an increase

in investor-borne information costs. Underpricing compensates investors for these costs.Thus, IPO underpricing improves liquidity by fostering greater ownership dispersion.

Empirically, Booth and Chua nd a positive relationship between underpricing and own-ership dispersion. Kligman et al. (1999) examine the relationship between underpricing andshort-term (i.e., through the rst ve post-IPO trading days) trading volume for 611 IPOsissued from 19931995. They document a positive relationship. We examine the relation-ships between underpricing and both short- and longer-term post-IPO trading volume usingthousands of IPOs issued over the years 19761998. We document evidence of a positiverelationship at both volume horizons. In addition, we nd that the relationship is inuencedby the both the level of share retention and the presence of a lockup provision.

2.3. Share retention and liquidity

As noted above, IPO underpricing is well recognized as a mechanism to alleviate the infor-mation asymmetry problem. Surprisingly, the IPO literature has not focused substantiallyon an alternative signal, share retention, despite Leland and Pyles (1976) widely-citedtheoretical argument that an entrepreneurs willingness to invest in his own project (i.e., toretain shares) is a powerful signal of value.

However, as pre-IPO owners retainmore shares, fewer sharesare oating in theaftermar-ket, ceteris paribus . With fewer oating shares, IPO stocks will have lower trading volume


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and thus lower liquidity. In addition, when more shares are retained, outside investors aremore likely to trade with pre-IPOowners (i.e., after trading restrictions expire, and notwith-standing the prohibition on insider trading), who generally have inside information aboutthe rm. As such, outside investors face greater moral hazard risk in trading, which furtherreduces their trading interest. These arguments lead to the prediction of a negative rela-tionship between share retention and trading volume. However, this relationship may beaffected by the underpricing and lockup decisions, as we discuss below.

2.4. Tradeoffs: Underpricing, share retention, and liquidity

Bothunderpricing andshareretentionimpart benets for, andcosts to,pre-IPO shareholders.

In brief, both underpricing and share retention benet pre-IPO owners as signals of value.However, underpricing is costly in terms of directwealth loss, while share retention is costlybecause pre-IPO shareholders must maintain substantial positions in the rms stock (i.e.,they cannot achieve the benets of diversication on personal account). Moreover, whileunderpricing improves liquidity, share retention reduces liquidity.

The tradeoff between underpricing and share retention is three-fold. First , as more sharesare retained, pre-IPO owners lose less initially, and potentially gain more later, from under-pricing. The more shares pre-IPO owners retain, the more shares they can sell later in theaftermarket. If the stock is liquid, investors will demand a lower liquidity premium on thestock, and thus the market price will be higher. In addition, higher liquidity means lowertrading cost (e.g., bid-ask spread), which further improves the (net) price that pre-IPO own-ers receive when they later sell retained shares. Thus, pre-IPO owners have more incentiveto improve the liquidity of the stock by underpricing when they retain more shares. On theother hand, if pre-IPO owners do not retain any shares, they care less about liquidity in theaftermarket, but are highly concerned about the offer price, so they have no incentive tounderprice the offering.

Second , when more shares are retained, the number of oating shares will be reducedand the stock will be less liquid, ceteris paribus . Thus, underpricing is required to improveliquidity.

Third , the more shares pre-IPO owners retain, the less costly underpricing is to them. Forexample, for a given level of underpricing, if pre-IPO owners offer only 10% of the originalshares to the market and retain 90%, the underpricing will cost them only 1% of the valueof their shareholdings. 1 On the other hand, if they offer 90% of their shareholdings in IPO,the underpricing will lead to a possible 9% loss in their wealth. 2 Obviously, higher shareretention will make underpricing less costly.

The rst argument above provides an incentive for pre-IPO owners to underprice the IPOwhen they retain a signicant number of shares. The second and the third effect strengthenthe rst effect. Overall, as pre-IPO owners retain more shares, they will underprice the IPOmore substantially. Thus, these arguments suggest following testable hypotheses:

(1) Share retention is positively related to IPO underpricing.(2) When pre-IPO owners retain few shares, the IPO will not be underpriced.


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Bradley and Jordan (2002) document evidence consistent with hypothesis (1) above (seetheir Figure 2, p. 604). Loughran and Ritter (2004) also document evidence consistent withhypothesis (1) above (see their Tables II, V, and VI). We document evidence consistent withboth hypotheses.

2.5. The effect of lockup

Many IPO contracts include a lockup restriction, which prohibits pre-IPO owners fromselling retained shares for a certain period. The standard lockup period is 180 days. It isdifcult to determine the net effect of lockup on liquidity. On one hand, lockup preventsthe trading of retained shares, reducing the number of oating shares and thus reducingliquidity. On the other hand, lockup prevents insiders from taking advantage of outsideinvestors in stock trading during the lockup period, which would otherwise reduce tradingvolume. In addition, if there is less insider-based information content in the aftermarkettrading of an IPO stock with lockup, the stocks bid-ask spread will be lower. Both of the latter effects encourage trading. It is difcult to determine whether they outweigh thenegative effect of lockup on trading volume. We must rely on empirical data to determinethe net effect of lockup on trading volume.

It is also difcult to determine the effect of lockup on the relation between IPO under-pricing and share retention. However, we suspect that, if underpricing can improve liquiditymore signicantly for IPOs with lockup, pre-IPOowners will be more willing to underpricethe IPO for the same magnitude of share retention, and the relation between share retentionand underpricing will be more substantial. Our argument is based in part on Aggarwal et al.(2002), who present a model in which the issuers strategically underprice the IPO in order

to maximize their wealth from selling shares at lockup expiration. They argue that rstday underpricing creates information momentum, i.e., it generates incremental commentsand recommendations by research analysts, especially by non-lead underwriter analysts.Assuming a downward sloping demand curve, they suggest that this increased researchcoverage shifts the demand curve for the stock outward, allowing pre-IPO owners to sellshares at the lockup expiration at prices higher than they would otherwise be able to obtain.(See also Brav and Gompers (2003).)

3. Data and empirical results

3.1. Sample characteristics and preliminary evidence

Our preliminary sample consists of IPOs of U.S. rms collected from Security Data Com-panys (SDC) new-issuesdatabase. We identify a total of 6,421 IPOs issuedbetweenJanuary1976 and December 1998. We chose year-end 1998 as our ending date in order to avoiddealing with the bubble period of 19992000 (see Loughran and Ritter, 2004). We thendelete observations with either missing data or where SDC data conicts with correspond-ing data in the Center for Security Prices (CRSP) database. The nal sample consists of 5,183 IPOs. Included among the variables that we collected for these IPOs is daily post-IPO volume data, obtained from the CRSP daily le. The volume reporting conventions for


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Nasdaq are such that we halved the reported volumes for Nasdaq stocks. We also note that,due to missing data, we have slightly smaller numbers of observations for tests involvingtrading volume data. In addition, trading volume data is not available for Nasdaq stocksprior to November 1982; consequently, our volume data for IPOs prior to this date consistsof only NYSE and AMEX IPOs.

The yearly distributions of the IPOs in the original sample and the nal sample arereported in Table 1. Comparing the preliminary sample to the nal sample, we nd that oursample selection criteria resulted in the discarding of most IPOs before 1980. For the otheryears, our nal sample compares closely to the preliminary sample. The distributions in thetable indicate that the number of offerings uctuates substantially over time. For example,our nal sample contains 534 IPOs in 1996 but only 66 IPO in 1982. Apparently the lockuprestriction was initiated in 1988, as no IPOs prior to that year include a lockup. In that

Table 1 . The IPO sample: Yearly distributions and totals

Initial sample Final sample

Year Not locked Locked All Not locked Locked All

1976 35 0 35 4 0 41977 25 0 25 1 0 11978 34 0 34 0 0 01979 57 0 57 4 0 41980 118 0 118 21 0 211981 279 0 279 178 0 1781982 96 0 96 66 0 661983 559 0 559 461 0 4611984 246 0 246 196 0 1961985 279 0 279 228 0 2281986 550 0 550 431 0 4311987 389 0 389 303 0 303

19741987 2,667 0 2,667 1,893 0 1,893

1988 86 110 196 66 90 1561989 51 96 147 42 89 1311990 53 80 133 41 70 1111991 52 213 265 41 195 2361992 86 314 400 72 294 3661993 138 428 566 120 406 5261994 57 342 399 48 320 3681995 31 360 391 26 339 365

1996 40 566 606 26 508 5341997 31 379 410 27 312 3391998 24 217 241 8 150 158

19881998 649 3,105 3,754 517 2,773 3,290

Total 3,316 3,105 6,421 2,410 2,773 5,183

The initial sample is collected from the SDC database. The nal sample is obtained after deletingobservations with either missing data or where SDC data conicts with corresponding data in theCRSP database.


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year, more than half of the IPOs are locked. Since then, the vast majority of IPOs includea lockup restriction. In 1998, only 8 of the 158 IPOs in the nal sample do not include alockup restriction.

Table 2 reports mean statistics for several sample variables, both for the full nal sampleand for three sub-samples. The rst sub-sample includes IPOs issued before 1988, the yearin which the lockup restriction rst appears. The second and third sub-samples includeIPOs after 1988 without and with the lockup restriction, respectively. Following Downs andHeinkel (1982), we dene the retention ratio as the ratio of the number of shares retainedby pre-IPO shareholders to total shares outstanding after the IPO. This ratio is denoted asRetention1.

Table 2 . Mean values of variables and t -testsIPOs after 1988

IPOs before Not t -stat. forAll 1988 locked Locked difference

Offer price ($) 10.98 10.47 12.10 11.11 2.471st day market price ($) 12.20 11.27 12.29 12.78 2.13Shares offered (Millions) 3.43 2.32 9.99 2.94 8.97Shares retained (Million) 5.31 4.08 2.20 6.70 9.44Retention 1 0.58 0.62 0.26 0.63 24.82Proportion backed by VC 0.32 0.25 0.08 0.40 21.39Proportion listed in Nasdaq 0.75 0.74 0.38 0.83 20.35Secondary 0.12 0.15 0.03 0.11 11.85Percentage with nonzero UP1 7.53 0.00 5.80 12.74 5.73Nonzero UP1 (%) 19.05 10.00 19.64 19.03 0.12Percentage with nonzero DW1 10.20 0.00 6.77 17.51 8.12Nonzero DW1 (%) 17.59 13.52 17.89 2.89Percentage with nonzero UP2 29.53 24.36 13.15 35.96 13.05Nonzero UP2 (%) 11.08 10.36 10.04 11.47 1.52Percentage with nonzero DW2 37.36 31.08 11.41 35.52 14.42Underwriter market share (%) 3.74 3.17 8.04 3.31 10.80Nonzero DW2 (%) 13.49 14.71 11.38 12.55 0.88Overallot 0.15 0.15 0.14 0.15 1.62LAG 11.93 9.36 11.09 13.78 8.79RUNUP 1.50 0.90 1.97 1.81 1.14Initial return (IR) (%) 11.44 8.87 5.89 14.22 10.61

Shares retained is the difference between shares outstanding after the IPO and shares offered. Secondary is theproportion of secondary shares among all the shares offered in IPO. Overallot is the proportion of over-allotment

shares relative to shares offered. Underwriter market share is the percentage average equity IPO market share of the lead underwriter by year. Retention1 is (shares retained)/(shares outstanding after IPO). LAG is the averagepercentage initial return for all IPOs on calendar days 1 to 30 before the issue date. RUNUP is the cumulativepercent return on the CRSP equally weighted index for fteen trading days before the issue. UP1 (DW1) is thepercentage difference between the original mid-le price relative the amended mid-le price for rms that amendtheir original le range up (down), zero otherwise. UP2(DW2) is the percentage difference between the nalmid-le price relative to the nal offer price for those companies that had offer prices above (below) the nal midle price, zero otherwise. Initial return is the difference between offer price and 1st day closing price, divided byoffer price.


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Comparing mean statistics across the three sub-samples,we note the following importantdifferences:

(1) UnlockedIPOsafter1988 generallyinvolvemore shares, 9.99million shares onaverage,compared to 2.32 million and 2.94 million for unlocked IPOs before 1988 and lockedIPOs after 1988, respectively.

(2) On average, pre-IPO owners retain a smaller proportion of the shares of unlocked post-1988 IPOs than for the other two sub-samples (26% compared to 62% and 63% forunlocked IPOs before 1988 and locked IPOs after 1988, respectively). Indeed, for morethan half of the post-1988 unlocked IPOs, pre-IPO owners do not retain any shares.

(3) On average, a smaller proportion of the post-1988 unlocked IPOs were backed by aventure capital rm (VC) (8%, compared to 25% and 40% for unlocked IPOs before1988 and locked IPOs after 1988, respectively).

(4) On average, a smaller proportion of post-1988 unlocked IPOs were listed on NASDAQ(as opposed to NYSE/AMEX) (38%, compared to 74% and 83% for unlocked IPOsbefore 1988 and locked IPOs after 1988, respectively).

(5) On average, the proportion of secondary shares to total shares offered was smaller forpost-1988 unlocked IPOs (3%, compared to 15.4% and 11% for unlocked IPOs before1988 and locked IPOs after 1988, respectively).

(6) On average,a smaller proportion of post-1988unlocked IPOs incurred either an upwardrevision or downward revision in their offering price prior to the IPO.

(7) Post-1988 unlocked IPOs are more likely to have been underwritten by a larger, moreprestigious investment bank.

(8) Finally, post-1988 IPOs with lockup have a higher average initial return (14.22%) than

either pre-1988 IPOs (8.87%) or unlocked post-1988 IPOs (5.89%). Thus, locked IPOsare more substantially underpriced, on average.

Regarding point (8) above, in the next section we test whether underpricing is related to thelockup restriction per se, or is driven by other, correlated factors.

3.2. Testing the relation between share retention and underpricing

3.2.1. The general pattern. To test hypotheses (1) and (2) discussed in Section 2.4, weexamine the relationship between share retention and IPO underpricing. We sort IPOs intosix groups according to the level of Retention1 (proportion of shares retained), and then

compare average underpricing across these groups. Retention1 is not distributed uniformlyacross the range of zero and one, so to determine breakpoints we imposed the restrictionthat each group has more than 500 observations in the full sample. As a result, the rstgroup contains IPOs with Retention1 under 0.01. The second group includes IPOs withRetention1 between 0.01 and 0.5. IPOs with Retention1 between 0.5 and 0.6 are assignedto group 3. IPOs in the fourth group are those with Retention1 between 0.6 and 0.7. IPOs inthefthgroup are those with Retention1 between 0.7 and0.8. Finally, IPOs with Retention1above 0.8 are assigned to group 6.


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Figure 1 . Underpricing for all IPOs in the sample, grouped by retention level.

Figure 1 shows the mean and median underpricing for IPOs in each Retention1 group.Mean underpricing is nearly monotonically increasing in share retention. When pre-IPOowners retain less than 1% of the shares, the IPOs are underpriced by 1.82% on average(0.0% in the median). This is consistent with our hypothesis that IPOs will not be substan-tially underpriced when pre-IPO owners retain few shares. As share retention increases,mean underpricing also increases. When pre-IPO owners retain more than 80% of all theshares, the IPOs are underpriced by nearly (a median of) 16%, consistent with our hy-pothesis that underpricing is positively related to share retention. However, as shown therelationship is noticeably weaker based on mean statistics.

Of course, other factors also affect underpricing, and must be controlled in order to moreaccurately gauge the net effect of share retention on underpricing. Next, we usemultivariateregression analysis to test the relation between share retention and IPO underpricing.

The multivariate regression model is as follows:

IRi = b0 + b1 Retention 1 + X i B + u i , (1)

where IR is the rst-day or initial return on IPO stock i , calculated as the percentagedifference of therst-dayclosing price to theofferprice,Retention1 is aspreviously dened,

and X is a vector of control variables. The coefcient b1 will be positive if the relationshipdocumented in Figure 1 is robust to controls for other factors.We select control variables based on the existing literature on IPO underpricing. Hanley

(1993) and Loughran and Ritter (2002) nd that IPOs with upward price revision areunderpriced more severely. Following Bradley and Jordan (2002), we use four variablesto measure offer price revision. UP1 (DW1) is equal to the percentage difference betweenthe original mid-le price relative to the amended mid-le price for rms that amend theiroriginal led price range up (down), and is zero otherwise. UP2 (DW2) is equal to the


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percentage difference between the nal mid le price relative to the nal offer price forthose companies that had nal offer prices above (below) the nal mid le price, and is zerootherwise.

Also following Bradley andJordan, we useLAG, denedas theaverage percentage initialreturn on all IPOson calendar days 1 to 30 before the issue date. We include this variableto control for possible time seriesautocorrelation of IPO initial returns (i.e., the hot versuscold IPO market phenomenon (Loughran and Ritter, 2000; Lowry and Schwert, 2001)).

Hanley (1993)nds that IPOunderpricing is positively related to themarket returnbeforeIPO. To control for this factor, we use RUNUP, the cumulative percentage return of CRSPequally weighted index in the fteen trading days leading up to the issue date.

We also control for the inuence of insider selling as reported in Habib and Ljungqvist(2001). Our control variable for this factor is SECON, the proportion of secondary shares

among all shares offered.Previous researchers (Beatty and Ritter (1986), Carter and Manaster (1990), etc.) nd

that IPO underpricing is related to the market share of the lead underwriter, the size of theoffering, and the offer price. To control for the effects of these characteristics, we includethe following three variables: (a) UWMS, the percentage average equity IPO market shareof the lead underwriter by year; (b) LISIZE, the natural log of number of shares offered;and (c) INVP, the inverse of offer price.

Therelationshipsbetween IPO underpricing andothercharacteristicseither have notbeenexploredor areunclear, so we includeadditionalvariables to control for these characteristics.These variables are ALLOT, VENTURE, NASDAQ and LOCK. ALLOT is the proportionof over-allotment shares relative to shares offered. VENTURE is a dummy equal to onewhen the IPO rm is backed by a VC, and zero otherwise. NASDAQ is a dummy equal toone when the IPO is issued in Nasdaq, and zero otherwise. LOCK is a dummy equal to onewhen the IPO has lockup provision, and zero otherwise. The regressions also include 13industry dummies to control for any possible industry effects.

The regression results for the entire sample are reported in the rst two columns of Table 3. The coefcient on Retention1 is positive and highly signicant. Thus, the posi-tive relationship between share retention and underpricing is robust to controls for otherfactors, and is consistent with the results of the grouping analysis shown in Figure 1.The hypothesis that IPO underpricing is positively related to share retention is stronglysupported.

The coefcients of UP1, UP2, DW2, LAG, INVP, RUNUP are all positive and highlysignicant, and that of SECON is negative and signicant. The coefcient for VENTUREis negative and signicant, suggesting that IPOs backed by VCs are less underpriced. Theseresults are consistent with previous studies including Bradley and Jordan (2002). The co-

efcient of NASDAQ is positive and signicant, indicating that NASDAQ IPOs are moreunderpriced.

3.2.2. The inuence of lockup. The coefcient of the nal independent variable shownin Table 3, LOCK, is positive and signicant, with a value of 1.41 ( t -value of 2.37). Thissuggests that locked IPOs are slightly more underpriced, even after controlling for manyfactors, including share retention.


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and highly signicant (10.10; t -value of 4.62). Thecoefcient of Retention1 is also positiveand signicant for post-1988 IPOs without lockup; however, the size and signicance levels(6.98; t -value of 2.30) are much lower than for the post-1988 locked IPOs. These resultsindicate that thepositive relationshipbetween share retentionand IPO underpricing is muchstronger for IPOs with lockup.

Additional perspectives on the inuence of lockup on underpricing are provided inFigures 24. These gures show average initial returns for each of the three sub-samplesof IPOs by the previously-dened ranges of Retention1. The patterns are very different

Figure 2 . Underpricing for IPOs before 1988, grouped by retention level.

Figure 3 . Underpricing for IPOs without lockup after 1988, grouped by retention level.


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Figure 4 . Underpricing for IPOs with lockup after 1988, grouped by retention level.

across the three sub-samples. For IPOs before 1988, an inverse U shape is apparent in un-derpricing as a function of retention. For post-1988 IPOs without lockup, underpricing rstincreases with share retention, but then stabilizes as retention increases further. In contrast,for post-1988 IPOs with lockup, underpricing monotonically and substantially increaseswith share retention. This evidence further indicates that the positive relationship betweenshare retention and underpricing is much stronger for IPOs with lockup.

3.3. Testing the relation between underpricing and liquidity

3.3.1. The time series behavior of trading volume. According to our main hypothesis,pre-IPO owners underprice their IPOto improve the liquidityof the stock in theaftermarket.Our hypothesis draws support from the empirical results of Reese (2003), who providesevidence that aftermarket trading volume is positively related to IPO underpricing. Reese(2003) examines the aftermarket weekly trading volume of IPO stocks. We contend that itis better to use daily trading volume because the number of trading days may be differentin different weeks. However, daily trading volume can be very volatile, so we use the timeseries averages of daily trading volume. To determine the range of the time series, weinitially investigate trading volume behavior for IPO stocks over the 500 trading days after

the IPO date.For each stock and each of the 500 trading days after the IPO date, we multiply tradingvolume by 1000 and then divide it by shares outstanding to obtain an adjusted daily tradingvolume for the stock. Then we calculate the cross sectional average of the adjusted dailytrading volume for each of the 500 trading days after the IPO date. Figure 5 displaystime series values of these cross sectional averages of adjusted daily trading volume. InFigure 5, arvol is the cross sectional average adjusted trading volume for the IPOs in thefull sample. Adjusted trading volume is highest during the rst few days after the IPO date,


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Figure 5 . Cross-sectional averages of post-IPO adjusted daily trading volume. From (generally) highest to lowestare trading volumes for locked IPOs (arvollk), all IPOs (arvol), non-locked IPOs after 1988 (arvoll2), and non-locked IPOs before 1988 (arvoll1).

then decreasesduring therst 80 trading days and reaches an asymptote. After an additional40 days or so of at trading volume, the adjusted volume jumps at the expiration of lockup.

Thereafter, volume increases slowly. Around the 358th trading day (i.e., approximately 18months after the IPO date), trading volume increases again, possibly because of anotherround of lockup expirations. Volume then drops and than attens.

We also examine the behavior of average adjusted trading volume separately for each of the previously-dened sub-samples of IPOs. The corresponding series are also shown inFigure 5. As expected, trading volume jumps are much stronger for IPOs with lockup. ForIPOs before 1988, the volume jumps are much smaller. For post-1988 IPOs without lockup,volatility is greater in part because there are fewer rms in this group. Most importantly,we observe that IPOs with lockup have higher average adjusted trading volume than IPOswithout lockup. We provide additional discussion of this difference evidence later.

3.3.2. The general pattern. We are interested in determining whether a relationship existsbetween underpricing and aftermarket trading volume for IPO stocks, so we examine timeseries averages of adjusted daily trading volume for two periods: from the 5th trading daythrough trading day 122 and from the 129th trading day to trading day 500. For each IPOstock (i.e., those that survive to be included), we calculate time series averages of adjusteddaily trading volume over each of the two periods. Then we examine the relation betweenthe averages of adjusted daily trading volume and IPO underpricing using regression (2).

VOi = h 0 + h 1 LIRi + h 2 Retention 1i + X i H + u i (2)


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VO is the time series average of adjusted daily trading volume; LIR is the log of initialreturn; h 1, h 2 and H are coefcients; and X is the vector of control variables as denedearlier. According to our earlier argument that underpricing enhances liquidity, we expecth1 to be positive.

The results of regression (2) for the full sample are reported in the rst two columnsof Tables 4 and 5. For both trading periods examined, average adjusted trading volume

Table 4 . Regression results: Dependent variable is average adjusted trading volume, day 5 to day 122

IPOs without lockupAll IPOs IPOs before 1988 after 1988 IPOs with lockup

Coefcient t -stat. Coefcient t -stat. Coefcient t -stat. Coefcient t -stat.

Intercept 3.62 2.32 8.92 5.57 10.19 3.03 1.74 0.58LIR 7.25 13.89 3.67 5.87 4.62 3.14 8.78 11.42Retention1 3.90 10.74 4.43 11.07 3.66 3.51 4.65 8.18UP1 0.05 5.24 0.15 0.54 0.04 1.97 0.03 2.50DW1 0.00 0.41 0.04 0.84 0.01 0.49UP2 0.02 1.87 0.02 1.71 0.11 2.44 0.00 0.31DW2 0.01 0.85 0.00 0.17 0.03 0.79 0.00 0.20LAG 0.08 9.53 0.02 1.62 0.04 1.11 0.12 10.11UWMS 0.02 1.23 0.06 3.34 0.03 1.58 0.01 0.32LISIZE 0.03 0.26 0.26 2.45 0.24 1.20 0.20 1.05INVP 0.17 1.81 0.01 0.12 0.46 1.36 0.34 1.26RUNUP 3.27 1.49 6.06 2.81 1.30 0.22 5.84 1.62ALLOT 1.25 2.74 1.28 3.02 2.23 0.91 0.22 0.30

SECON 0.81 2.27 0.10 0.30 4.16 2.64 1.27 2.16VENTURE 0.08 0.51 0.12 0.65 1.51 1.94 0.16 0.71NASDAQ 2.09 11.25 0.82 4.85 3.69 5.53 2.30 7.33LOCK 1.73 11.04

No. obs. 4,979 1,688 517 2,774

Adj. R2 0.206 0.151 0.407 0.180

The dependent variable is the time series average of Adjusted Daily Trading Volume from Day 5 to Day 122 foreachIPO rm.AdjustedDaily TradingVolumeis measuredas daily tradingvolumedividedby shares outstandingon the same day. LIR is the log of initial return. Initial return is measured as the difference between rst tradingday closing price and offer price, divided by offer price. Retention1 is measured as (shares retained)/(sharesoutstanding after IPO). UP1 (DW1) is equal to the percentage difference between the original mid le pricerelative the amended mid le price for rms that amend their original le range up (down), zero otherwise.UP2(DW2) is equal to the percentage difference between the nal mid le price relative to the nal offer pricefor those companies that had nal offer prices above (below) the nal mid le price, zero otherwise. LAG is

dened as the average percentage initial return for all IPOs on calendar days 1 to 30 before the issue date.UWMS is the percentage average equity IPO market share of the lead underwriter by year.

LISIZE is the log of number of shares offered. INVP is the inverse of offer price. RUNUP is the cumulativepercentage returnof CRSP equally weighted indexfteen trading days beforethe issue.ALLOT is theproportionof over-allotment shares relative to shares offered. SECON is the proportion of secondary shares among all theshares offered. VENTURE is a dummy which is equal to one when the IPO rm is backed by venture capital,zero otherwise. NASDAQ is a dummy which is equal to one when the IPO is issued in Nasdaq, zero otherwise.LOCK is a dummy which is equal to one when the IPO has lockup provision. The regressions also include 13industry dummies not reported in this table.


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Table 5 . Regression results. Dependent variable is average adjusted trading volume, day 129 to day 500

IPOs without lockupAll IPOs IPOs before 1988 after 1988 IPOs with lockup

Coefcient t -stat. Coefcient t -stat. Coefcient t -stat. Coefcient t -stat.

Intercept 8.32 5.22 1.75 1.34 4.55 1.58 16.29 4.86LIR 5.38 10.04 3.21 6.37 3.12 2.47 6.30 7.31Retention1 0.73 1.95 2.57 7.78 1.11 1.25 0.12 0.19UP1 0.06 5.86 0.12 0.51 0.04 2.07 0.04 2.82DW1 0.01 1.18 0.06 1.59 0.01 0.54UP2 0.04 3.63 0.03 3.01 0.05 1.39 0.03 1.66DW2 0.00 0.31 0.00 0.75 0.03 0.72 0.02 1.30LAG 0.00 0.28 0.05 5.16 0.01 1.18 0.02 1.25

UWMS 0.00 0.10 0.06 3.83 0.03 1.51 0.01 0.37LISIZE 0.67 6.47 0.15 1.70 0.03 0.18 1.25 5.76INVP 0.33 3.31 0.13 2.11 0.48 1.69 0.61 2.01RUNUP 0.08 3.52 0.03 0.02 0.06 0.01 0.14 3.46ALLOT 0.61 1.29 0.42 1.15 2.23 1.06 0.28 0.34SECON 0.35 0.98 0.36 1.37 3.26 2.41 0.17 0.26VENTURE 1.62 9.80 1.08 7.63 0.10 0.15 2.07 7.95NASDAQ 1.70 9.02 0.50 3.61 1.04 1.82 2.47 7.02LOCK 2.05 12.69

No. obs. 5,183 1,893 517 2,773

Adj. R2 0.227 0.125 0.319 0.183

The dependent variable is the time series average of Adjusted Daily Trading Volume from Day 5 to Day 122 foreachIPO rm.AdjustedDaily TradingVolumeis measured as daily trading volumedividedby shares outstandingon the same day. LIR is the log of initial return. Initial return is measured as the difference between rst tradingday closing price and offer price, divided by offer price. Retention1 is measured as (shares retained)/(sharesoutstanding after IPO). UP1 (DW1) is equal to the percentage difference between the original mid le pricerelative the amended mid le price for rms that amend their original le range up (down), zero otherwise.UP2(DW2) is equal to the percentage difference between thenal mid le price relative to the naloffer price forthose companies that had nal offer prices above (below) the nal mid le price, zero otherwise. LAG is denedas the average percentage initial return for all IPOs on calendar days 1 to 30 before the issue date. UWMS isthe percentage average equity IPO market share of the lead underwriter by year.

LISIZE is the log of number of shares offered. INVP is the inverse of offer price. RUNUP is the cumulativepercentage returnof CRSP equally weighted index fteentrading days beforethe issue.ALLOT is theproportionof over-allotment shares relative to shares offered. SECON is the proportion of secondary shares among all theshares offered. VENTURE is a dummy which is equal to one when the IPO rm is backed by venture capital,zero otherwise. NASDAQ is a dummy which is equal to one when the IPO is issued in Nasdaq, zero otherwise.LOCK is a dummy which is equal to one when the IPO has lockup provision. The regressions also include 13industry dummies not reported in this table.

is signicantly positively related to LIR. This supports our argument that pre-IPO ownersunderprice the issue to improve aftermarket liquidity.

Note that thecoefcients for thedummy variableLOCK in thefull-sample regressions arepositiveand highlysignicant.These results indicate that IPOswithlockup aremoreactivelytraded, andthus theresult isconsistent with theresultsshown inFigure2. Consideringearlierdiscussions about the effect of lockup on liquidity, the evidence supports the argument that


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lockup prevents insiders from taking advantage of outside investors in trading, and that thispositive effect on liquidity outweighs the negative effect of lockup on the numberof oatingshares. Next, we explore the relationships among lockup, underpricing, and trading volumemore closely.

3.3.3. IPOs with and without lockup. Our nding that IPOs with lockup are more activelytraded reminds us that in Section 3.2, we found higher underpricing and stronger relationbetween underpricing and share retention for IPOs with lockup. Thus, the observed higherliquidity for locked IPOs may merely be due to higher underpricing for locked IPOs. Butwhy are IPOs with lockup more underpriced? Possibly, lockup provides pre-IPO owners anincentive to take actions that increase long runliquidity. Lockup mayalso encourageoutsideinvestors to trade more actively. If underpricing improves long run liquidity more signi-

cantly for IPOs with lockup, then pre-IPO owners will be more likely to use underpricingto improve long run liquidity. If underpricing does not improve liquidity more signicantlyfor IPOs with lockup, pre-IPO owners will be more willing to use other methods, such aspromotion, to improve liquidity. So, the stronger relationship between underpricing andshare retention for IPOs with lockup may be associated with a stronger relation betweenunderpricing and aftermarket trading volume. Thus we have two hypotheses to test:

(3) The relation between underpricing and aftermarket trading volume is stronger for IPOswith lockup; and

(4) At least part of the higher trading volume for IPOs with lockup is related to greaterunderpricing.

We apply regression (2) (excluding the control variable LOCK) on the three previously-dened IPO sub-samples. The results are reported in the remaining columns of Tables 4and 5. Consistent with hypothesis (3) above, the coefcient on LIR is larger and much moresignicant for IPOs with lockup for both trading periods examined. It appears that investorswill trade IPO shares more actively given the same degree of underpricing if the IPO haslockup provision. Thus, pre-IPO owners will be more likely to use underpricing to improveliquidity when the IPO is locked. This leads to the stronger relation between share retentionand IPO underpricing for IPOs with lockup that we reported earlier.

To examine hypothesis (4), we attempt to measure the net effect of underpricing onliquidity. We do this by calculating the product of the mean of LIR and the coefcient of LIR in the regression. The mean of LIR is the cross-sectional average of LIR. The productcan be interpreted as incremental adjusted volume associated with underpricing. Then we

compare this product to mean adjusted volume, which is the cross-sectional average of thetime series averages of VO. The results are reported in Table 6.Clearly, underpricing is more substantially positively associated with higher trading vol-

ume for IPOs with lockup. For IPOs with lockup, the adjusted trading volume associatedwith underpricing for the two trading periods are 1.04 and 0.75 respectively, much higherthan the values of 0.15 to 0.27, respectively, for IPOs without lockup. Overall, the resultssuggest that underpricing explains a signicant proportion of the trading volume differencebetween IPOs with and without lockup.


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Table 6 . Summary evidence on the effect of log initial return on trading volume

Mean of Mean of Adjusted volumeadjusted log initial Regression associated with log

Categories volume return coefcient initial return

Panel A. Regressions using adjusted trading volume from day 5 to day 122All 5.56 0.10 7.25 0.70Before 1988 3.91 0.07 3.67 0.27After 1988, not locked 4.37 0.05 4.62 0.22With lockup 6.79 0.12 8.78 1.04

Panel B. Regressions using adjusted trading volume from day 129 to day 500All 5.17 0.10 5.38 0.52Before 1988 3.26 0.08 3.21 0.24After 1988, not locked 3.54 0.05 3.12 0.15With lockup 6.78 0.12 6.30 0.75

Mean of adjusted volume is the cross-sectional average of the time series averages of adjusteddaily trading volume. Mean of loginitial returnis thecross-sectional average of LIR. Initial returnis measured as thedifferencebetweenoffer price andrstday closing price,dividedby offerprice.The regression coefcient is the coefcient of LIR in the regressions relating time series averageof adjusted daily trading volumes to log onitial returns. Adjusted volume associated with loginitial return is the product of mean log initial return and the regression coefcients.

4. Conclusion

In our analysis of IPOs, we take the stance that pre-IPO owners prime objective is to

establish a liquid market for their shares, as a means of maximizing the market value of theirwealth. The owners attempt to accomplish this objective by optimally manipulating criticalvariables including and especially share retention, underpricing, and a lockup restriction.We develop and test hypotheses regarding the effects of, and interactions among, thesevariables. Theory suggests that share retention by pre-IPO owners reduces the liquidity of the IPO stock. To improve liquidity, pre-IPO owners underprice the issue to attract moreinvestors to follow the stock and trade it. Thus, we predict a positive relation between shareretention and underpricing and a positive relation between underpricing and aftermarkettrading volume. Our empirical evidence supports these predictions. In addition, we ndthat the positive relations are stronger for IPOs with lockup. This evidence suggests thatunderpricing improves liquidity more effectively for IPOs with lockup and thus pre-IPOowners use underpricing for that purpose more frequently.

Finally, our arguments do not preclude other explanations for IPO underpricing. The IPOprocess is complex, involving many factors. Pre-IPO owners motive to improve liquidityis just one aspect of that process. Other aspects of the process, such as interactions amongthe factors, may also contribute to the underpricing decision. However, our results doindicate that underpricing is strongly related to share retention, and is negligible for IPOswith very little retention. Therefore, it is reasonable to conclude that the share retentiondecision (as well as the lockup decision) should be integrated into any theory of IPOunderpricing.


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Acknowledgments

Ogden is grateful for nancial support provided by the UB School of Managements 2004Summer Research Fellowship Program. This paper is based on part of Zhengs dissertationcompleted at the University at Buffalo. The authors wish to thank William Reese and twoanonymous RQFA referees for helpful suggestions. Any remaining errors are the authorsresponsibility.

Notes

1. Here the value of their shareholdings is measured using the IPO offer price. If the market price is used, the losswill be even smaller.

2. The 9% loss is based on the assumption that the offer price remains the same.

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trading volume and share retention (1)

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