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Underpricing and Partial Adjustment in Brazilian Private Equity Backed IPOs

Marcelo Luzatti Otero

Andrea Maria Accioly Fonseca Minardi

Abstract

This paper analyzes how the sponsorship of a private equity firm impacts underpricing of

initial public offerings (IPOs). Underpricing is well documented in financial literature, and

there are evidences that one of its causes is partial adjustment. Partial adjustment occurs

when the underwriter of an issue does not adjust the offering price to the demand observed

during the bookbuilding process, creating positive initial returns. We analyze IPOs issued in

Brazil between 2004 and 2014. We considered the overallotment option in estimating the

underpricing, and our results conclude that partial adjustments and underpricing are higher for

private equity backed IPOs.

Key words: IPO, underpricing, partial adjustment, private equity

I. Introduction

The purpose of this work is to analyze whether private-equity backed Initial Public

Offerings (IPOs) exhibit significantly different levels of underpricing when compared to non-

sponsored IPOs, examining offerings that occurred in Brazil between 2004 and 2014.

Private-equity (PE) firms are investment vehicles managed by General Partners, which

are responsible for raising funds, investing and monitoring the companies in their portfolio

(Minardi et al., 2013). PE/VC firms maintain the companies in their portfolio for a period, no

longer than the funds limited life, in which they actively work on the company`s performance,

through changes in management, financial restructuring and operational improvements,

among other ways to increase the company`s profitability and deliver high returns to the firm

and its investors. PE firms usually exit their investments through IPOs, sale to strategic buyers

or sale to other PE firms. The PE industry is relatively new in Brazil, but it has experienced

sustained growth in the last decade and attracted established international players, such as

Advent, KKR, Carlyle and Blackstone. Brazil also faced an IPO wave starting in 2004 (Saito

and Maciel (2006)) as the result of better institutional structure, high liquidity in international

markets and increased macroeconomic stability. During this period, many private-equity deals

exited through IPOs (ABDI and GVCEP, 2011), which enables the comparison of whether

private-equity backed IPOs exhibit statistically different levels of underpricing than non-

sponsored IPOs.

The initial price performance of IPOs has been widely investigated in finance

literature. Several studies (See, e.g., Ibbotson (1975) and Brav and Gompers (1997), among

others) find the existence of statistically significant stock underpricing, which is defined as

the percentage change between the closing price of the first trading day and the initial offering

price.

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Reilly and Hatfield (1969) discuss factors that might influence underwriters in IPO

pricing, expecting a downward bias in the pricing of new stock issues. Reasons for this

expectations include uncertainty of the public’s evaluation of the firm, increased probability

that the issue will be successful if it is underpriced and the underwriter’s fee structure, that

allows the investment bank to receive part of their fee in stock or receive options to purchase

a large block of the new stock at a price near or below the original offering price. It is argued

that a possible complaint by the issuing firm, which would prevent the underpricing of an

issue, is not a relevant constraint, because corporate officers, like the underwriters, often

receive stock options close to the original offering price, benefitting directly from an issue

that rises to a premium. The results of the study support the hypothesis of the existence of

underpricing, showing superior short-run results for the investor in new stock issues, meaning

that the lead underwriter could have raised the offering price to increase value to the issuing

firm.

McDonald and Fisher (1972) find significantly large returns for initial subscribers on

IPOs and support an idea of rapid adjustment of prices to available information, because the

initial return was not followed by superior returns in the long-term. This result is opposed to

Reilly and Hatfield, who have suggested that the short-run adjustment should continue for

more time, as the market processes available information and adjusts for the underpricing.

Ibbotson (1975) studies the initial and aftermarket performance on newly issued

common stocks which were offered to the public during the 1960s, with results confirming

that average initial return is positive, at 11.4%. The results on aftermarket are similar to

McDonald and Fisher (1972), supporting the efficiency theory and indicating that the market

adjusts quickly to issue offerings that are underpriced.

Leal (2004) analyzes Brazilian IPOs between 1974 and 1994 and finds a mean initial

return of 34% for new stock issues and declining returns in the medium to long term, which

strongly indicates underpricing. CVM (Comissão de Valores Mobiliários – the Brazilian

Security Exchange Comission) adopted bookbuilding in IPOs only after 2003 (Saito and

Pereira (2006)). Silva and Famá (2011) studied IPOs issued between 2004 and 2007, and

found an underpricing of 4.8%.

Beatty and Ritter (1986) argue that there is a relationship between the uncertainty of

investors regarding a company’s fair value and underpricing, which would compensate

investors for taking the initial risk. They also propose that there exists an underpricing

equilibrium, in which the investment bank has to find a middle ground between creating value

for the issuing firm and compensation its institutional clients for being an active participant in

the bank’s IPOs.

Benveniste and Spindt (1989), focus on how informational frictions between agents

can affect IPO pricing. This could happen because issuing firms are asymmetrically well

informed about their situation, and have an incentive to misrepresent themselves to potential

investors as of higher quality than they in fact are. In this context, underwriters collect

information during the preselling period and, as a way to compensate investors for giving

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truthful information during the bookbuilding process and engaging in an issue with high

informational asymmetry, price their issues below fair value in order to create a meaningful

return for the investors.

Hanley (1993) defines the partial-adjustment hypothesis, which is central to

underpricing and for the purpose of this work. As the underwriter is able to review the final

offering price after the bookbuilding process, he could generate underpricing by not fully

adjusting the price to the observed demand. The work finds that the relation of the final offer

price to the range of anticipated offer prices disclosed in the preliminary prospectus is a good

predictor of initial returns, which means that underwriters intentionally decided priced only

part of the perceived demand. Issues in which final prices were above the preliminary price

range exhibit greater underpricing and are more likely to increase the number of shares issued,

which indicates that underwriters only partially adjusted the offerings to the information

received in the bookbuilding process.

Minardi et al. (2015) find evidence of partial adjustment in IPOs that occurred in the

Brazilian market between 2004 and 2012, meaning that when underwriters observe high

demand for a new issue during the bookbuilding process, he adjusts the price upwards but

below the estimated fair market value. This leads to positive first day return and the issue of

new shares in the aftermarket. If the underwriter does not adjust the offering parameters

according to the demand that he observes, there will be a potential case of underpricing and

the exercise of overallotment option, also known as Greenshoe option. The exercise of

overallotment option brings new shares to the marked and pushes the equilibrium price down,

but to a level that is still above the issuing price. Therefore the company’s shareholders pre

IPO sell shares at a lower price than they could, they are diluted through the issue of new

shares in the aftermarket, and the institutional clients benefit from buying shares at a lower

price.

Megginson and Weiss (1991) compares VC backed IPOs with a control sample of

non-VC backed IPOs from 1983 to 1987. They find that the underpricing of venture capital

backed IPOs is significantly lower than the control sample. The presence of VC firms as

investors in a public offering can certify to investors that the price of the issue reflects all

available and relevant inside information, and that the company is better prepared to go

public. The paper supports the certification role of VC firms.

Francis and Hasan (1999) also examine difference in underpricing between VC and

non-VC backed IPOs. Their findings suggest that underpricing of IPOs is impacted not only

by factors such as third party certification, but is also influenced by factors that lead to

deliberate underpricing by underwriters pre-issue, which occurs in order to reduce the costs of

stabilization in the after-market. Regarding differences in underpricing between VC and non-

VC backed IPOs, their results differ from literature, as they find that venture backing actually

increases the average underpricing of an issue.

Chemmanur and Loutskina (2005) also find that the backing of a VC firm results in

lower underpricing. According to the authors, in addition to the certification effect, VCs also

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work with better qualified market participants. VCs are able to select better quality firms to

back (screening), and help create higher quality firms by adding value to them pre-IPO,

resulting in a higher certification for the issue. But VCs also have “market power”, and

attract a higher number of better qualified market participants (such as underwriters,

institutional investors and analysts to an IPO), and therefore are able to obtain a higher

valuation for theirs firms in the IPO. They find that while venture backed and non-venture

backed IPOs are overvalued relative to the intrinsic value, VC backed IPOs are more

overvalued. Regarding the difference in valuation, they find that a significant portion of the

valuation premium is explained by the fact that VC backed IPOs are associated with top tier

underwriters, more participation by institutional investors and greater analyst coverage,

supporting the “market power” effect. They also indicate that firms going public with VC

backing are indeed of higher quality than firms without backing, which supports the screening

and monitoring hypothesis.

Sonoda (2008) examined 98 IPOs of Brazilian companies between 2004 and 2007 and

tested for differences between private-equity / venture capital backed and non-sponsored

IPOs. The author did not find statistically significant evidence of a Private Equity or Venture

Capital effect on IPO underpricing. Botai (2013) found evidences that PE funds were

irrelevant to explain underpricing, except for issues that were launched at a price in the upper

limit or above the preliminary prospect price range.

In this study, we take into account partial adjustment effect, since underpricing is

higher for issues launched at a price above the preliminary price range. Therefore we classify

IPOs according to the issuing price position relative to preliminary prospect price range:

bellow the range, inside the range and above the range. Also, we estimate underpricing as the

percentage difference of launching price to the price at the end of the stabilization process.

This allows us to consider the exercise of the overallotment option in the fair price. We

expected that PE backed IPOs had a lower underprice than non-venture backed IPOs, due to

the certification hypothesis, more qualified market players, and better monitoring of PE in

establishing a launching price closer to the fair price.

Our results, contrary to our expectations, indicate that PE backed IPOs actually have a

higher underprice than no PE backed IPOs. One possible reason is that PE recurrently brings

new companies to IPOs, and as it is the case for underwriters, PE firms also have to

compensate institutional investors for participating in IPOs of other portfolio companies.

Also, the institutional investors that buy shares of the portfolio companies that go public are

the same that invest in the PE fund as the firm raises capital.

II. Database

We collect data on 149 IPOs that took place in Brazil between January 1, 2004 and

December 31, 2014, including re-IPOS. The choice of 2004 as the initial year is due to the

fact that there were only a very limited number of offerings previously and that CVM

regulated the bookbuilding process only in 2003, which is central to the partial-adjustment

investigation.

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The database includes, for each IPO, the year of the offering, the primary and

secondary volume, the proportion of retail investors and foreign investors in the offering, the

minimum and maximum price according to the preliminary prospectus, the effective price, the

lead underwriter and, if applicable, the private-equity fund that backed the IPO.

We validated data according to preliminary prospectuses, final prospectuses and

notices of termination. The sources of the documents are CVM, BMF&BOVESPA,

underwriter and issuer investor relation sites.

Figure 1 shows the number of IPOs per year, as well as the percentage of IPOs backed

by PE. We observe that there was a peak of IPOs in 2006 and 2007, a decline with the global

crises in 2008 and 2009, and that the IPO market did to recover, because after 2012

international mood with Brazil started to be negative.

As in Hanley (1993) and Minardi et al. (2015), we grouped IPOs in three different

groups: issues with offering prices below or at the bottom limit of the preliminary prospectus

price range, issues with final prices within the preliminary range (excluding the limits) and

issues with final prices above or at the upper limit of the range. This is appropriate given the

partial-adjustment phenomenon, according to which underwriters only partially adjust the

final offering price to the information available. Therefore, offerings with final prices above

the preliminary range should exhibit higher average underpricing. In the database, there were

62 cases of offerings in which the final price was at or below the range lower limit, 56

offerings within the range and 31 offerings at or above the upper limit.

The chosen variable for the measurement of underpricing is the percentage difference

between the offering price and the closing price after the stabilization period. It will be

calculated as:

UNDERPRICINGi = (P1i – P0i)/ P0i (1)

Figure 1: Number of IPOs per year

2 513

44

2 3 5 3 2 4

1

54

13

20

2 36 8 1 3

79

26

64

4 6

11 113 7

1

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Non-sponsored IPOs PE backed IPOs

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In which,

P0i: launching price of the issue

P1i: closing price after the stabilization period

This measure is chosen instead of the initial return on the first day because of the

potential additional issue of shares in the aftermarket (caused by the exercise of Greenshoe

option). The fair share price will adjust down to the increase in the number of shares. The

exercise of the Greenshoe option makes sense from the underwriter perspective, since it

allows him to collect fees with the additional issue of shares and enables him to compensate

the institutional investors with extra allocation. The larger the return, larger the underpricing,

suggesting the underwriter did not fully adjust the offering price to the information received

during the bookbuilding process.

Table 1 shows the breakdown of the IPOs in the database according to the relative

position of launching price to the preliminary range and backing of a private equity firm. We

observe that the higher the relative position of launching price to the preliminary price range,

the higher the underpricing. Above the range IPOs have higher underpricing than inside the

range, and below the range have negative mean underpricing. We confirm this pattern for PE

and non PE backed IPOs. PE backed issues above the range exhibit an average underpricing

of 16.23%, against 7.85% for PE issues inside the range, while non-sponsored issues above

the range have an average underpricing of 9.75% above the range against only 2.69% inside

the range. These results support the partial-adjustment hypothesis, as a higher price revision is

associated with greater underpricing. Interestingly PE-backed IPOs show larger underpricing

than non-sponsored ones for issues classified above and inside the range. This difference

between average PE and non-sponsored IPOs underpricing is also statistically significant,

following a t- test with unequal variances, in the above and inside the range categories

Table 1: Underpricing according to relative position of the final price to the preliminary

valuation range

“*”, “**” and “***” represent statistical significance below 10%, 5% and 1%, respectively

Table 2 contains descriptive statistics of price and number of shares revisions during

the bookbuilding process, grouped according to the offering prices position in the preliminary

range. Price revision is calculated as (Po - PE)/PE, where PE is the midpoint of the preliminary

Total Above the range Inside the range Below the range

Underpricing PE Non-PE PE Non-PE PE Non-PE PE Non-PE

Observations 65 84 18 13 19 37 28 34

Mean 5.88%*** 2.35%* 16.23%*** 9.75%*** 7.85%*** 2,69% (2,10%) (0,84%)

Standard deviation 11,7% 9,7% 11,2% 10,5% 9,9% 10,5% 6,2% 6,6%

Standard error 1,4% 1,1% 2,6% 2,9% 2,3% 1,7% 1,2% 1,1%

Means difference test (PE - Non-PE) 3.52%** 6.47%* 5.16%** (1,26%)

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range and PO is the final offering price. The change in the number of shares offered is

calculated as (NO - NE)/ NE, in which NO is the number of shares offered in the IPO and NE is

the number of shares disclosed in the preliminary prospect.

While price revision in negative in the first group (below the range), it is around zero

in the second (within the range) and positive in the third (above the range). It is also possible

to see that downward revisions are higher in absolute terms than upward ones, showing that

price revisions have an asymmetrical format, which may be an additional evidence of partial-

adjustment (if the choice of the preliminary range is unbiased and the revision truly reflected

market demand, there would be no reason for price revisions to be different in magnitude). It

is also possible to see that it is much more likely that offers in the above the range group will

have upward revisions in the number of shares offered (29.0%) than in the below the range

group.

Table 2: Offering adjustments between preliminary and final prospectuses

Descriptive statistics of the final offer price and volume in comparison with the expected in the preliminary

prospectus. Below the means, medians are in brackets.

III. Econometric Tests

We run OLS cross-section regression to confirm that PE backed IPOs have higher

underpricing than non PE backed IPOs.

Our dependent variable is the underpricing, and our variable of interest is a dummy, PE, with

a value of one when the IPO is backed by a private equity firm and zero otherwise.

We use dummy variables to control for the relative position of the launching price according

to the preliminary price range: ABOVE, will equal one when the offering price of the issue

was above the prospect range and zero otherwise and BELOW will equal one when the final

offering price of the issue is below the prospect range. We also controlled for the following

variables:

All IPOs

IPOs with offering price

below or at the minimum

value of the range

IPOs with offering price

within the valaution

range (excluding limits)

IPOs with offering price

above or at the

maximum value of the

range

Mean percentage difference -5,4% -19,9% -0,1% 14,0%

from expected offering price to -1,6% -17,1% - 11,8%

final offering price

Mean percentage difference from 2,5% (0,4%) 4,6% 4,4%

minimum or maximum range values 0,0% 0,0% 0,0% 0,0%

and the final offer price

Percentage of IPOs with positive 22,1% 6,5% 28,6% 29,0%

change in the number of shares

Average ratio of offered volume in 1,1x 0,8x 1,1x 1,3x

relation to expected volume

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- VOLUME: Total offered volume. Investors prefer larger offerings, and therefore we

expect that larger offerings have higher demand, influencing underpricing and partial

adjustment.

- RANGE_SIZE: Size of the range of the preliminary prospectus. A big difference

between the minimum and maximum price of the preliminary prospectus indicates

more uncertainty regarding the issue. In this context, the underwriter would rather

make a more attractive offer to guarantee the success of the issue, in order not to face

the reputational and financial damage of a failed IPO. It is expected that a larger range

size will have a positive impact on underpricing.

- Year Dummies: We include three year dummies to control for differences between the

time periods of the issues:

a. YEAR1: Dummy that equals one when the year of the issue was 2006 or 2007,

years when occurred an IPO wave in Brazil (90 IPOs out of our 149 sample

occurred in those two years).

b. YEAR2: Dummy that equals one for issues launched in 2008 2009, in order to

capture the effects of the global financial crisis.

c. YEAR3: Dummy that equals one for the years 2010-2014, reflecting the

deterioration of Brazilian economic policy and loss of confidence in the

Brazilian economy by international investors.

- UNDERWRITER: A dummy that equals one if the lead underwriter of the IPO is

Credit Suisse, UBS Pactual or BTG Pactual. This variable will be used as a proxy for

underwriter reputation, as these investment banks participated in the majority of deals

that occurred in Brazil during the period studied. It is expected that this variable will

have a negative effect on underpricing because of the certification effect, though

which a qualified third party certifies the quality of the issue and increase the

willingness of institutional investors to participate in the offering.

- PRICE_CHANGE: measures the percent change from the expected price to the final

price, calculated as (PO-PE)/PE, in which PO is the final offering price and PE is the

midpoint of the preliminary prospect range

We run the three regression models:

𝑈𝑁𝐷𝐸𝑅𝑃𝑅𝐼𝐶𝐼𝑁𝐺 𝑖 = 𝛽𝑜 + 𝛽1 ∗ ln(𝑉𝑂𝐿𝑈𝑀𝐸𝑖) + 𝛽2 ∗ 𝑅𝐴𝑁𝐺𝐸_𝑆𝐼𝑍𝐸𝑖 + 𝛽3 ∗𝑈𝑁𝐷𝐸𝑅𝑊𝑅𝐼𝑇𝐸𝑅𝑖 + 𝛽4 ∗ 𝑃𝐸𝑖 + 𝛽5 ∗ 𝑌𝐸𝐴𝑅1𝑖 + 𝛽6 ∗ 𝑌𝐸𝐴𝑅2𝑖 ( model 1)

+ 𝛽7 ∗ 𝑌𝐸𝐴𝑅3𝑖 + 𝛽8 ∗ 𝑃𝐸𝑖 ∗ 𝐴𝐵𝑂𝑉𝐸𝑖 + 𝑒𝑖

𝑈𝑁𝐷𝐸𝑅𝑃𝑅𝐼𝐶𝐼𝑁𝐺 𝑖 = 𝛽𝑜 + 𝛽1 ∗ log(𝑉𝑂𝐿𝑈𝑀𝐸𝑖) + 𝛽2 ∗ 𝑅𝐴𝑁𝐺𝐸𝑆𝐼𝑍𝐸𝑖 + 𝛽3 𝐴𝐵𝑂𝑉𝐸𝑖 +

𝛽4 ∗ 𝐵𝐸𝐿𝑂𝑊𝑖 + 𝛽5 ∗ 𝐴𝐵𝑂𝑉𝐸𝑖 ∗ 𝑃𝐸𝑖 + 𝑒𝑖 (model 2)

𝑈𝑁𝐷𝐸𝑅𝑃𝑅𝐼𝐶𝐼𝑁𝐺 𝑖 = 𝛽𝑜 + 𝛽1 ∗ 𝑃𝑅𝐼𝐶𝐸𝐶𝐻𝐴𝑁𝐺𝐸𝑖

+ 𝛽2 ∗ 𝑃𝐸𝑖 + 𝛽3 ∗ 𝑃𝑅𝐼𝐶𝐸𝐶𝐻𝐴𝑁𝐺𝐸𝑖∗ 𝑃𝐸𝑖 + 𝑒𝑖 (model3)

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IV. Results

Table 3 presents the results of the regressions. We observe in model (3) that PE backed IPOs

have higher underpricing, and that this effect is higher for IPOs with higher price revision.

We also find evidence that PE firms in the above the range group have higher underpricing in

models (1) and (2). PE backed IPOs in the below group have negative underpricing of higher

magnitude than non PE backed IPOs.

Our results are in accordance to the partial adjustment hypothesis. We find positive and

significant coefficient for the dummy above the range and negative and significant coefficient

for the dummy below the range for model (1), and positive and significant coefficient for the

percentage change in model (3).

We find that the higher the offer volume, the higher is the underpricing, but we do not find

significant relation to IPO underpricing and percentage width of valuation range.

The results support the partial-adjustment hypothesis, as price revisions and positions in the

prospect range were very good predictors of underpricing in Brazil in the last decade. The

results confirm the mean difference test results, where the backing of a private equity

increases underpricing. Tehy are in accordance to Francis and Hasan (1999), and it may be

the case that PE prefer to launch shares at a lower price to favor price stabilization.

V. Conclusion

We expected that PE backed IPOs have a lower underpricing than non PE backed IPOs. PE

could select better companies for their portfolio, improve their performance and governance

before the IPO through active monitoring and hiring high quality executives, prepare them

better for going public, and therefore providing a certifying effect to the market. As PE are

recurrently bringing companies to the market, we also expect that they select high quality

underwriters and auditing companies, and also have higher bargaining power with the

underwriter to prevent launching the IPOs at a price significantly lower to the fair price.

But our results showed the opposite, even when we estimate the underpricing using the end of

stabilization closing price instead of the first day closing price. PE backed IPOs actually have

higher underpricing than non PE backed IPOs, and this difference is significantly higher for

the group above the range, in which IPOs have higher price revision, and generate higher

investors’ demand. Mean underpricing for PE backed issues in total IPOs was 5.88%,

compared to 2.35% for non-sponsored ones. It was also statistically greater than non-

sponsored issues in the price ranges above (16.23% compared to 9.25%) and inside the

preliminary prospect price range (7.85% compared to 2.69%). The regressions confirm our

results.

Underpricing creates cost to PE. Funds face higher dilution in the equity stake they keep after

the IPO, and they receive less money for the shares they sell in issue launching day. One

possible interpretation is that PE accept the cost of underpricing to have an easier stabilization

process in the after market, as proposed by Francis and Hasan (1999). But it is also possible

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that PE prefer to launch shares at a price lower than the fair value to remunerate institutional

investors, and compensate them for recurrently buying shares of companies they bring to

IPOs, even if the companies do not generate such high demands (priced bellow the range).

Institutional investors that buy shares in the IPOs may also invest in a further fund launched

for the PE firm.

Table 3: OLS Regression Results: Relation between underpricing and

pre deal information

T-test results are in brackets below the coefficients.

“*”, “**” and “***” represent statistical significance below 10%, 5% and 1%, respectively

Model

(1) (2) (3)

Constant -0.7656*** -0.4843*** 0.0392***

(4,2206) (2,7806) (3,7139)

ln (Volume offered) 0.0410*** 0.0255***

(4,4765) (2,9230)

Percentage widht -0,1051 0,0483

of valuation range (1,0877) (0,5759)

Underwriter dummy -0,0162

(1,0040)

PE dummy 0,0143 0.0395**

(0,8357) (2,5523)

Dummy for 2006-2007 0,0123

(0,4609)

Dummy for 2008-2009 -0.0677*

(1,8094)

Dummy for 2010-2014 -0.0490*

(1,7338)

Dummy for the 0,0441

above group (1,6014)

PE dummy X 0.1055*** 0.0632*

dummy for the above group (4,0026) (1,9537)

Dummy for the -0.0546***

below group (3,2840)

Percentage change from the offering 0.2388***

price to the expected price (3,6732)

Percentage change from the offering 0.2781***

price to the expected price X PE dummy (2,8830)

R-squared 0,3141 0,3371 0,3316

Adjusted R-squared 0,2749 0,3139 0,3178

Log likelihood 149,8819 152,4283 151,8080

F-statistic 8,0131 14,5454 23,9769

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