CUHK Business School Reveals the Importance of Prospectus-based Disclosure in the Interpretation of IPO Pricing Outcomes

HONG KONG, CHINA -�Media OutReach - 27 June 2019 – A research study by Paul B. McGuinness,
Professor of Department of Finance at The Chinese University of Hong Kong
(CUHK) Business School, entitled “Risk
factor and use of proceeds declarations and their effects on IPO subscription,
price ‘fixings’, liquidity and after-market returns” reveals how discretionary disclosure practice shapes
IPO capital funding and investor returns. The following article was first
published in CUHK Business School’s China Business Knowledge website – https://bit.ly/2KwDJcM.

My recent publication in the European Journal of Finance assesses the
link between voluntary prospectus-based disclosure and a range of IPO pricing
outcomesⁱ for issuers listing on HKEX. A significant amount of
disclosure is necessary for an entity contemplating stock listing on an organised
exchange market. For any firm granted initial public offering (IPO) approval,
publication of a listing prospectus precedes the general invitation for
investor subscriptions.ⁱⁱ Prospectus disclosure information is
wide-ranging and addresses, among other things, the listing entity’s business
focus, ownership, governance, industry and regulatory background, as well as
its pre-listing financial performance. As a legal document, the mass of
prospectus information on offer serves an important role in reducing information
asymmetry between insider-owners and outside public investors. Careful study of
such prospectus disclosure potentially helps in attenuating investors’ adverse
selection risks. Two of the pivotal areas to consider in this regard are the
issuer’s declarations on risk factors and planned use of issue proceeds. The
voluntary or discretionary disclosure component concerns the amount of detail
divulged. While all issuers provide some level of disclosure on both risk
factors and planned fund uses, the level of coverage varies considerably across
IPO firms.

With regard to declarations on risk factors, issuers and their advisors
typically disclose on (1) macroeconomic (2) business, and (3) offer-based
risks. For the second area of disclosure on planned use of proceeds, issuers
routinely earmark funds to at least one of the following: (1) Drawing-down
liabilities, (2) new investments, and (3) working capital. In many IPOs,
issuers indicate an intention to channel proceeds to all three end uses. The
question then of course is how does the balance of fund uses impact on pricing
outcomes?

The outcomes of relevance include the “fixing” of final offer
price, IPO subscription demand, initial investor returns, after-market stock
volatility and liquidity, and longer-run returns. A pivotal issue is whether
disclosure is exogenous or endogenous. The latter presupposes that declarations
anticipate subsequent pricing outcomes. Exogenous disclosure suggests voluntary
declarations shape pricing outcomes.ⁱⁱⁱ In reality, most disclosure
contains endogenous and exogenous elements. The challenge is thus one of
determining which of the two dominates. I discuss more on this topic later in
this piece.

Discrete risk factor counts yield significant explanatory power.
Enumerations on business-, global- and issue-based factors generate
countervailing pricing outcomes. Issue-based counts exert short-lived effects
on return volatility. On the other hand, business and global risk factor counts
bear little connection with initial pricing, but display strong negative
linkage with long-run returns. Issue-based enumerations thus forewarn on
adverse-selection, while non-issue counts inform on the longer-run.

With regard to my study’s second major disclosure area, greater
assignment of issue proceeds to real investment (debt repayment) supports
(weakens) IPO subscription. Final offer prices thus tend to be higher in firms
that explicitly prioritize growth options. The price formation process strongly
embeds this outcome. Firms stressing greater focus on investment uses are more
likely to price new stock at the top of disclosed offer ranges. Such findings
offer prescriptive value for issuers and supporting bank sponsors: Greater
“specificity”^iv on growth options typically boosts issue
proceeds.

My study also suggests that greater assignment of proceeds to growth
options benefits subscribers, given the enhanced initial and after-market
returns that ensue. In contrast, greater de-leveraging uses correlate with
weaker initial and after-market returns. Strong liquidity effects are also
apparent. Greater allocation of IPO proceeds to investment underlies more
stable post-listing trading volumes. Again, the opposite holds for entities
prioritizing fund use for debt repayment. Analysis of the foregoing pricing
effects offers important extension and development of the associated IPO
literature.

My analysis also assesses risk factor and IPO fund use determinants. To
some extent, an issuer’s (and its associated advising banks’) management of
legal risks determines disclosure form. Under certain circumstances, legal risk
promotes voluntary disclosure, while an issuer’s desire to preserve competitive
advantage circumscribes disclosure. My empirical results suggest that risk
factor counts and debt repayment uses are both increasing in the reputation of
the appointed bank sponsor.

The determination of risk factor counts and fund uses also serves in
generating instrumental variables for my study’s in-depth assessment of
causality. Baseline equations presuppose that IPO pricing outcomes are a
function of the two major disclosure items. Such a structure assumes exogenous
disclosure. However, there is always the possibility that declarations on risk
factor counts and fund uses anticipate subsequent pricing outcomes. Overall,
baseline results appear resilient to the inclusion of instrumental variables.

In summary, my recent article in the European
Journal of Finance offers guidance on how listing firms’ disclosure
practice shapes investor demand, final offer price determinations, IPO
underpricing, after-market return volatility, stock liquidity, and longer-run
returns. The form and extent of voluntary disclosure exerts notable impact on
many of these dimensions. Investors might therefore wish to consider perusing
the content of prospectus pronouncements on risk factor and fund uses. My study
also offers guidance for founders and entrepreneurs wishing to do IPO. Among
other things, disclosures that signal greater commitment, and thus detail on an
issuer’s real option plans, act in supporting more favourable pricing outcomes.
Above all, the vibrancy and scale of the local IPO market^v amplifies
the importance of my study’s empirical findings on primary market disclosure.

Reference:

ⁱ Paul B. McGuinness, 2019. Risk factor
and use of proceeds declarations and their effects on IPO subscription, price
“fixings”, liquidity and after-market returns, The
European Journal of Finance, Online 3 February 2019.

ⁱⁱ IPOs on the HKEX Main Board separate offers shares into international “book-built”
placing and local retail investor tranches. For the retail tranche, investors
apply shortly after prospectus release, with applications subject to ballot if
oversubscription occurs. For the book-built component, relevant banks collect
information on investors’ preliminary indications of interest in the run-up to
prospectus release. However, determination of share allocations only occurs as
listing nears, and thus sometime after prospectus release [see Sherman and
Titman (2002, Journal of Financial
Economics, 63: 3-29) for discussion of the book-building process]. The
exception is where investor parties broker a contractual commitment ahead of
prospectus release, commonly known as a Cornerstone agreement. The relevant
issue prospectus must offer detailed disclosure on such allocations. For
discussion of Cornerstone agreements and some of the related Exchange
disclosure requirements, see article by
McGuinness (Indian Management,
February 2016).

ⁱⁱⁱ For detailed discussion of the properties and characteristics of
exogenous and endogenous disclosure, see Leone, Rock & Willenborg (2007, Journal of Accounting Research, 45:
111-153).

^iv In the sense of Leone et al. (2007, Op. Cit.).

^v HKEX attracted more capital funding for new listing firms than any
other IPO setting in 2018 (see PWC’s
Greater China IPO Watch 2018, Page 6). HKEX has achieved this top
ranking six times in the period 2009-18 (see HKEX News
Release, 21/12/2018).

About CUHK Business School

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in Hong Kong in 1963, CUHK Business School is the first business school to
offer BBA, MBA and EMBA programs in the region. The School currently has 4,400
students and the largest number of business alumni (36,000+)
in Hong Kong.

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