The Importance of Prospectus-based Disclosure in the Interpretation of IPO Pricing Outcomes
How does discretionary disclosure practice shape IPO capital funding and investor returns?
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My recent publication in the European Journal of Finance assesses the link between voluntary prospectus-based disclosure and a range of IPO pricing outcomes1 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.2
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 declared risk factor and intended 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 pricing outcomes.3 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.
In my study, discrete risk factor counts yield significant explanatory power. 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 prioritise 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’4 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 prioritising fund use for debt repayment. Analysis of the foregoing effects deepens and develops the IPO literature.
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.
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 market5 amplifies the importance of my study’s empirical findings on primary market disclosure.
About the Author & Researcher
Paul B. McGuinness is a Tenured Professor in the Department of Finance at The Chinese University of Hong Kong. His research focuses on securities analysis, corporate finance, governance and Chinese equity markets. He has published numerous papers in internationally refereed journals, as well as a book (A Guide to the Equity Markets of Hong Kong, Oxford University Press, 1999). Prof. McGuinness has extensive teaching and consulting experience. He has also served as Chairman of CUHK’s Department of Finance for two separate four-year terms. Prof. McGuinness has degrees from the University of Leeds (PhD), University of Cambridge (MPhil) and University of Newcastle (BA Hons, First Class).
[1] 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 (https://www.tandfonline.com/doi/full/10.1080/1351847X.2019.1572023).
[2] IPOs on the HKEX Main Board separate offer 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 McGuinness (Indian Management, February 2016: Article available at: https://www.bschool.cuhk.edu.hk/featured-stories/boosting-investor-conf…).
[3] 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).
[4] In the sense of Leone et al. (2007, Op. Cit.).
[5] 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, https://www.pwccn.com/en/ipo/greater-china-ipo-watch-2018.pdf). HKEX has achieved this top ranking six times in the period 2009-18 (see HKEX News Release, 21/12/2018: https://www.hkex.com.hk/News/News-Release/2018/181221news?sc_lang=en).
