The decision to go public and the Initial Public Offer (IPO) underpricing with locally biased investors

Published in The European Journal of Finance


Financial literature about optimal asset allocation shows that a large proportion of investors’ portfolios is invested in geographically proximate stocks, due to lower information asymmetries or feelings of familiarity investors have toward the firms headquartered in the local area where they reside. As a consequence, the firm geographic location affects corporate market value: given that a portion of local wealth is anyway invested in local stocks, the short supply of local stocks (that is, the presence of a few listed firms available for investment in the local area) pushes market prices of geographically isolated firms up, and vice versa when local stocks are plentiful.

Overall, the literature shows that firm geographic location emerges as a not negligible asset-pricing factor. In fact, listed firms gain from their spatial isolation due to a large audience of “dedicated” investors.

Taking the same perspective, we expect that Initial Public Offers (IPOs) of isolated firms would face a lower risk of failure since the issuing securities are more likely to meet local investor preference. The same conclusions might be applied to SEOs.

In both events, the cost of capital would shrink, with important practical implications for firm financing choices. Ultimately, because the extra-premium local investors would ask to give away local securities, the local context could even represent an implicit poison pill against hostile takeovers.

In this paper, we move a step further, as we argue that local investors are peculiarly more biased toward local IPO stocks. More specifically, we posit that the local investor demand for stocks is shared between the locally listed firms and the local IPOs, with the latter attracting far more investors than the former. We show that local investors provide important additional demand for local IPOs and that local IPOs abnormally increase local stock market participation.

Using equity holdings data for more than 55,000 households over the years 2000-2012, we provide new evidence that the probability of owning stocks increases with the number of IPOs in the same region where the investor resides, but is not affected by the IPOs outside the region.

Consistent with a familiarity effect, this preference for local IPOs is largely driven by individuals born and raised in the region, disappearing when only individuals who have moved to the area are considered.

We move forward in our empirical analysis testing whether the abnormal local investor participation in local IPOs consistently affects the likelihood of a private firm going public. More in particular, for the universe of private firms and IPOs over 1999–2012, we show that the probability of having an IPO increases for isolated private firms, when the local investors’ demand for local IPO stocks is especially high.

Finally, we find IPO firms for which the local investors’ demand is particularly high are more underpriced than IPO firms with low local investor demand because insiders have more difficulties in valuing the former over the latter. In fact, issuers and underwriters appear not able to properly quantify the local investors’ abnormal demand and to incorporate this information into the IPO price-setting process.

Consistent with that, we find the average IPO underpricing increases with the remoteness of the issuing firm from the other listed firms. Taken together our findings suggest that the abnormal local demand provided by the local investors in local IPOs further complicates the IPO valuation problem faced by insiders. What’s more, our results indicate that underwriters significantly underestimate the local investors’ demand for local IPOs. As a consequence, isolated firms end up being adversely selected in going public or, in the best scenario, leave substantial money on the table when going public.

The main implication of our findings is that isolated private firms can count on an unexploited local clientele for their newly issued local stocks. Local retail investors are therefore crucial for the IPO decision. In fact, when properly considering the local additional demand provided by the local investors, the local isolated IPOs could find it convenient to go public as they are more likely to meet a stronger local investor preference, eventually facing a lower risk of failure.

Published in The European Journal of Finance: read the full article

Authors at the Department of Management

Giulia Baschieri - Associate Professor

Academic disciplines: Corporate Finance

Teaching areas: Corporate Finance

Research fields:  Corporate Finance, Corporate Evaluation, Enterprise Risk Management

Giulia is a core faculty member of the Bologna Business School. She has a Master in Science in Finance, Intermediary, and Markets, and a Ph.D. in Markets and Financial Intermediaries with a thesis on the local home bias in the Italian context. Her research interests refer to asset-pricing dynamics tied to corporate geographic location, and corporate evaluation.

Stefano Mengoli – Full Professor

Academic disciplines: Corporate Finance

Teaching areas: Corporate Finance

Research fields:  Corporate Governance, Local Home Bias, Family Firms, Pyramiding

Stefano Mengoli obtained his Ph.D. in Financial Markets from the University of Siena and was a Ph.D. Visiting Student at City University Business School and Academic Visiting at London School of Economics. His research interests are in the areas of Corporate Finance, Corporate Governance, and the effects of Geography on firm value. He is the Director of the Department of Management office in Bologna.