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

June 28, 2019 - 10:27
CUHK Business School Reveals the Importance of Prospectus-based Disclosure in the Interpretation of IPO Pricing Outcomes

HONG KONG, CHINA - Media OutReach - 27 June2019 - A research study by Paul B. McGuinness,Professor of Department of Finance at The Chinese University of Hong Kong(CUHK) Business School, entitled "Riskfactor and use of proceeds declarations and their effects on IPO subscription,price 'fixings', liquidity and after-market returns" reveals how discretionary disclosure practice shapesIPO capital funding and investor returns. The following article was firstpublished in CUHK Business School's China Business Knowledge website -

My recent publication in the European Journal of Finance assesses thelink between voluntary prospectus-based disclosure and a range of IPO pricingoutcomesi for issuers listing on HKEX. A significant amount ofdisclosure is necessary for an entity contemplating stock listing on an organisedexchange market. For any firm granted initial public offering (IPO) approval,publication of a listing prospectus precedes the general invitation forinvestor subscriptions.ii Prospectus disclosure information iswide-ranging and addresses, among other things, the listing entity's businessfocus, ownership, governance, industry and regulatory background, as well asits pre-listing financial performance. As a legal document, the mass ofprospectus information on offer serves an important role in reducing informationasymmetry between insider-owners and outside public investors. Careful study ofsuch prospectus disclosure potentially helps in attenuating investors' adverseselection risks. Two of the pivotal areas to consider in this regard are theissuer's declarations on risk factors and planned use of issue proceeds. Thevoluntary or discretionary disclosure component concerns the amount of detaildivulged. While all issuers provide some level of disclosure on both riskfactors and planned fund uses, the level of coverage varies considerably acrossIPO firms.

With regard to declarations on risk factors, issuers and their advisorstypically disclose on (1) macroeconomic (2) business, and (3) offer-basedrisks. For the second area of disclosure on planned use of proceeds, issuersroutinely earmark funds to at least one of the following: (1) Drawing-downliabilities, (2) new investments, and (3) working capital. In many IPOs,issuers indicate an intention to channel proceeds to all three end uses. Thequestion then of course is how does the balance of fund uses impact on pricingoutcomes?

The outcomes of relevance include the "fixing" of final offerprice, IPO subscription demand, initial investor returns, after-market stockvolatility and liquidity, and longer-run returns. A pivotal issue is whetherdisclosure is exogenous or endogenous. The latter presupposes that declarationsanticipate subsequent pricing outcomes. Exogenous disclosure suggests voluntarydeclarations shape pricing outcomes.iii In reality, most disclosurecontains endogenous and exogenous elements. The challenge is thus one ofdetermining which of the two dominates. I discuss more on this topic later inthis piece.

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

With regard to my study's second major disclosure area, greaterassignment of issue proceeds to real investment (debt repayment) supports(weakens) IPO subscription. Final offer prices thus tend to be higher in firmsthat explicitly prioritize growth options. The price formation process stronglyembeds this outcome. Firms stressing greater focus on investment uses are morelikely to price new stock at the top of disclosed offer ranges. Such findingsoffer prescriptive value for issuers and supporting bank sponsors: Greater"specificity"iv on growth options typically boosts issueproceeds.

My study also suggests that greater assignment of proceeds to growthoptions benefits subscribers, given the enhanced initial and after-marketreturns that ensue. In contrast, greater de-leveraging uses correlate withweaker initial and after-market returns. Strong liquidity effects are alsoapparent. Greater allocation of IPO proceeds to investment underlies morestable post-listing trading volumes. Again, the opposite holds for entitiesprioritizing fund use for debt repayment. Analysis of the foregoing pricingeffects offers important extension and development of the associated IPOliterature.

My analysis also assesses risk factor and IPO fund use determinants. Tosome extent, an issuer's (and its associated advising banks') management oflegal risks determines disclosure form. Under certain circumstances, legal riskpromotes voluntary disclosure, while an issuer's desire to preserve competitiveadvantage circumscribes disclosure. My empirical results suggest that riskfactor counts and debt repayment uses are both increasing in the reputation ofthe appointed bank sponsor.

The determination of risk factor counts and fund uses also serves ingenerating instrumental variables for my study's in-depth assessment ofcausality. Baseline equations presuppose that IPO pricing outcomes are afunction of the two major disclosure items. Such a structure assumes exogenousdisclosure. However, there is always the possibility that declarations on riskfactor 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 EuropeanJournal of Finance offers guidance on how listing firms' disclosurepractice shapes investor demand, final offer price determinations, IPOunderpricing, after-market return volatility, stock liquidity, and longer-runreturns. The form and extent of voluntary disclosure exerts notable impact onmany of these dimensions. Investors might therefore wish to consider perusingthe content of prospectus pronouncements on risk factor and fund uses. My studyalso offers guidance for founders and entrepreneurs wishing to do IPO. Amongother things, disclosures that signal greater commitment, and thus detail on anissuer's real option plans, act in supporting more favourable pricing outcomes.Above all, the vibrancy and scale of the local IPO marketv amplifiesthe importance of my study's empirical findings on primary market disclosure.


i Paul B. McGuinness, 2019. Risk factorand use of proceeds declarations and their effects on IPO subscription, price"fixings", liquidity and after-market returns, TheEuropean 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, investorsapply shortly after prospectus release, with applications subject to ballot ifoversubscription occurs. For the book-built component, relevant banks collectinformation on investors' preliminary indications of interest in the run-up toprospectus release. However, determination of share allocations only occurs aslisting nears, and thus sometime after prospectus release [see Sherman andTitman (2002, Journal of FinancialEconomics, 63: 3-29) for discussion of the book-building process]. Theexception is where investor parties broker a contractual commitment ahead ofprospectus release, commonly known as a Cornerstone agreement. The relevantissue prospectus must offer detailed disclosure on such allocations. Fordiscussion of Cornerstone agreements and some of the related Exchangedisclosure requirements, see article byMcGuinness (Indian Management,February 2016).

iii For detailed discussion of the properties and characteristics ofexogenous 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 anyother IPO setting in 2018 (see PWC'sGreater China IPO Watch 2018, Page 6). HKEX has achieved this topranking six times in the period 2009-18 (see HKEX NewsRelease, 21/12/2018).

About CUHK Business School

CUHKBusiness School comprises two schools -- Accountancy and Hotel andTourism Management -- and four departments -- Decision Sciences andManagerial Economics, Finance, Management and Marketing. Establishedin Hong Kong in 1963, it is the first business school to offer BBA, MBA andExecutive MBA programmes in the region. Today, the Schooloffers 8 undergraduate programmes and 20graduate programmes including MBA, EMBA,Master, MSc, MPhil and Ph.D.

Inthe Financial Times Global MBA Ranking 2019,CUHK MBA is ranked 57th. In FT's 2018 EMBA ranking, CUHK EMBA is ranked 29thin the world. CUHK Business School has the largest number of business alumni (36,000+)among universities/business schools in Hong Kong -- many of whom are keybusiness leaders. The School currently has about 4,400undergraduate and postgraduate students and Professor Kalok Chan is the Dean ofCUHK Business School.

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