IPOs involve a great deal of uncertainty, which makes them risky. Thus, investors expect higher returns as compensation for the higher risk. However, there is a large body of evidence that demonstrates that, unless you are sufficiently well-connected (to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have underperformed the overall market.
Daniel Hoechle, Larissa Karthaus and Markus Schmid contribute to the literature on IPO performance with their March 2017 paper, “The Long-Term Performance of IPOs, Revisited.” Their original data set consisted of U.S. companies going public between January 1975 and December 2014.
After applying several screens (such as depositories, real estate investment trusts, closed-end funds, partnerships and low-priced stocks), the final sample consisted of 7,487 IPOs. While prior studies looked at the returns of IPOs in the first few years, Hoechle, Karthaus and Schmid analyzed IPO performance over varying time horizons, ranging from one to 40 quarters.
Following is a summary of their findings:
- IPOs tend to be high-beta stocks and have negative exposure to the value factor.
- The Carhart four-factor (beta, size, value and momentum) model explains IPO underperformance over three- to five-year post-issue periods.
- IPO firms continue to underperform over the first two years after going public—even when differences in size, book-to-market and momentum are accounted for.
- Underperformance peaks at a risk-adjusted -2.4% per quarter exactly one year after going public—translating to underperformance in the first year in excess of 10%.
- Underperformance gradually declines, becoming insignificant beyond two years after going public.
- The findings were robust to different asset pricing models (specifically, the Fama-French three-factor and their newer five-factor model, which includes profitability and investment).
- IPO underperformance substantially decreased after the internet bubble burst in 2000. While IPO underperformance stayed economically meaningful at 1.5% per quarter and statistically significant at the 1% level, even for five-year post-IPO periods between 1975 and 2000, there was no evidence of significant IPO underperformance beyond one year after going public post 2000.
The authors reported other interesting findings: