IPOs: The Third Year On
Jessica West, Giovanni Fernandez,
and K.C. Ma
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A
Jessica West virtue of capitalism is that capital
is an assistant professor is market driven to businesses
of finance at Stetson
with the most profitable, produc-
University in DeLand,
Florida. tive opportunities. In a perfect
jwest1@stetson.edu world, two firms with similar production
should have equivalent value, but they may
Giovanni Fernandez have different mixes of financing depending
is an assistant professor on each owner’s risk and return preference
of finance at Stetson
University in DeLand,
on capital. In this regard, an initial public
Florida. offering (IPO) is considered no more than a
gfernan1@stetson.edu funding or liquidity event. Private compa-
nies, having limited access to public capital,
K.C. M a often risk diluting their own returns in
is the Roland George
exchange for outside capital in order to grow
Professor of Applied
Investments at Stetson and scale the firm. As the “Oracle,” Warren
University in DeLand, Buffett, said,
Florida.
kcma@stetson.edu Families that own successful busi-
nesses have multiple options when
they contemplate sale. Frequently,
the best decision is to do nothing.
There are worse things in life than
having a prosperous business that
one understands well… If the con-
glomerate form is used judiciously, it
is an ideal structure for maximizing
long-term capital growth. With all its
excesses, market-driven allocation of
capital is usually far superior to any
alternative. Buffett [2014, p. 8]
Although the Oracle’s view is consistent
with the argument that the particular form
Summer 2017
of financing may be irrelevant, the general
public remains broadly enamored with IPOs,
which can be as addictive as the Wheel of
Fortune; rival investment opportunities rarely
produce such astonishing returns in a short
period of time. For that, the Oracle has a
stronger opinion:
You don’t have to really worry about
what’s really going on in IPOs. People
win lotteries every day but there’s no
reason to let that affect [your invest-
ment strategy] at all. You have to
find what makes sense and follow
your own course. If they want to do
mathematically unsound things and
one person gets lucky … it’s nothing
to worry about. You don’t want to
get into a stupid game just because
it’s available. Buffett [2016]
IPO ONE-DAY POPS
Ironically, several early academic studies
may have been responsible for the common
misperception that IPOs are, across the board,
great investments (Logue [1973], Ibbotson
[1975], and Ritter [1984]). Other than the
65% average one-day gain during the Internet
bubble period (1999–2000), IPO day returns
have averaged approximately 20% since
1961 in the United States, consistent across
the world exchanges. However, most of the
The Journal of Portfolio M anagement    137
 Exhibit 1
IPO First-Day Returns
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IPO “pops” happened on the day of the IPOs, which
is mainly a result of the “underpricing discount,” mea-
sured by the percentage change in the first-day closing
price and the IPO offer price (Exhibit 1). These returns
seem more speculative than those that can be explained
by theory. Such prosperity has been attributed to both
the issuers and the underwriters managing the IPOs’
process taking advantage of the information asymmetry
of the private companies.1 As a result, the IPO pop is
not quite as interesting or relevant, because it is merely
leaving owners’ money on the table, and the average
public investors miss out on the opportunity all together.
IPO FIVE-YEAR FLOPS
Perhaps a more meaningful issue is the long-
standing finding that IPOs have underperformed their
benchmarks for as long as five years after issuance. For
the 74 years between 1935 and 2008, though not in the
same order of magnitude, a number of authors found a
consistent pattern of underperformance in IPO returns
as significant as 20% –30% for the three-to-five-year
period after their issuances. However, the long-term
underperformance should not be hastily dismissed as
the result of the previous one-day pops because doing
so would not make economic sense. An efficient capital
market would not allow an asset class with consistently
abnormal returns to exist over the long haul; simple
arbitrages would eliminate any known or persistent risk-
adjusted excess returns, positive or negative.2
The conventional argument attributes the under-
performance to various forms of market frictions. The
underperformance develops as a result of prolonged
information asymmetry that gives some investors a
competitive advantage that is often manufactured by
138    IPOs: The Third Year On Summer 2017
the owners and underwriters. The typical methods
include, for example, lockup options (primarily con-
sidered defensive arguments to avoid the controversial
Commissions, Laddering, Analyst conf licts of interest,
and Spinning (CLAS) prior to IPO releases),3 the 60-day
post-IPO cool-off period, the up-to-two-year lockup
period, private equity pull outs, and the resolution of
the information asymmetry.
WHY SHOULD IPOS BE DIFFERENT?
The consistent evidence that IPOs underperform
in the long run begs an obvious question: Why should
IPOs be singled out and expected to perform differently
from seasoned stocks? After initial hurdles are met in
the first year, an IPO transforms into a seasoned stock.
Consider that going public, or initiating the IPO pro-
cess, signifies an important rite of passage in the life of
a young company. Rational owners should constantly
weigh the costs and benefits of staying private versus
going public.4 Such a decision should inherently depend
on whether the public shares would be worth more than
the private shares. The reverse works for owners who
decide to go private. On that front, one plausible expla-
nation for potential underperformance is that IPOs on
average are overvalued relative to comparable firms and
can be expected to grow much faster than comparable
seasoned firms.5 Therefore, underpricing is an oppor-
tunity cost to firms that want to go public.
To find the costs and benefits of going public, or
initiating an IPO, we draw on the previous research and
existing theoretical framework of other experts in the
field. Ritter [2011] estimated that the direct cost of IPOs
is around 7% of the net proceeds. Additionally, for the
first-day-18% return and 30% outstanding shares sold
 Exhibit 2
Post-IPO Long-Term Returns
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during IPOs, the opportunity cost that issuers leave on
the table is around 9%. Why would a company choose
to go public if the costs are so high? Some obvious rea-
sons include the desire to raise capital, to allow current
shareholders to cash out, to have publicly traded stock to
clarify the firm’s valuation, and to provide a currency for
making stock-financed acquisitions. Many companies
are acquired shortly after going public.
The opportunity to tap the public market for
equity capital is the most convincing argument about
why firms would go public—especially firms with
high-growth prospects but with limited access to other
financing alternatives because of high leverage and
transaction costs (Kim and Weisbach [2008]). Although
this argument is consistent with minimizing the cost
of capital and maximizing firm value (Modigliani and
Miller [1963]), the availability of capital is more impor-
tant than the cost of capital for an aging private com-
pany that exhausts all the capital from private sources.
A related argument is the liquidity benefit of being pub-
licly traded. For example, firm managers benefit from
control and inf luence over investment decisions despite
potential disagreements with shareholders. However,
firms prefer to deal with outside shareholders versus
suppressing inside shareholders. Therefore, there is an
obvious tradeoff between the benefits of corporate con-
trol and the cost of liquidity. The role of the IPO is to
establish a price/value for a firm as a base to provide
public market liquidity (Amihud and Mendelson [1988]
and Boot, Gopalan, and Thakor [2006]).
When a firm is public and widely held, investors
may be less informed than insiders and information may
be costly to obtain. Thus, investors are less informed
than the issuers about the true value of the companies
going public. As a result, investors are concerned that
Summer 2017
they may be buying a lemon, which could stall or derail
the IPO altogether. Investors may disagree over com-
pany quality and offer price prior to the IPO, and they
may have disputes over strategy throughout the public
life of the firm (Brealey, Leland and Pyle [1977]).
The cost of sequestering duplicate information is
usually paid by a large number of investors in public
firms. It can be reduced by the availability of a public
price that conveys information to all investors so that
only a fraction of the investors will incur the informa-
tion production cost (Chemmanur and Fulghieri [1999]).
Similarly, the public market provides a tradeoff between
duplicate information costs and the benefits from the
useful signals from serendipitous information, aggregated
from the diverse information that stock market investors
collect randomly (Subrahmanyam and Titman [1999]).
A more novel idea is to suggest that IPOs are a
prelude to future takeover activities (Zingales [1995],
Brau, Francis, and Kohers [2003], and Brau and Fawcett
[2006]). An IPO can serve as the first step toward selling
a company at an attractive price through a takeover.
Similar to the capital market access argument, IPOs
create public shares for a firm that may be used as
currency in acquiring other companies, such as being
acquired in a stock deal.
The IPO is a complex process, and to this point,
most of the previous empirical studies emphasized the ex
post explanation of the empirical irregularity. We would
like to propose a positive model that will predict the
time-varying risk and returns over the life of the equity.
AN OPTION TO GO PUBLIC
Inevitably, company owners face a crucial decision
with regard to strategy over implementation of the best
The Journal of Portfolio M anagement    139
 business platform and discretion on sources of capital,
given a variety of choices. At any given point in time,
business owners have the option to either go public or
stay private (with non-negative values), and vice versa.
When a firm is private (public), the going-private
(-public) option value is zero. The equity in a firm,
public or private, is a residual claim on profits, assuming
the firm is liquidated and all outstanding debts and other
financial claims are paid off. Thus, it is customary to
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consider that the stock is a call option on the firm’s
liquidating value, with an exercise price on outstanding
debts. As private firms always have an option to go
public and public firms an option to go private, the
decision to initiate an IPO may be valued as a call option
to maximize the equity share values.
Entrepreneurs start their businesses with family
capital to test their products. Despite very small odds, a
young business may become profitable and generate high
“entrepreneurial” returns. Soon enough, before private
returns start diminishing, some form of external capital
is sought to maintain the owner’s returns. Unless one
is Warren Buffett,6 everyone thinks short-term. Private
firms often claim they are in business for the long haul.
But it is only rational, in maximizing firms’ value, to be
eventually out in the public market within 5 to 10 years.
When owners wish to cash out their financial
interests, they usually consider public company mergers
and acquisitions. When a private company’s profit-
ability is constrained and the company needs to scale
up, seeking outside capital or a public offering often
makes sense. To this end, access to the public capital
market and increased liquidity are the two major ben-
efits for the original private shareholders. However, this
has to be accompanied by giving up some ownership to
gain access to the public capital market. In other words,
owners are forced to share the entrepreneurial returns
and their private shares become diluted.
However, there is a price to pay for the owners
to access the public capital. Because insiders are always
more informed, including outside shareholders will
reduce the risk premium originated from the infor-
mation asymmetry. On that count, the public shares
are expected to produce lower returns than the private
shares. Rational owners constantly weigh the costs and
benefits of staying private versus going public, and it
is in their best interest to restore the risk premium by
creating some artificial information asymmetry along
with the process of initiating the IPO.
140    IPOs: The Third Year On Summer 2017
A standard exception would include a firm not
publishing research reports or releasing information
during the 25-day quiet period after a deal has been
completed.7 In addition, IPO firms often voluntarily
pull back the offering information just weeks prior to
the IPO dates, amid “potential shareholder litigation.”
Further maneuvering involves firms allowing under-
writers to stabilize deals—that is, to buy shares of an
IPO to boost its price, up to 30 days after a deal under
SEC rules. After firms file the required S-1 reports with
minimum information for the SEC registration, it is a
common practice for the companies to only release year-
to-year financial statement comparisons to the general
public, even after the quarterly information is available.
This situation allows firms to delay release of prior year’s
reports up to another three quarters. The design of the
up-to-2-year lockup period—which prevents insiders
such as owners, private equity backers, and investment
bankers from selling their shares—can be considered a
way to prolong the information asymmetry.
However, a maneuver of restoring information
asymmetry through the investment banking process
is, at best, transitory because all firms are required to
follow regulations, laws, or prospectus disclosures that
have prespecified, short timelines. The rationale is that
efficient outside investors will price in the net reduction
of information risk premium, because they realize that
they will inevitably become more informed through
increasing analyst coverage, monitoring, and market
scrutiny. Therefore, one would predict that the public
shares, in their early issuing stage, or IPOs, will under-
perform their counterpart seasoned public shares. This is
consistent with the stylized empirical findings that IPOs
underperformed in the first few years of their issuances.
On the other hand, the interplay of higher entrepre-
neurial returns and lower information risk premium will
eventually play out. After the “growing pains” in the
short run, most young IPO firms should still be able to
produce higher entrepreneurial returns so to start out-
performing the market. At this point, there is not yet
any empirical finding showing IPO outperformance.
Given the extensive existing research literature on
post-IPO long-term performance, we are not joining
the debates on the rationales or their significance. As a
practical matter, our study is restricted by the general
lack of private company data before going public and
public company data after going private. Consequently,
we focus more on the IPOs’ performance two years
 after their issuance. We believe it is more interesting
that most of the institutional restrictions have been
lifted and information asymmetry has been resolved.
Provincially, young stocks have finally traded in a reg-
ular market environment, which allows us to assert some
economic sense.
For the 90-year period between 1926 and 2015,
with over 35,000 IPOs, we uncover new evidence that
IPOs have outperformed their counterparts by 5% a year
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from the third year on. Accompanying the underperfor-
mance in the first two years, the result is consistent with
the argument that young companies need to dilute their
private share returns as a “one-time price” to pay for the
access to the public capital market. The added liquidity
will enhance the new firms’ growth and the entrepre-
neurial public returns. In the following sections, we
will describe the empirical procedures for the findings.
EMPIRICAL DESIGN
To this day, the empirical procedures to examine
the IPOs’ return performance have been well developed.
We select the most appropriate methods used in most
recent studies to answer the questions we posit in
this study.
THE U.S. IPO UNIVERSE
One consensus among previous authors is that
the measurement of IPOs’ long-term performance is
extremely sensitive to both the sample firms and the
time period used in the studies. The reason is that firms
from the same industry tend to ‘IPO’ during the period
when the industry is doing better than the general
market. Because all publicly traded stocks have at least
one IPO, the entire historical U.S. stock universe, live
or dead, is the IPO stock universe. Thus, to avoid the
industry clustering and sampling bias issue, we elect to
use the entire U.S. stock universe for our study.
To that end, we start with any publicly traded
stocks with price history from the usual academic
databases—CRSP, COMPUSTAT, and DataStream—
and industry databases such as Morningstar, Thompson
Reuters, Bloomberg, and the OTC. The time period in
our study is 1926 to 2015, and we identified all 67,260
stocks traded during that period. For reasons that will
soon be clear, the initial universe includes the price
history of both currently live (54%) and historically dead
Summer 2017
(46%) stocks. As of the end of 2015, the live stocks were
actively traded and the dead stocks were not.
Following the standard procedures used in pre-
vious studies, we further narrowed down the IPO stock
universe based on the following criteria: (1) the stock
must have an identifiable IPO date, (2) the first-day
close price or offer price has to be at least $1.00, (3) the
stock has to be traded for at least 2/3 of the first five-year
period, and (4) the stock has to be a true first-time ini-
tial public offering, rather than a seasoned or secondary
offering, nor a result of change in corporate control, such
as a merger and acquisition or restructuring.
The dataset is further “scrubbed” for accuracy in
the following ways. First, when prices on the same stock
come from different sources, these prices are verified for
consistency and accuracy. Even though the number of
errors in price data is relatively small, mainly from typos,
the magnitude of these errors on the return computations
would be enormous if not corrected, often in the order of
a million times. Second, if the stock is listed on multiple
exchanges, only one price, the primary issue, is used.
Third, because we include over-the-counter (OTC)
stocks, great care has been taken to make sure that the
OTC IPOs were not a result of the falling angels delisted
from the major exchanges. For stocks delisted from the
major exchanges and moved onto the OTC, we recon-
nect the price history between the two in order to correct
for survivorship bias, which we discuss later. Between
the number of stocks outstanding in the past year and the
number of stocks newly issued, we are able to estimate
the number of stocks that ceased trading (not delisted).
In Exhibit 3, the final stocks included in our study
are summarized. On average, there were 7,906 active
stocks traded during a typical year, 7,540 new IPOs, and
7,144 IPO stocks with an offer price above $1.00. Starting
in September 2011, the number of stocks increased across
the board significantly as the OTC data became avail-
able to academics. Notably, there was a significant varia-
tion in the number of new issues coming to the market,
consistent with the issuers’ timing based on the prior
industry performance. A more stable delisting pattern
appears to be a result of general stock market movements.
EVENT-TIME VERSUS CALENDAR-TIME
PORTFOLIOS
The issue of selecting the relevant time point is
nontrivial. The standard “event-time” methodology
The Journal of Portfolio M anagement    141
 Exhibit 3 Exhibit 4
IPO Universe Percentage of Dead IPOs
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uses the IPO months as time zero, and the subsequent

return is averaged across all IPOs, obviously at different
historical calendar-time points. Because most IPOs have
been clustered over time, this approach may introduce
some biases in hypotheses testing. A wealth index is first computed for each stock
by comparing the current price by the IPO first-day
close price and averaging the index across the stocks.
BUY AND HOLD VERSUS The latter approach is often preferred because it com-
EQUAL-WEIGHTED RETURNS pounds the returns on the stock level. Though the
Tracking stock performance is always a tricky arithmetic return is known to bias the true return by
issue. The technology has been well developed in the understating (overstating) the negative (positive) returns,
IPO literature. In Equation 1, an arithmetic portfolio both measures suffer the same implementation issue of
return index is constructed by first equally weighting all costly monthly rebalancing.
IPO monthly returns at the same point in time, event
time or calendar time, and subsequently compounding SURVIVORSHIP BIAS
the average return over time:
Perhaps the word “survivorship” has originated
 from IPOs. Young firms are notorious for their fragile
m
 P
n

EWR t = ∏  1 + ∑  it − 1  (1) life. Approximately 37,000 “dead” stocks have ceased
t =1  i =1  Pit −1  trading (Exhibit 4). Nearly 45% of this attrition was
due to involuntary unfavorable fundamentals, such as
Pit : price of stock i at month t since IPO financial distress, bankruptcy, or poor market condi-
n: number of IPO stocks tions because of failure in reporting or nontrading, while
m: number of months since IPOs. 55% of the dead stocks were associated with voluntary
changes in control, such as liquidation, mergers and
For comparison, Equation 2 constructs a buy-and- acquisitions, or exchanges. In Exhibits 4 and 5, the
hold portfolio index: average public life of an IPO is around 11.3 years, while
the majority ‘died’ within five years. As expected, there
n
 Pit  1 is a relatively high attribution rate for young firms. IPO
HRRt = ∑  P  (2)
i0  n
i =1 firms have a 10% chance of failure by the end of the first
year, 25% chance of failure by the end of the second year,
Pit : ith stock close at month t since IPO. and 50% chance of failure to the five-year anniversary.
Pi0 : close price of the first trading day. In contrast, while there is a 54% chance that a one-year

142    IPOs: The Third Year On Summer 2017

 Exhibit 5 Finally, for all stocks whose prices become unavailable,
Number of Live IPOs and if the stocks were still within the first five-year
period after their IPOs, the remaining return data points
were “filled” in with the assumption that the stock
returns would be reduced at annual rates of 33%, so that
the stock value would go to zero after the three years of
untraceable delisting outcomes. Unlike previous studies
that assumed the delisted stocks would have market per-
formance with a zero excess return, our treatment is
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more conservative by building in the natural demise of

dead stocks.

RISK-ADJUSTED PROCESS

One of the major reasons to account for the sig-

nificant inconsistencies in the magnitude of the post-
IPO long-term excess returns is the various risk-adjusted
old company will not survive the following five years,
procedures authors used. Most authors elected to use the
a 20-year old company has less than a 5% attrition rate
standard asset pricing models, such as the Capital Asset
for the same time period.
Pricing Model (CAPM) or versions of Fama–French,
For those firms that expired early, the subsequent
momentum, or liquidity risk factor models to adjust for
change in values after delisting is nontrivial. Stocks that
the systematic risks in the expected returns. However,
involuntarily delisted experienced drastic drops in value
we do not think that these conventional risk-adjusted
subsequent to the delisting. The average payoff values
procedures are sufficient to account for IPOs’ risk and
for bankrupt stocks have been in the order of 10%–15%
return tradeoffs. Similar to old companies in financial
of the last trading levels. For firms fortunate enough to
distress or in bankruptcy, the volatility or the risk of new
migrate from the major exchanges to the OTC markets,
young firms is mainly attributable to company-specific
“first print” prices were usually at around a 30% discount
idiosyncrasies, rather than the standard systematic
of the last trade prices. On the other hand, for stocks
market related risks.
that delisted voluntarily because of mergers and acquisi-
To illustrate the merit of this argument, we esti-
tions or going private, estimated subsequent shareholder
mate the average Fama–French, momentum, and
returns amounted to a 20%–30% premium over the last
liquidity risk factors (Equation 3 in the next paragraph)
publicly traded prices on the exchanges. However, we
for stocks the first two years out and then three to five
do not infer that the wealth effect between the different
years after their IPOs. The average risk factors across all
delisted groups will cancel each other if survivorship is
stocks in the two periods are summarized in Exhibit 6.
left unchecked. In fact, because there is a higher chance
Other than the size factor, which is consistent with the
that IPOs will be delisted and the resulting changes in
fact that most IPOs are small-capitalization stocks, the
values will be significant, the performance measurement
comparisons suggest that the systematic risk factors are
of the surviving stocks will be seriously overstated.
significantly lower in the first five years after the IPOs.
In our study, we elect to correct for the positive
In other words, the conventional measures of systematic
selection and survivorship bias inherent in the IPO
risk are less important for young public firms, espe-
universe using several procedures. For firms being del-
cially in the immediate time periods following the IPOs.
isted, every effort has been made to link the price data
This finding emphasizes the importance of diversifica-
from exchange to exchange listings in order to pre-
tion in IPO portfolios, including an adjustment of the
serve the longest live price history. For stocks that did
idiosyncratic risk more prevalent in the young stocks.
not have data available after the delisting, the resulting
In the absence of finding a convincing model to
valuation outcomes, if available, were identified—albeit
price the idiosyncratic risk, and being able to compare
liquidation, merger and acquisition, or bankruptcy.
our findings with previous studies, we reluctantly follow

Summer 2017 The Journal of Portfolio M anagement    143

 Exhibit 6
IPO Systematic Risk Models

Note: *** and ** represent the 1% and 5% significance levels.

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the typical procedures used in the existing literature. and

Therefore, we estimate both the traditional CAPM as
n m
in Equation 3. For verification, we also construct a five- 1
CAR1t = ∑ ∏ (1 + εit )
factor model (FFSC) using Fama and French’s [1993] i =1 t =1 n
market risk, value risk, and size risk factors, Carhart’s
n m
[1997] momentum factor, and Pástor and Stambaugh’s 1
CAR2t = ∑ ∏ (1 + δit )
[2003] liquidity risk factors, as specified in Equation 4: i =1 t =1 n
Rit − R ft = α i + βi ( Rit − Rmt ) + εit (3)
EVENT-TIME VERSUS CALENDAR-TIME
Rit : Return on stock i for month t PORTFOLIOS
Rft : Risk free rate for month t
βi : Beta of the stock i In Exhibit 7, we first report the results for stock
Rmt : Market return returns over the same time period after their respective
IPO events. The first-year and second-year stock excess
and returns, subsequent to their IPOs, averaged around -1.1%
and -7.71%, with the equal-weighted portfolio returns
Rit − R ft = α i + βi ( Rmt − R ft ) + si SMBt + hi HML t lower than the buy-and-hold returns as expected.
Although our finding of IPOs’ early underperformance
+ miUMDt + li LIQt + δit (4)
is similar to most previous studies, the magnitude of
the negative excess returns is in the same order of the
where Rmt - Rft is the market excess return for month t,
findings reported by Ritter [2011], a more recent study
SMBt is the size risk premium, HMLt is the value risk
that has a slightly shorter time period (1980–2008) and
premium, UMDt is the momentum risk premium, and
a smaller sample size of 7,314. Moreover, the underper-
LIQt is the liquidity risk premium. The risk factors in
formance is robust regardless of how the performance
Equations 3 and 4 are estimated over the first five years
return is measured or how the return is risk adjusted.
of the IPOs. The conventional cumulative abnormal
However, the more fascinating result is on returns
returns CAR1 and CAR2, in equal-weighted basis and
from the third year on. While the third-year raw return
buy-and-hold basis, are calculated by compounding the
averaged 17%–18%, the excess return is between +1.74%
two monthly excess returns estimated using εit and δit
and +5.71%, statistically significant at the 1% level.
from Equations 3 and 4 in the following manner:
A similar pattern emerges in the fourth and f ifth
years. In Exhibits 8 and 9, the cumulative abnormal
m
 n
ε 
CAR1t = ∏  1 + ∑ it  returns are presented over the five-year period after
t =1  i =1 n  the IPOs. On average, although the stocks underper-
formed 7% –9% the first two years, they outperformed
m
 n
εit  risk hurdles by somewhere between 15% –20% in the
CAR2t = ∏  1 + ∑ n
t =1
 following three years. All in all, IPOs outperformed
i =1
their risk benchmarks by a minimum of 5% over the

144    IPOs: The Third Year On Summer 2017

 Exhibit 7
Event-Time Post-IPO Annual Returns
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Note: T-statistics in the parentheses; *** and ** represent the 1% and 5% significance levels.
Exhibit 8
Event-Time Buy-and-Hold CARs
five years after their issuances. If this pattern holds,
we begin thinking differently about IPOs.
To show further robustness, we replicated the same
event-time tests in various 10-year calendar-time subpe-
riods. The findings are summarized in Exhibit 10. The
qualitative result is remarkably consistent across most
subperiods. From the third year on, the negative excess
returns stubbornly reversed to positive returns.
We further test the “third-year and on returns”
using the calendar-time approach. In this case, we iden-
tify stocks that were first issued during the previous
48-month period. A fifth-year annual portfolio return
index is computed by averaging the next 12-month
Summer 2017
returns for stocks issued four years ago. A fourth-year
return is also constructed for stocks issued three years
ago, and so on. Under the same calendar-time basis,
the next 12-month returns for the current month IPOs
become the first-year return index. Finally, the one- to
five-year return index is obtained by averaging over all
calendar months over the entire time period. Exhibit 11
shows the annual risk-adjusted excess returns for each of
the five years after the IPOs using a calendar-time basis.
In comparison to the event-time approach, in gen-
eral, the magnitude is less extreme in that the excess return
is f lat or around a slightly negative -1% to -2% for the
first two years and +10% for the remaining three years,
We note that the difference in magnitude between the
two approaches is understandable. Because most IPOs are
time clustered in the same industry, the calendar-time
portfolios are inevitably affected by the sector risk,
which is not fully accounted for. Exhibit 12 shows the
excess returns associated with five individual annual
intervals over the calendar time. Exhibits 13 and 14 also
demonstrate the time-series patterns of the cumulative
abnormal returns on a calendar-time basis. Although it
is seemingly more volatile over time, we still can draw
a similar qualitative conclusion that IPOs outperformed
from the third year on.8
LOTTERY-LIKE IPO RETURNS
On the other hand, we are still puzzled by the
“consistency” found in this study and many previous
The Journal of Portfolio M anagement    145
 studies showing that at least for the first two years,
IPOs underperformed. It begs a simple question: why
does the underperformance still exist to this day? Or,
why would anyone invest in IPOs during the first two
years, knowing that they will most likely deliver a subpar
performance? An intuitive answer is that investors may
reckon that investing in IPOs is fundamentally synon-
ymous with playing a high-stakes lottery—paying to
play for extremely high potential returns with extremely
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small odds.
To get some insight on this issue, we compare
the return distributions between IPOs and seasoned
stocks. In Exhibit 15, Panel A, IPO monthly return
Exhibit 9
Event-Time Equal-Weighted CARs
Exhibit 10
Event-Time “Third-Year Returns” in Subperiods
Note: *** and ** represent the 1% and 5% significance levels.
146    IPOs: The Third Year On Summer 2017
distributions are classif ied based on the particular
year since the IPOs. Using the buy-and-hold index,
we show that the 99th percentile IPO in a year pro-
duced over 2,770% in the first year, compared with
the average return in the same 99th percentile of 288%
(Exhibit 15, Panel B). Further, the 288% return from
the top 1% IPO performers is approximately 29 times
the average U.S. stock annual return. Other than the
fact that extreme IPOs produced nearly 10 times the
returns of the average (extreme) stocks, along with
sharp declines in the superior returns over time, they
indicate the lottery nature of the early IPO market.
However, caution should be taken against overgeneral-
izing, as the IPO extreme return multiples drastically
dropped off just a few years out of the gate.
Collectively speaking, we have found stellar and
emerging evidence for the first time that IPOs have
excess returns after the second year—which challenges
the widely held idea that IPO returns are negative. More
specifically, IPOs, as a group, reverse their first two-
year stock return losses into gains in the following three
years. For the five years after going public, IPOs have
mildly outperformed their benchmarks. The reversal of
IPO returns is consistent with many hypotheses we pos-
ited. It may simply be a result of the information asym-
metry created during the IPO process finally dissipating
over time. It is also consistent with the argument that
the early loss in public shares is the one-time “price” the
private owners pay, in the form of public scrutiny, to get
access to public capital markets. As a result, the capital
 and liquidity enable the young firms to grow at higher
rates and produce positive excess stock returns.
A more elegant explanation is that the reversal of
IPO returns is also consistent with the notion that the
decision to initiate IPOs, or go public, is the exercise of
the call option on the private value of the firm. Imme-
diately after the IPOs, the option to go public is replaced
with an option to go private. The going-private option
is valued near zero, just because the likelihood of going
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private right after going public is near zero by definition.
However, a fundamentally outperforming young firm
with stock market undervaluation will create positive
Exhibit 11
Calendar-Time Post-IPO Annual Returns
Notes: T-statistics in the parentheses; *** and ** represent the 1% and 5% significance levels.
Exhibit 12
Calendar-Time “Third-Year Returns” in Subperiods
Note: *** and ** represent the 1% and 5% significance levels.
Summer 2017
value on the option to go private, which helps explain
why the IPO stocks start turning around “later” in
the game.
Similarly, our finding is consistent with the notion
that the likelihood of going private can be predicted
at the point of the IPOs. Bharath and Dittmar [2010],
using a number of factors that were available at the
time of IPOs, were able to predict over 80% of the
future going-private decisions. On average, more than
two-thirds of the IPOs that eventually go private will do
so before the 13th year of their public life. It is reasonable
to assume that the first two-year underperformance has
The Journal of Portfolio M anagement    147
 Exhibit 13
Calendar-Time Equal-Weighted CARs
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been a result of the low probability that the majority of
the new IPOs will go private.
UNDERSTATING INDUSTRY EFFECT
Our evidence may appear to be at odds with the
majority of the previous findings that there is a long-
term post-IPO underperformance (Exhibit 2). Because
the difference could be academic, it warrants some
academic discussions: First, as many previous studies
illustrate, as well as Exhibits 7 and 11, the conclusion
can be very sensitive to the sample and the specific
time period used in each study. The common reason
cited is that the IPOs, concentrating in one industry,
tend to cluster one industry at a time. This clustering is
also a result of issuers timing the issuances at the peak
of the seasoned stock performance. Because there is a
documented industry effect, it is reasonable to expect
that there is a horde of new issuances from a similar
industry near the peak of industry performance. Fol-
lowing through with the same argument, we would
also expect that the subsequent industry reversion alone
will produce the post IPOs’ underperformance, if the
industry effect is not accounted for in the risk model. In
almost all of the previous studies, the industry effect was
not accounted for in the risk model. Not surprisingly,
when Gompers and Lerner [2003] included an industry
factor in the risk model, the negative excess returns dis-
appeared. Our study, covering the entire 90-year IPO
universe, is not a concentrated industry sample. Thus,
the result is less affected by this bias.
148    IPOs: The Third Year On Summer 2017
Exhibit 14
Calendar-Time Buy-and-Hold CARs
OVERSTATING RISK RETURNS
The less-pronounced negative excess return per-
formance in the first two years could also be explained
by the different risk-adjusted procedures used. Most pre-
vious studies elected to use a matching risk factor sample
to compare with the IPO sample. That is, each IPO stock
was assigned and compared with one of the 25 Fama and
MacBeth [1973] value/growth and large/small portfo-
lios. The expected or risk-adjusted returns were esti-
mated using the ex ante systematic risk profile of IPOs.
As shown in Exhibit 6, the ex post risk factors of early
IPO years are 10%–50% significantly lower than in the
later years. This, in turn, implies that the matching risk
procedure would have overestimated the risk-adjusted
returns, or underestimated the excess returns.
An additional confirmation is that Ritter [2011]
found that the equal-weighted returns for the IPOs
were -4.8% for the first year, -8.1% through the second
year, and -3.3% through the first five years. In his own cal-
culations, Ritter shows that the excess return between Year
3 and Year 5 should be around +4.8%, which is remarkably
close to the same order of our estimates. We are pleased to
see that Ritter—who has an almost 30-year career as the
leading authority on IPOs—said the following:
I have expressed support for the view that there
is little evidence that IPOs underperform in the
long run relative to other companies with sim-
ilar characteristics, except for the sunsets of small
companies (Ritter [2011, p. 28]).
 Exhibit 15
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In addition, the more encouraging message from
our results is that there appears to be no inefficiency in
the IPO market as is often implied in previous studies.
Many sensible arguments are offered to explain the
IPOs’ persistent initial underperformance and subse-
quent rebounds, which result in a reasonably muted
mispricing over the entire five-year period; this is not
considered a prolonged time interval to value the effi-
ciency of an asset class. Even for the most aggressive
investors, investing in the first two-year IPO market,
with an expected 7% annual excess return but 200 times
the top 1% IPO performance relative to the benchmark,
should be fundamentally synonymous with playing a
high-stakes lottery—a paradigm that jives with previous
research on IPO negative returns.
A BRANDING EVENT OR A FUNDING EVENT
Rational owners make calculated decisions at all
times to increase their public or private share values.
Such decisions are invariably linked to the timing of
changing the form of business—that is, the timing to
go public (private). Therefore, the initiation of an IPO
symbolically declares the rite of passage for a young firm
gaining access to public capital markets or, more impor-
tantly, signals that public shares will be worth more
Summer 2017
than the otherwise private shares. This line of reasoning
would suggest that a positive stock return resulting from
such a branding effect should follow the IPO.
During a typical life cycle, businesses raise capital
first from friends and families, followed by venture
capital, private equity, public equity, and back to pri-
vate equity, in that order. An IPO should be no more
than a funding or liquidity event, subject to market con-
ditions, just like any other seasoned issuances. In that
sense, IPOs’ underperformance due to the dilution after
the IPOs’ issuances are understandable. Moreover, the
impact of funding events should be temporary—and
it should be reversed after two years. This long-term
investment prospect for IPOs is our most significant
finding.
Although the initial returns on IPOs appear disap-
pointing with underperformance around -5% for the
first two years, one may consider it an entrance ticket
price for private owners to “pay to play” in the public
capital market, which some widely regard as a lottery.
However, the more interesting finding is that IPOs were
able to recoup more than their previously realized losses
from the third year on. On average, IPO stocks outper-
formed their counterparts by 5% a year from the third
year on and, in total, by a modest +6% excess return
over the entire five-year period.
The Journal of Portfolio M anagement    149
 ENDNOTES
The authors thank the Business Foundation at Stetson
University for its financial support. The research assistance
from Gonzalo Baudet and Christopher Landers is acknowl-
edged. The usual disclaimers apply.
1
Ljungqvist [2007] provided a comprehensive review
on the underpricing discount.
2
Ritter and Welch [2002] were somewhat surprised that
the anomaly still existed after Ritter’s [1991] published study.
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Later it became the basis for Gompers and Lerner’s [2003]
study on a pre-NASD sample, and they concluded the same
result of underperformance.
3
Underwriters usually insist on lockup agreements
when managing IPOs. These agreements prevent corporate
insiders from selling their private stock for a set period fol-
lowing the IPO. The lockup period can vary, but is normally
180 days. During this time, owners of private stock must hold
onto their shares. Some states require lockup agreements,
and the SEC mandates that the issuer publicly disclose the
terms of the lockup agreement. After the lockup period ends,
corporate insiders can sell their shares to the public.
4
Bharath and Dittmar [2010] did a comprehensive review
of theories about why firms go public. As there are no theories
of going private, they have reverse engineered a framework
from the going public models to predict firm’s going private.
5
Purnanandam and Swaminathan [2004] argue a higher
future growth prospect to support the relative values between
public versus private shares.
6
For the 50-year period between 1965 and 2014,
Berkshire has returned 1,826,163% to its shareholders, an
annual return of 21.6%, compared with the 9.9% S&P 500
total return (2016 Berkshire’s Shareholder Meeting).
7
The JOBS Act allows banks to publish research on an
IPO they are working on the day of the IPO or even ear-
lier. But banks, fearful of legal actions, wait exactly 25 days
before publishing.
8
Although, the calendar-time portfolio is more imple-
mentable, the number of stocks in the portfolio is around
5–10 stocks, which is less desirable than that needed for diver-
sifying the idiosyncratic risk often observed in the young
IPOs.
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