Directors' Dealing and Post‐IPO Performance

• DOI: http://doi.org/10.1111/j.1468-036X.2013.12013.x
• Date: 01 January 2015
• Published date: 01 January 2015

Previous studies show that IPOs generate no or negative excess returns in the long run, despite their relatively high exposure to market risk and level of underpricing. This relatively low performance emanates from a combination of extreme differences of opinion among investors, costly short selling, and small public floats on many IPOs. In this paper, we contribute to this extensive literature by assessing whether the trading behaviour of insiders, defined as board members, affects IPO long‐run performance. We follow previous studies on insider trading (e.g., Seyhun, ; Lakonishok and Lee, ) and expect directors to know better the true value of their IPO than outside investors and their trades will be informative. Since IPOs underperform because of high information asymmetries (Ritter and Welch, ), we test the hypothesis that directors' trades increase the long‐run stock price accuracy and discovery by mitigating the relatively significant information asymmetries inherent in IPOs, thus leading to a more efficient long‐run pricing.

Huddart and Ke () argue that, in the case of insider trading, both Grossman and Stiglitz () price‐taking model and Kyle () imperfect competition model, predict that higher information asymmetry leads to more positive (negative) abnormal returns following buy (sell) trades, and, thus, higher returns to directors. Given the great uncertainty about the value of their IPOs, directors are likely to benefit from their trades if they hold perfect information, suggesting that their trades will only affect strongly stock prices if their information is precise and credible, and if outsiders have lower information about the value of the IPO. Therefore, in line with previous studies (e.g., Lakonishok and Lee, ; Jenter, ), we expect directors to adopt contrarian strategies by buying (selling) shares in under‐ (over‐) performing IPOs and those where they are net buyers (sellers) will generate positive (negative) long‐term returns. This post‐trade stock price behaviour will also be consistent with the agency theory framework (Jensen and Meckling, ) because directors' buy (sell) trades will lead to lower (higher) agency conflicts, and, consequently, to higher (lower) long‐term returns. However, if they trade for non‐private information reasons, such as liquidity and portfolio rebalancing considerations, or if they sell because the lockup has expired, then we expect weak or no relationship between insider trading and the long‐run returns of IPOs.

To test these hypotheses we construct a unique hand‐collected dataset of 830 UK IPOs containing all information from prospectuses and insider trading events, and assess their three‐year post‐IPO stock returns. We find contrasting results to our expectations as IPOs where directors are net sellers (Net Sell) generate positive returns, while those where they are net buyers (Net Buy) underperform substantially throughout the 36‐months post‐IPO period. We find similar results using the style‐adjusted, equal and value‐weighted cumulative abnormal returns, and the Fama and French () three‐factor model. Our regression results provide further support for these findings, as the coefficient of the net purchase ratio, NPR, defined as directors' net purchases over total transactions, measured in terms of trading value or volume, is negative and significant, suggesting that Net Sell (Net Buy) IPOs generate positive (negative) long‐run returns, even after accounting for the IPOs' fundamental factors.

We find that the directors' trades are not clustered around the lockup expiry dates; they are relatively evenly distributed across the 36 months sample period as the median number of years from the IPO date to the trading date is 1.45 years for both the Net Buy and Net Sell samples. We, thus, split our sample period into months 2 to 18 and months 19 to 36. We show that while the excess returns of Net Sell IPOs are positive in the first, but not significant in the second period, they are negative for the Net Buy IPOs in both sub‐periods.

We investigate further the causality of our results, the drivers of this asymmetric performance, the timing ability of directors, and the information content of insider trading, by assessing the market reaction to each individual trade. We find that the pre‐sell trades' excess returns are positive and significant. On the announcement date, share prices decrease, but, in the post trade period, they are mainly not significant, suggesting that directors time their trades by selling when they know that the price of their IPO is optimised. In contrast, for the buy trades, we find significant negative excess returns in both the pre‐ and post‐event periods.

We account for any look‐ahead bias in our results by running calendar time regressions with the Fama‐French calendar time 3‐factor model starting from the date of the trade rather than the IPO date. We expect the alpha of the buy (sell) trade portfolios to be positive (negative) and significant. We find similar results as the portfolio of Net Sell (Net Buy) IPOs earns positive (negative) alphas in the 3‐factor regressions. Our results imply that directors' trades are a response to past performance, but they are less likely to be based on insider information and to predict future returns.

Overall, our results are puzzling as they indicate that the stock returns following the sell trades are not negative, and, for the buy trades, they are negative and significant in the pre‐ and the post‐trade periods. Our results are not consistent with the information content of insider trading in seasoned firms documented in the previous literature (e.g., Seyhun, ; Lakonishok and Lee, ; Jenter, ). While the buy trades of directors in failing IPOs may be consistent with the price support hypothesis our results indicate that this aim is not achieved as the post‐trade returns are not positive, suggesting that directors do not reverse the performance, systematically make losses on purchases, and the market does not value their trades. Similarly, the sell trades are not undertaken when the IPO is expecting bad news.

It is difficult to rationalise why the IPO directors adopt such perplexing strategies. One explanation could simply be that directors sell when they know that their IPO has reached its optimal valuation, but that they purchase more stock in their underperforming IPO to avoid admitting failure implicitly, in line with the disposition effect in behavioural finance. While this may remain a possibility, we are not aware of other means of testing further this hypothesis. An alternative explanation for our results may be specific to IPOs. Huddart and Ke () argue that the impact of insider trading depends on two fundamental factors: the precision of the insider's information and the level of uncertainty in the marketplace regarding the firm's value. We consider that, unlike seasoned firms, in the case of IPOs, there is great uncertainty about the value of the firm, and the directors' signal is likely to be less precise, resulting in low excess returns, and thus lower informativeness and weak signal. Nevertheless, we find that Net Buy IPOs perform better than No Trade IPOs, suggesting that the former IPOs could have had a worst performance without the buy trades of directors. The Net Sell IPOs are likely to have low information asymmetries as they perform well before the sell trades, but their signal is also weak as the post‐trade returns are not negative, although the results suggest that these IPOs have reached their optimal valuation.

We contribute to two main areas of research that are not so far considered conjointly: IPO long‐run performance and insider trading. Since Ritter () documented the long‐run underperformance of IPOs, a number of studies have sought to link this intriguing performance puzzle to factors such as prestigious underwriters and venture capital (VC) backing (e.g., Brav and Gompers, ) and more recently to mergers and acquisitions activity (Brau et al., ). We show that the trading activity of directors can also explain this underperformance. Our regression results show that directors' trades are affected by the IPOs' long‐run returns, but not strongly by the previously documented signalling factors such as underpricing (Jenkinson and Ljungqvist, ), overhang (Mikkelson et al., ), reputation of underwriters (Carter and Manaster, ), venture capitalist (Brav and Gompers, , Krishnan et al., ), and private equity backing (Levis, ). Our results are also not consistent with the agency theory which predicts a positive relationship between ownership structure and IPO long‐run performance. Moreover, unlike previous insider trading literature, which focussed mainly on seasoned firms (See Korczak et al. () for recent review), we do not find, as in Lakonishok and Lee (), that insider purchases, not sells, are more likely to predict future stock returns, and insider trading informativeness is not affected by free float, and is not more pronounced in smaller firms or IPOs listed on the Alternative Investment Market (AIM), a relatively less regulated market for mainly small and high growth firms. Our results also do not support Marin and Oliver () who find that insiders sell up to 12 months before large monthly price drops, but buy one month before large price jumps, and Jiang and Zaman () who show that insiders' ability to predict future cash flow news, rather than their adoption of contrarian strategies, explains the predictive ability of their aggregate trades. Overall, our results are likely to be specific to IPOs but raise further the puzzle as to why the underperformance of IPOs does not revert after the directors' purchases and why IPOs do not underperform after their sell trades.

The rest of the paper is structured as follows. Section presents our data and the methodology. Section provides the empirical results, and the conclusions are in Section .

We first...