Conventional wisdom suggests that the presence of positive first day returns for initial public offerings (IPOs), documented for almost every capital market in the world, constitutes evidence of deliberate underpricing. A number of recent studies, however, appear to cast doubt on this long-established position. They show that firms that obtained a public listing during the 1970s and 1980s underperformed similar size and industry firms by as much as 29% by the third anniversary of their first day of trading. Such evidence has major repercussions to corporate financial strategists. First, it implies that judicious timing of the offering may provide significant savings in the cost of raising new equity finance. Second, it suggests that small firms tend to go public at the peak of their long-run performance and/or the public listing by itself may be considered by the original shareholders as the ultimate corporate objective. Third, it highlights the difficulties that some of the smaller firms are facing in making an effective transition from a private to a public company. The evidence of long-run underperformance, apart from the implications for the functioning of capital markets and the cost of raising funds for individual firms, is also central to the debate regarding the fundamental premise underpinning several explanations offered to account for the positive initial returns. If, for example, it is the case that firms choose to go public when investors are irrationally overoptimistic about the future potential of certain industries, then the significant returns in the early aftermarket may not necessarily be the result of intentional underpricing. The availability of a sizable dataset (712 IPOs in 1980-1988) from a different major capital market (the London Stock Exchange is the third largest equity market in the world) offers a unique opportunity to test the robustness of Ritter's conclusions and to shed some further light into a number of issues left unresolved by his study. Furthermore, the differences in institutional characteristics between the U.S. and UK markets allow for an independent test of the most prominent issues in the U.S. literature and the impact of the institutional setting on the performance of IPOs. The study also shows that initial public offerings in the UK underperformed a number of relevant benchmarks in the 36 full months of public listing following their first day of trading. However, cumulative adjusted returns for IPOs are still positive by the third-year anniversary of their public listing when first day returns are included. The evidence also suggests that initial return is not a good indicator of aftermarket performance; the 36-month performance of IPOs in the highest initial return group (above 24.7%) is notably worse than the equivalent performance of IPOs with modest initial returns. Moreover, the size of the offering emerges as an important determinant of long-run performance; large issues in the Main Market outperformed the smaller issues in the Unlisted Securities Market. In short, the UK evidence sheds light on a number of issues left unresolved by the U.S. studies. First, it demonstrates that the long-run underperformance of initial public offerings is not a phenomenon unique to U.S. new issues. Poor aftermarket performance emerges as a persistent feature of initial public offerings. Second, our results for IPOs in 1980-1985 suggest that the long-run underperformance extends beyond 36 months. This evidence, however, has to be interpreted with caution because of the marked changes in the actual composition of the sample that take place during prolonged test periods. A detailed analysis of subsequent changes in listing details (takeovers, bankruptcies, suspensions, transfers, etc.) may provide useful insight into the causes of the long-run underperformance of initial public offerings. Third, the apparent tendency for the firms with the highest initial returns to have the worst aftermarket performance together with the marginal long-run outperformance of firms with moderate first day returns, casts further doubt on the conventional belief that positive initial returns are entirely due to deliberate underpricing. The emerging evidence is more consistent with the proposition that while a certain level of first day returns is the result of intentional underpricing, marked deviations from this baseline level represent some form of market overreaction.
