Initial Public Offerings in the Hospitality Industry: Underpricing and Overperformance

Cornell University School of Hotel Administration The Scholarly Commons

Articles and Chapters School of Hotel Administration Collection

10-1996

Linda Canina Cornell University, [email protected]

Follow this and additional works at: https://scholarship.sha.cornell.edu/articles

Part of the Hospitality Administration and Management Commons

Recommended Citation Canina, L. (1996). Initial public offerings in the hospitality industry: Underpricing and overperformance. Cornell Hotel and Restaurant Administration Quarterly, 37(5), 18-25.Retrieved [insert date], from Cornell University, School of Hospitality Administration site: http://scholarship.sha.cornell.edu/articles/673/

This Article or Chapter is brought to you for free and open access by the School of Hotel Administration Collection at The Scholarly Commons. It has been accepted for inclusion in Articles and Chapters by an authorized administrator of The Scholarly Commons. For more information, please contact [email protected].

If you have a disability and are having trouble accessing information on this website or need materials in an alternate format, contact [email protected] for assistance. Initial Public Offerings in the Hospitality Industry: Underpricing and Overperformance

Abstract Underwriters may view the primary issue of most hotel and casino stocks as more risky than stocks of new companies generally. Still, newly issued stocks of hospitality companies have generally outperformed the market in their first eary .

Keywords initial public offerings (IPO), hospitality companies, stocks

Disciplines Hospitality Administration and Management

This article or chapter is available at The Scholarly Commons: https://scholarship.sha.cornell.edu/articles/673 Initial Public Offerings in the Hospitality Industry—

Underwriters may view the primary issue of most hotel and Underpricing and Overperformance casino stocks as more risky than stocks of new companies generally. Still, newly issued stocks of hospitality companies by Linda Canina have generally outperformed the market in their first year.

number of initial public offerings of stock (IPOs) in hospi tality companies has increased sub stantially in recent years. From 1991 through 1994 an average of 16 hos pitality companies per year have gone public, compared to an average of just under seven hospitality IPOs per year from 1979 to 1990. In 1992 numerous restaurant chains went public, while casinos rushed to the market in 1993. What’s noticeable about these transactions is that for many of them the offering price is

18 HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY NANCE substantially lower than the first present the main theoretical expla market conditions, the firm’s specific day’s closing price in the secondary nations of IPO underpricing. These situation, and the policies of the market. The average initial-day re explanations provide a framework investment bankers underwriting turn for all hospitality issues is 16.32 for comparing underpricing and the issue. percent, as compared to 15.26 per long-run performance of hospital New issuers search for the best cent in the overall IPO market.1 ity-company IPOs with the overall underwriter and the most favorable That is not a large difference, but as IPO market’s performance. I analyze conditions possible. A firm that I will explain, certain industry seg the relationship of the initial-day wants to go public seeks the assis ments encounter considerable un return and risk with the long-run tance of an underwriter or syndicate derpricing. performance of IPOs. As an instruc of underwriters. An IPO is the re Moreover, on average, hospitality tive case, I also note the perfor sult of a match between the issuer IPO investors earn a higher first- mance of one of the most famous and the underwriter. The issuer year return than other IPO inves and successful IPOs in the hospital prefers the most prestigious under tors. During the period of my study, ity industry, that of Boston Chicken. writer possible—that is, a firm hospitality investors earned an aver known for bringing high-quality age excess return of 14.11 percent, Going Public companies to market. The under relative to the Standard and Poor’s Most companies get their initial writing firm’s notoriety provides a average of 500 stocks (S&P 500), in equity capital from a small number favorable signal to the market. Pres the year following the IPO. In con of investors.2 This form of financing tigious investment banking firms, trast, the average IPO return for the is relatively illiquid, however, as however, remain that way only by overall IPO market was less than the there is no ready market to accom carefully choosing the firms they return on the S&P 500. Examining modate those investors who later agree to underwrite, often refusing restaurant and lodging—casino IPOs wish to sell their ownership share of speculative issues. separately, lodging—casino IPOs are the company. If a company prospers Best efforts. The offering can underpriced more than the overall and needs additional equity capital, be made by either of two methods, IPO market, although the under its owners may eventually decide to “best efforts” or “firm commit writers considered to be above- sell stock shares to a large number ment.” In best-efforts contracts, the average in reputation underprice of investors in a public offering. issuer and underwriter negotiate an their IPOs by a smaller amount Compared to privately held invest offering price. The underwriter than underwriters who are less- ments, going public allows the com then uses its best efforts to raise all established. pany to raise capital on more favor of the desired capital at the negoti This paper analyzes the pricing able terms, makes capital more ated price, usually receiving a per and long-run performance of initial readily available, allows the original centage of the capital raised as its public offerings of stock in hospital owners to diversify their holdings, fee. If there is not enough demand ity companies, and compares those and provides management and at the established price, the offer is results to the overall market for shareholders with a gauge of the withdrawn from the market and the IPOs. This comparison is useful firm’s value based on the publicly issuer raises no capital. Moreover, it both to entrepreneurs who are con traded price. is unlikely that a second offering sidering making an initial stock By making the decision to go will be made at a lower price. The offering and to investors who might public, the would-be issuer of stock best-efforts offering minimizes the wish to purchase newly issued stock. is deciding to sell a portion of the risk faced by the underwriter and Sellers can use the information to firm. It stands to reason that the leaves most of the risk to be borne choose an underwriter and to evalu principals want to receive as much by the issuer. ate the performance of investment money as possible in return for a Firm commitment. In the banks in marketing and pricing share of the company. The price at more-common firm-commitment IPOs. Investors can gauge how to which the company can trade own offering, by contrast, the under maximize their expected return per ership for cash depends on overall writer guarantees that a specific unit of risk. I start by describing the amount of capital will be raised. In 2 For example, the New England Applebee’s process of going public and then franchisee started with an investor pool of two, effect, the underwriter buys all of the owner and one financial backer. See: Michael the stock issued at an agreed-upon 1 The initial-day return is the difference be L. Oshins,“‘Skip’ Sack and Applebee’s: How Pub price (with a price spread intended tween the closing price and the offer price as a Ventures Went Public,” Cornell Hotel and Restau percentage of the offer price, at the close of the rant Administration Quarterly, Vol. 37, No. 3 (June to compensate the underwriter) and first day of trading. 1996), pp. 55-63. is then responsible for selling it all.

October 1996 • 19 The underwriter may later reduce after the underwriter surveys the eral reasons have been proposed to the public-offering price to clear market and investigates the issuer, explain why a firm would willingly the market, but nonetheless delivers however, considerable uncertainty underprice its securities and thereby to the issuer the entire sum that remains about how the broad mar limit the funds received for selling was originally specified. In a firm- ket will receive the issue. The diffi a share of the company. The two commitment offering, then, it is culty in pricing arises from the fact main theoretical explanations are crucial to the underwriter that the that IPO firms, by definition, have the winner’s curse5 and signaling- initial price be set appropriately no price history. A final point re based models.6 * Both the issuer and the under garding the IPO process is that the Winner’s curse. The winner’s writer of an IPO must comply with investors who have the first chance curse model is drawn from auctions. the Securities Act of 1933, which at the stock are those who are in The highest bidder in an auction for requires disclosure of certain infor vited by the underwriter. The gen a given item is the participant who mation to potential investors and eral public is usually in a secondary places the highest value on the auc gives them the right to sue if there is position of buying stock from the tioned object. The winner’s curse misleading information or material investors who, in turn, purchased it proposes that the winning bidder omission of fact. The restrictions are at the offering price set by the un has an overly optimistic assessment stricter for offerings greater than derwriter. This point is important in of the object’s true value. By win $7.5 million in gross proceeds considering the potential gains of ning the auction, according to this (known as S-l offerings, after the would-be IPO investors. logic, one has overpaid for the item. code section that pertains to them) In the case of IPOs, the ability to than they are for those of less than IPO Underpricing purchase an allotment of shares may $7.5 million (S-l8 offerings). Offer While managers of a firm going signal that the stock is overpriced. ings of less than $1.5 million in public are eager to secure the high Otherwise, knowledgeable buyers gross proceeds are eligible for their est possible price for their stock, the would have subscribed the entire own treatment under the act’s underwriters of a firm-commitment issue. Regulation A, which involves even offering are likely to be cautious For stock issues, the winner’s fewer disclosure requirements. because they will be left with any curse concept is based on the same Regulations promulgated by the unsold stock if they overestimate idea that some investors are less Securities and Exchange Commis investor demand at a given price. As informed than others. Unless those sion (SEC) under the 1933 act re a result, underwriters typically try to less-expert investors can spot which quire the underwriter, after investi underprice the IPO. Underpricing, issues are underpriced, the unin gating the issuing firm, to file they argue, is necessary to reduce formed investors are likely to sub specific information (e.g., type of the cost of marketing the issue to scribe a small proportion of the business, nature of security, financial customers and to tempt investors to cheap issues (compared to knowl statements) in a preliminary pro buy the stock. The accompanying edgeable investors) and a large pro spectus. Then there is a period of at sidebar on Boston Chicken’s IPO portion of the expensive ones. least 20 days, during which the SEC gives an example of underpricing. Here’s why: If an issue is under- reviews the submitted material. IPO underpricing is a well- priced, both informed and unin During this “cooling off” period, documented phenomenon.3 An the underwriter surveys the market historical analysis published in 1994, 3K. Rock, “Why New Issues are Underpriced,” and sends information to prospec for example, found that the average Journal of Financial Economics, Vol. 15 (1986), tive investors. first-day IPO return was 15.26 per pp. 187-212; R. Beatty and Jay Ritter, “Invest In a firm-commitment offering, ment Banking, Reputation, and the Underpric cent in the years 1960—1992.4 Sev- ing of Initial Public Offerings J Journal of Finan investors are asked to indicate their cial Economics, Vol. 15 (1986), pp. 213-232; and willingness to purchase shares at R. Carter and S. Manaster, “Initial Public Offer 3 Among the first to document apparent under- ing and Underwriter Reputation,'n Journal of some price (i.e., to “circle” their pricing were: D. Logue, “On the Pricing of Finance, Vol. 45 (1990), pp. 1045-1067. demand). The underwriter uses the Unseasoned Equity Issues, 1965-69 ''Journal of 6 F Allen and G. Faulhaber, “Signaling by responses to set the offering price. Financial and Quantitative Analysis,Vol. 8 (1973), Underpricing in the IPO MarketJJournal of pp. 91-103; and Roger Ibbotson, “Price Perfor Financial Economics, Vol. 23 (1989), pp. 303-323; The final price is usually set at a mance of Common Stock New Issues,” Journal of M. Grinblatt and C. FIwang, “Signaling and the pricing meeting the afternoon be Financial Economics, Vo1. 2 (1975), pp. 235-272. Pricing of New Issues f Journal of Finance, Vol. 44 fore the formal offering. 4 Roger G. Ibbotson, Jody L. Sindelar, and Jay (1989), pp. 393-420; and I.Welch,“Seasoned Setting an appropriate price is R. Ritter,“The Markets Problems with the Offerings, Imitation Costs and the Underpricing Pricing of Initial Public Offerings,” Journal of of Initial Public O fferingsJournal of Finance, crucial to a successful IPO. Even Applied Corporate Finance, Vol. 7 (1994), pp. 66—74. Vol. 44 (1989), pp. 421-449.

20 LUK1MLL HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY NANCE formed investors will want to buy it. preserve their reputations, presti (SDC). I selected firms for analysis The uninformed investors are pur gious underwriters screen the firms from the list of corporate securities chasing IPO stocks more or less that go public and select the less- offerings if (1) the firm’s primary indiscriminately, while the informed risky ones by using information business was in the hospitality in investors recognize an underpriced unavailable to the general public. dustry (SIC codes 5812 or 7011); stock as a wise investment. Because This, in turn, reduces the uncer (2) they made a firm-commitment everyone wants some of the under- tainty and information asymmetry offering of at least $1 per unit; (3) priced stock, the underwriters between informed and uninformed the unit contained only a single will not have enough stock to go investors. Investors know that they share of stock (no warrants at around, and both types of investors can limit their risk by subscribing to tached);10 * (4) the issue was an initial are likely to get only a small share of issues of reputable investment banks. public offering; and (5) the firm a hot issue. If the stock is over Consequently, the underwriters feel was subsequently listed on the Uni priced, on the other hand, informed less obligation to underprice well- versity of Chicago Center for Re investors are unlikely to want it and chosen issues to attract investors, search in Security Prices (CRSP), the underwriter will be only too and the initial-day return should be NASDAQ, American Stock Ex delighted to sell it to the unin lower for screened issues than for change (AMEX), or New York formed. When the uninformed in those that the underwriters regard as Stock Exchange (NYSE) daily tapes. vestor “wins” and gets her entire more risky. As a result, the degree of A total of 143 firm offerings met all allocation in this scenario, it may be underpricing and future perfor five requirements. because those who knew better— mance should be related to the The initial return was calculated the informed—avoided the issue. reputation of the underwriter. I using the offer price and the first- Having been burned enough examine this relationship below. day closing price. It is defined times, the uninformed investors will Signaling. The other main ex throughout this paper as: eventually stop subscribing to IPOs planation for underpricing a stock closing price on first day of altogether, making it difficult for the issue is that price is a signaling de trading - offer price underwriters to place their stock. To vice. One researcher conjectured day = ------counteract that possibility, the un that new issues may be underpriced retum offer price derwriter must price the stock low to “leave a good taste in investors’ The offer price is taken from the enough for the uninformed investor mouths.”8 Picking up on that thread, Directory of Corporate Financing and to make money on enough invest other studies hypothesized that the from SDC. The first-day closing ments to keep her in the market. owner’s incentive to leave a good price is taken from the 1994 CRSP (Most investors recognize that some taste with investors is due to the tapes when available; otherwise, it is portions of a portfolio will lose possibility of the owner’s subse collected from the Wall Street Journal. money, while others will do well.) quently coming back to the market The long-run performance was Since uninformed investors will for the sale of additional securities the one-year excess return of the subscribe to the issues only if there on more favorable terms.9 That is, stock compared to the S&P 500’s is substantial underpricing, the only the underpriced new issues are said return for the same period, calcu way underwriters can counteract to “leave a good taste” with inves lated as the stock’s geometric return the winner’s curse and attract the tors (because the investors profit starting with the day after the firm average investor is to underprice from them), allowing companies to went public, minus the S&P 500 new issues (on average) so that this sell future offerings at a higher price geometric market return for the investor still makes a profit. than would otherwise be the case. same period. In each case I recorded One of the implications of the the IPOs’ lead underwriter, as sup winner’s curse model is that riskier Sample Description and plied by SDC. This sample involved issues should have, on average, Empirical Results 77 different underwriters. In nine greater underpricing. Two different My sample firms were obtained transactions just one underwriter studies found that the greater an from the annual editions of the leads, two underwriters lead in ap investment-banking firm’s prestige Directory of Corporate Financing and proximately six of the transactions, the lower the risk of the IPOs with from Securities Data Company which the firm is associated.7 To 10 Purchasing a warrant gives the investor the 8 Ibbotson (1975), p. 270. right to exchange the warrant for stock in the 9 See: Allen and Faulhaber, pp. 303-323; company when the stock is issued. Warrants are 7 See: Rock, pp. 187-212; and Carter and Grinblatt and Hwang, pp. 393-420; and Welch, traded like stock shares; that is, the prices of both Manaster, pp. 1045—1067. pp. 421-449. vary according to market demand.

October 1996 • 21 Boston Chicken’s IPO and nine underwriters lead in three tality industry, I categorized the data Gauging by the firm's reception in the market, or four transactions.The variable of sample by year. As shown in Exhibit Boston Chicken (which operates and fran underwriter reputation was based on 2, the number of offerings in the chises Boston Market restaurants) launched rankings supplied by SDC. Its rank hospitality industry varied by year, one of the most successful IPOs of the past three years. This transaction demonstrates ings are based on the value of the from a low of one in 1980 to a high the characteristics of a successful IPO: an IPOs underwritten by the invest of 23 in 1993. The table also shows easily understood product, an impressive ment bank as of the end of 1994. the great variation in the average management resume, a well-planned “road initial return across years, from a low show" (to inform and encourage investors), Many Happy Returns... and a reputable underwriter, the firm of o f-3.58 percent in 1990 to 57.38 Merrill Lynch. The average return for the first trad percent in 1979. Most of the time, In addition, Boston Chicken’s timing was impeccable and demand was high, partly be ing day for the 143 hospitality firms the average initial return is positive. cause the IPO market was in a hot phase. In in my sample is 16.32 percent (see In fact, the average initial return is the offering, the orders placed by individual Exhibit 1). This initial-day return is positive in 14 out of the 16 years in investors went unfilled (as often happens). Fund managers snapped up the IPO, and in insignificantly greater than the aver the sample period. dividual investors could buy shares only after age initial-day return of 15.72 per The table in Exhibit 2 shows that the stock started trading—at considerably cent for the overall IPO market in the hospitality industry participates higher prices than the offering price. On November 8,1993, Boston Chicken the same 1979-1994 period.11 The in the hot and cold cycles that char offered 1.9 million shares at $20 per share. In range of initial returns in the hospi acterize the general market. For the secondary market, trading started at tality industry is dramatic, with a example, 1991-1994 was a hot cycle $45.25 per share, reached a high of $51, and closed at $48.50. Boston Chicken made IPO minimum first-day return of -43.75 for both. The mid-1980s was also a history by soaring nearly $30 above its initial percent and a maximum of 150 hot period (1983—1987 for the gen price, or about 143 percent, in one day. (It percent. Nearly 76 percent of the eral market and 1981—1986 for the was not until early 1996 that this performance was matched, when Netscape's IPO firms experienced positive first-day hospitality industry). The mean achieved similar numbers.) returns, and 12.6 percent incurred number of offerings per year during Boston Chicken raised $38 million from its negative returns, while 11.4 percent a hot cycle was 12.5 compared to IPO. However, by the end of the first trading day, the stock was valued at $92 million. showed no price movement at all. only three during cold cycles. Therefore, Merrill Lynch underpriced the of On average, the degree of under- Ibbotson, Sindelar, and Ritter fering by $54 million. Such underpricing ben pricing of hospitality-industry IPOs twice demonstrated that for the efits the investor at a cost to the issuing firm and to the benefit of the underwriter, which was similar to the level of under- entire market, hot cycles are associ makes certain of selling its shares. The pricing in the market as a whole. ated with relatively high average greater the underpricing, the less money the The dollar size of the IPO also initial returns and cold cycles with issuer receives for the portion of the company sold. Thus, underpricing represents an indi varies greatly across the sample. The lower average initial returns.13 This rect cost of issuing new securities. In this mean dollar value of each transac implies that firms that issue shares case, the cost was high. tion is $20.22 million, but the IPOs during high-volume periods typi One year later, Boston Chicken was trad ing at $38.25 (adjusted for stock splits). This range between $1.5 million and cally experience high initial price represents a yearly return of 91.25 percent $294 million. The average size of the run-ups. In other words, periods of based on the offer price, or -21.1 percent hospitality-company offerings is less high volume are associated with based on the closing price on the first day of trading in the secondary market. The annual than the average size in the overall periods of high discounts in the return on the S&P 500 over this period was market, which is about $30 million. primary market. about 1.51 percent. The primary investors On average, however, that rela outperformed the S&P 500, but the second ...But Not All Are Happy ary investors who had bought it at the closing tionship did not appear to hold for price on the first day of trading clearly The IPO market experiences hot hospitality firms (see Exhibit 3). In underperformed the S&P 500. and cold cycles. That is, the number fact, the opposite was true: the aver This example is typical—on average, the offering price is lower that the closing price of offerings varies substantially across age initial return was lower during on the first day. Thus, subscribers earn an different time periods. The overall hot cycles (16.21 percent) and extraordinary return if they sell early. How market, for example, recorded 198 higher during the cold cycles (17.11 ever, over a holding period of a year, the in vestment does not outperform the S&P 500, offerings in 1982 versus 848 offer percent).14 based on the closing price in the secondary ings in 1983.12 To identify whether market. there are similar cycles in the hospi- 13 Roger G. Ibbotson, Jody L. Sindelar, and Jay Underpricing represents a cost to the R. Ritter, “Initial Public Offerings,'” Journal of existing owners, since the new investors Applied Corporate Finance, Vol. 1 (1988), pp. 37-45; are allowed to buy shares in the firm at a fa and Ibbotson et al. (1994), pp. 66-74. vorable price. The cost of underpricing can 11 See: Ibbotson, Sindelar, and Ritter (1994), 14 The difference between the average initial be very large as was the case with Boston pp. 66-74. return in the two cycles is insignificantly differ Chicken.—L.C. 12 Ibid. ent from zero.

22 CORNELL HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY NANCE

Casinos, Hotels, and Restaurants To gain a better understanding of Exhibit 1 the nature of underpricing among Initial-day return and size of hospitaltty IPOs hospitality companies, I divided the sample into restaurants (SIC code Initial-Day Return (percent) IF50 Size ($ millions) Mean 16.32 20.22 5812) and hotels and casino-hotels Minimum -43.75 1.50 (SIC code 7011). This allowed me Maximum 150.00 294.00 to investigate whether the charac teristics of lodging and casino IPOs Based on 143 observations between 1979 and 1994. are different from those of restau closing price on first day of For all exhibits, the initial-day return is defined as: trading - offer price rant IPOs. initial-day return = The differences between the two offer price industry divisions are dramatic, as The IPO size is defined as the offer price times the nijmber of shares offered. shown in Exhibit 4. The average initial return for lodging—casino properties (22.46 percent) is signifi Exhibit 2 cantly higher than for restaurants Hospitality IPOs compared with the overall IPO market (14.62 percent). In addition, the average size of hotel and casino ------Hospitality Industry------Overall Market------offerings—$43.46 million—is sub Average Average Average stantially greater than for the res Number initial-day IPO size Number initial-day taurant IPOs—at $13.80 million. Year of IPOs return ($ millions) of IPOs return 1979 3 im b m $42.10 103 24.61% Moreover, the number of restaurant 1980 1 1.48 4.10 259 49.38 IPOs is four times greater than the 1981 9 12.46 7.71 438 16.76 number of lodging—casino IPOs. 1982 8 8.74 18.23 198 20.31 Until recently, the IPO activity 1983 17 9.85 14.51 848 20.79 1984 8 5.31 16.21 516 11.52 in lodging—casino properties consti 1985 8 9.17 9.18 507 12.36 tuted a small but steady stream. 1986 11 14.35 5.69 953 9.99 IPOs have only recently become 1987 3 -0.57 21.77 630 10.39 popular in the lodging-casino seg 1988 2 57.69 3.60 435 5.27 1989 6 5.24 19.22 371 6.47 ment. In fact, 17 out of the 31 IPOs 1990 3 -3.58 10.10 276 9.47 were issued in 1992-1994, or just 1991 10 21.31 27.59 367 11.83 three years of the 16-year sample. It 1992 17 20.35 25.36 509 10.90 is noteworthy that the level of un 1993 23 28.37 39.97 NA NA 1994 14 13.65 15.76 NA NA derpricing for the lodging—casino Total 143 16.32 20.22 6,410 15.72 IPOs consistently fell during this period (as gauged by the plunge in initial-day returns). The 1992-1994 Exhibit 3 hot cycle for lodging—casino IPOs Initial-day hospitality IPO returns coincided with the industry’s eco Hot Cycles Cold Cycles nomic recovery. Restaurant IPOs, (1981-86, ’91-94) (1979-80, ’87-90) on the other hand, came in batches. Average initial-day return 16.21% 17.11% Ninety percent of all restaurant Average IPO size ($ millions) $20.59 $17.67 IPOs occurred during the hot- Number of IPOs 125 18 cycle periods of 1981—1986 and 1991-1994. Exhibit 4 Blowing hot and cold. The pattern of initial-day returns in hot Comparison of restaurant and lodging-casino IPOs and cold cycles is mixed in the two Restaurants Lodging-Casinos hospitality-industry segments. For (SIC Code 5812) (SIC Code 7011) restaurants, the hot cycle is associ Average initial-day return 14.62% 22.46% ated with high average initial re Average IPO size ($ millions) $13.80 $43.46 turns and the cold cycle with low Number of IPOs 112 31

October 1996 • 23 average initial returns (see Exhibit Exhibit 5 6). This relationship does not hold for the lodging—casino firms. Dur Results of hospitality IPOs by segment ing hot cycles, the average initial Number of IPOs Average Initial-Day Average IPO Size return is lower than during the cold Return ($ millions) cycle. The average initial return Lodging- Lodging- Lodging- during the hot cycle is 17.10 per Year Casino Restaurant Casino Restaurant Casino Restaurant cent, but that return is 28.96 per 1979 2 1 86.50% -0.86% $42.10 $11.60 cent during the cold cycle. These 1980 0 1 — 1.48 — 4.10 results are not conclusive, since the 1981 0 9 — 12.46 — 7.71 1982 1 7 0.62 9.89 100.00 6.56 hot cycle coincides with the 1983 1 16 8.33 9.95 60.00 11.66 industry’s economic recovery.15 1984 1 7 0.00 6.06 51.00 11.24 Notice that for lodging—casino 1985 3 5 4.91 11.73 14.80 5.80 firms, the level of underpricing 2 9 8.56 15.64 10.35 4.66 1986 consistently falls during the 1992- 1987 0 I 3 — -0.57 — 21.77 1988 1 1 100.00 15.38 2.00 5.20 1994 period. The decline could be 1989 1 5 35.42 -0.80 3.00 22.46 due to the market’s increasing expe 1990 1 2 -18.75 4.01 3.50 13.40 1991 1 9 75.00 15.35 12.00 29.32 rience with IPOs in the industry or 1992 4 13 24.96 15.85 43.32 19.83 a reduction in uncertainty about 1993 8 15 13.34 36.39 83.78 16.60 the industry’s future prospects. 1994 5 9 8.84 16.33 24.60 10.84 The Winner’s Curse Exhibit 6 As I stated above, one of the impli Effects of hot and cold cycles on hospitality IPOs cations of the winner’s curse model is that as an issue’s risk level in Lodging-Casino IPOs Restaurant IPOs creases so should the level of under- Hot Cycle Cold Cycle Hot Cycle Cold Cycle pricing. Also as mentioned above, Average initial-day return 17.10% 28.96% 16.36% 1.40% the most-prestigious investment Average IPO size ($ millions) $56.85 $27.20 $13.33 $17.33 bankers are associated with the Number of IPOs 17 14 99 13 least-risky IPOs. As a result, the more prestigious underwriters Exhibit 7 should be associated with less un Underwriter prestige and hospitality IPO returns derpricing relative to the averages. The overall IPO market demon strates this inverse relationship All hospitality Lodging-Casinos Restaurants between the reputation of the High Low High Low High Low underwriter and the level of prestige prestige prestige prestige prestige prestige underpricing. Initial return 16.81% 15.99% 18.22% 26.98% 16.27% 13.63% For the hospitality IPOs in my IPO size ($millions) $36.61 $9.05 $66.94 $18.41 $25.05 $7.04 sample, however, the reverse rela Number of IPOs 58 85 16 15 42 70 tionship holds, although the differ ence is not statistically significant. The more-prestigious underwriters underprice hospitality issues more than do the less-prestigious firms (as shown in Exhibit 7).The under-

1:5 When the industry’s recession was isolated as a separate period—with 1988—1991 defined as a cold cycle and 1979-1987 and 1992-1994 as hot cycles—the average initial returns were 47.92 percent for the cold cycle and 18.69 percent for the hot period.

24 CORNELL HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY NANCE

pricing of lodging—casino properties by prestigious underwriters, how Exhibit 8 ever, is significantly lower than for IPOs as a whole. Initial-day and first-year excess returns for hospitality IPOs Long-Run Performance 250-day excess return* Initial-day return Hospitality 14.11% 16.32% A general characteristic of IPOs is Lodging and casinos 10.24 22.46 their poor stock-price performance Restaurants 14.96 14.62 in the long run relative to the gen *Excess return is the stocks’ geometric return compared to that of the Standard and eral market.16 That is, after the ini Poor’s average of 500 stocks. tial-day price run-up, IPOs as a group do not prosper. This phe nomenon is not evident in the hos Exhibit 9 pitality industry, however, as shown Underwriter prestige and excess return in Exhibit 8. Unlike the overall IPO market, IPOs in the hospitality in ------Prestigious------Less Prestigious dustry outperform the S&P 500 in 1979-94 1979-91 1992-94 1979-94 1979-91 1992-94 250-day the long run. For example, over a excess return 10.65% 0.81% 27.26% 16.98% 13.28% 34.66% 250-day holding period, the average return on the sample of hospitality The excess return is the stock’s geometric return that exceeds that of the S&P 500 IPO firms was 14.11 percent higher stocks. The prestigious underwriters are defined as the top 10 underwriters in terms of than the S&P 500 return. capital position. Restaurants generally did better than lodging and casino firms, but both groups outperformed the mar ket. The 250-day excess returns for sented by the top investment banks, study. As for the IPO market as a restaurants was 14.96 percent, while but that figure rises to 52 percent whole, hospitality IPOs saw hot and that figure for lodging-casino firms during the 1992-1994 period. In an cold cycles in both volume and the is 10.24 percent. attempt to isolate these two factors, extent of underpricing, with a posi Notice that the excess return for Exhibit 9 presents the 250-day ex tive association between underpric lodging—casino IPOs is less than that cess return for prestigious and less ing and number of issues for restau of restaurant issues but that lodging- prestigious investment banks for rants and a negative relationship casino IPOs’ underpricing is greater three time periods: 1979-1994, between underpricing and the eco than that of restaurant stocks. This 1979-1991 and 1992-1994.The nomic condition of the industry for provides some evidence of a positive 250-day excess return is less for the lodging—casino stocks. For lodging- association between underpricing more-reputable investment banks casino stocks, the study’s findings and performance over the 1979— over the entire period and over were in keeping with the concept 1994 period. each of the two subperiods. It is that the prestige of the underwriter The differences in the relation possible that the prestige of the is a proxy for the riskiness of the ship between the degree of under- investment bank is a proxy for the issue. Specifically, the more presti pricing and long-run performance riskiness of the issue. Given that the gious underwriters discount the over the two time periods could be more reputable investment banks issues less than their less-well- due to the difference in the propor underwrite less risky IPOs, the known competitors. Perhaps the tion of IPOs underwritten by the expected return should be lower, most encouraging finding was that, more reputable investment banks on average. unlike the overall IPO market, IPOs over the two periods or to the re in the hospitality industry generally covery of the lodging—casino indus Mixed News for Issuers and Investors outperform the S&P 500 in the first try. Over the 1979—1994 period, Compared to the pricing of initial year after issue. That is favorable 41 percent of the IPOs are repre restaurant issues and the overall news for both the investors who IPO market, underwriters generally wish a favorable return and for en 16 See: Ibbotson, Sindelar, and Ritter (1994), underpriced lodging—casino stocks trepreneurs who hope to sell their pp. 66—74. over the 1979—1994 period of my shares at a favorable price. CQ

October 1996 • 25