Signalling Roles of Prestigious Auditors and Underwriters in an Emerging IPO Market

Abstract

This study examines the signalling roles of auditors’ and underwriters’ reputation and its interacted effects on the initial public offering (IPO) initial returns before, during and after the Global Financial Crisis in an emerging market. Cross-sectional data comprising of 228 IPOs from the Malaysian Stock Exchange (Bursa Malaysia) is used for the period 2005–2012. The ordinary least square method using multiple linear regressions is used to test the hypotheses. The findings indicate that both auditors’ and underwriters’ reputation plays a significant role in reducing asymmetric information and signals firm value to the potential investors. Auditors’ reputation documents a positive relationship, whilst the underwriters’ reputation indicates a negative relationship. The interacted signalling variables indicate that underwriters’ reputation plays a dominant role in assisting potential investors in their investment decision-making.

Keywords

Auditors underwriters IPO initial returns signalling hypothesis asymmetric information

Introduction

An initial public offering (henceforth, IPO) is a ‘desire for a firm to raise equity capital and to create a public market in which the founders and other shareholders can convert some of their wealth into cash at a future date’ (Ritter & Welch, 2002). Raising funds by means of an IPO, which is also known as ‘going public’, is a momentous landmark in the life cycle of a company. A comprehensive understanding of the IPO setting and the roles of all participants is fundamental to the progress and sustainability of the worldwide equity financing market.

Studies on IPOs have mostly been undertaken in the developed markets, with established legal system, proper governance and relatively high levels of transparency (low corruption). The issue of contention is, ‘Can the established relationships between underwriters/auditors’ reputation and IPO initial returns be generalized and automatically imputed into countries with a different institutional background?’ Hence, this research attempts to shed some light on the aforementioned concern and will focus on the signalling effects of underwriters’ and auditors’ reputation on IPO initial returns in Malaysia, which is an emerging market, as no studies have been undertaken on this area. Since underwriters are advisors to the firm owners and have a consultative role, an additional contribution to the existing literature will be the effects of an interaction between auditors’ and underwriters’ reputation on IPO initial returns. In the Malaysian context, the Malaysian Stock Exchange (known as Bursa Malaysia) is divided into two different markets, namely the Main and the ACE Market. During the revamp of the Malaysian Stock Exchange, the ACE Market replaced the Malaysian Exchange of Securities Dealing and Automated Quotation (MESDAQ) Market, and the Main and Second Boards amalgamated to become the Main Market. The intention of the revamp is to allow efficient access to capital and investments as well as making Bursa Malaysia a more attractive platform for Malaysian and foreign companies. While the Main Market consists of established companies with strong track records, the ACE Market facilitates the listing of emerging companies. Thus, this study will also examine the presence of any difference in the influence of the signalling effects between these two markets. Finally, since the study period covers pre-and post-Global Financial Crisis, the signalling effects are tested over three event windows: before, during and after the Global Financial Crisis. The purpose is to determine the presence of any difference in the signalling roles of auditors and underwriters during these three event windows.

Extant literature documents that the level of underpricing¹ significantly differs across markets. The phenomenon of IPO underpricing is higher in developing markets compared to the developed ones (Loughran, Ritter, & Rydqvist, 1994). Numerous studies have stated that the main causes for IPO initial returns are asymmetric information (Beatty & Ritter, 1986; Benveniste, Busaba, & Wilhelm, 1996; Firth & Liau-Tan, 1998; Loughran & Ritter, 2002; Ritter & Welch, 2002). Due to the presence of asymmetric information, potential investors in the IPO environment are dependent on auditors and underwriters for various signals of firm quality. In that context, one of the most important hypotheses in the study of IPO initial returns is known as the signalling hypothesis (Bhattacharya, 1979; Certo, Daily, & Dalton, 2001; Keasey & Short, 1997; Lawless, Ferris, & Bacon, 1998; Marshall, 1998; Ross, 1977). Signalling hypothesis refers to the signal sent by the issuing companies to the potential investors via engaging reputable underwriters/auditors, ownership retention, etc. Many researchers have claimed that employing reputable auditing firms to conduct the audits play a pivotal role in sending signals of firm quality (Beatty, 1989; Brau & Johnson, 2009; Daily, Certo, Dalton, & Roengpitya, 2003; Datar, Feltham, & Hughes, 1991; Michaely & Shaw, 1995; Teoh & Wong, 1993; Titman & Trueman, 1986). The auditors’ attestation of the firm’s financial information reduces asymmetric information between owners and investors and, thus, reduces the cost to the owners of initial underpricing of the securities. It has been argued that higher quality auditors can reduce information asymmetry more than lower quality auditors (Balvers, McDonald, & Miller, 1988; Beatty, 1989; Datar et al., 1991). Besides having a reputable auditing firm, companies intending to go public would also engage highly reputable investment banks as underwriters for the IPOs. A strong signal is portrayed when the company issuing the IPO hires a reputable underwriter (Beatty & Ritter, 1986; Booth & Smith, 1986). Past studies reveal that reputable underwriters significantly reduce underpricing and have a positive influence on the long-term performance of the IPOs, which proves that this can be a positive signal for potential investors (Bansal & Khanna, 2013; Bruton, Chahine, & Filatotchev, 2009; Carter & Manaster, 1990; Carter, Dark, & Singh, 1998; Megginson & Weiss, 1991).

As an extension to the aforementioned, this study attempts to meet several objectives. First, we examine the relationship between underwriters’ and auditors’ reputation on IPO initial returns. Second, we determine the relationship between the interacted underwriters’ reputation and auditors’ reputation on IPO initial returns. Subsequently, we attempt to identify if the relationship holds in both the Main and the ACE Markets and during the different periods of economic conditions, that is, before, during and after the Global Financial Crisis. The outcomes of this study indicate that both auditors’ and underwriters’ reputation play a significant role in reducing asymmetric information and signal firm value to the potential investors. Auditors’ reputation documents a positive relationship, whilst the underwriters’ reputation indicates a negative relationship. We conjecture that both the signalling variables impact investors’ perception from different perspectives; reputable auditors are perceived by investors as giving a true and fair view of the audited reports, thus increasing firm value (most evident before and after the crisis), whilst reputable underwriters are perceived as being cautious with their reputation capital and, thus, avoid overly underpricing the IPOs. These are most evident during the crisis. The interacted signalling variables indicate that underwriters’ reputation plays a dominant role in assisting potential investors in their investment decision-making.

The rest of this article is organized as follows: The next section builds the hypotheses; third section introduces the data and variables. Results are presented in the fourth section and the last section concludes the findings.

Review of Literature

Auditors’ Reputation

The past literature detailed various measurements on audit quality: size of accounting firms (DeAngelo, 1981), aggregate sales revenue of audit firms (Francis & Wilson, 1988) and brand name/image of audit firms (Dopuch & Simunic, 1982). However, most empirical studies have utilized the size of audit firms as a gauge of the audit quality. Large audit firms maintain a higher quality as their reputation capital is very valuable. Audit quality plays a vital role as auditors provide extra credibility to the financial disclosures (Hayes, Dassen, Schilder, & Wallage, 2005). Choosing an auditor with a high reputation will increase the credibility, reduce underpricing and gain higher bidding price (Balver et al., 1988; Hogan, 1997; Misnen, 2003). The financial statements attested by a reputable auditor provide confirmation regarding the information quality certified by the accountants to the investors. When firms go public, the issuing company has inside information regarding the company’s future growth which is not available to the potential investors. This asymmetric information problem may lead to a demand for auditor credibility for two reasons: first, to signal firm value, and second, to minimize monitoring costs.

A huge breakthrough study by Titman and Trueman (1986) offered a framework showing that reputable auditors deal with low-risk companies that obligate high information quality. Simunic and Stein (1987), Beatty (1989), Bachar (1989) and Michaely and Shaw (1995) provided an empirical proof to support the findings of Titman and Trueman (1986). In fact, Balvers et al. (1988), Jacobs (1983) and Sutton and Benedetto (1988) documented that investment bankers (underwriters) have enticements to encourage the clients to select credible auditors. The bankers will undergo a reputational loss if it is concluded in the market later that the issuing company had offered information that was misleading or that the offering was not priced appropriately (Beatty & Ritter, 1986; Booth & Smith, 1986). Utilization of professional advisers (reputable auditors and underwriters) is a form of signal on the level of quality of a firm and to advance the subsequent sale of shares (Francis & Wilson, 1988). Likewise, Albring, Elder and Zhou (2007) suggested that the selection of auditors is essential as the reputation of the auditors may have an effect on the share prices. This idea is also concurred by Wang and Wilkins (2007), who revealed that the IPOs that were audited by the then Big-6 audit firms face less underpricing compared to the IPOs that were audited by non-Big firms.

However, the study by Datar et al. (1991) revealed that the selection of an auditor of high quality only lowers the potential of misrepresentation of the information in the prospectus by the issuing company. Datar et al. (1991) developed a framework that forecasted a positive relationship between audit quality and IPO risk. A positive relationship is documented between audit quality and IPO market valuation. The positive relationship between auditors’ reputation and IPO initial returns may also be due to the reason that while initial investors utilize these indicators in their evaluation of the company, the secondary investors also utilize this information and react more favourably (Aggarwal, Prabhala, & Puri, 2002; Hanley & Wilhelm, 1995). Datar et al. (1991) and Firth and Liau-Tan (1998) explained that even though the firm is audited by quality auditors, the underwriters underprice the issues to avoid unsubscribed issues, which will lead them to unfavourable positions. Chang, Gygax, Oon and Zhang (2008), Agathee, Sannassee and Brooks (2012) and Daily et al. (2003) also documented a positive relationship between prestigious auditors and IPO initial returns. Nevertheless, based on the empirical evidence, most of the studies conducted in the USA have findings that supported the forecast framework of Titman and Trueman (Beatty, 1989; Feltham, Hughes, & Simunic, 1991; Simunic & Stein, 1987). Interestingly, a research conducted by Chang et al. (2008) in Australia on 361 companies from 1996 to 2003 revealed no empirical proof that the quality of audit mitigated the ex-ante uncertainty and in turn lowered underpricing.

Specifically in the context of this study, we hypothesize a positive relationship between auditors’ reputation and initial returns of IPOs, but not for reasons suggested by Datar et al. (1991). Our justification differs slightly from the existing literature (which is also the contribution of this study); we conjecture that a reputable auditor sends a positive signal to potential investors on the credibility of the firm and its financial disclosures, thus lowering investment risk. The credibility of the financial disclosures signalled by the reputable auditors will minimize uncertainty and information asymmetry surrounding the IPO. This may entice potential investors, including those who were unable to obtain shares in the primary market to increase their demands on the first day of trading in the secondary market. An increased demand will cause a surge in the market price on the day of IPO listing, thus causing a high closing price. A high closing price will consequently cause an increase in the initial returns of IPOs. Therefore, our view is that reputable auditors act as a signalling agent to potential investors on the credibility of IPO firms, thus contributing to a positive relationship.

Underwriters’ Reputation

IPO is a complicated process and underwriters are needed for their experience and skills in marketing, pricing, administration and research. Carter and Manaster (1990) used underwriter’s relative placements in stock offering ‘tombstone’ announcements as a measure of underwriters’ reputation and are widely acknowledged as one of the breakthroughs in measuring underwriters’ reputation. Alternatively, Johnson and Miller (1988) and Megginson and Weiss (1991) used a modified form of the Carter–Manaster method. Megginson and Weiss used the ‘relative market share of the underwriters’ as a proxy for their reputation.

Several prominent studies have examined the association between underwriters’ reputation and IPO initial returns, and have discovered a negative relationship, that is, reputable underwriters are concomitant to lower levels of IPO underpricing (Aggarwal & Conroy, 2000; Beatty & Ritter, 1986; Carter & Manaster, 1990; Carter et al., 1998; Johnson & Miller, 1988; Kirkulak & Davis, 2005; Kenourgios, Papathanasiou, & Melas, 2007; Kim, Krinsky, & Lee, 1995). Several reasons have been identified for the inverse relationship, which includes reputable underwriters designating lower uncertainty in the IPO environment, thus depressing the underpricing of IPOs (Carter & Manaster, 1990; Carter et al., 1998; Johnson & Miller, 1988; Lange, Bygrave, Nishimoto, Roedel, & Stock, 2001; Megginson & Weiss, 1991). Carter and Manaster (1990) in their breakthrough study extended the study of Beatty and Ritter (1986) and Rock (1986) and established that prestigious underwriters are associated with low-risk firms (thus, lesser uncertainty) and that their IPOs have low initial returns. Though reputable underwriters are costly, issuing firms with low-risk characteristics use these reputable underwriters as a platform to market their credibility. On the same note, reputable underwriters market IPOs of low-risk firms to maintain their reputation capital. This signals the market on the firm credibility and low-risk characteristics of firms, thus establishing a significant negative relationship between underwriters’ reputation and initial returns of IPOs. Potential investors also see this as a positive sign of the company’s value and its future prospects.

Kenourgios et al. (2007) and J. Booth and L. Booth (2010) are of the opinion that reputable underwriters have an inverse relationship with IPO initial returns as they are concerned about their reputation and will thus avoid extreme underpricing. Firms on the other hand, capitalize on the reputation of the underwriters to indicate the firm value and enhance investors’ perception on the quality of the firm. Benveniste and Wilhelm (1997) and Sherman and Titman (2002) also documented that underwriters’ discretion is seen as an important tool utilized to give advantage to the issuing company. When the underwriters use their discretion to bundle the IPOs, issues arising from the asymmetric information are minimized (Ritter & Welch, 2002), thus causing lower initial returns on IPOs.

In contrast to the aforementioned, a host of other studies discover a positive association between underwriters’ reputation and initial returns, that is, reputable underwriters are associated to higher levels of underpricing (Bates & Dunbar, 2002; Beatty & Welch, 1996; Chemmanur & Fulghieri, 1994; Cooney, Singh, Carter, & Dark, 2001; Liu & Ritter, 2011). Here again, there are several views to the positive relationship which includes change in the economic conditions, structural changes in the USA, market after the tech-boom and emphasis on analyst coverage. Beatty and Welch (1996), Loughran and Ritter (2002) and Liu and Ritter (2011) have acknowledged the significance of reputable underwriters being associated to analyst coverage and of attracting media attention as a tool of marketing and increased publicity in the market. Additionally, issuing firms and underwriters may set the price of an IPO below the market value as a protection against future litigation by investors for any omission of content presented in the prospectus, protecting investors from losses or risk of bankruptcy in case of IPO failure and finally to protect uninformed investors from negative initial returns if the IPOs are overpriced. Furthermore, several theoretical model of underpricing such as market feedback hypothesis, lawsuit avoidance hypothesis and market microstructure hypothesis state that underwriters underprice the IPOs for reasons such as raising more capital during seasoned equity offering and avoiding litigation.

In the context of this study, we hypothesize a positive relationship between underwriters’ reputation and IPO initial returns in the Malaysian context. Our justification is relatively similar to the earlier mentioned, that is, reputable underwriters minimize ex-ante uncertainty and asymmetric information between issuers and potential investors. Reputable underwriters are seen as a representation of firm quality and enhanced future potential of companies going public. This will further enhance demand by investors for the IPOs on the first day of trading, thus causing an upsurge in the closing price and hence higher initial returns.

Based on the extensive literature discussed earlier, both auditors’ and underwriters’ reputation is expected to have a positive impact on IPO initial returns.

Research Methodology

Data Collection

This study examines IPO firms listed in Bursa Malaysia between 2005 and 2012. A total of 256 IPOs were listed in Bursa Malaysia during this period of study, but 29 IPOs were excluded due to lack of sufficient information to support the analysis.

To ensure accuracy, all data are carefully hand collected. Data are compiled from the prospectuses, the official website of Bursa Malaysia),² the Star Online),³ and the Yahoo Finance.⁴ Data on the offer and closing price on the first day trading were obtained from Thomson Datastream Database and a few other websites.⁵ The market index is obtained from Yahoo Finance Malaysia and Thomson Financial Datastream Database. The breakdown on the number of IPOs is as shown in Figure 1.

Figure 1.

Source: Bursa Malaysia.

Statistical Model and Variable Measurement

We first test the data for heteroscedasticity, using the Breusch–Pagan Godfrey (BPG) and are corrected using the White’s test. Subsequent to both the diagnostic tests, the ordinary least square regression method using the multivariate regression is performed to test the research hypotheses. The model is specified as follows:

I R_{i t} = f (A u d R_{i t}, U w R_{i t}, C_{i t}, Y_{i t}) + ε,

(1)

where IR represents the IPO initial returns, subscript i denotes the firm and subscript t denotes the year. AudR refers to auditors’ reputation and UwR represents underwriters’ reputation, whilst C includes the control variables and Y is a set of time-specific dummies.

LogIR is measured as the log of the initial returns. Mathematically, it is denoted as follows:

L o g I R = \ln (\frac{F i r s t D a y C l o \sin g \Pr i c e}{O f f e r \Pr i c e}) .

(2)

Megginson and Weiss (1991) method is used to compute underwriters’ reputation, whereby underwriters’ market share is used as a proxy. As for auditors’ reputation, this research adopts the method used in the studies of Beatty and Ritter (1986) and Titman and Trueman (1986) by identifying the auditors’ reputation based on the Big-4 auditors (Deloitte, KMPG, PricewaterhouseCoopers and Ernst & Young). A binary variable of 1 is given to reputable auditors, whilst a 0 is given to non-reputable auditors. Firm age is calculated by taking the natural logarithm of the difference between the incorporation date of the firm and the date it is listed on Bursa Malaysia as a public company. In terms of firm size, market capitalization is used (Chen, Lee, & Lin, 1999). Market conditions are computed as a natural logarithm of the three-month weighted average market returns before a firm goes public.

Analysis

Descriptive Statistics

Table 1 details the descriptive statistics for the dependent, independent and control variables. It reveals the outcomes for the mean, standard deviation, minimum, maximum and kurtosis of IPOs listed in Bursa Malaysia from 2005 to 2012.

As documented by the empirical evidence in Table 1, most IPO firms underprice their shares. The lowest initial return value is –1.227 (minimum) and the highest is 1.290 (maximum), with a mean of 0.0753 and a standard deviation of 0.322. Underwriters’ reputation has a mean of 9.906, meaning an average market share of the underwriters is about 10 per cent. The minimum is 0.1 per cent, whilst the maximum is 51.8 per cent.

Table 1.

Descriptive Statistics of All Variables

	Minimum	Maximum	Mean	Std. Deviation	Skewness	Kurtosis
IR	–1.227	1.290	0.0753	0.322	0.107	3.45
UwR	0.1	51.8	9.906	13.552	1.775	2.044
AudR	0	1	0.46	0.5	0.159	–1.992
MktCon	–0.304	0.3179	0.048	0.100	–0.23	1.334
FS	20.57M	41.6B	1.05B	4.72B	6.874	50.199
FA	3	43	10.81	6.709	2.326	6.966
Observations	228	228	228	228	228	228

Source: Authors’ own findings.

Notes: IR, Initial returns; AudR, Auditors’ Reputation; UwR, Underwriters’ Reputation; MktCon, Market condition; FA, Firm Age; FS, Firm Size; M, Million; B, Billion.

As for auditors’ reputation, the highest value is 1 and the lowest is 0, as dummy variables are used to represent the auditors’ reputation. The average size of the company going public is RM 1.05 billion with a standard deviation of RM 4.71 billion; the minimum value is RM 20.57 million and the maximum of 41.6 billion. The IPO firm age is on average 10.81 years (mean) with a standard deviation of 6.71. The minimum age is 3 years and the maximum is 43 years. In short, it can be concluded from the descriptive statistics that IPO firms in Malaysia do have a relatively significant variation in all the variables tested.

Correlation Analysis

Table 2 shows the correlation analysis between IPO initial returns, auditors’ reputation, underwriters’ reputation and the control variables (market condition, firm age and firm size).

Table 2.

Correlation Estimates of the Data Set

	IR	AuD	Correlation Matrix	MrktCon	LNFA	LNFS
	IR	AuD	LNUwR	MrktCon	LNFA	LNFS
IR	1
AuD	0.109*	1
UwR	–0.151*	0.173**	1
MrktCon	0.213**	0.068	–0.153*	1
FA	0.078	0.124*	0.090	–0.034	1
FS	–0.084	0.285**	0.456**	0.077	–0.156**	1

Source: Authors’ own findings.

Notes: IR, Initial returns; AudR, Auditors’ Reputation; UwR, Underwriters’ Reputation *p significant at the 10% level; **p significant at the 5% level; ***significant at the 1% level. MktCon, Market condition; FA, Firm Age; FS, Firm Size; M, Million; B, Billion.

The results indicate a moderate correlation between all the variables tested. The correlation estimates testify that multicollinerity is not a problem in this study as none of the correlation is above the threshold of 0.80.

Relationship Between Auditors’/Underwriters’ Reputation and IPO Initial Returns

Table 3 represents the relationship between auditors/underwriters’ reputation and IPOs’ initial returns from 2005 to 2012. The regression equation is as follows:

I R_{i t} = β_{0} + β_{1} A u d R_{i t} + β_{2} U w R_{i t} + β_{3} F A_{i t} + β_{4} F S_{i t} + β_{5} M k t C o n_{i t} + ε_{i t},

(3)

where IR_it is the IPO initial returns of firm i at year t, whilst UwR_it represents underwriters’ reputation of firm i at year t and AuD_it represents auditors’ reputation of firm i at year t. FA_it, FS_it and MktCon_it represent firm age, firm size and market condition, respectively, for firm i in year t, which are the control variables used in this study.

The empirical results indicate a significantly positive relationship between auditors’ reputation and IPO initial returns, with a coefficient of 0.079. Hypothesis 1 is thus accepted. As hypothesized earlier, audit quality plays a vital role as auditors provide extra credibility to the financial disclosures (Hayes et al., 2005). The financial statements attested by a reputable auditor provide confirmation regarding the information quality certified by the accountants to the investors. The reputation of the auditors assists in minimizing the uncertainty and asymmetric information between the issuers and the potential investors instantaneously signalling potential investors on the firm quality, risk levels of their investments and potential growth. Taking these factors into account, investors increase their demand for the shares in the secondary market, thus causing an upsurge in the closing price of IPOs, thus causing a higher initial return. The extant literature that concurs to the aforementioned results are Hanley and Wilhelm (1995), Aggarwal et al. (2002), Datar et al. (1991), Firth and Liau-Tan (1998), Chang et al. (2008), Agathee et al. (2012) and Daily et al. (2003). Nevertheless, the results do not correspond to the studies by Balver et al. (1988), Misnen (2003), Titman and Trueman (1986), Simunic and Stein (1987), Beatty (1989), Bachar (1989), Michaely and Shaw (1995), Balvers et al. (1988), Jacobs (1983), Sutton and Benedetto (1988), Beatty and Ritter (1986) and Albring et al. (2007).

Table 3.

Regression Results for the Relationship between Signalling Variables and IPO Initial Returns

	Coefficient	p-value
AudR	0.078*	0.064
UwR	–0.030**	0.030
MrktCon	58.657***	0.005
FA	0.005*	0.089
FS	0.010***	0.000
Adjusted R-squared	0.062
No. of observation	228

Source: Authors’ own findings.

Notes: Standard errors are adjusted for heteroscedasticity, using the White’s test. *p significant at the 10% level; **p significant at the 5% level; ***significant at the 1%. IR, Initial returns; UwR, Underwriters’ Reputation; AuD, Auditors’ Reputation; MrktCon, Market condition.

As for the relationship between underwriters’ reputation and initial returns of IPOs, the regression results in Table 3 document a negative relationship between prestigious underwriters and IPO initial returns. The coefficient is –0.030 at a significance level of 5 per cent. The results indicate that reputable underwriters (unlike auditors) decrease the level of IPO underpricing. Thus, hypothesis 2 is rejected. The empirical evidence does not support the hypothesis developed in terms of reputable underwriters signalling firm value and enticing potential investors to increase demand for the IPOs and eventual initial returns. Nevertheless, the results obtained from the regression are consistent with those of Beatty and Ritter (1986), Carter and Manaster (1990), Carter et al. (1998), Johnson and Miller (1988), Kirkulak and Davis (2005) and Aggarwal et al. (2000). They conjecture that prestigious underwriters do signal low-risk companies thus reducing the asymmetric information among issuers and potential investors, but their prediction of the scenario is that it lowers the initial returns of the IPOs. The rationale is that reputable underwriters are concerned about their reputation and thus they have an incentive to avoid extreme underpricing. They underprice suitably to reach a successful public offering which will not affect their reputation and will satisfy the issuer as well as leave lesser money on the table. The results are also consistent with some recent studies by Wang and Yung (2011); Sundarasen (2013); Bruton et al. (2009); and Lowry, Officer and Schwert (2010), who have also documented a negative relationship.

Roles of Interacted Independent Variables (Underwriters’ Reputation and Auditors’ Reputation) on IPO Initial Returns

Table 4 shows the empirical results of hypothesis 3 which refers to the relationship between the interacted independent variables, that is, interaction between underwriters’ and auditors’ reputation and IPO initial returns. The variable representing the underwriters’ reputation (UwR) is centred and interacted with the variable for the auditors’ reputation (AudR). Auditors’ reputation (AudR) is not centred as it is a binary variable. The rational for the interaction is the fact that an underwriter may have an influence in the selection of the auditors when a company decides to go public. There is a tendency for the investment bankers (underwriters) who are acting as advisers to the issuers/company that is aiming to go public to recommend the auditors, that is, Big-4 or otherwise.

Table 4.

Regression Result for the Relationship between IPO Initial Returns and the Interacted Independent Variables (Auditors’ and Underwriters’) Reputation)

Model	Coefficient	p-value
IPO Initial Returns
Underwriters’ reputation (UwR)	0.003	(0.233)
Auditors’ reputation (AudR)	–0.704***	(–10.875)
UwR × AudR	–0.030**	(–1.987)
Firm Age (FA)	0.000	(0.926)
Firm Size (FS)	0.115***	(8.939)
Market	0.135***	(6.578)
Condition (Mcon)
Adjusted R²	0.042
No. of observations	228

Source: Authors’ own findings.

Notes: Standard errors are adjusted for heteroscedasticity, using the White’s test. *p significant at the 10% level; **p significant at the 5% level; ***significant at the 1% level. UwR × AudR indicates the interaction between underwriters’ and auditors’ reputation.

The centred variable representing the underwriters’ reputation is interacted with the variable representing the auditors’ reputation and is regressed against the IPO initial returns. The main effects, which are the underwriters’ reputation and auditors’ reputation, are controlled for in the regression. The regression equation is as follows:

I R_{i t} = β_{0} + β_{1} U w R_{i t} + β_{2} A u d R_{i t} + β_{3} U w R_{i t} \times A u d R_{i t} + β_{4} F A_{i t} + β_{5} F S_{i t} + β_{6} M k t C o n_{i t} + ε_{i t},

(4)

where IR_it is the IPOs initial returns of firm i at year t, whilst UwR_it represents underwriters’ reputation of firm i at year t and AuD_it represents auditors’ reputation of firm i at year t. FA_it, FS_it and MktCon_it represent firm age, firm size and market condition, respectively, for a firm i in year t, which are the control variables used in this study. UwR_it × AudR_it refers to the underwriters’ and auditors’ reputation of company i in year t, respectively. The coefficients for the interacted variables indicate that the interaction between underwriters’ reputation and auditors’ reputation have a negative relationship (the coefficient of –0.030 at 5 per cent significance level). This implies that a combined effect from both the auditors’ and underwriters’ reputation reduces the IPO initial returns. Therefore, hypothesis 3 is rejected. The negative relationship indicates that the initial returns of the IPOs are lower when the reputable underwriters and auditors are interacted. The combined effect may have a very dominant impact on the potential investors’ perception of the underwriters’ credibility in pricing the IPOs, the association with reputable analyst and the expectation that the information provided by the reputable auditors in terms of the offer price and all other information disclosed in the prospectus be at a true and fair view. Thus, it may minimize the uncertainty on the value of the company, assuming the offer price to be a true reflection of the firm value and thus reducing the initial returns.

Table 5.

Regression Result for Different Market Structure (Main Market and ACE Market)

	Main Market		ACE Market
	Coefficient	p-value	Coefficient	p-value
AudR	0.072*	0.090	0.059	0.507
UwR	–0.024*	0.084	–0.058**	0.047

FA	0.001	0.790	0.006*	0.061
MC	0.019	0.162	0.017	0.166
FS	0.000*	0.069	0.000**	0.000
Adjusted R²	0.018		0.0298
No. of observation	144		84

Source: Authors’ own findings.

Notes: Standard errors are adjusted for heteroscedasticity, using the White’s test. *p significant at the 10% level; **p significant at the 5% level; ***significant at the 1% level. IR, Initial returns; AuD, Reputation of Auditors; UwR, Log of Underwriters’ Reputation.

The proceeding section further analyses the presence of any differences in the signalling effects between companies listed in the Main and ACE Market. Companies listed in the ACE Market are predominantly technology-based companies.

Relationship Between Auditors’ Reputation, Underwriters’ Reputation and IPO Initial Returns in the Main and ACE Market

Table 5 shows the relationship between the signalling variables and IPO initial returns in the Main and ACE Market for the period 2005–2012.

The empirical results indicate that auditors’ reputation has a positively significant relationship (coefficient of 0.0725) in the Main Market but no relationship is documented in the ACE Market. As discussed in the earlier section, reputable auditors deliver extra credibility to the financial disclosures and signals firm quality to the potential investors. As for the ACE Market, reputable auditors do not seem to have any impact on the perception of investors on IPO firms. This could be due to the fact that most companies listed in the ACE Market are relatively young firms, with relatively minimal track record of prior performance.

Though a positive relationship is documented for auditors’ reputation and IPO initial returns, it is interesting to note that underwriters’ reputation has a significantly negative relationship with the IPO initial returns in both the Main and ACE Markets. The reputation of underwriters seems to be having an impact even in the ACE Market. The findings may suggest that issuers in both markets have preference to reputable underwriters as they are perceived as avoiding extreme underpricing in both markets. These underwriters make all attempts to price the offer price of an IPO closest to the fair value of the companies going public, thus minimizing ‘money left on the table’ for the issuers. This is particularly important for companies listed in the ACE Market, who are relatively low capitalized, growth companies.

Relationship Between Signalling Variables and IPO Initial Returns Before, During and After Global Financial Crisis

Table 6 shows the regression result for the relationship between auditors’ reputation, underwriters’ reputation and IPO initial returns before, during and after crisis.

The empirical results in Table 6 indicate that auditors’ reputation had a positively significant relationship (coefficient of 0.107) with the IPO initial returns before the crisis but a negative relationship (coefficient of –0.106) is evidenced after the crisis. The results can be supported with signalling hypothesis, which states that hiring a reputable auditor gives a positive signal to the investors about the firm quality. When the financial report is being audited by the prestigious auditors, it gives confidence to the investors that the report is free from misleading information. As discussed earlier, this may increase the demand for the IPOs in the secondary market, thus causing an increase in the IPO initial returns. Nevertheless, the same justification cannot be conjectured for the period after the crisis. Reputable auditors do not seem to give any sort of attestation to induce investors to increase demand in the secondary market. Investors may be relatively cautious on the performance of these IPOs as they have just gone through the crisis period. Alternatively, it could also be due to the fact that investors are of the opinion that underwriters have placed a fair value to the offer price and that they are sceptical in bidding for a higher price during this period.

As for underwriters’ reputation and IPO initial returns, there was a significantly negative relationship (coefficient of 0.100) during the crisis, but no significance is noted before and after the crisis. This may be an indication that investors are relatively more dependent on the signals from reputable underwriters during the crisis as compared to before or after.

Table 6.

Regression Result for Before, During and After Global Financial Crisis

	Before Crisis	During Crisis	After Crisis
	2005–2007	2008–2009	2010–2012
AuD	0.107*	0.089	–0.106*
	(0.088)	(0.471)	(0.068)
UwR	–0.019	–0.100***	–0.008
	(0.408)	(0.005)	(0.596)
FA	0.005*	0.001	0.003
	(0.089)	(0.790)	(0.291)
MC	0.018**	0.019	0.024**
	(0.047)	(0.162)	(0.033)
FSIZE	0.010**	0.000*	0.000**
	(0.000)	(0.069)	(0.000)
Adjusted R²	0.011	0.191	0.045
No. of Observations	127	32	69

Source: Authors’ own findings.

Notes: Standard errors are adjusted for heteroscedasticity, using the White’s test. *p significant at the 10% level; **p significant at the 5% level; ***significant at the 1% level. IR, Initial returns; AuD, Reputation of Auditors; UwR, Underwriters’ Reputation.

Conclusion

The purpose of this research is to examine the influence of underwriters’ and auditors’ reputation on IPO initial returns. Control variables used are firm age, firm size and market condition. Both auditors’ and underwriters’ reputation play a significant role in reducing asymmetric information and signalling firm value to the potential investors. Auditors’ reputation indicates a significantly positive relationship with the IPO initial returns. Reputable auditors are perceived by investors as giving a true and fair value of the audited reports and thus increase the demand for the IPOs in the secondary market. This subsequently causes the closing price on the first day to increase, thus impacting the initial returns. Nevertheless, after the Global Financial Crisis, a negative relationship is documented. As for the relationship between underwriters’ reputation and IPO initial returns, a negative relationship is documented. Reputable underwriters are cautious in their reputation capital and thus avoid overly underpricing the IPOs and leaving issuers money on the table. The negative relationship could also be due to investors’ perception that reputable underwriters would have placed the offer price of IPOs as close as possible to the market/fair value of the shares. These are most evident during the crisis.

Underwriters’ reputation plays a major role in an emerging market like Malaysia due to the presence of active retail investors who are less informed about the new issues. The negative relationship between the interacted auditors’ and underwriters’ reputation and IPO initial returns further strengthens the argument. Reputable underwriters and auditors have a signalling effect on the investors’ perception of the fair value of IPOs.

Implications

The result of this study may provide some insights about issuers and investors in an IPO environment. Both auditors and underwriters reputation reduce asymmetric information and signals firm quality, but the manner in which issuers and investors would want to use these signalling variables is very much dependent on their motivation and desires in an IPO environment. Reputable auditors undoubtedly add credibility to firm quality and thus firms should consider employing reputable auditors as these auditors assist in increasing the demand and liquidity for IPOs. It may create platforms for any exit strategies that venture capitalists or issuers have in the medium term. Investors who are risk-averse and intend to invest for medium to long-term should consider the reputation of auditors for the IPOs they plan to invest. As for underwriters’ reputation, if the issuers’ preference is to rather leave money on the table as a hedge against any uncertainty on the demand for IPOs and/or as part of their plans for future seasoned offerings, they may settle for non-reputable underwriters as the cost is much cheaper in terms of underwriters’ fee. Nevertheless, this will be at the expense of leaving more money on the table. Issuers who are confident on the companies’ future performance may prefer to minimize leaving money on the table and, thus, work with reputable underwriters in setting a price close to the fair value of the company. This will maximize shareholders value in both the short run and the long term. Thus, both issuers and investors should use this as guidance to aid in making their decision in terms of raising funds or investment in Bursa Malaysia IPOs. The results can also be used by regulators, that is, incorporating regulations pertaining to auditors and underwriters in an IPO environment.

Footnotes

Acknowledgements

The authors are grateful to the anonymous referees of the journal for their extremely useful suggestions to improve the quality of this article. Usual disclaimers apply.

Notes

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