Is the new issue puzzle real? Evidence from implied cost of capital

What is it about?

This study sheds new light on the question why IPO firms underperform the market within a 3-5 years period after the offerings. Previous studies have been arguing that IPO reduce the risk exposure of newly listed firms as leverage reduces and liquidity improves, contributing to the underperformance. However, employing market implied cost of capital (ICC) as proxy for ex-ante expected returns, I find that the market expects to earn higher (rather than lower) risk premium for new listing firms than similar firms, contradictory to the documented new issue puzzle and explanation of reduced risk exposure. The higher expected returns likely come from higher idiosyncratic volatility for newly listed firms, which are young and have more growth opportunities. I also provide evidence suggesting that investors are negatively surprised by lower-than-expected performances of newly listed firms. My results also provides supplementary empirical evidence that ex-post realized returns can be a noisy proxy for ex-ante expected returns, especially for newly listed firms with limited information.

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