In recent years, investors and others in the financial community have devoted increasing attention to the role of sustainability in financial markets and the economy at large. Sustainability is now seen as an alternative form of risk management, a way to create and preserve non-monetary value for future generations, and an area in which markets and clients expect financial institutions and corporations to take significant action. With research showing that investors consider sustainability and ESG ratings in their investment decisions, accounting and investor-relations professionals are including ESG reporting and related strategies in their financial communications, including in analyses of initial public offereings.
In a new study, “ESG and the Pricing of IPOs: Does Sustainability Matter,” we find a significant relationship between ESG communications and IPO pricing and valuation: An increase in ESG disclosure is negatively associated with observed underpricing (first-day returns) and firm valuation. Thus, first-day returns, price revisions, and firm valuation decrease in response to more ESG disclosure.
Following Alexander Ljungqvist’s 2007 article, “IPO Underpricing,” our study elaborates on the concept that asymmetric information models have a first-order effect on underpricing. One of the three primary parties to an IPO – the issuer, the underwriter, and the investors – typically has more information than the others, and “the resulting information frictions give rise to underpricing in equilibrium” (Ljungqvist, 376). Furthermore, ESG disclosure alone can benefit a company’s financial performance.
Our model can detect and measure the amount of information about sustainability that the companies disclosed to investors just before their IPOs, looking specifically at the amount of ESG disclosure in the applicable Forms S-1 prospectuses, which are read mostly by institutional investors. These documents also serve as a primary source for financial media to disseminate information about future public companies. Thus, we argue that disclosing more ESG information in an S-1 prospectus diminishes the information asymmetry between a company and investors, positively benefiting the company’s financial performance in terms of less underpricing and valuation.
Our paper analyzes the amount of ESG disclosure in the S-1 prospectuses for 783 U.S. IPOs between 2012 and 2019, with the relevant shares trading on Nasdaq or NYSE. The study detects ESG communications embedded within broader IPO communications, representing the amount of ESG-related actions corporations are willing to commit to. The fact that S-1 textual-based ESG measures are independent from ratings by external agencies and are disclosed without a particular agenda make them more robust.
The paper’s framework is consistent with the expectation that information asymmetries will decrease, because disclosing new information diminishes the information asymmetry between the firm and investors. Our findings suggest that reducing information asymmetries is associated with a more accurate estimates of offer price, leading to lower first-day returns, lower price revision, and a more precise company valuation.
Our results show a significant negative association between ESG variables and underpricing, price revision, and firm valuation. Furthermore, the negative relationship with underpricing is greatest for all three ESG factors combined, next greatest for governance, then social, and then environmental one, while for the industry-adjusted Tobin’s Q (firm valuation) the greatest negative relationship is found as to governance, ESG overall, social, and environmental. By contrast, price revision is associated primarly with ESG disclosure as a whole, then environmental, then governance, and finally, social. In general, more ESG disclosure results in better understanding of IPO pricing and valuation.
ESG disclosure before an IPO – and the consequent reduction of information asymmetry – are, therefore, significantly associated with less underpricing and a more precise firm valuation, even when they are included within broader IPO communications.
This post comes to us from Alessandro Fenili and Carlo Raimondo at the University of Lugano. It is based on their recent paper, “ESG and the Pricing of IPOs: Does Sustainability Matter,” available here.