The ESG Movement Has Led to Better IPO Disclosure
Environmental, social and governance (ESG) investing has grown in popularity. This has coincided with more comprehensive ESG disclosures by firms in their initial public offerings (IPOs) and has reduced the historical underpricing. This benefited companies and reduced returns to IPO investors.
A large body of academic literature, such as the study, “The Long-Term Performance of IPOs Revisited,” has found underpricing of IPOs – a positive return from the offer price to the closing price of the first trading day. The literature has also documented that IPOs with both high and low underpricing significantly underperformed mature firms over the first year after going public, and that the underperformance existed even if the IPO occurred in a period of “hot” issuance.
In the last few years, investors and the financial community have devoted increasing attention to the role of sustainability in financial markets. Alessandro Fenili and Carlo Raimondo contributed to both the IPO and the sustainable investing literature with their June 2021 study, “ESG and the Pricing of IPOs: Does Sustainability Matter?” Their hypothesis was that “information frictions may be what cause most of the underpricing.” They argued that disclosing more ESG information in the S-1 prospectus (mandatory communication occurring before the IPO date) diminishes the information asymmetry between the company and the investors, positively benefiting the companies’ financial performance in terms of less underpricing and evaluation. Their second hypothesis was that the most negative relationship with underpricing, in order of magnitude, would be found with the governance disclosure, second the environmental disclosure, third the social disclosure, and last with the ESG disclosure as a whole. Their third hypothesis was that there is a negative correlation between the amount of ESG disclosure in the S-1 and the firm’s evaluation because disclosing information diminishes the information asymmetry.
Based on a sample of 783 U.S. IPOs over the period 2012 through June 2019, they computed a text-based measure of ESG disclosure in IPOs. Following is a summary of their findings:
- The amount of ESG disclosures in S-1s was negatively associated with IPO underpricing. For example, IPOs in the first environmental quartile had average first-day returns of 29.8% compared to 14.9% for the fourth environmental quartile, a difference of 15.0 percentage points. The difference between the other extreme quartiles of social, governance and ESG was 7.3, 9.3 and 12.0 percentage points, respectively.
- A large increase in the number of environmental, social, governance and ESG words (the cumulative number of E, S, G) in the S-1 form led to reduced information asymmetry, a decrease in underpricing, and a positive effect for the company.
- The most negative relationship with underpricing, in order of magnitude, was found with ESG as a whole, second governance, third social and then environmental – this result may be due to retail investors finding more useful the disclosure of all three ESG variables as a whole rather than singularly.
- Not only has there been a trend that sees the S-1 forms on average becoming more prolonged and detailed, but the same is happening for the ESG disclosure as a whole. Such a trend likely is a result of companies seeing that it is ever more critical to disclose more, and possibly be more detailed, on such topics.
- Their findings were robust to various tests.