Disclosure of Downside Risk and Investors' Use of Qualitative Information: Evidence from the IPO Prospectus's Risk Factor Section

I use the context of a company's initial public offering ( IPO ) of equity securities as a capital‐market setting to empirically study the economic consequences of risk factor disclosures. Using data from A ustralian IPOs , I examine the relation of textual risk disclosures in the prospectus to initial underpricing. I find that the quantity of disclosures in the risk factor section itself has no significant impact on initial underpricing. However, an increase in the informativeness of risk factor disclosures is associated with lower IPO underpricing. My results suggest that IPOs that provide informative risk factor disclosures have less ex ante uncertainty, in the sense that the disclosures help investors estimate the dispersion of secondary market value. The effect of informative risk factor disclosures on IPO underpricing is more pronounced for IPOs with less prestigious lead underwriters and is mainly driven by younger firms, smaller firms, and firms with poorer operating performance prior to their IPOs . Collectively, my findings suggest that informative disclosures of downside risk are useful for investors to evaluate IPOs .