Question

6) Evidence on IPO underpricing is provided in several empirical studies, including a seminal paper by Loughran and Ritter (2004). 7) On average, IPOs traded at a premium and one reason can be underpricing of IPO at the offer time. Briefly discuss whether this result is consistent with previous empirical studies (Loughran and Ritter (2004)about IPO traded at premium if they were underpriced at offer time.

Answer 1

Ans:

The purpose of this study is to provide empirical evidence for the phenomenon of underpricing of Initial Public Offerings. On the basis of sample IPOs from the NYSE and NASDAQ exchanges, the underpricing of stock IPOs is found to still be prevalent after the information technology bubble petered out in the early 21st century. A model has been developed to analyze the accuracy of a number of theories put forward to explain this underpricing, some which have not been the object of a comprehensive investigation, yet. The results indicate that underpricing can in part be explained by the informational asymmetry between the underwriters, issuing firms and investors. Furthermore, IPO underpricing is found to exhibit mild cyclicality and seasonality, and variations across economic sectors. Finally, this study finds that underpricing of IPOs is more severe on the NASDAQ than on the NYSE, and then examines the variations in underpricing across these two stock exchanges.

Most models of IPO underpricing are based on asymmetric information. There are two agency explanations of underpricing in the IPO literature. Baron (1982) presents a model of underpricing where issuers delegate the pricing decision to underwriters. Investment bankers find it less costly to market an IPO that is underpriced. Loughran and Ritter (2002) instead emphasize the quid pro quos that underwriters receive from buy-side clients in return for allocating underpriced IPOs to them. The managers of issuing firms care less about underpricing if they are simultaneously receiving good news about their personal wealth increasing. This argument, however, does not explain why issuers hire underwriters who will ex post exploit issuers’ psychology. Neither does the realignment of incentives hypothesis. One can view issuers as seeking to maximize a weighted average of IPO proceeds, the proceeds from future sales (both insider sales and follow-on offerings), and side payments from underwriters to the people who will choose the lead underwriter:

Underwriters, as intermediaries, advise the issuer on pricing the issue, both at the time of issuing a preliminary prospectus that includes a file price range and at the pricing meeting when the final offer price is set. If underwriters receive compensation from both the issuer (the gross spread) and investors, they have an incentive to recommend a lower offer price than if the compensation was merely the gross spread.

The willingness of buy-side clients to generate commissions by sending trades to integrated securities firms depends on the amount of money left on the table in IPOs. Underwriters have an incentive to underprice IPOs if they receive commission business in return for leaving money on the table. But the incentive to underprice presumably would have been as great in the 1980s as during the internet bubble period unless there was a “supply” shift in the willingness of firms to hire underwriters with a history of underpricing. We argue that such a shift did indeed occur, resulting in increased underpricing.

Why has underpricing changed over time? We explore three non-mutually exclusive explanations: changing risk composition, a realignment of incentives, and a changing issuer objective function. A small part of the increase in underpricing can be attributed to the changing risk composition of the universe of firms going public. The physical riskiness of firms going public, as measured, for example, by age or assets, did not change very much between the 1980s and the 1990s, although the bubble period saw a high proportion of very young firms go public, and the post-bubble period saw a high proportion of older firms.

The reasons that IPOs are underpriced vary, depending on the environment. In the 1980s, it is conceivable that the winner’s curse problem and dynamic information acquisition were the main explanations for underpricing that averaged 7% in the US. During the internet bubble, we think that these were not the main reasons for underpricing. Instead, analyst coverage and side payments to CEOs and venture capitalists became of significant importance.