Truland Building, 400A
January 29, 2009, 07:00 PM to 07:00 PM
Companies go public in order to get access to equity-financing. Initial public offering (IPO) is the first issue of company’s shares to investors. This study will primarily focus on the efficiency of the IPO process since the majority of companies raise external equity finance only once at the time of their IPO. The focus on IPOs in the recent two decades has arisen in particular due to the empirical evidence of consistent initial underpricing. The definition of the IPO underpricing is the difference between the IPO price and the closing market price on the first day of trading on the stock market. The important implication of the initial underpricing is that it raises the cost to the firms of going public, and ‘leaves money on the table’ for the investors who purchase the shares at the IPO. The average initial underpricing was 7.4% in the 1980s, 14.8% during 1990-1998, and an astounding average of 65% in 1999-2000, averaging between 11% and 18% thereafter. It is the amount of underpricing in 1999-2000 and the investment banking scandals in early 2000s that have raised serious questions about the conduct of the underwriters and the choice of an IPO pricing and allocation mechanism. The existing IPO mechanisms are discussed and scrutinized in this chapter to shed light on the objectives of the participating parties in the IPO. The existing mechanisms are book-building, fixed-price offers, and varieties of auctions. Ever since the first empirical observation of underpricing, various models have been put forth that attempt to explain the persistence of underpricing as a strategy. This study reviews such theories and models. Due to the lack of conclusive evidence I study the questions using experimental laboratory methods. I use an asymmetric-information game-theoretic signaling model, in which underpricing can serve as a signal of a firm’s high quality. Two equilibria, a separating and a semi-pooling, are derived, and the strategic implications of each are discussed. For each equilibrium condition I describe and compare the performance of two institutions, by which a firm can offer equity. The data analyses suggest that the underpricing levels are different for the two institutions considered. Underpricing-signaling is observed in a separating equilibrium and only initially in a semi-pooling equilibrium in the environment of uncertainty. The institution that allows for competitive bidding among investors produces lower levels of underpricing compared to a posted price offer equivalent to book-building method.