ipo underpricing paper final

6/24/2015

IPO Underpricing Why do shareholders leave money

on the table?

Moritz Grahm, Buenyamin Oezyuerek, Tiancheng Tian and Rajil Shah BEHAVIORAL FINANCE

Moritz Grahm, Buenyamin Oezyuerek, Tiancheng Tian and Rajil Shah Behavioral Finance Gregory Lablanc

HULT INTERNATIONAL BUSINESS SCHOOL San Francisco Campus | 1355 Sansome Street San Francisco, CA 94111 1/15

Contents

1. Introduction ........................................................................................................................................... 2

2. IPO Methods .......................................................................................................................................... 3

3. Asymmetric Information ....................................................................................................................... 4

3.1. Information Revelation ................................................................................................................. 5

3.2. Adverse Selection .......................................................................................................................... 7

4. Behavioral Explanations ........................................................................................................................ 8

4.1 Investor Sentiment and Informational Cascades .......................................................................... 8

4.2. Prospect Theory .......................................................................................................................... 10

5. Conclusion ........................................................................................................................................... 11

References ................................................................................................................................................... 13

Appendix...................................................................................................................................................... 14

Appendix A .............................................................................................................................................. 14

Appendix B .............................................................................................................................................. 15



1. Introduction

IPOs are a major milestone for the company’s original shareholders – entrepreneurs, angel investors and

venture capitalists – as the point to withdraw their investments and harvest their assets. Given the

sophistication of the entrepreneurial, investment banking and investor industry, the IPO process should

run smoothly and result in efficient allocation of resources. However, the phenomenon of IPO

underpricing may raise questions about this inference (Jenkinson and Ljungqvist, 2001).

Underpricing refers to the percentage difference between the first day closing price and the offer price

to new shareholders. Empirical literature has abundantly documented large initial returns for newly

trading stocks. For instance, Ljungqvist (2007) provides evidence of underpricing in the U.S. market and

for a range of other developed countries (see Appendix A). Figure 1 reveals interesting observation

about underpricing: the degree of underpricing varies substantially over time (Ljungqvist, 2007).

Figure 1: Initial IPO returns in the United States, 1960 to 2003.

Source: Ljungqvist (2007), p. 382.



Existing shareholders suffer from two effects when the IPO is underpriced. First, if an individual

shareholder decides to sell her shares in the IPO, her loss reflects the underpricing multiplied by the

shares sold. Second, even if a shareholder does not sell her shares in the IPO, she will experience a loss

from additional dilution due to the underpricing of new shares. However, the shareholders’ total loss is

usually far smaller than the above documented underpricing as they only sell a fraction of their shares in

the IPO and few new shares are issued in the IPO. Thus, the measured underpricing overstates the loss

experienced by shareholders. Yet, shareholders could substantially benefit from less underpricing

(Jenkinson and Ljungqvist, 2001).

Underpricing thus raises the question, why original shareholders offer stakes in their company at a

considerably lower price than what the shares are worth in the aftermarket? Or put differently, why do

shareholders “leave money on table” in the IPO process?

2. IPO Methods

Before we turn to the various explanations for the underpricing phenomenon, we shortly discuss the

three IPO methods. In general, companies can choose between auctioning, fixed-price offers and book

building. Since underpricing varies across the IPO methods, the choice directly affects the money left on

the table.

Book building is a process managed by the underwriters in order to extract investors’ private

information about the issuing company (Benveniste and Spindt, 1989). As the initial pricing is highly

complex, the book building process aims to gather and aggregate investors’ valuation and demand in the

upcoming IPO. In doing so, the underwriter tries to simulate the market process and find the market-

clearing price. The dynamic book building process is able to include both negative and positive feedback

from investors about the underwriter’s pricing deliberations (Jenkinson and Ljungqvist, 2001). While the

book building is in process, investors may already commit to buy shares in the IPO, revealing even more

information to the underwriters. This commitment and revelation of private information has to be

rewarded by underwriters, otherwise investors will not cooperate (Benveniste and Spindt, 1989). This

compensation for being truthful can either come from underpricing or additional allocation of shares. As

the final allocation of shares is at the underwriter’s discretion, cooperating investors can easily be

rewarded and free riding is not worthwhile. In addition, book building allows controlling information

expenditures and thus reducing underpricing and aftermarket volatility (Sherman, 2005).



Book building has therefore evolved as the dominating method for going public, although it has been

criticized to entail various drawbacks (Jagannathan and Sherman, 2006). For instance, agency conflicts

arise since the underwriting investment banks have an incentive to increase underpricing in order to

reduce their underwriting risk (Adams, Thornton and Hall, 2008). Moreover, investors can induce

underwriters to excessive underpricing by offering them side payments via higher trading commissions

(Ljungqvist, 2007). Despite those agency issues, book building still seems to offer the most benefits to

shareholders.

In contrast to book building, auctions are not subject to agency problems and they have demonstrated

to allocate assets efficiently in various settings. However, auctioning is troublesome for IPOs since

companies going public are difficult to value and a large uncertainty exists about the number of bidders

(Sherman, 2005). For instance, auctions face free rider problems if information about the value of the

IPO is costly. If investors are not rewarded for their information acquisition, they will ultimately leave the

market. Furthermore, common value auctions give raise to the winner’s curse. If the number of bidders

is unexpectedly high, the IPO is likely to be oversubscribed and overpriced, while an unexpectedly low

participation will lead to undersubscription (Jagannathan and Sherman, 2006). As a result, auctions are

not the optimal method, which is empirically supported by its low application in the IPO process.

In a fixed-price IPO, the offer price is set by the underwriter prior to share requests from investors. If the

IPO is oversubscribed, the shares are allocated on a pro rata or lottery basis. Thus, investors do not have

an incentive to reveal their private information to the underwriter, who has less information about

pricing the offer. Due to higher uncertainty about investors’ valuation and demand, underpricing should

be higher in fixed-price offers than book building (Ritter, 2003).

3. Asymmetric Information

One string of explanations for IPO underpricing focuses on asymmetric information between the three

parties involved: issuing company, underwriter, and potential investors (both informed and

uninformed). In the asymmetric information setting, one party is supposed to have superior information.

Furthermore, the incentives between the parties vary substantially. For instance, the issuer is more likely

to overestimate the value of the company (e.g. by hiding negative information to outsiders). In doing so,

they can obtain higher offer prices and avoid leaving the money on the table (Benveniste and Spindt,

1989). In contrast, informed investors have no incentives to reveal their private positive information



about the company in order to benefit from lower initial offer prices. Uninformed investors trade on

noise and are thus more likely to participate in both high and low quality IPOs. However, if they cannot

at least break even, they will ultimately leave the market and reduce market demand below required

levels (Adams, Thornton and Hall, 2008). Agency problems concerning the underwriters have already

been discussed section 2. Generally, issuers try to align underwriters’ incentives by tying underwriting

fees to the IPO proceeds (usually 7%). Therefore, underwriters suffer from underpricing, i.e. receive

lower commissions. However, both the issuer and the underwriter do not want undersubscription,

which induces them to set a lower offer price (see Appendix B for a summary of expectations each party

holds in the IPO process).

3.1. Information Revelation

As mentioned above, the book building process aims to extract the investors’ private information in

order to find the market’s willingness to pay for the IPO. Although investors will voluntarily reveal

negative private information about the company to lower the initial price, they have an incentive to

conceal their positive information. Lowry and Schwert (2004) confirm this inference, finding that public

information is fully reflected in the offer price while private information is only partially incorporated.

However, investors’ private information is essential in finding the optimal offer price. Benveniste and

Spindt (1989) show that book building can be a mechanism to induce investors to reveal their

information truthfully. The underwriter starts the book building process by proposing an initial price

range for the IPO and goes on a road show. As the investors indicate their interests for shares, the

underwriter can draw conclusions about the investors’ willingness to pay and set the final offer price

accordingly. Yet, the underwriter has to reward the investors, who reveal positive information by

bidding aggressively. First, underwriters only partially adjust the filed price range upward to the

indicated positive information, i.e. underprice the stock (Ritter, 2003). Hanley (1993) finds empirical

evidence for underpricing by partial adjustment. She documents that offer price revisions of the

preliminary prospectus coincides with higher underpricing. Second, underwriters assign

disproportionately large allocations of shares to investors who reveal positive information. Meanwhile

the underwriter allocates less or no shares to the investors who conceal positive information by bidding

conservatively (Benveniste and Spindt, 1989). Therefore, investors have a strong incentive to

communicate their private positive information to the underwriter and underpricing is the reward for

truth-telling investors. We will model this inference by applying game theory.



Game Theory of Information Revelation1

Underwriters typically face the issue of not knowing whether investors have revealed all of their private

information. In addition, investors might have different opinions on revealing their information to the

underwriter. Therefore, information revelation may not be the only equilibrium in a single game setting.

However, repeated participation in the IPO process will ultimately force all investors to reveal their

positive private information about the issuing company as underwriters have the power to exclude

untruthful investors from future IPOs.

Suppose investor A and investor B (illustrated in the table) have two choices: reveal positive information

to the underwriter or conceal. If both investors choose to reveal, they face a higher offer price but

receive higher underpricing to reward their cooperation (10/10). If both investors choose not to reveal

their private information, they face a lower offer price and thus get a higher payoff (15/15). If one party

chooses to reveal and the other does not, the one who reveals gets a higher payoff (12) as more shares

are allocated to her and the other investor receives no shares and thus a payout of zero. If investors

make the same choice, the underwriter cannot detect if all private information has been revealed.

However, if investors differ in their choice, the underwriter will reward the investor who reveals her

information with additional shares and punish the other investor by assigning him no shares.

Investor B: Reveal Investor B: Not Reveal

Investor A: Reveal 10/10 12/0

Investor A: Not Reveal 0/12 15/15

Table 1: Payoff Matrix for Information Revelation.

As a result, in the single game setting there are two equilibria: either both of them choose to reveal or

both of them choose not to reveal. This means that investors’ bidding strategy is dependent on other

investors’ decision to maximize her individual interest. The game above has another important

implication. If there is only a single game, investors get the highest payoffs from both choosing not to

reveal their private information. This comes at the expense of the issuing company, which will price its

stock at a lower level when investors do not communicate any positive information.

1 This section builds on the idea of game theory according to Fudenberg and Tirole (1991).



In reality, the underwriter “forces” the investors into the revelation equilibrium for several reasons.

First, informed investors are regular game players who repetitively participate in IPOs. The underwriter

can identify investors’ behavior by observing the stock price in the aftermarket. Therefore, the

underwriter can decide to exclude untruthful investors from future IPOs (i.e. changing all payoffs for not

revealing information to zero). As investors want to participate in attractive future IPOs, they will tend to

reveal their information. Second, informed investors will reveal reliable information, as they do not want

to deteriorate their reputation. Independent and objective valuations are valuable for underwriters in

finding the best offer price, while the provision of unreliable information will ultimately be detected and

underwriters will punish those investors. Therefore, investors have an incentive to avoid free riding and

deliver independent valuations to the best of their knowledge. As a result, investors tend to reveal

positive and reliable information as their optimal choice (Ljungqvist, 2007).

3.2. Adverse Selection

In addition to the information revelation, the winner’s curse can help to explain IPO underpricing. Rock

(1986) studies the winner’s curse by setting up an asymmetric information model. He assumes that

investors can be divided in two groups: informed and uninformed investors. While informed investors

have superior information about the true value of the issuing company, the uninformed investors have

less valuable information. Thus, informed investors will stay away from weak IPOs and only bid for

attractive offerings. In contrast, uniformed investors bid indiscriminately. As a result, uninformed

investors face the winner’s curse: they will overpay in unattractive IPOs. In addition, uninformed

investors will only receive a small fraction of the desirable offerings since they have to share the gains

with the informed investors. Hence, uniformed investors will receive a return below the average

underpricing (Ritter, 2003).

If the expected returns for uniformed investors become negative, they will eventually withdraw from the

IPO market, leaving only informed investors. Rock (1986) assumes that the participation of uninformed

investors is essential for the primary market since demand from informed investors is insufficient to sell

out (even the most attractive) offerings. However, Ljungqvist (2007) agrees to this assumption and

shows a market of only informed investors is not in equilibrium. If all investors are informed, only

attractive IPOs will take place while all others fail. With a single uninformed investor, unattractive

offerings would still lack demand and fail. Thus, the uninformed investor can free ride on the other

market participants, who face the cost of information acquisitions. Hence, free riding is a profitable



strategy in the world of informed investors and more investors are induced to stay uninformed.

However, in a world of uninformed investors it pays to become informed and omit unattractive IPOs.

Consequently, both informed and uninformed investors exist in equilibrium and the excess return of

informed over uninformed investors should equal the cost of information acquisition. The existence of

uniformed investors, who realize below average returns, and the necessity to have sufficient demand

require all IPOs to be underpriced in expectation, turning uninformed investors’ returns non-negative.

However, the individual issuing company does not have a strong incentive to contribute to the long-term

viability of the IPO market. As going public is a one-off event, the single company benefits from reduced

underpricing while issuing companies collectively gain from underpricing. In order to avoid free riding,

underwriters, who recurrently participate in the IPO process, ensure sufficient underpricing to reduce

the winner’s curse for investors (Jenkinson and Ljungqvist, 2001). Moreover, the book building process

can used to reduce the winner’s curse even further. Underwriters can reward participation in weak IPOs

with subsequent larger allocations in more attractive deals. This intertemporal pooling improves the

average return for those investors and therefore, reduces the need for underpricing (Ritter, 2003).

4. Behavioral Explanations

While asymmetric information can explain, why IPOs should generally be underpriced, the concepts

discussed in section 3 have trouble explaining high degrees of observed underpricing and its high

variation over time (Ljungqvist, 2007). Figure 1 shows particularly large underpricing during the dotcom

boom between 1999 and 2001 with average underpricing exceeding 50%. Therefore, we turn to

behavioral concepts in order to explain excessive underpricing.

4.1 Investor Sentiment and Informational Cascades

Investor sentiment is referred to as the overall belief or attitude of investors toward a security or the

financial market as a whole. This belief may be excessively optimistic or pessimistic for people with

positive and negative sentiments respectively (Bower, 1981 and 1991). Hence, investors’ choices may

not always be governed by information on hand, driving prices away from fundamentals. The latter can

particularly be observed in IPOs since companies going public are typically young, immature, and lack

total information transparency, resulting in difficulties to determine fair value (Ljungqvist, 2007). In

“hot” markets, sentiment investors seems to heavily overstate valuations and cause stocks to surge

during the first trading days. However, the sentiment will eventually fade and stocks revert to their



fundamental value, resulting in poor long-term performance of IPOs (Ljungqvist, Nanda, and Singh,

2006). The opposite is true for cold markets. Yet, companies rather choose to defer their IPO than going

public in a pessimistic market environment, providing unfavorable valuations. As a result, companies try

to time their IPOs in order to capture the excessive valuations during boom times while passing over

recessions (Baker and Wurgler, 2000).

Ljungqvist, Nanda, and Singh (2006) develop a model of optimal response in the presence of sentiment

investors when going public. The issuing company tries to maximize the excess valuation over the

fundamental value of the stock, by capturing the optimistic view of sentiment investors about the

company’s future prospects. Instead of flooding the market with stock and suppress prices, the issuer

should hold back shares and continuously release small portions in order to avoid share prices from

falling. This allows the company to ride the upward trend. However, the stock will eventually revert to its

fundamental value. The resulting long-term underperformance has been documented in various

empirical research (Ljungqvist, 2007). If regulatory constraints prevent the issuer from directly exploiting

this strategy, he can do so via regular investors, who resell the shares to sentiment investors. In such a

scenario, regular investors realize gains from trading with sentiment investors and thus, the offer price

will still be higher than the fundamental value to the benefit of the issuer (Ljungqvist, Nanda, and Singh,

2006).

Investor sentiment increases underpricing if positive sentiment causes the stock to overshoot and close

above the fundamental value during the first trading day while the opposite holds true for negative

sentiment. However, issuers time their IPO in order achieve more favorable valuations and sell at higher

prices. Thus, investor sentiment usually results in higher underpricing.

In addition to the overall market sentiment, informational cascades can cause prices to deviate from

fundamentals. The occurrence of such cascades is hence another explanation to the underpricing

phenomenon. Market sentiment develops over time while informational cascades can spontaneously

emerge without the appearance of any relevant information. Those cascades occur when investors base

their investment decisions on the observed behavior of other investors instead of trading on their

original information (Welch, 1992). Despite having favorable information about a company’s stock, an

investor may omit an investment if he observes that other investors choose not to buy the stock.

Consequently, cascades rely on positive feedback mechanisms, which can affect the IPO process (Ritter,

2003).



From the issuer’s perspective, a positive cascade is desirable while a negative cascade can be

devastating. In order to start a positive cascade, the issuer can artificially reduce the initial offer price to

encourage purchases. Once investors have started to purchase, a cascade will unfold where all the later

investors will buy the stock regardless of their initial information about the company. Hence, successful

initial sales signal favorable information to other investors and induce them to disregard their own

information. However, the opposite can occur if initial sales are slow. As a result, demand either surges

or collapses in the IPO (Ljungqvist, 2007).

Similar to market sentiment, positive informational cascades will lead to higher closing prices, above the

fundamental value. Therefore, observed underpricing increases in the presence of informational

cascades. Yet, issuers also have an incentive to reduce the offer price (i.e. underpricing) in order to

increase the likelihood of a positive cascade. Concisely, investor sentiment and informational cascades

can explain the very high degrees of underpricing if enough irrational exuberance prevails in the market.

4.2. Prospect Theory

While the paragraph above has covered investors’ irrationalities, the prospect theory helps to

understand why the decision makers may agree to severe underpricing and leave money on the table. By

linking reference-point preferences with mental accounting, Loughran and Ritter (2002) explain the

shareholders’ fallacy when calculating their change in wealth. The authors argue that shareholders use

the midpoint of the initial price range in the preliminary prospectus as a reference point for their

potential gains. Then they evaluate their accumulated first-day gains and losses against the reference

point. As shareholders usually retain most of their shares, they experience a substantial increase in

wealth in the aftermarket while the loss from dilution and selling own shares is marginal.

We provide an example to illustrate the prospect theory explanation. We assume that a company has a

single shareholder owning 100,000 shares (100%). The initial price range in the prospectus is $15-25 and

we use the midpoint ($20) for the calculations. In the IPO, the company sells 10,000 share at the offer

price of $20 per share and creates 20,000 new shares. Thus, the original shareholders retains 90,000

shares (a 75% stake post-IPO). Initially, the shareholder estimates her wealth to $2,000,000. After the

IPO, the equity value amounts to $2,700,000 (=$30*90,000 shares). In addition, she receives $200,000 in

cash for selling 10,000 shares. Her losses come from selling her shares at a low price ($30-$20)*10,000 =



$100,000 and dilution ($30-$20)*20,000 = $200,000. In total, her wealth has increased by $600,000

although she has left $300,000 on the table.

Prospectus Price Range Aftermarket

Share Price $20 (midpoint) $30 (first day closing price)

Shares Retained 100,000 90,000

Share Sold 10,000

New Shares 20,000

Equity Value $2,000,000 $2,700,000

Cash Proceeds 200,000

Loss from Sale $(100,000)

Dilution $(200,000)

Total Wealth $2,000,000 $2,600,000

Table 2: Prospect Theory and Shareholder Wealth.

Prospect theory can explain, why this shareholder is satisfied with 50% underpricing and leaving

$300,000 on the table. Furthermore, prospect theory makes an argument for experiencing higher

underpricing. If decision makers use the initial price range as a reference and do not adjust it upward,

underwriters can exploit this behavior by setting artificially low price ranges and thus increase

underpricing. Additionally, prospect theory reveals why offer price only partially adjust to market

fluctuations during the book build process. Since decision-makers see their wealth increasing, they

bargain less hard to achieve a higher offer price (Ljungqvist, 2007).

5. Conclusion

In this paper, we compiled the most relevant explanations for underpricing. However, in academic

literature various alternative explanations can be found, which are beyond the scope of our discussion.

For instance, institutional frictions and explanations relying on the retention of ownership and control

have been deliberately omitted as asymmetric information and behavioral concepts seems to have the

largest influence on the degree of underpricing.



We started our discussion with a short review about the IPO methods. By combining the three IPO

methods with asymmetric information models, book building has demonstrated to serve all IPO

participants the best.

Then we focused our attention on asymmetric information models, which seems to have a first-order

effect on underpricing. In order to have a successful IPO, underwriters need to make sure to have i)

enough demand and ii) set an appropriate price. The discussed concepts address those very points. The

winner’s curse explains why underpricing is necessary in order to generate sufficient demand. The IPO

market relies on both informed and uninformed investors. However, uniformed investors are at a

disadvantage in selecting IPOs and leave the IPO market if they experience continuously negative

returns. Therefore, IPOs have to be underpriced in the first place. In contrast, information revelation is

needed to price IPOs appropriately. Informed investors have an incentive not to share their positive

private information with the underwriter. If the underwriter wants to extract these valuable pieces of

information, investors have to be offered a reward, i.e. underpricing. In short, underpricing is a

requirement in order to go public and the money left on the table can be interpreted as indirect costs in

the IPO process.

While asymmetric information models explain why IPOs should be priced below their fundamental

value, behavioral biases generate valuable insights into why IPOs tend to close above fundamentals. By

timing the IPO and inducing a positive informational cascade, issuers can realize extreme first day

returns. However, prices will ultimately revert to the fundamental value. As the underpricing associated

with behavioral biases relates to excessive valuations during the first trading day, shareholders are

hardly able to capture those. Setting higher offer prices may prevent positive cascades from occurring or

even induce negative ones. Thus, shareholders do not seem to leave money on the table, as they cannot

exploit the irrational exuberance in the IPO process. Finally, prospect theory is another explanation why

shareholders are not upset about high initial returns. Since they retain most of shares, shareholders’

total wealth usually increases during the first trading day compared to their reference point.



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Appendix

Appendix A

Figure 2: Initial IPO returns in Europe, 1990 to 2003.

Source: Ljungqvist (2007), p. 383.



Appendix B

Players Expectations

Issuing company High price, sell out shares

Underwriter High price, no undersubscription

Informed Investors Low price, high allocation of shares

Uninformed Investors Low price, break even over sequential IPOs

Table 3: IPO parties and their expectations.

ipo underpricing paper final

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