272 B.E. Eckbo et al.
3.3. Underpricing of SEOs
Underpricing is typically the most important indirect flotation costs in a security offer-
ing. There are several ways to measure underpricing of security issues. The offer price
can be compared to the closing price, bid, ask or midpoint on the prior trading day or
the first trade day following SEO completion. The offer price relative to the closing
price on the offer date is generally termed the underpricing level. Researchers have also
examined the offer price relative to the prior day’s high and low prices.
We will focus most of our attention on recent empirical developments in IPO and
SEO underpricing.Ljungqvist (2007)provides an excellent review of the theory and
evidence on IPO underpricing elsewhere in this book. He concludes that much of the
underpricing effect can be explained by information frictions including theBenveniste
and Spindt (1989)theory that underwriters reward investors for information on issue de-
mand through underpricing, as well as underwriter certification and various agency the-
ory models which explore the conflict between IPO investors and issuer/management.
In a recent IPO study,Li and Masulis (2006)explore the effects of pre-IPO eq-
uity investments by major financial institutions including commercial banks, investment
banks, venture capitalists and insurance companies, controlling for whether these finan-
cial institutions are also lenders to the firm or underwriters in its IPO. They examine
these venture investment effects on IPO underpricing, offer price revisions from the fil-
ing range, post-IPO long run performance. Li and Masulis also employ a large number
of other control variables used in earlier studies. They find evidence consistent with fi-
nancial institution certification through venture investment, that is associated with lower
IPO underpricing and offer price revisions and better long run performance. They also
find that there are incremental certification effects as additional classes of financial in-
stitutions invest in these issuers. These results are robust to controlling for several forms
of endogeneity. They also report that the coverage of pre-IPO loans is more completely
reported in offering prospectuses than in the Dealscan loan database.
In another recent IPO study,Edelen and Kadlec (2005)develop a model of under-
pricing based on the probability of offer withdrawal and the importance of a successful
offering. In essence, when the firm’s stock price is rising before the offer day, managers
are more willing to increase IPO underpricing to enhance the likelihood of a successful
offering. Their model can explain why there is partial adjustment to public information
released between the filing date and the offering date and it takes into account pub-
lic information spillovers from the issuers industry. They report that their model can
explain a large portion of the cross sectional dispersion in IPO underpricing and can
explain hot issues markets. In their analysis, they useHeckman (1979)’s two step pro-
cedure where in the first step they estimate the probability of offer withdrawal and then
in the second step they estimate the determinants of underpricing. They find that the
estimated probability of an offer withdrawal has a significant negative effect on IPO un-
derpricing. Their model also predicts an inverse relation between withdrawal frequency
and industry stock returns between the filing and withdrawal dates. They argue that the
asymmetric partial adjustment effect to industry information spillover effects found in