376 A. Ljungqvist
5.2. Underpricing as a means to reduce agency costs 411- Behavioral explanations 412
6.1. Cascades 412
6.1.1. Testable implications and evidence 413
6.2. Investor sentiment 414
6.2.1. Testable implications and evidence 414
6.3. Prospect theory and mental accounting 416
6.3.1. Testable implications and evidence 417- Concluding remarks 417
References 418
Abstract
When companies go public, the equity they sell in an initial public offering tends to
be underpriced, resulting in a substantial price jump on the first day of trading. The
underpricing discount in the United States averaged more than 20% during the 1990s,
implying that firms left considerable amounts of money on the table. What explains this
phenomenon?
This chapter reviews the principal theories that have been proposed to explain IPO
underpricing and discusses the empirical evidence. Theories of underpricing can be
grouped under four broad headings: asymmetric information, institutional, control, and
behavioral. The key parties to an IPO transaction are the issuing firm, the bank under-
writing and marketing the deal, and the new investors. Asymmetric information models
assume that one of these parties knows more than the others, and that the resulting in-
formation frictions give rise to underpricing in equilibrium. Institutional theories focus
on three features of the marketplace: litigation, banks’ price stabilizing activities once
trading starts, and taxes. Control theories argue that underpricing helps shape the share-
holder base so as to reduce intervention by outside shareholders once the company is
public. Finally, behavioral theories assume the presence of ‘irrational’ investors who
bid up the price of IPO shares beyond true value.
Broadly speaking, the empirical evidence supports the view that information fric-
tions have a first-order effect on underpricing. At the same time, the enormous variation
in the extent of underpricing over time raises doubt in some people’s mind whether
information-based explanations on their own can account for the huge amounts of
money left on the table in hot markets, such as the internet bubble of 1998–2000. Arising
from this debate, there is continued interest in behavioral explanations, cross-country
tests that exploit interesting institutional differences, conflicts of interest within invest-
ment banks, and the use of auctions to market and price IPOs.