Handbook of Corporate Finance Empirical Corporate Finance Volume 1

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Ch. 7: IPO Underpricing 379


in which underpricing is used to induce optimal selling effort.Welch (1989)and others
assume that the issuer is better informed about its true value, leading to an equilibrium
in which higher-valued firms use underpricing as a signal.Rock (1986)assumes that
some investors are better informed than others and so can avoid participating in over-
valued IPOs. The resulting winner’s curse experienced by uninformed investors has to
be countered by deliberate underpricing. Finally,Benveniste and Spindt (1989)assume
that underpricing compensates better-informed investors for truthfully revealing their
information before the issue price is finalized, thus reducing the expected amount of
money left on the table.
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 shareholder base so as to reduce intervention by outside
investors once the company is public. Behavioral theories assume either the presence
of ‘irrational’ investors who bid up the price of IPO shares beyond true value, or that
issuers suffer from behavioral biases causing them to put insufficient pressure on the
underwriting banks to have underpricing reduced.
Broadly speaking, the empirical evidence supports the view that information frictions
(including agency conflicts between the issuing company and its investment bank) con-
tribute to IPO underpricing. The evidence regarding institutional theories is more mixed,
not least because we still observe underpricing in countries where litigation, price sta-
bilization, and taxes play no role in the IPO market. Control theories are relatively new
and the final word is still out on their plausibility. Behavioral approaches, finally, are at
present still in their infancy, though what evidence is available is generally consistent
both with the presence of overoptimistic investors and with behavioral biases among the
decision-makers at IPO firms.
The empirical IPO literature has become increasingly sophisticated, focusing on test-
ing specific hypotheses or entire models, sometimes in a structural econometric fashion,
rather than simply describing the phenomenon of underpricing or correlating it with
more or less ad hoc variables. The move towards more sophisticated, theory-led tests is
a very positive development. As we will see, it has on more than one occasion led to
received wisdom being overturned.
In addition to becoming more sophisticated econometrically, the empirical IPO lit-
erature has also increasingly recognized the importance and power of the institutional
framework within which IPOs are conducted. To provide a benchmark, consider the
way the typical IPO is conducted in the U.S. Having chosen an investment bank to
lead-manage its IPO, the company first files a registration (or S-1) statement with the
Securities and Exchange Commission, containing descriptive and accounting informa-
tion about the company’s history, business model, performance, and so on. The S.E.C.
vets the information for misstatements and omissions, a process which takes several
weeks. Once the S.E.C. declares the offer ‘effective’, the investment bank introduces
the company to institutional investors on a so called ‘road show’. The managers pitch
the company’s investment case, and the investors provide feedback in the form of more
or less explicit, but always non-binding, indications of interest. On the basis of these

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