Ch. 7: IPO Underpricing 391
A second advantage of repeated interaction is that is allows underwriters to ‘bundle’
offerings across time. To ensure continued access to lucrative IPOs in the future, in-
vestors will from time to time buy poorly received IPOs, as long as the loss they suffer
in any given IPO does not exceed the present value of future rents they expect to derive
from doing business with the underwriter. This leads to an important implication for the
allocation patterns we expect to see. Underwriters should treat regular investors more
favorably than occasional investors even when the latter bid more aggressively into the
book than the former. This follows because the value of the bank’s underwriting activ-
ities depends more on the future cooperation of regular investors than on being able to
price any given IPO more fully.
3.2.1. Extensions
TheBenveniste and Spindt (1989)paradigm has been extended in numerous ways.
Benveniste and Wilhelm (1990)investigate its interaction withRock’s (1986)winner’s
curse. If bookbuilding succeeds in extracting the informed investors’ private infor-
mation, the informational asymmetry among investors will be reduced. This, in turn,
reduces the winner’s curse and thus the level of underpricing required to ensure un-
informed investors break even. As argued earlier, regulatory constraints on allocation
decisions, common outside the U.S., reduce the effectiveness of bookbuilding, because
they undermine underwriters’ ability to reward informed investors for truth-telling. Such
constraints can therefore weaken underwriters’ ability to reduce the winner’s curse,
again resulting in higher underpricing.^7
Giving underwriters discretion over allocation decisions is not the only way to lower
information acquisition costs. Generally, any tool that allows the underwriter to more
directly and exclusively target the reward at those investors who reveal their private in-
formation can reduce the overall cost of information acquisition, to the benefit of issuers.
One such tool, proposed byBenveniste, Busaba, and Wilhelm (1996), is the promise of
selective price support—effectively, a put option offered selectively to co-operative in-
vestors. In many countries underwriters intervene in the after-market to prevent prices
from falling below the offer price. Empirical evidence suggests this ‘money-back guar-
antee’ benefits large investors especially, who are likely to be the type of investors
underwriters seek to involve in the bookbuilding process.^8
Busaba, Benveniste, and Guo (2001)show that underwriters can reduce the required
extent of underpricing if the issuer has a credible option to withdraw the offering.
Downplaying positive information increases the likelihood that the issuer will with-
draw, which reduces an investor’s gain from misrepresenting positive information. This
in turn reduces the reward required to induce truthful revelation. Consistent with this
(^7) Note that here theexistenceof underpricing is due to asymmetric information and a winner’s curse, while
institutional factors affect the level/extent of underpricing.
(^8) I will discuss price support more fully in Section4.2.