Ch. 7: IPO Underpricing 401
quality of the board of directors, and in particular the choice of non-executive directors,
who similarly would put their reputation on the line; and direct disclosure of informa-
tion to IPO investors, backed by a mechanism designed to deter fraudulent disclosure
(Hughes, 1986).
3.4.1. Testable implications and evidence
The signaling models generate a rich set of empirical implications predicting that under-
pricing is positively related to the probability, size, speed, and announcement effect of
subsequent equity sales.^12 In common with the other asymmetric information theories
of underpricing, the signaling models also predict a positive relation between under-
pricing and the ex ante uncertainty about firm value. This follows because a noisier
environment increases the extent of underpricing that is necessary to achieve separa-
tion.
One of the most notable empirical tests of the signaling models is due toJegadeesh,
Weinstein, and Welch (1993). Using data on IPOs completed between 1980 and 1986,
Jegadeesh, Weinstein, and Welch find that the likelihood of issuing seasoned equity and
the size of seasoned equity issues increase in IPO underpricing, as expected. However,
they note that these statistically significant relations are relatively weak economically.
For instance, the least underpriced quintile of IPOs face a 15.6% likelihood of issuing
seasoned equity, compared to 23.9% in the most underpriced quintile. The results are
equally consistent with a pooling equilibrium: firms pool at the IPO and reissue equity
only once the market learns their true quality. Consistent with the possibility of pooling,
Jegadeesh, Weinstein, and Welch find that post-IPO share price returns better explain
whether a company subsequently raises equity than the degree of IPO underpricing.
AsMichaely and Shaw (1994)note, the decision how much money to leave on the
table and whether to reissue equity later on are not independent of each other in the
signaling framework. The same logic applies to the size of any seasoned equity offering.
Thus, these decisions should be modeled simultaneously. Michaely and Shaw estimate a
simultaneous system using underwriter reputation to identify the underpricing equation
and post-IPO performance to identify the equation modeling the size of the seasoned
equity offering. The results do not support the signaling models: the decision how much
to underprice is not significantly related to the reissue decision and vice versa, consistent
withJegadeesh, Weinstein, and Welch (1993).
Welch (1996)endogenizes the decision how long to wait before returning to the eq-
uity market. The longer a firm waits, the greater is the probability that nature will reveal
its true value. Thus a high-quality firm can afford to wait longer, but the cost of this
strategy is that it may not receive funds when it most needs them. Empirically, Welch
finds that the time to SEO increases in IPO underpricing while firms that return to the
market earlier do so after experiencing high post-IPO stock market returns.
(^12) For a survey of seasoned equity offers more generally, seeChapter 6by Eckbo, Masulis, and Nørli in this
volume.