416 A. Ljungqvist
same time, the reduction in offer size aggravates long-run underperformance, given the
negative slope of the sentiment demand curve.
Recall from Section3.1that the empirical evidence on the relation between under-
writer reputation and underpricing is mixed. Consistent with evidence from the 1990s
(Beatty and Welch, 1996), Ljungqvist, Nanda, and Singh (2004)predict that underpric-
ingincreases in underwriter reputation. Underwriters enjoying a large IPO deal flow can
more easily punish regular investors who attempt to free-ride on the inventory-holding
strategy by dumping their shares prematurely, before the price falls. This in turn implies
that the more active banks can underwrite larger IPOs, as more inventory can be held
over time. Since underpricing is compensation for the expected inventory losses in the
face of a non-zero probability that the hot market will end before all inventory has been
unloaded, the more active underwriters will be associated with greater underpricing.
6.3. Prospect theory and mental accounting
Loughran and Ritter (2002)propose an explanation for IPO underpricing that stresses
behavioral biases among the decision-makers of the IPO firm, rather than among in-
vestors. Combining prospect theory-style reference-point preferences withThaler’s
(1980, 1985)notion of mental accounting, Loughran and Ritter argue that issuers fail to
‘get upset’ about leaving millions of dollars ‘on the table’ in the form of large first-day
returns because they tend to sum the wealth loss due to underpricing with the (often
larger) wealth gain on retained shares as prices jump in the after-market. Such ‘com-
placent’ behavior benefits the investment bank if investors engage in rent-seeking to
increase their chances of being allocated underpriced stock.
Loughran and Ritter (2002)assume that the decision-maker’s initial valuation beliefs
are reflected in the mean of the indicative price range reported in the issuing firm’s
IPO registration statement. This belief serves as a reference point against which the
gain or loss from (as opposed to the expected utility of) the outcome of the IPO can be
assessed. The offer price for an IPO routinely differs from this reference point, either
because the bank ‘manipulated’ the decision-maker’s expectations by low-balling the
price range, or in reflection of information revealed during marketing efforts directed
at institutional investors. As argued earlier, offer prices appear only to ‘partially adjust’
(Hanley, 1993) in the sense that large positive revisions from the reference point are
associated with large initial price increases from the offer price during the first day
of trading. Such partial adjustment is consistent with both theBenveniste and Spindt
(1989)information-acquisition model of IPO underpricing and Loughran and Ritter’s
complacency argument.
The decision-maker perceives a positive revision from the reference point as a wealth
gain (assuming he retains shares after the IPO). At the same time, a positive initial return
is perceived as a wealth loss under the assumption that shares could have been sold at
the higher first-day trading price. If the perceived gain exceeds the underpricing loss,
the decision-marker is satisfied with the IPO underwriter’s performance at the IPO.