Handbook of Corporate Finance Empirical Corporate Finance Volume 1

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388 A. Ljungqvist


might be to identify specific uses or risk factors that, if present, indicate higher un-
certainty.Ljungqvist and Wilhelm (2003), for instance, argue that firms intending to
use their IPO proceeds mainly to fund “operating expenses” rather than investment or
debt repayment are potentially more risky. Finally, aftermarket variables such as trading
volume (Miller and Reilly, 1987) or volatility (Ritter, 1984, 1987) rely on information
which was not in fact available at the time of the IPO. Indeed, it is even possible that
such variables are endogenous to the outcome of the IPO. For instance, heavily under-
priced IPOs tend to generate more investor interest and so more after-market trading,
with the causation running from underpricing to after-market trading behavior rather
than the other way around.


Underwriters that underprice too much (too little) lose business from issuers (inves-
tors).


Consistent withBeatty and Ritter’s (1986)claim that underwriters coerce issuers into
underpricing to prevent uninformed investors leaving the IPO market,Nanda and Yun
(1997)find that overpricing (but not high levels of underpricing) lead to a decrease in
the lead underwriter’s own stock market value, whereas moderate levels of underpricing
are associated with an increase in stock market value, perhaps indicating that underwrit-
ers can extract quid pro quo benefits from investors to whom they allocate moderately
underpriced shares. In a similar vein,Dunbar (2000)finds that banks subsequently lose
IPO market share if they either underprice or overprice too much, squarely supporting
Beatty and Ritter’s claim.


Underpricing can be reduced by reducing the information asymmetry between informed
and uninformed investors.


As underpricing represents an involuntary cost to the issuer, there are clear incentives
to reduce the information asymmetry and the resulting adverse selection problem be-
tween informed and uninformed investors.Habib and Ljungqvist (2001)generalize the
notion that issuers have an incentive to reduce underpricing, and model their optimal
behavior. They argue that if issuers can take costly actions that reduce underpricing,
they will do so up to the point where the marginal cost of reducing underpricing further
just equals the marginal benefit. This marginal benefit is not measured by underpricing
itself, but by the reduction in the issuer’s wealth loss that underpricing implies. Wealth
losses and underpricing are not the same: compare an issuer who floats a single share
with one who floats the entire company. Clearly the latter’s wealth would suffer much
more from underpricing, giving him a stronger incentive to take costly actions to reduce
underpricing. Using data for a large sample of IPOs completed on Nasdaq in the early
1990s, Habib and Ljungqvist find that issuers optimize, in the sense that spending an
additional dollar on reducing underpricing would reduce wealth losses by 98 cents at
the margin—resulting in a net benefit that is statistically zero.
A specific way to reduce the informational asymmetry is to hire a prestigious un-
derwriter (Booth and Smith, 1986; Carter and Manaster, 1990; Michaely and Shaw,
1994 ) or a reputable auditor (Titman and Trueman, 1986). By agreeing to be associ-
ated with an offering, prestigious intermediaries “certify” the quality of the issue. For

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