Ch. 7: IPO Underpricing 411
response to large-scale buying. This will tend to make it unprofitable to assemble a large
block of shares in the aftermarket, the more so the more diffuse the ownership structure
is to start with. Empirically, however, this argument meets with little success.Field and
Sheehan (2004)find next to no relation between the creation of new blocks after the
IPO and the level of underpricing at the IPO.
5.2. Underpricing as a means to reduce agency costs
Brennan and Franks (1997)implicitly assume that, in the wake of the separation of
ownership and control, managers try to maximize their expected private utility by en-
trenching their control benefits. However, it could be argued that managers should
actually seek to minimize, rather than maximize, their scope for extracting private ben-
efits of control. Why? Agency costs are ultimately borne by the owners of a company,
in the form of lower IPO proceeds and a lower subsequent market value for their shares.
To the extent that managers are part-owners, they bear at least some of the costs of their
own non-profit-maximizing behavior. If their stakes are large enough so that the agency
costs they bear outweigh the private benefits they enjoy, it will be in their interest to
reduce, not entrench, their discretion.
Based on this intuition,Stoughton and Zechner (1998)observe that, in contrast to
Brennan and Franks, it may be value-enhancing to allocate shares to a large outside
investor who is able to monitor managerial actions. Monitoring is a public good as
all shareholders benefit, whether or not they contribute to its provision. Since a large
shareholder will monitor only in so far as this is privately optimal (which is a function
of the size of her stake), there will be too little monitoring from the point of view of
both shareholders and incumbent managers. To encourage better monitoring, managers
may try to allocate a particularly large stake to an investor. However, if the allocation
is sub-optimally large from the investor’s point of view (say, because it is not easily
diversified), an added incentive may be offered in the form of underpricing. Such un-
derpricing may not even represent an opportunity cost: in the absence of monitoring, the
firm would have had to be floated at a lower price anyway, owing to outside shareholders
anticipating higher agency costs.
A closer look at Stoughton and Zechner’s model is constructive. The selling mecha-
nism is modeled as a two-stage process akin to bookbuilding. In the first stage, issuers
extract the demand schedule from a likely monitor and set the offer price such that this
investor optimally demands a large enough number of shares to subsequently engage
in effective monitoring. In the second stage, small investors are allocated shares at the
same price (unless price discrimination is possible, which in practice it rarely is). Ra-
tioning is observed at this stage, as small investors would like to buy further shares at
the low offer price.
Why are the predictions of Brennan and Franks and Stoughton and Zechner so differ-
ent? There are at least two reasons. The first is the different institutional environments in
which the models are placed. Brennan and Franks effectively model an IPO mechanism
involving prices that are fixed rather than responsive to demand and shares that are allo-