IPOs
IPO Anomalies and Stylized Facts
• Underpricing
– On average IPO shares are underpriced in the market (18%).
• Aftermarket Price Stabilization
– Underwriter sells more shares than they buy (Aggarwal 2000).
• Strong demand? Cover short position via overallotment option.
• Weak demand? Cover short position via open market purchases.
• IPO Lockups
– Information Asymmetry?
– Moral Hazard?
• Waves (Lowery and Schwert 2003, Loughran and Ritter 2002)
• Long-run (under)performance
– Ritter (1991), Barber and Lyon (1997), Gompers and Lerner (2001)
Benveniste and Spindt
• Point out that there are two types of asymmetric
information of concern in the IPO process
– Between the firm and the market
• Certification role
• Underwriter reputation backs this role
– Between different types of investors
• Bookbuilding process
• Investors have little incentive to reveal positive information
• Underwriter being a repeated player in the market is
important here as well
Benveniste and Spindt
• Underpricing combined with differential allocation is
used to provide informed investors with the incentive to
truthfully reveal positive information.
– Underpricing provides a benefit to receiving an allocation.
Payment for truthful disclosure.
– Skewing the allocations to investors in the “premarket”
who reveal positive information and away from those who
reveal negative information makes truthful revelation
incentive compatible and can help minimize underpricing.
– This is how Benveniste and Spindt model the roadshow and
the bookbuilding process that characterize the actual IPO
procedures in the US.
Benveniste and Spindt
• Empirically:
– Underpricing is directly related to the ex ante
marginal value of private information.
– Underpricing is directly related to the level of
interest in the premarket.
– Underpricing is directly related to the level of
presales.
– Underpricing is minimized if priority is given to
orders from investors who indicate good
information.
Litigation
• Litigation risk:
– Underpricing has been conjectured by Ibbotson 1975,
Tinic 1988, Hughes and Thakor (1992) to be a form of
insurance against future litigation.
– Section 11 of the securities act of 1933 gives investors
the right to sue issuers and underwriters for declines in
value below the offer price if there are material
omissions in the prospectus.
– The inherent uncertainty of IPO pricing and the
potential reputational losses associated with litigation
suggest that issuers and underwriters may attempt to
hedge litigation risk by underpricing.
Cornelli and Goldreich 2001
• Data on “books” and allocations for 39
international equity offerings (23 IPOs and 16
SEOs) from 1995 - 1997.
– They can study how information is provided by
investors in the indications of interest.
– They can also study who gets what and why.
Cornelli and Goldreich 2001
• Bids
– A strike bid is a request for shares regardless of the
issue price
– A limit bid specifies the maximum price that the
bidder is willing to pay for the shares
– A step bid is a demand schedule submitted as a
step function
Allocations
• Strike bids for fixed quantities of shares reveal no
information on pricing the issue.
– If all bids were strike bids for a fixed quantity of shares the
demand curve would be perfectly inelastic.
• Limit bids revel information
– Limit bids provide specific information on the elasticity of
demand.
– They also put the bidder at risk:
• If the limit price is too low, the issuer may set the price higher and the
bidder receives no allocation.
• If the limit price is too high, the issuer may raise the offer price and the
bidder receives an over-priced issue.
• A testable implication of the information extraction theories
is therefore that limit bids should see favorable allocations.
Allocations
• Beatty and Ritter 1986: riskier issues are more
underpriced.
– Pooling offerings allows the underwriter to reduce
average underpricing.
– Underwriter uses his discretion over allocations to
enable him to pool offerings (Benveniste and Spindt).
– Underwriter should discriminate in allocations based
on past participation in offerings.
– Frequent investors should not receive higher returns on
average as they are simply being compensated for
buying less successful offerings.
Allocations
• Welch 1992: informational cascades
– Underwriter may attempt to encourage early
demand for shares by informed investors as this
may encourage other investors to follow.
– Requires that the underwriter “hint” at the early
demand to investors.
– Underwriter may give larger allocations to early
bids as the “encouragement.”
Allocations
• Other predictions:
– Ownership distribution – spread ownership to
increase liquidity and so favor investors who
demand a smaller number of shares (Brennan and
Franks 1997) or look to build blockholders.
– Issuer or the investment bank may prefer investors
from the issuing firm’s country or it may prefer a
widely dispersed set of equityholders.
– Lead underwriter may favor investors who place
bids directly with them.
Results
Profits
Hanley and Hoberg 2010
• The underwriter may expend resources prior to
filing the prospectus with the SEC to collect
information about the offer and use this to set the
initial price range.
• However, the information will be believed only to
the extent it supported by informative disclosure
in the prospectus and during the road show.
• This disclosure may itself have a cost for some
firms as it may reveal strategic or proprietary
information to rivals.
Hanley and Hoberg 2010
• Alternatively, the underwriter and the issuing firm
may rely on the information produced by
investors during the bookbuilding period.
• Investors must be compensated for gathering and
revealing valuable information.
• There is then a tradeoff between the cost of
gathering and revealing information in the
prospectus and gathering information during the
bookbuilding period.
• They examine whether there is evidence of this
tradeoff and evaluate its impact on IPO pricing.
Hanley and Hoberg 2010
• Cannot measure the amount of premarket
information gathering. Instead they consider
disclosure in the prospectus.
• Decompose the initial IPO prospectus into
standard content and informative content.
– Standard content is exposure to information that is
already contained in recent and past industry IPOs.
– Informative content is the residual.
• Greater information gathering and revelation
should result in more content that is unique to a
particular IPO.
Hanley and Hoberg 2010
• To the extent it is efficient, greater information
gathering in the premarket period should result in
more accurate initial offer prices relative to the
final offer price before bookbuilding begins and
so reduce the need for information gathering
during bookbuilding.
– Offers with greater informative content will have
smaller absolute changes in offer prices relative to the
initial price range.
– Offers with greater informative content will have
lower underpricing.
Hanley and Hoberg 2010
• Use algorithms to gather prospectuses and to sort the
texts into “normalized word vectors” that can be
compared across IPOs.
• Consider the total prospectus as well as the four main
sections: Prospectus Summary, Risk Factors, Use of
Proceeds, Management’s Analysis and Discussion.
• Use a measure of “document similarity” to decompose
“standard” content (similar to recent prospectuses from
the same underwriter and similar to past prospectuses in
the same industry) and content that is not similar
(informative content).
Hanley and Hoberg 2012
• Litigation Risk
– Section 11 of the Securities Act requires a loss and material
omissions in the prospectus.
– Disclosure and underpricing are substitute hedges against
liability risk.
– They use a similar methodology as in the last paper to
study this tradeoff and its impact on IPO pricing.
– Cannot measure a “material omission” but they can
examine the extent to which the disclosure strategy of the
issuing firm adjusts to the arrival of information during the
bookbuilding period.
• Consider 1) the extent to which the initial price range is adjusted
and 2) whether the initial prospectus is not substantially revised
during the offering period.
Hanley and Hoberg 2012
• Litigation Risk Hedging
– If an issuer receives bad news during the bookbuilding period, its
price is set too high. The issuer will be able to reduce the price
but its ability to use underpricing as a hedge may be limited by a
minimum proceeds constraint or the threat of a pulled offer.
Increased disclosure becomes paramount.
– If the issuer receives good news during the bookbuilding period,
its price is set too low. The issuer will raise the price and in this
case both underpricing and disclosure can be freely used as
hedges against litigation risk. Underpricing protects the
underwriter from section 11 lawsuits.
• Underwriter is named in over 70% of all section 11 lawsuits but only in
3% of 10b-5 suits.
• Underwriter suffers significant reputational and market share losses
when named in a suit.