Initial Public offering Underpricing

Initial Public Offering Underpricing

        Initial public offerings (IPOs) of common stock attract a great deal of interest from potential investors.  The primary reason for this interest is the widely known fact that IPOs tend to be priced well below the price investors are apparently willing to pay for them.  A 1975 study by Ibbotson found that an investor who purchased shares of each of 112 issues at the initial offering price and then resold them one month later would have earned an average abnormal return of 11.4%.  Think about this for a moment — an average return of 11.4% per month above and beyond what one would expect from a similarly risky security.  In  fact, it’s even better than that.  A number of subsequent studies that have examined a large fraction of IPOs brought to market over the last three decades provide evidence of average abnormal returns in excess of 15% over the first day of trading for firm commitment offerings.  Abnormal returns for best-efforts offerings appear to be on the order of three times this large!

        Now of course not all IPOs exhibit such remarkable performance.  But this evidence suggests an apparently airtight investment strategy: simply buy every IPO which comes to market and close your position at the end of one month, or better yet, at the close of the first day of trading.  Although you would certainly take losses on some of your purchases, if the market holds true to form, the winners will more than offset your losses.

        If the apparent benefits of such a strategy are widely known (which they are), why aren’t investors beating down the doors of investment banks to invest in IPOs and thereby bidding away these excess returns?  Should they?  Answering these questions requires that we learn more about the process of bringing an IPO to market and the forces that come to bear during this process that might lead to underpricing.

Marketing an IPO

        Firms involved in an IPO do not sell the issue directly to the ultimate investors.  Rather, the firm is represented by an investment bank (underwriter).  Prior to the offering the investment bank performs an analysis of the firm and its prospects for the future and reports the conclusions of this analysis in a preliminary prospectus, or “red herring.”  Even at this first stage of the process we can see the value of engaging the underwriter.

        Suppose the firm were to produce the preliminary prospectus internally.  Since the underwriter must bear a substantial cost to become as knowledgeable about the firm as the firm is about itself, on the surface this would appear to make perfect sense.  On the other hand, if the firm does not plan to issue additional equity in the future, it would have a strong incentive to overstate its prospectus in an effort to drive up the price investors are willing to pay for the issue.  Unfortunately for the firm, a wise investor would recognize this incentive, and therefore discount the firm’s claims.  In fact, the firm’s prospectus would probably be treated as largely meaningless.  Lacking useful information about issuing firms’ prospects, investors would only be willing to pay an “average” price for the shares of any single firm.  The net result would be that “bad” firms would still tend to raise more capital through the IPO than their prospects would warrant while “good”  firms would raise less.

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