When firms access public equity markets via an Initial Public Offering (‘IPO’), it is very common for the offering price to be substantially below the first day’s closing price. This ‘IPO underpricing’ has puzzled researchers and has been a topic of academic interest for several decades. Many proposed theories center around the underwriter (typically an investment bank), positing how the offering price of the firm is set, and why that offering price is systematically below the value of the firm. In ‘Investing in Security Price Informativeness: The Role of IPO Underpricing’, I present a new theory, along with supporting evidence, that firms, with the help of an underwriter, use underpriced shares to compensate investors for producing valuable, firm-specific information after the IPO.
The premise is that firms desire informative stock prices to guide future decision making. For example, when a firm’s stock price is higher than expected, managers can use that cue to increase investment. When firms utilize this ‘price feedback’, they desire more informative stock prices that make decision making (and the value of the firm) even better. A firm’s IPO provides an opportunity to target investors who produce information. These investors profit from their information through trading, which also makes prices more informative and the firm more valuable ex ante. Furthermore, allocating shares to information-producing investors can enhance information production. By owning part of the firm, investors internalize the benefits to firm value, leading to more aggregate information production. However, the benefits of internalized incentives can only be realized when investors have sufficiently large stakes. Unfortunately, when information is very valuable, which is likely for young, high-growth companies undergoing IPOs, providing sufficiently large stakes to many different investors may be infeasible.
To allow for larger groups of investors, I introduce underwriters and an additional source of incentives. While firms are one-time participants in the IPO market, underwriters conduct, and investors participate in, many offerings per year. As a result, this repeated interaction between underwriters and investors can be exploited to align incentives for information production, even after the IPO has occurred. The incentive for increased information production comes from increasing the underpricing of all IPOs. While the underpricing of a particular IPO has no bearing on investors’ incentives to produce information after that IPO (as the benefit is sunk), the potential to receive more underpriced allocations in the future does provide strong incentives. The implicit agreement is that investors will be rewarded for good, value-adding behavior (post-IPO information production) through future IPO allocations.
By connecting the IPOs through time, the underwriter is able to provide incentives that a firm cannot provide on its own. Thus, underwritten IPOs can provide incentives to many more investors by increasing underpricing, leading to more post-IPO information production and more valuable firms. Importantly, the increased underpricing should not be viewed as dead-weight loss to firms. Rather, the degree of underpricing optimally trades off the cost of a lower offering price against the benefit of a more informative future stock price.
Empirically, I use quarterly institutional investor holdings data to test several novel implications of the model. First, I find that investors who have more actively traded past IPOs are more likely to report holdings of future IPOs, consistent with the model’s repeated game. Second, younger firms with more growth options include more investors in their IPOs and their offerings are more underpriced, suggesting more intensive use of the proposed mechanism. Finally, these same firms’ investment decisions are more sensitive to their stock returns, consistent with the hypothesized price feedback channel.
My research suggests that investors and their reputations for providing value to firms is an important aspect of the IPO pricing process. Firms’ desires for an informative stock price provide a rationale for why certain investors are desirable, and underpricing provides a mechanism for firms to attract those investors. Underwriters serve a critical role in the process, connecting IPOs across time, certifying the quality of investors and allowing for repeated-game incentives that individual firms cannot provide.
David Brown is an Assistant Professor of Finance at the University of Arizona.