View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Number 94-10, March 11, 1994

The IPO Underpricing Puzzle
A large number of initial public offerings (IPOs)
have come to market recently, and many have
had a substantial run-up in price during early
trading. A striking example is the offering by
Boston Chicken, in which shares were offered
at $20 and appreciated to $48.50 by the end of
trading the first day. This level of price appreciation is by no means common, and many initial
public offerings are followed by price declines.
Nevertheless IPOs in the
have consistently
shown substantial initial-day returns averaging
15.3 percent for the 1960 to 1992 period, and
similar results have been found for at least 25
other countries (Loughran, Ritter, and Rydqvist


While several explanations of IPO underpricing
have been presented, it remains something of a
puzzle to academic researchers who generally
support the concept of efficient markets. This
Letter discusses the structure of the IPO market
and presents a summary of the explanations that
have ben proffered to account for IPO underpricing. Finally, it looks at the available evidence to
distinguish the relative importance of each explanation and briefly discusses some of the
questions that remain.

Going public
In the u.s. market, companies going public most
frequently issue their equity securities through
an investment bank using a "firm commitment"
contract, in which the investment bank temporarily purchases the shares before they are allocated to the public. A less popular method is a
"best efforts" offering, typically used for small
and very young firms. In this case, the investment bank agrees to undertake its best efforts
to sell the issue within a designated marketing
period (usually 90 days).
In firm commitment contracts, the investment
bank and firm agree on a preliminary price
range for the shares. Then, during a pre-issue
marketing period, indications of interest are collected from potential subscribers. Just before the
offer date a final offer price is agreed upon that

in the majority of issues is within the initial price
range. The investment bank then has discretion
to allocate the shares among potential subscribers at this price. Thus, when there is substantial
oversubscription, as often happens, some potential subscribers may receive only a fraction of the
shares desired or be excluded from the issue.


Outside the
these procedures often differ.
For example, new issues on the French Bourse
require the issuing firm to state a minimum price
and then accept sealed bids for price and number of shares. The issuer, investment bank, and
exchange agree on a market-clearing price. The
most common difference is in the way oversubscription is handled, because not all countries
give investment banks discretion to allocate
shares. An extreme example is the Singapore IPO
market where shares must be allocated by lottery
within different classes of order size. Loughran,
et aI., find that, typically, investment banks use
discretionary procedures for allocating shares,
unless such procedures are ruled illegal. Regardless of the procedures used, they find initial
underpricing in all 25 countries considered.

Theories on (PO underpricing
If markets are efficient, as qcademic researchers
often contend, then the widely documented large
initial returns to IPOs are puzzling, because firms
appear to be leaving large amounts of money on
the table when going public. But analysis suggests that underpricing does not necessarily
occur for every issue at every point in time. Ritter
(1987) finds that only 54 percent of a large sample of IPOs in the
had positive initial-day
returns. Also, evidence indicates that the market
for IPOs goes through cycles, with larger amounts
of underpricing in "hot" periods, when a lot of
issues are coming to market, and smaller
amounts of underpricing in "cold" periods,
when only a few firms are going public.


This suggests that it is difficult to determine the
value of shares in this market. Consistent with
this, the rationales for IPa underpricing offered
often rely on assumptions that the value of firms

cannot be estimated precisely and that there are
information asymmetries among groups of market participants.
An early explanation along these lines suggested
that the initial underpricing is designed to "leave
a good taste in the mouth" of investors. Initial investors, it is argued, remember the firm favorably
when it returns to the market later to raise capital. This will increase the demand for shares for
the subsequent offerings and allow the firm to recover some or all of the lost proceeds from the
initial underpricing. An extension of this argument suggests that large initial underpricing leads
to more potential investor interest in the IPO-a
lot of "hype;' in the jargon-which produces
additional information about the firm. That additionalinformation lowers the costs associated
with future issues by the firm.
A second explanation focuses on the interests of
the investment bank. Investment bankers may use
superior information to underprice an issue intentionally to reduce their marketing costs or to
create good will with investors. This explanation
runs into trouble in terms of the potential damage
to their reputation with other firms going public.
Perhaps the most popular explanations of initial
underpricing rely on adverse selection associated
with receiving an allocation of particular IPOs.
Even if values are uncertain, investors with superior information would be less likely to purchase
issues that are overpriced. As a result, less informed investors would be allocated more of the
shares in the less attractive overpriced issues. As
a result, .less informed investors would earn
lower, even negative, average returns on the issues they are allocated and might choose not to
participate in IPOs. Thus to attract these investors to the IPO market, investment bankers must
deliberately underprice new shares to overcome
this form of the winners' curse problem and permit less informed investors to earn a positive
While this explanation has some appeal, it leaves
many questions unanswered. Perhaps most important is whether an equilibrium level of underpricing exists that will attract these less informed
investors given that the better informed investors
will increase demand in response to deliberate
An extension of this framework relies on the less
informed demand as a lever to extract informa-

tion from those with superior estimates of the
value of the shares. If some potential investors
have better estimates of value than the investment bankers, then the investment bankers'
threat of allocating to the less informed investors
motivates the better informed to reveal their true
demand for shares. This information can then be
used in setting the final offer price to maximize
proceeds. In this framework initial underpricing
continues to exist as compensation to those with
superior information for truthfully revealing their
demand for shares. To make this explanation consistent with equilibrium, investors with superior
information must be able to affect the final offer
price by understating their demand for shares.
Second, this behavior cannot damage their reputation with investment banks who might ration
them out of future issues. These interdependent
assumptions appear unlikely to hold in equilibrium, particularly if there are several informed
In a related explanation,investment bankers reduce the adverse selection consequences associated with the issuers' superior information about
the value of the firm. If investment bankers develop a reputation for certifying that issues are
priced consistent with any superior inside information, they have reason to protect their reputation for this service. Thus investment bankers
may underprice to protect their reputation with
A more recent explanation suggests an information framework where the success of an issue
depends on getting investors approached early in
the IPO process to view it favorably; subseq uent
investors then base their opinions and demand
on the reaction ofearly potential investors.

Empirical evidence
Each of the explanations for underpricing IPOs
has some appeal, but they lack convincing empirical support. Studies that attempt to distinguish
between the various explanations for underpricing are rare. Beatty and Ritter (1986) document
that investment bankers who underprice more or
less than the average for each risk level lose future IPO market share. This suggests that reputation plays an important role in establishing the
equilibrium level of underpricing for any particular issue. This evidence is inconsistent with the
notion that investment bankers are underpricing
to take advantage of less informed issuing firms.
Koh and Walter (1989) provide evidence related
to the adverse selection characteristics associated
with investing in IPOs. They find in theSingapore IPO market that underpricing is positively
related to the level of oversubscription and that
the ratio of shares requested by large investors

increases with the level of underpricing. Thus
small investors are more likely to be allocated
shares in less underpriced issues. However, they
find that issues are oversubscribed on average by
40 times the number of shares. These results appear, at best, mixed regarding whether initial
underpricing is used to attract less informed
investors to purchase shares.


More recent evidence for the
market by
Weiss-Hanley (1993) relies on data for the preliminary filing range price data relative to the
final offer price. With firm commitment issues in
the preliminary prospectus lists a preliminary price range and then on the offering day
the final offer price is set. Evidence shows that
if the final offer price is above the midpoint of
the filing range then underpricing is higher, because a final offer price above the midpoint of
filing range is interpreted as evidence of strong
preliminary demand for the issue. These results
are consistent with investment bankers adjusting
the final offer price to reflect unexpectedly large
demand for a particular issue. Why the price is
not fully adjusted to reflect the increased demand is not clear.


Perhaps the most interesting evidence related to
initial underpricing is found in McDonald and
Jacquillat (1974). Using data from the sealed-bid
auctions of companies to be listed on the French
Bourse, they found that even after the issuing
firm, bankers, and the exchange know the demand curve for the shares, they attempt to underprice by approximately 3 percent to encourage
potential investors to continue to bid for the
shares. It is worth noting that the relatively low
underpricing they attempt to achieve is for established and well-known firms.
Data presented in these studies, plus the international evidence that initial underpricing is common across different markets, suggest that the
bias toward underpricing is intentional. Additionally, it appears that investors' costs of participating in these markets are of concern when attempting to set the level of underpricing. That is,
the average underpricing of IPOs may be necessary to compensate potential buyers for the cost
of participation.

Large initial-day returns to IPOs on average are
and in other marwell-documented in the


kets. What is less understood is the rationale for
this apparent practice of "leaving money on the
table" when firms go public. Explanations for this
behavior have traditionally relied on some form
of informational asymmetry among the issuer, the
investment banks, and the different groups of
investors. Limited empirical evidence suggests
oversubscription and underpricing are positively
related and that issues are intentionally underpriced even when the issuer can observe the
demand for shares through a sealed-bid auction.
A lack of data on discretionary allocation decisions in oversubscribed issues limits research
distinguishing between theories presented to
date. Virtually ignored in explanations of initial
underpricing is the potential benefit to secondary
market liquidity from pricing to promote secondary market liquidity.

James Booth
Visiting Scholar, and
Associate Professor of Finance
Arizona State University

Beatty, Randolph, and Jay Ritter. 1986. "Investment
Banking, Reputation, and the Underpricing of Initial
Public Offerings:' journal of Financial Economics,
Koh, Francis, and Terry Walter. 1989. "A Direct Test of
Rock's Model of the Pricing of Unseasoned Issues:'
journal of Financial Economics, pp. 251-272.
Loughran, Tim, Jay Ritter, and Kristian Rydqvist. 1994.
"Initial Public Offering Underpricing: International
Insights." Pacific-Basin Finance journal (forthcoming in March).
McDonald, John G., and Bertrand C. Jacquiliat. 1974.
"Pricing of Initial Equity Issues: The French Sealedbid Auction." journal of Business, pp. 37-47.
Weiss-Hanley, Kathleen. 1993. "The Underpricing of
Initial Public Offerings and the Partial Adjustment
Phenomenon:' Journal of Financial Economics,
pp. 231-250.

Correction: Due to a clerical mistake, the example

of a nominal income targeting rule in the last issue of
the Weekly Letter (94-09) contained an error: In the
third to last paragraph, trend growth in real GDP
should read "2112 percent:'

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.




'S)jU! ueaqAos lIl!M
'!)I' Jaded papAOaJ uo palulJd

Ont6 V:) 'OJSPUI?JJ ui>s
lOLL xog "O"d

JO ).fU08
aAJaSa~ IOJapa:l

~uew~Jodea 4)JOeSe~

Index to Recent Issues of FRBSF Weekly Letter




The Federal Budget Deficit, Saving and Investment, and Growth
Adequate's not Good Enough
Have Recessions Become Shorter?
California's Neighbors
inflation, interest Rates and Seasonality
Difficult Times for Japanese Agencies and Branches
Regional Comparative Advantage
Real Interest Rates
A Pacific Economic Bloc: Is There Such an Animal?
NAFTA and the Western Economy
Are World Incomes Converging?
Monetary Policy and Long-Term Real Interest Rates
Banks and Mutual Funds
Inflation and Growth
Market Risk and Bank Capital: Part 1
Market Risk and Bank Capital: Part 2
The Real Effects of Exchange Rates
Banking Market Structure in the West
Is There a Cost to Having an Independent Central Bank?
Stock Prices and Bank Lending Behavior in Japan
Taiwan at the Crossroads
1994 District Agricultural Outlook
Monetary Policy in the 1990s


The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.