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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. IPO Basics. Key Definitions. Key Questions and Answers.
IPO Background and History. How It Works. Deeper Dive. Company Profiles IPOs. What Is Underpricing? Key Takeaways An IPO may be underpriced deliberately in order to boost demand and encourage investors to take a risk on a new company.
It may be underpriced accidentally because its underwriters underestimated the demand in the market for this company's stock. In any case, the IPO is considered underpriced by the difference between its first-day closing price and its set IPO price.
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A hot IPO is an initial public offering of strong interest to prospective shareholders such that they stand a reasonable chance of being oversubscribed. This means that the companies issuing securities are leaving money on the table! It is amazing that such a trend is emerging despite the fact that capital markets all over the world are competitive, and hence any pricing discrepancies should immediately get corrected.
In this article, we will understand why IPOs are often underpriced and the role that investment bankers play in it. There have been formal studies that have been conducted by many organizations to help zero down the reason behind the underpricing of IPOs. The four major reasons that have been listed in these studies are discussed below:. Monopoly of Investment Bankers: Many studies have argued that since investment banks had a monopoly on the underwriting of shares, the issues were being underpriced.
This is because the investment banker has an incentive to underprice the shares. If the price of shares is sold below the market price, then the investment banker has a higher probability that they will be able to sell all the shares easily.
However, if the issue is fairly priced, there is always a chance that all the shares might not be sold off at once. Hence, pursuant to the underwriting clause, the investment bank will have to hold on to some of the shares on their books. This would mean that their own capital gets locked, and they have to undertake the risks. This is the reason that investment bankers deliberately underprice their shares. Investment bankers have been arguing that this is incorrect.
This is because it is not true that they hold a monopoly over the underwriting of shares anymore. Ever since the Glass Steagall Act has been repealed, commercial banks, foreign banks, and a wide variety of institutions have the ability to underwrite shares. Hence, the competition amongst various underwriters should ideally eliminate the underpricing of shares.
But underwriters still discount the stock to incentivize aggressive bidding and to ensure that the bids are not even lower since the more bids there are, the more information is revealed about the appropriate price for the stock.
Issuers accept this underpricing because it allows underwriters to better gauge a higher sale price. This theory too has found empirical support in the academic literature. A third strand of the informational asymmetry theory asserts that underpricing is associated with the weakness of the issuer.
The underpricing is intended to compensate the purchasers for this weakness. This theory has found weak evidential support. The investment bank conflict theory, the one Mr. Nocera supports, posits that investment banks arrange for underpricing as a way to benefit themselves and their other clients. There is some mixed evidence to support this argument. A number of papers have found that investment banks do respond to appropriate incentives to reduce underpricing.
Higher I. At least one paper has found that underpricing is reduced by more than 40 percent when an American bank and American investors are involved. This is attributable to the higher underwriting fees that American investment banks charge.
Papers have also found that underwriters who incorrectly underprice their business do lose the chance for future I. The managerial conflict theory posits that management is the primary cause of the underpricing. In its principal form, the manager conflict theory postulates that management creates excessive demand for I.
Alternatively, management allows underpricing to ensure that there are many purchasers of the shares. This means there are no large shareholders created by the I.
There is not much evidence to support either form of this theory. This theory posits that the underpricing is because of American securities laws that impose strict liability on the issuer and underwriter for material misstatements and omissions made in connection with the I. The underwriter deliberately underprices the I.
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