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Home > Financing Best Practice > The Cost of Going Public: Why IPOs Are Typically Underpriced

Financing Best Practice

The Cost of Going Public: Why IPOs Are Typically Underpriced

by Lena Booth

Executive Summary

  • The underpricing of initial public offerings (IPOs) is an indirect cost of going public that is borne by the issuing firm. Its magnitude varies across IPOs with different issue characteristics, allocation mechanisms, underwriter reputations, and general financial market conditions.

  • Commonly used share allocation methods in IPOs are auction, fixed price, and book-building. Book-building is the most popular method, and it allows smaller, less known companies to go public.

  • IPOs are underpriced to signal issue quality, mitigate adverse selection problems, reward investors for truthfully revealing information, lessen underwriters’ potential legal liabilities, allow underwriters to curry favor with their clients, promote ownership dispersion for liquidity and control, and attract media attention/publicity.

  • Issuing firms can attempt to reduce underpricing by engaging reputable underwriters and auditors, having frequent disclosures, waiting until they possess desirable characteristics, and/or using the auction method if they are of high quality.

Introduction

When firms go public, they incur direct and indirect costs associated with the initial public offering (IPO) process. Direct costs are fairly predictable—they include registration, underwriting, and attorney and auditing fees. The indirect cost, commonly known as IPO underpricing, is one of the most perplexing puzzles in finance. It is observed in almost every financial market in the world and across all procedures of share allocation. IPOs are, on average, underpriced by 18–20% in the United States. During the hot issue period, underpricing was much higher, as many of the IPO firms did not have strong financials or growth potential and simply rode the wave to go public. In countries where regulations and restrictions are imposed in the IPO market, underpricing is higher as well.

What Is IPO Underpricing?

Underpricing refers to the price run up of the IPO on the first day of trading. It is also known as the initial return or first-day return of the IPO.

Underpricing = (First-day closing price – Offer price) ÷ Offer price × 100%

The first-day closing price represents what the investors are willing to pay for the firm’s shares. If the offer price is lower than the first-day closing price, the IPO is said to be underpriced and money is left on the table for new investors. Since existing shareholders settle for a lower offer price/proceeds than what they could have got, money left on the table represents the wealth transfer from existing shareholders to new shareholders.

Money left on the table = (First-day closing price – Offer price) × Number of shares

On average, the amount of money left on the table is about twice the amount of direct underwriting fees, and for many IPO firms it can equal several years of operating profit.

Although most IPOs are underpriced, the level of underpricing varies across IPOs with different issue characteristics, allocation mechanisms, underwriter reputation, and general financial market conditions. For example, the level of underpricing is reduced for larger IPOs, those underwritten by prestigious investment banks, firms with a longer operating history or more experienced insiders on the board, and those which intend to use the proceeds to repay debt. On the other hand, technology firms, firms backed by venture capital, firms with negative earnings prior to the IPO, or firms that went public during a bull market experience greater underpricing.

Share Allocation in IPOs

IPO underpricing happens regardless of whether issuers use the auction, the fixed-price, or the book-building method to go public. In the auction method, investors submit their desired price and quantity bids. The offer price that will allow the firm to sell all its shares is determined after bids are submitted, and hence incorporates the demand for the shares. A maximum price is usually chosen as well, so that unrealistic bids (bids well over the clearing price) can be eliminated. This is done to prevent investors from placing very high bids to ensure that they are allocated shares. Shares are then allocated, on a pro rata basis, to all the investors who placed bids between these two prices. In a uniform price auction, all the investors receiving shares will pay the same market clearing price. In the less common discriminatory price auction, investors pay the prices they bid for.

In a fixed-price offer, the issuer and the underwriter jointly determine the offer price, and investors place orders for shares at this price. If the issue is oversubscribed, shares are either allocated through lottery or on a pro rata basis.

In the book-building method, the underwriter promotes the IPO by disseminating information about the issuing firm via road shows. They gather indications of interest by soliciting from potential investors their desired prices and quantities for the issue. The underwriter then uses this information to determine the final offer price. Under this method the underwriter has complete discretion on the allocation of new shares.

Of the three allocation mechanisms, evidence has shown that IPOs under the auction method show the lowest average underpricing. However, firms that choose the auction method sometimes fail to go public because bids for their shares are insufficient. This problem is especially common for smaller, less known companies, which require substantial information production and dissemination by the underwriters. For these firms, the book-building method might be the only option that will allow them to go public. It is therefore not surprising to see the book-building method, a method that is used predominantly in the United States, gaining popularity around the world.

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Further reading

Book:

  • Jenkinson, Tim, and Alexander Ljungqvist. Going Public: The Theory and Evidence on How Companies Raise Equity Finance. 2nd ed. Oxford: Oxford University Press, 2001.

Articles:

  • Derrien, François, and Kent L. Womack. “Auctions vs. book-building and the control of underpricing in hot IPO markets.” Review of Financial Studies 16:1 (Spring 2003): 31–61. Online at: dx.doi.org/10.1093/rfs/16.1.31
  • Ritter, Jay R., and Ivo Welch. “A review of IPO activity, pricing, and allocations.” Journal of Finance 57:4 (August 2002): 1795–1828. Online at: dx.doi.org/10.1111/1540-6261.00478

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