2. LITERATURE REVIEW
2.5 LITERATURE REVIEW SUMMARY FOR THE THEORIES OF IPO
2.5 LITERATURE REVIEW SUMMARY FOR THE THEORIES OF IPO UNDERPRICING
The following table 2-1 summarize the literature review for the theories of IPO underpricing:TABLE 2-1 LITERATURE REVIEW SUMMARY FOR THE THEORIES OF IPO UNDERPRICING
IPO UNDERPRICING AND ASYMMETRIC INFORMATIONAuthor Research Methodology Research Result
Baron (1982) The asymmetric information arises from that the banker is better informed than the issuer.
In the example, the optimal offer price is below the first-best offer price indicating that new issues would be underpriced when the banker is better informed than the issuer. Furthermore, Investment bankers find it less costly to market an IPO that is underpriced.
ROCK (1986) The asymmetric information arises from that the privileged investors whose information is superior to the issuer as well as all other investors.
Rock theorizes "winner's curse", issuers must underprice the securities to compensate uniformed investor.
They regard the number of use of proceed listed in prospectus as a proxy for ex ante uncertainty.
They prove there is a positive relation between the ex-ante uncertainty about initial public offering's value and expected initial return.
Their justification for this proxy is the empirical regularity that smaller issues are generally more speculative than larger issues. Beatty and Ritter find that both the number of uses for the proceeds and the inverse of the gross proceeds are statistically significant explanatory variables of initial returns.
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IPO UNDERPRICING AND SIGNALING THEORIES
Author Research Methodology Research Result
Welch’s (1989) The hypothesis is that the owner’s incentive to leave a good taste is the possibility of coming back to the market for the sale of additional securities on more favorable terms.
“leave a good taste in investors’ mouths”
Welch’s model implies that good firms, which underprice more, experience a less unfavorable price response at the time of the seasoned issue.
Allen and Faulhaber (1989)
The new firm itself possesses the best information about its own prospects. Good firms use a low IPO price thus signaling to investors that they expect to recoup this loss in their later performance, while bad firms cannot afford such signaling, since they do not expect to perform well.
The analysis distinguishes between a separating equilibrium, where good firms signal their type to investors with a low IPO, and a pooling equilibrium, where no underpricing occurs, and hence investors cannot tell good and bad firms apart. Pooling is more profitable for good firms if they are likely to remain good, and signaling is more profitable if they are likely to get worse.
Empirical evidence confirms that underpricing can signal favorable prospects for the firm, and that it is temporary, industry-specific, and associated with improvements in the profitability of entry.
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BOOK-BUILDING METHOD AND INFORMATION PRODUCTION THEORY
Author Research Methodology Research Result
Benveniste and Spindt (1989)
They model the premarket as an auction, conducted by the underwriter, in which investors understand how their indications of interest affect the offer price and the stock allotments they receive.
IPO offer prices must be set low to provide profit to compensate investors for revealing information. The amount of compensation required depends on how much investors may expect to profit by hiding the information. Clearly, this depends directly on the extent to which withholding positive information results in a lower expected offer price.
Based on the theory, the offer price may be partial adjusted to meet the market value, the unadjusted part is to compensate the investors with private information.
Therefore, offer price may be fully adjusted to the market value under the public information.
The analysis yields a number of empirical implications, including that new issues will be underpriced and that distributional priority will be given to an underwriter's regular investors
Sherman and Titman (2002)
The model is based on two premises. The first is that collecting information is costly, which is a fairly standard and intuitive assumption. The second is that there are economic benefits associated with generating information in order that the IPOs are priced more accurately in the secondary market.
Increased participation increases underpricing.
When information is costly, the level of underpricing is determined by the desire for information. For firms with the most to gain from accurate pricing, more investors will be invited to participate in the offering and underpricing will be greater.
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IPO UNDERPRICING AND OPTIMISTIC INVESTORS
Author Research Methodology Research Result
Derrien (2005) Sentiment investor (noise trader) demand is the primary determinant of price run-ups in initial IPO trading. Sentiment investors are willing to overpay for the firm’s shares at the time of IPO
In Derrien (2005) model, the information consists two types of signals: first, private signals about the firm’s fundamental value that the underwriter has to extract from informed investors followed the Benvesiste and Spindt’s (1989) model. Second, a public signal about the sentiment investors by offering the firm’s shares. The underwriter, who is in charge of choosing the IPO offer price, has to provide aftermarket price support, which is costly if the shares trade at a lower price than the fundamental value per share of the firm obtained by aggregating private signals from informed investors, but lower than the price sentiment investors are willing to pay.
Cook, Kieschnick and Van Ness (2006)
Investment bankers have an incentive to promote an IPO to induce sentiment investors into the market for it.
They expect that the promotional efforts of investment bankers should influence the compensation of investment bankers, the valuation of an IPO, its initial returns and trading, the wealth gains of insider shareholders,
Consistent with their first prediction, they find a positive and significant correlation between retail trading activity during the first day of trading in an IPO and the IPO’s pre-issue publicity. Consistent with their second prediction, pre-issue publicity is positively correlated with upward revisions in IPO offer prices and offer price valuations that are above comparable firms in their industry. In addition, they find that insider wealth gains exceed their dilution losses when more pre-issue publicity is associated with their IPO.
Consistent with their third prediction, initial IPO returns are positively
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and the likelihood that an issuer switches investment bankers for a subsequent seasoned equity offering.
correlated with pre-issue publicity. And finally, consistent with their fourth prediction, they find that investment banker compensation is positively and significantly correlated with pre-issue publicity. Reinforcing the importance of marketing to issuers and investment bankers, they find that issuers are less likely to switch lead investment bankers when they are effective at promoting their IPO but, when they do switch, they often are able to increase the pre-offer publicity associated with their SEO.