There has been empirical evidence suggesting that there is an incentive for companies to underprice their shares as a mean to signal the quality and projected value of a firm. In “Signaling by Underpricing in the IPO Market” Allen and Faulhaber (1989) build a model that attempts to illustrate the circumstances and context in which underpricing would be desirable for the issuer.
He divides his sample into good and bad firms based on their expected dividend stream. The stream is dependent upon two instances of the IPO which in term bear different levels of information asymmetry i.e. planning and execution of innovation. These two instances are said to be different in that the investors don’t hold enough information about the quality of the innovation of the issuer. The innovation that the issuer is trying to implement is unknown to the investors. The information gap remains after implementation and is only through the first payment of dividends that the investors are able to readjust their original perceptions of the company. The conclusions of his work found that when information asymmetry exists there will be an incentive to underprice. Allen finds that all things being equal companies will be less underprice should they not issue equity within a reasonable amount of time prior to the IPO. His work also suggests a higher level of underpricing in the case of venture capital involvement.
2.2.2 Insurance to Underwriter Liabilities
In his work “Anatomy of Initial Public Offerings of Common Stock” (1988) Tunic explores the possibility of underpricing acting as an insurance mechanism for unforeseen liabilities arising after the initial public offering process. Tunic contends that as underpricing rewards the investor with an initial stock price lower than the aftermarket value, the reward would ameliorate the probabilities of a potential legal suit brought against the issuer. Tunic hypothesis states that companies that have higher exposure to legal liabilities would tend to increase the discount on the initial offer compared to companies which legal risk is low. To test this hypothesis Tunic analyzes issuances that took place both before and after the Securities Act of 1933. His results confirm that the Act of 1933 had a deep impact in the pricing and returns of unseasoned new issues as it increased the potential liabilities associated with underwriting. While he argues that
these results are perfectly compatible with earlier data asymmetry hypothesis he questions the extent to which the underpricing phenomena can be by explained exclusively through one hypothesis.
2.2.3 Hot and cold Issue Markets
In light of the investors’ avid enthusiasm for new issues during the period of 1961-1962 Reilly (1977) study tries to understand the reason triggering this unusual behavior. The study assumes a downward bias in the new issues’ stock price and suggests some reasons to explain why this is the case namely; ameliorate uncertainty of the public’s valuation, increase probability of the success of issue or decrease the time in which the stocks sell. While Reilly notes that the issuers could be sensitive to the cash left behind, he argues that corporations are not looking to obtain all their planned capital through the initial public offering as they could increase the price of the stock in future issues inasmuch as they keep investors satisfied. Draho (2004) states that during periods of hot issue market first day returns tend to be higher. While 18% first day return is the rule in the American IPO market, the internet hot market
Ibbotson and Jaffe (1975) investigate the nature of hot issue markets and its implications in stock price and aftermarket performance. They find that the presence of hot/cold issue months suggests the probability of following hot/cold issue months is higher. However, he notes that the results are stationary and acknowledges that this tendency will only last for a limited amount of time.
The results also indicate that cold market could prove to be more profitable for investors as they could potentially obtain higher offering prices.
2.2.4 Irrational Herding
In “Rational herding in financial economics” Devenow and Welch (1996) describe herding as a common phenomenon in financial economics. He recognizes two different types of herding non rational and rational. The first one involves investors following each other behavior without regards for any rational analysis. Rational herding on the other hand is the phenomena in which optimal decision making is hampered by noise and information asymmetry. The study of herding is based on Principal Agent models that analyze the breach between optimal decision making and non-rational/ rational herding. One of the most popular explanations of the imperfect behavior of
decision making has to do with the agent’s reputation. In order to maximize their reputation in the market agents would either decide to “hide in the herd” to be less evaluable or “ride in the herd”
to signal quality. These models tend to show that agents, when the market is moving inefficiently, tend to ignore their own research or other optimal decision making.
2.2.5 Cost Theory
Beneviste and Spindt (1989) suggested a cost related theory that places the underwriter as a facilitator for market efficiency. They illustrate their theory with the example of a new financial institution trying to sell equities in the market. Since the market has little knowledge of the new company investors are weary of their equity products. Hemce, the entity is force to create a mechanism to attract investors by reducing their risk aversion. Beneviste and Spindt contend that underpricing is a natural consequence of the entity’s need to create reputation capital within the market. Hence, they understand underpricing as a risk premium given to investors to reward them for their risk. Furthermore, they show that the underwriter ability to leverage its expected future cash flows to increase efficiency and hence reduce underpricing.
2.2.6 Winner’s Curse
The winners curse suggests that the highest bidding investor has necessarily the highest valuation among all participants. Hence, this implies that the winner could pay more than the fair value of the issue. This problem creates an incentive for investors to exert downward pressure on the issue’s price. Conversely, Rock’s (1986) model illustrates how the information asymmetries between different investors can create a negative incentive to uninformed investors to participate in an auction. If it is the case that informed investors possess more information about the issuer than uninformed investors then uninformed investors would always win when there is a bad issue and could lose in the case of good issues. Hence, this could potentially create a negative incentive for uninformed investors to participate in auctions decreasing the demand for the issue.
2.3 Theories of Underperformance