IPOs and Underpricing Redux

You're undoubtedly familiar with the IPO underpricing phenomenon. Although it has gotten a great deal of press in recent years (with the advent of 'net stock offerings), Finance researchers have been aware of it for quite some time.

Literally dozens of empirical studies have examined this phenomenon since the mid-1970s; a nice summary of the results appears in Chapter 15 of the fourth edition of RWJ Fundamentals. RWJ point out that possible explanations include (1) underpricing for the purpose of attracting investors, (2) underpricing to counteract the "winner's curse" suffered by the small investor in purchasing IPO shares, and (3) underpricing as a form of "insurance" for investment bankers against shareholder lawsuits.

Interestingly, a recent issue of The Wall Street Journal sheds a bit more light on the issue. In an article entitled "Risky Business: Internet IPO Aftermarket," reporter Dunstan Prial examines the returns on Internet offerings and reports some interesting results. For example, he finds that:

(1) "31 of 53 online-related new issues this year have doubled in value on their first day of trading."

(2) Of the 31 issues mentioned above, about half are below, and half are above, their first-day values.

(3) Perhaps most interesting is the explanation given for IPO underpricing in general:

"[C]onsider that underwriters generally try to price a new issue so that it will jump about 15% on its first day. The process is known as discounting the IPO. 'It's not done with the intent of leaving money on the table with concern to the issuer. It's done because investors are providing the issuer with capital to grow a business and [the investors] are looking for something in return,' said Michael Essex, head of equity syndicate at McDonald & Co. The traditional 15% bounce also helps give the stock market some upward momentum."

What do you think? Raise this issue with your students. Is it really necessary to "repay" investors by offering shares at a low price? Is it not "leaving money on the table" when an investment banker purposely underprices shares byt "the traditional 15%"? More food for thought!

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