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Journal of Financial Economics 24 (1989) 3
awrence
Boston College, Chestnut Hill, MA 02167, USA
au1
Uniuersi[v of North Carolinu, Chapel Hill, NC 27599-3490, USA
Received October 1988, final version received August 1989
We investigate how investment bankers use indications of interest from their client investors to
price and allocate new issues. We model the process as an auction constructed to induce
asymmetrically informed investors to reveal what they know to the underwriter. 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. We also find that tension
between an unde.rwriter’s propensity to presell an issue and an issuing firm’s desire to obtain
maximum proceeds affects the type of underwrit;ng contract chosen.
ctio
The sizable early returns earned by investors who buy initial public equity
offerings (IPOsj have puzzled financial researchers for at least a decade.
Recent research has attemptc,! to rationalize the persistence of this apparent
ntradiction to market efficiency as a r onse to asymmetric information.
ut, so far, this research has largely ignor how informational frictions bear
on the marketing of IPQs. In practice, underwriters solicit indications of
interest from investors as part of their efforts to factor as much information as
possible into IPO prices. In this pdper, VV~analyze underwriters’
how the information it yields is used i
ing process and sh
e conclude, contrary to the hypothesis
allocating an IPO.
olmstrom (1980), that by using their access to inves
information, underwriters can reduce
*We would like to thank Narayana Kocherlakota,
(the editor), and participants at semin
University of Michigan, Boston College,
Federal Reserve Bank of Chicago, the Fe
tion meetings for their useful comments.
support from the Ranking
/89/$3.5Oc
J.F.E.- E
1989, Elsevier Science
344
L. M. Benveniste and P.A. Spdndt, Investor information and 6PQ pricing
Two kinds of informational frictions affect IPO pricing. One arises because
issuing firms are likely to be asymmetrically well informed about their own
usiness situation. This asymmetry can afl’ectpricing because i
incentive to misrepresent themselves to potential investors as
than they actually are. Overcoming this type of asymmetry is the motive for
th and Smith (1986) and Smith (1986) call the certification role for
ers.
ock (1986) has suggested another potentially important informational
nvestors are likely to be asymmetrically well informed about factors
outside the issuing firm. They may, for example, have superior information
about an issiring firm’s competitors. They also may have rivate information
about certain characteristics of an issuing firm that the firm cannot convey
credibly; the quality of management is an example. In view of these inhibitions, setting the sales price for an IPO is problematic; neither the issuing firm
nor its underwriter can know precisely what the market’s valuation of the
stock will be.
The basic difficulty facing an underwriter wishing to collect information
useful to pricing an issue is that investors have no incentive to reveal positive
such information to theminformation before the stock is sold. B
selves until after the offering, investors c
to benefit; they would pay a
low initial price for the stock and then could sell it at the full information
price in the postoffering market. To study how these incentives may be
overcome, we 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. By suitably choosing the
rule relating the offer price and share allocation to investors’ indications of
interest, an underwriter can induce investors to reveal their information.
As in all auction design problems, our analysis has two stages. In the first
stage, we identify sets of rules for tr&nslating the indications of interest into an
offer price and allocation schedule that will induce investors to disclose
positive information - by indicating strong interest - if they have it. The
underwriter’s advantage, and most of our empirical implications, derive from
this stage of the analysis. In the second stage, we determine the set of rules
that yields the best expected outcome for the issuing firm.
We show that underpricing is a natural consequence of the premarket
auction: IPQ offer prices must be set low to provide profit to compensate
investors for revealing ositive information. The amount of compensation
required depends on ho much investors may expect to profit by hiding the
ormation. Clearly, this depends directly on he extent to which withholding
sitive information results in a lower expecte offer price. On the other hand,
investor has less incentive to bid low for an issue he or she values highly if
his or her allocation. This is especially true if the
ce is fully revealin
L. M. Benveniste and P.A. Spindt, I’nvestor ~n~ar~~at~a~~
In principle, issuing firms c
without employing an underwriter.
underpricing by se
we are able to qu
proceeds - that can be realized b
firm, which deals regularly in IPOs,
selling repeatedly to the same inve
the auction in favor of the issuing firm. In
who regularly are given
priority in IPO allocations by an investment
This gives the investment banker a lever - namely, the threat to reduce an
investor’s allocation priority in future - that can be used to induce regular
investors to be forthright with their information in the premarket. Thus the
investment banking firm’s leverage over its client investors can be used to
reduce expected IPO underpricing.
Other empirical implications derived from the solution to the auction design
problems are:
Underpricing is directly related to the ex ante value of investors’ information.
Underpricing is directly related to the level of presales.
Investment bankers give regular priority to tbc same investors.
Underpricing is directly related to the level of interest in the premarket.
The final choice among incentive-compatible rules relating indications of
interest to offer prices and allocations is complicated by the basic tradeoff of
early sales for more significant underpricing. A tension arises because underwriters tend to prefer maximum presales, whereas issuing firms want to
maximize proceeds.
In the last section of the paper, we argue that the desire to control the
choice of rules is relevant in the decision to use a firm-commitment or
best-efforts underwriting contract. Under a firm-commitment contract, controlling interest in the issue belongs to the underwriter, whose incentive is to
presell the whole offering. This incentive promotes underpricing.
the greater is the ex ante price uncertainty about the offering, the stronger is
the underwriter’s incentive to presell the whole issue. Thus firms facing the
most price uncertainty are most adversely affected by the underwriter’s incentive to presell under firm-commitment contracts.
To remove the underwriter’s incentive to pre
underpricing, firms facing high price uncertainty
underwriting contract. The cost of t
proceeds are more uncertain under a
can be reduced by stipulating a
underwriter’s incentive to prese
346
L. M. Benveniste and P.A. Spindt, Investor information; and IPO pricing
bias in the choice of underwriting contract: firms facing more price uncertainty, and whose IPOs will therefore be most severely underpriced, are more
likely to choose best-efforts contracts, whereas those whose owners are most
risk-averse are more likely to choose firm-commitment contracts.
Observing that some investors may be asymmetrically well informed about
the prospects of an IPr3, Rock (1986) deduced that underpricing could result
from a kind of ‘lemons’ problem because informed investors withdraw from
the market when an issue is overpriced. Provided that the issuer allocates
shares even-handedly, in the sense that orders from all investors, informed or
uninformed, have an equal chance of being filled, uninformed investors are
more likely to receive their full allocation if the issue is overpriced - which is
to say, the issuing firm is low quality - than if the issue attracts demand from
informed investors. This analysis rests heavily on the assumptions that the
issuer cannot acquire information from the informed investors in advance, and
that the allocation of shares does not distinguish informed from uniformed
investors. Our analysis suggests that the expected proceeds of an issue may be
higher if both the offering price and the allocation are determined using
information solicited from investors through premarket indications of interest.
The practical fact that offer prices of IPOs are not determined until investment
bankers have analyzed premarket results suggests that offer prices are affected
by investor interest.
In firm-commitment offerings, as we have noted, underwriters have incentives to presell the whole issue, which leads to greater underpricing. To counter
these incentives. issuing firms may elect best-efforts contracts, which involve
greater proceeds uncertainty. Rock’s (1986) and Ritter’s (1985) models produce testable implications about the use of minimum-sales constraints in
best-effort contracts that dif!& from those we develop here. In Ritter’s (1985)
analysis, minimum-sales constraints serve to insure uninformed investors
against the lemons problem; thus, underpricing should be inversely related to
the size of the constraint. Our analysis, in contrast, suggests that minimum-sales
constraints are designed to reduce proceeds risk by forcing some amount of
preselling, so underpricing should be directly related to the size of the
constraint.
ur results complement the monitoring theory presented by Smith (1986)
ooth and Smith (1986). If, as we suggest, an underwriter’s business
ith a core of regular investors,
their insiders is tied
L. M. Benveniste
und P.A. Spindt,
Investor
information
and IPO
pricing
Several other theories of underpricing have
ture. Examples include the signaling theories o
Grinblatt and Hwang (1989), and Welch (1989b), and the lawsuit avoidance
theory of Ibbotson (1975) and Tinic (1988). Such influences indeed may be
operative; the theory we present here does not necessarily contradict these
hypotheses. However, we are interested specifically in how investment bankers
elicit information from investors during the preselling period, and how this
information is used to establish an IPO’s offer price and allocation. These
questions are not answered by the other theories cited.
3.
I
e model
We first consider the situation faced by a single corpxption making an
initial public offering. In the next section, we expand the model to account for
underwriters’ long-term relationships with their investors.
Our basic model consists of a private firm offering a fixed fraction of its
future cash flows for sale, and a population of investors. WLether the new
funds will be used for additional projects or owner diversif Aon, the future
cash flow for sale is summarized as a random variable I? Borkj &hefirm making
the offer and the investors in the model have some info:rl;$Aon about the
mean value of I/. The firm decides to sell off V in Q shares. The marginal
investor is assumed to be risk-neutral, so the price of fhe >:“i’eringshould be
equal to the expected present value of V/Q.
We d.istinguish two types of investors - regular and :,7,:e,asional- to capture
regularly in the
in the model the real-world fact that some investors pi*‘,jIbfate
‘iI
II?0 market while others participate only occasion&$ “Piere are H regular
investors and many occasional investors. Both types C2iv~some information
relevant to the expected value of the issuing firm’s CY&Wow.
For simplicity, we assume that each regular ; G. i et,or has one piece of
information that is either ‘good’ or ‘bad’. F,ac .:GCCof information has an
equal (absolute) marginal impact on the stock”:.v%a~ To reflect this, we write
~~‘EES
underwriter’s information)
the expected price (which already incorpor::*~~~.t
conditioned on the information of all 12 ~gaz,iarinvestors in the form
P,=A-(H-h)ar.
L. M. Benveniste und P.A. Spindt, Tnvestorinformation and IPO pricing
348
the value of the stock is
P. ,=A-(H-h)a+X,
h
where h is a random variable with mean zero that represents the effect of
occasional investors’ information on price.
e market proceeds in two stages. In the first, the issue is premarketed to
regular investors. In the second, the market is opened up to occasional
investors. We model the market this way to reflect the fact that only regular
0 investors are targeted in the premarket. Implicitly, this market structure
that the cost of conducting an all-inclusive premarket is prohibitive.
regular investors offer to buy in the premarket, they factor in their
expectations about what the aftermarket price of the stock will be.
the assumption that the aftermarket price reflects all the private info
all regular and occasional investors, i.e., that the aftermarket price is a
full-information-revealing e uilibrium price. We also assume that:
(A.l) Regular investors’ investment preferences are identical. Each regular
investor is willing to purchase up to q shares at a cost not exceeding his
or her expectation of the aftermarket value of the stock.
(A.2) Regular investors’ demands just exhaust the issue; that is, Hq = Q.’
(A.3) Regular investors’ information is independent. Each regular investor has
probability p of having a piece of good information and probability
1 - p of having a piece of bad information.
hatever the auction strut:ture of the premarket, regular investors’ responses will be based on theii- subjective valuations il:f the stock and their
expected profits. ecause each knows his or her own information, regulars
have an advantag in the premarket. In our model, regulars use their private
information to compute subjective estimates of the aftermarket price that are
ior to those of the underwriter and the issuing firm.
reser : this, we index the state of the premarket by the total number h
ieces of good information possessed by regulars. Unconditionally, the
ability of state h is q,, where
ph(l
-p)H-h.
oint of any regular who
iece of good informa-
g rationing in the premarket, i.e., the case Hq > Q, to streamline
ck (‘69861,include rationing, but the results would remain the
L..M. Benveniste and P.A. Spindt, Investor information
tion, state h, h = I,.
from the vantage
probability of sta
and IPO pricing
349
. .,
phjl
_.,)H-1-h.
regular’s premarket reservation price is his or her conditional est
the aftermarket price. The reservation price of a regular who has a
good information is
and the reservation price of a regular with a piece of bad information is
H-l
The empirical significancc’of the model parameter QLis apparent from these
expressions for regulars’ premarket expectations. ecause Pg - Ph = (Y,cr represents the marginal ex ante value of a regular’s information. The more valuable
private information relevant to the aftermarket price of the stock is, the
greater Q will be.
To market an IPQ, an underwriter first conducts its own analysis of the
issuer’s prospects and estimates an offer price range. The underwriter then
creates a ‘road show’ designed b
solicit information about the ma
that the underwriting firm tells 5vestors everything it kno
Thus, the potential for price sig
The term indications of int
prices that underwriters solic
Investors may, for example, express
within the underwriter’s proposed range, or
orders at prices outsi
the final offer price.
tions.
L. M. Benoeniste und P.A. Spindt, Investor information and IPO pricing
350
e volume of premarket orders at fa<e value, most I
oversubscribed. veryone understands the rules of t
and investors tend to overstate their true interest, expecting t
only a fraction of their indicated interest.*
the premarket indications of interest, the underwriter infers positive
on that can be used to determine the offer price and
and negative
n our model, we represent this process in reduced form
that regulars who participate in the premarket auction simply
t they have a good or bad piece of information. That is, we abstract
the question of how the underwriter infers information from the indications of interest.3 ssuming regulars are truthful in declaring their informatian, the underw er can compute the true conditional estimate for the
aftermarket equilibrium price. The rub is to make sure that regular investors
eir information truthfully.
the following notation in discussing the offer price and allocation
A) schedule conditioned on the premarket indications of interest.
ph” = offer price when
qg,h
=
qb,h
=
regulars indicate their information is good (state h),
shares allocated to an investor who indicates good in the premarket
when h - 1 others indicated good (state h),
shares allocated to an investor who indicated bad in the premarket
when h others indicate good (state h).
h
Shares that are not allocated in the pTemarket are assumed to be sold in the
aftermarket at the full-information price.
a& regular investor in the premarket chooses his or her intiication of
in our model amounts to declaring either g (good) or b (bad).
are also aware that declaring g or b amounts to choosing
between two OP A schedules, because the offer price and allocations depend
n and other investors’ declarations.
n view of the revelation r’rinciple of arris and Townsend (1981), we need
schedules that induce regulars to participate truths will satisfy two conditions: first,
vestor who has
ion must expect to profit more by
that other investors also indicate
rofit accruing to an investor who
unces it, is the expected return
that all of the IPOs it
oversubsctibed in the
the model tractable, but e:ttending
351
L. M. Benveniste and P.A. Spindt, Investor information end IP
between the premarket and the afte
H-l
h=O
n the other hand, the investor with a piece of good informati
indicates bad information will be allocated a b portio
reflect one less piece of good information. Such an
H-l
?r,‘o%+,-
y,“h,k
h =o
To induce this investor to be truthful, (1) must exceed (2). Using the fact that
Ph+l = a + Ph, we conclude that an investor with a piece of good information
will truthfully declare g in the premarket if
H-l
H-l
dph+l
-
h =o
p;+l)qg.~+l
2
+h(tph-
p;)
+
dqb
1 h*
(3)
h=O
Thus, the model conforms to the intuition suggested in. the introduction:
investors with good information have to be induced, by excess early returns, to
revcal it (through strong indications of interest). The size of the profits
depends on the allocations they might receive if they expressed weak interest,
i.e., announced bad information.4
Second, investors must be assured of nonnegative expected profits from any
premarket order they make because underwriters cannot force investors to
participate. Thus,
The following list summarized the outcomes that would result in state h
from a particular choice of OP&A schedule based on the premarket indications of interest:
Allocation to each g =
ected proceeds
qg, h9
=
4To be complete, we should verify also that
declare g. This is immediate because announci
egative expected profit.
b, h)*
e to
ates
L. M. Benveniste und P.A. Spindt, Investor information and IPO pricing
352
In calculating the expected state h proceeds, we have assumed that the
ted value of X is zero and that shares not allocated in the premarket are
in the aftermarket.
A schedule based on the premar
tive in choosing an
interest is to maximize the expected proceeds of the issue, the
unc’!erwriter needs only to settle on how much gf the issue to presell. Suppose,
for example, that it is decided that at least Q shares should be sold in the
A schedule can
premarket. Conditioned on Q, the proceeds-maximizing
mong the solutions to (there are several
degrees of
etting offer prices):
aximize
H q,(PhQA.=!)
(P,-P,O)(hqg,~+
(H-h)q,,&
subject to
H-l
H-l
%(Ph+*
-
P,o,&?,,h.,
h =o
qg .
7r;((Ph-
2
pho)
h=O
h_1+(H--h)q/, +fj,
7
+ (Y)qb . h,
h=O,.=-3,
h = 0,.
. . , M,
h = l,...,
H,
h=O,...,W-1.
nt
appendix, we prove:
speci$ed level of presales, 0, the proceeds-maximizing
schedule relating indications of interest to the offer price and share
will have the followingcharacteristics:
1.
= ij
For
a
jor every outcomeh,
h such that hq <
in states where ha 2
the issue are
L. IV. Benveniste und r A. Spila
Proof.
Investor inforination and IPO pricing
353
See appendix.
heorem 1 also implies th
regulars who in
- hq shares in
constraint (3), which is binding, gives expected
be allocated the remaining
The intuition behind Theorem 1 is compelling. Expected underpricing arises
to provide incentives for regulars to reveal good information. ecause the level
of profit is determined by the allocation to regulars who deck
ing is minimized by giving priority to regulars who declare R.
targeted a’i regulars with good informatiom most effectively by unde
when all regulars who declare g receive allocations - that is
Hn a model with more types of information, underpricing would be directly
related to the quality of information?
The following empirical implications flow from Theorem 1:
Underpricing
information.
Underpricing
Underpricing
indicate good
Underpricing
is directly related to the ex ante marginal value of private
is directly related to the level of presales.
is minimized if priority is given to orders from investors who
information.
is directly related to the level of interest in t
The first implication is difficult to test directly because a good proxy for the
asures of uncertainty, such as the
of disclaimers in the prospectus.
implication. The third implication could be teste
?o
analyze Rack’s (1986) environment,
le WQ
A SC
we
354
L. M. Berweniste und P. A. Spindt, Investor information and TPO pricing
premarket as is practical. This way, it will be possible to allocat _- small
taming the sale
quantities to investors who indicate low interest while
of the issue w en the indications of interest are unifo
e have so far ignored a major contribution an underwriter can make $0 the
marketing process by repeatedly selling I OS and giving priority in Ae
allocation to his regular investors. Loosely eaking, an underwriter provides
regular investors with fairly significant profits by including them in his list of
regulars. These
ts can be used occasionally to induce investors to take a
badly received
off the underwriter’s hands. Informally, the underwriter
holds out the threat that if an investor refuses to purchase the issue at hand, he
will be blackballed in future allocations and thus be denied the profits
accruing to regular investors in I
e can quantify the eirect of this additional power on the proceeds of an
by augmenting the model presented above. In particular, here we view the
single issuing firm described in the last section as one in a sequence of issuing
firms using the same underwritpr. From the present vantage point, neither the
investors nor the underwriter know for sure which firms will be going public in
the immediate future. ut they all will form some expectatibsn of the profit
from participating as regular buyer of future issues. For the moment, we
simply represent the expected fututre profit to a regular as L. Because L
derives from expectations about the underpricing of future issues, there is a
required equilibrium consistency between the expected profit to a regular from
ea
e address t’hisissue below.
lue of future participations in I OS into the analysis has
the effect of permitting the underwriter to expect investors to purchase shares
of the current issue even if by doing so they take a loss, provided that the loss
does not exceed the present value of future expected profits. This alters the
straint required to induce investors indicating low interest to
ir allotted shares. The new condition [compare with (4) above] is
ossibility that investors who indicate low interest in the
uces the incentive for
formation to lie.
2
A.h9
h=O
L. M. Benveniste and PA. Spindt, hvestor in~~~rnatiQn
and PPO pricing
lower
than when
355
the issue can be
regulars with some positive profit on average so that
unconditionally by the proceeds from an underwritten offering. This is state
formally in the following theorem:
Theorem 2. For a given minimum of presales, an underwriter can provide
unconditionallyhigher proceeds to an issuing firm by giving priority to
investors.
Unlike an issuing firm, an underwriter can pool new issues. This benefits
issuing firms because it offsets, to some extent, the informational a
possessed by investors. ut underpricing is not eliminated because
incomplete; not all issu are presented to the market at the same
analysis suggests that underwriters do the next best thing by using their
regular investors?
Theorem 2 establishes a clear role for underwriters that complements other
.
services - such as the monitoring described by Smith (1986) and
Smith (19%) - they provide. Underwriters’ distribution channels
reputations for certifying that inside information is disclose
an underwriter certifies a new issue, he risks the value of his
channels. An underwriter who fails to maintain his reputation for monitoring
diligently will lose his regular investors and the future rents he could earn
from his distribution channels.
Condition (6) constraining the premarket
underwriter using his levera
the underwriter can expect
can be shown that the empirical imphcatio
‘William Blair 81.Co. indicates that it
356
L. IV, Besweniste crndP.A. Spin& Investor information and IPO pricing
out
s, investors for
ir underwriter’s se
our
d the value of information (a),
r rssuing stock, will determine the
a&et allocation and offer price schedule.
the notation as simple as possible, we assume that issuing fir
ed by a one-dimensional random variable f with a distn
schedule for each firm f will be denoted as
function &Q. The
which must satisfy conditions (5) and (6).
egular investors do not know in advance what their information about a
e. Ex ante, regulars face a probability p of having good information
on any fS and their expected profit from f’s issue is the weighted average
H-l
H-l
lrh’(~+(Ph/-po.f))qh/.h+(1-P)
h=O
h=O
which equals
or consistency, Id must equal the present value of all future profits, i.e.,
L= Ef(uf)/r,
(7)
w&e r is the constant interest rate. Expected future profit is the present value
paying Ef(uf >, because there will be an infinite sequence of
athematically verifying that eq. (7) can be satisfied is straightforcreases, the necessary profit from :ach firm’s issue decreases.
reased, the right side of (7) decreases and the two will cross
nveniste and Spindt (1989) we demonstrate that eq. (7) can
hich the schedules are endogenously chosen.
L. M. Benvenrste
and
is strategy to increa
A. Spin& Investor in~~~~atienand I$0 pricing
357
s wit
firm-commitment others, the underwriter purchases all shares not
e offer price. This gives investment b kers incentives to sell the e
issue in the premarket, which they do much of the time. The incentive to
presell the whole issue motivates
under-writ
low-interest investors than he wo
otherwise,
The underwriter’s propensity to presell the whole issue is strongest
facing the greatest ex ante price uncertainty, i.e., firms with large ar.
One way to counter this effect is to include in the underwriting contract a
Green Shoe provision, which gives the
erwriter the option to ac
then sell) additional shares once the
is sold. A Cree
underwriter to cover overallotments, and this is the t
including the provision. But our analysis suggests that the
means of reducing underpricing: it limits the amount of stock an underwriter
has an incentive to presell, but leaves him the option to distribute a larger
amount when demand is high. Thus, allocations to vestors indicating low
interest can be lower when a Green Shoe is included
Another means to counter underwriters’ incentive
for issuing firms to elect best-efforts underwriting
offering is like a consignment sale: the underwriter markets the issue, but he is
not bound to purchase any shares remaining unsold at the close of the offering
period. While best-efforts contracts contain less incentive for underwriters to
presell whole issues, they also entail greater proceeds uncertainty than firmcommitment contracts. Proceeds uncertainty can be limited by stipulating a
minimum-sales-constraint clause, which specifies a threshold quantity of the
stock that must be sold during t offering period; if sales fall sho
threshold, the offer is withdrawn. owever, minimum-sales constraints tend to
reactivate underwriters’ incentives to presell.
These considerations suggest that the choice of contract is influenced by
three factors. First,
which measures the
most adversely affected by underwriters’ incentives under fir
contracts to wholly presell issues. Thus, high-a firms are more
best-efforts contracts i
and thereby limit dnd
358
L. M. Benveniste and P.A. Spindt, Investor information and IPO pricing
he second factor influencing the ch
aversion of the owners of the &In going public. $&$.Edelkerasd
e suggested t.hat one benefit
are guaranteed by the investment b
the price an issuer must pay to obtam
are less likely to sell under a firm-commitment contract.
he third factor has to do with the issuer’s financial ne
lit to raise new funds for expansion. Such firms
nimum levels of proceeds to meet their needs. Firm-commitment contracts
can guarantee adequate funds.
In Benveniste and Spindt (1989), we formally set up and solve the allocation
design problem faced y a private firm whose risk-averse principals wish to
take the firm public. e find that the solution is characterized by a level of
resales that increases with the level of risk aversion. e also find that when
firms can choose the presales volume, underpricing can be reduced for high-at
firms, because firms can choose lower levels of presales to investors expressing
low interest. Thus, not surprisingly, highly risk-averse owners and low-cwfirms
are most likely to choose firm-commitment contracts.7
elch (1989b) finds evidence that underpricing of best-efforts IPOs is
irectly related to the minimum-sales constraint, a hypothesis suggested by the
theory sketched out here. Welch also demonstrates that proxy variables related
to the level of premarket activity, such as the time it takes for an issue to sell
out, are directly related to underpricing. Thus as our theory predicts, efforts
for an early sale seem to be related to the level of underpricing.
e develop a theory of underwriting that explains the existence of underW
FS as institutions th
improve the economic eticiency of the initial public
equity offerings market. e begin by studying the marketing problem
g to sell equity claims on itself for the first time.
naturally as a cost of compensating investors with
ue of the stock for truthful disclosure of
onstrate that an underwriter can use
ts to reduce unde ricing and thus
acquisition process.
g high-yield bonds has many similarities t
example, investment bankers premarket
customers.
The analysis presented here yields a rich crop of empirLal predictions about
the IPO market. Some of these correspond to already catalogued stylized facts
about IPO prices. For example, the analysis predicts a selection bias in the
choice of underwriting contract that results in lower average underpric
firm-commitment offerings than of best-efforts offerings; Chalk and
(1985) and Ritter (1985) have already re orted results confirming this
tion. But other predictions of the model, particularly those relating the degree
of underpricing to the level of interest in the preqiarket, have yet to be tested
directly.8
Proof of Theorem I. From the definitions of Q and q’,
Ml
77h =
-P)
H-h
fl;
and
?Th+i= -
HP
h+=+
for h = 0,. . . , - I. Using these identities an
qh H = 0, we can rewrite the term
l
‘One suggestive finding that u
rices is provided by Sternberg (I
erpricing is positive:y relate
L. M. Benveniste and P.A. Spindt, Investor information and IPO pricing
360
pears in the objective functio
h=O
l)¶g.h+l+0 --PNPh -
-
, constraint (3) will bind.
we can rewrite (8) as
sing the
eq.
(3) and noting that
H-l
t&h +
t1 -P)(p,
- pho)qb
hl,
9
ch simplifies to
H-l
(9
fl
To maximize expected proceeds, the underwriter must minimize (9). He can do
this by minimizing qh, h, and setting Pt = Ph whenever qb, h > 0. To minimize
qb, h, the underwriter should allocate as much as possible to regulars who
icate g and allocate the remaining shares to regulars who indicate b. The
expression for expected proceeds given in the statement of the theorem is
erived by substituting these results into the objective function.
eorem 2. Suppose that (
the necessary
schedule without the use of future leverage. If Q > 0,
n be raised by e > 0 without violating condition (7) in
eeds in state h = 0. Our result will follow if prices in
be raised by 6 > 0 without violating conditions (6)
us, we must verify that
1H-
“, g{, & q)( ), }
Q&h+1
1
2
!l = 1
-6)4,
1
tc%O~
9
satisfies
E.
Benveniste cmd P.A. Spindt, Investor information alod IPO pricing
361
riceca
the inducement for regulars wit
reveal it.
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hypothesis, Journal of Financial Economics 15261-280.
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