Going Public, Selling Stock, and Buying Liquidity

Abstract:     
It is a well known anomaly of corporation finance that initial public offerings (IPOs) tend to be underpriced. That is, it appears that shares tend to be offered at a price that is below what the market would bear. Scholars have offered several explanations, most of which focus on various sorts of underwriter opportunism (and insider acquiescence therein). But it is difficult to believe that competition among underwriters does not force offerings to be made at the highest possible price, particularly in view of the numerous alternatives to traditional underwriting methods that have arisen in recent years. The persistence of underpricing suggests that it may be attributable to market forces. In this paper, I consider the reasons why firms go public and how the reason for a public offering might affect the method used. Based on analysis of the reasons why firms go public and the means by which they do so, I surmise that underpricing may be attributable to an inherent discount imposed by the market as the price of access to liquidity. Indeed, the notion of underpricing is somewhat misleading. It would be more accurate to think of it as akin to a negative takeover premium. The fact that a bidder must pay a premium to acquire control of a target is unremarkable even if one assumes that the market is efficient. Similarly, it is only natural that a firm that wants to sell stock to the public must do so at something of a discount. In addition, this discount may be attributable to some extent to the need to persuade otherwise diversified investors - who largely eschew stock-picking and instead tend to buy and sell stocks with a view to portfolio balancing - to assume firm-specific risk in connection with an IPO. To test this hypothesis, I gathered data relating to the 34 IPOs made during October 1999. I find that the aggregate amount of underpricing for each offering - money on the table - as a percentage of market capitalization after the offering is relatively constant - averaging 6.04% with a standard deviation of 4.75%. This finding is consistent with the hypothesis that underpricing may be related to offering size and total market capitalization. One possible explanation for how the market knows such things is that diversified investors who weight their portfolio holdings by market capitalization are willing to buy more shares of large capitalization issuers. If apparent underpricing is due to such factors, there is little reason for additional regulation of the new issues market.

Keywords: initial public offering, IPO, going public, underpricing, first-day price pop, money on the table, aftermarket, issuer, investment bank, underwriter, investor, diversification, firm commitment, fixed price, discount, litigation risk, spinning, dutch auction offering, direct public offering, reverse

JEL Classifications: G11, G32, K22, L22

Working Paper Series