Why Do IPO Issuers Grant Overallotment Options to Underwriters?

Abstract

In contrast to prior studies suggesting that overallotment option (OAO) provisions reflect underwriters’ exploitation of IPO firms, we provide evidence that they benefit both issuers and underwriters. We estimate that OAO provisions lead to lower underwriting fees, less underpricing, less negative post-IPO performance, lower post-IPO volatility and larger IPOs. OAO provisions are more likely for large firms undertaking relatively large IPOs, especially where a large portion of the shares are offered by selling shareholders. Our evidence also indicates that managers and other insiders may benefit if their shareholdings would be locked up unless the OAO call option feature was exercised.

Keywords: Overallotment options; Initial public offering; IPO pricing; Underpricing

JEL Classification: G20; G24; G32; L14