Underpricing Versus Underinvestment in Ipos

Abstract

We study signaling equilibria at the IPO when owners determine not only the price at which to sell primary equity but also the amount of investment proceeds to raise. This implies owners have a choice of two signals at the IPO, i.e., investment oriented signaling and underpricing. We show that in the most efficient signaling equilibrium, owners have a strict preference for scaling the investment project over underpricing primary shares. Underpricing survives in equilibrium if and only if owners lack flexibility in determining the level of investment required to fund future projects. By considering multiple signaling strategies, our model provides insight into the poor empirical relation between the degree of underpricing and the subsequent operating performance and the amount of proceeds raised at the SEOs.

Keywords: Initial public offering, IPO, signalling, underpricing, underinvestment

JEL Classification: G24, G31, G32