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The debate over the pricing of initial public offerings has been vigorous.
In his op-ed column in The New York Times, Joe Nocera wrote on Saturday that LinkedIn “was scammed by its bankers,” who underwrote LinkedIn’s initial public offering. The evidence: the money LinkedIn “lost” by underpricing its I.P.O.
On Monday Andrew Ross Sorkin disagreed on DealBook, offering several reasons why LinkedIn may have benefited from such underpricing and inviting a dialogue on the issue.
Who’s right?
Luckily for all of us, there are academics who have devoted their entire careers to studying I.P.O. underpricing. That is, why do companies’ repeatedly go public at a price significantly lower than the first-day closing price? In LinkedIn’s case, the underpricing was more than 100 percent, the amount LinkedIn’s shares rose on the first day of trading.
Academics have found that I.P.O. underpricing is ubiquitous. Jay Ritter has documented underpricing over the years. According to Professor Ritter, the average underpricing for I.P.O.’s in the United States was 14.8 percent from 1990 to 1998, 51.4 percent from 1999 to 2000 and 12.1percent from 2001 to 2009.
Over the last 50 years, I.P.O.’s in the United States have been underpriced by 16.8 percent on average. This translates to more than $125 billion that companies have left on the table in the last 20 years.
I.P.O. pricing is also a worldwide phenomenon. In China, the underpricing has been severe, averaging 137.4 percent from 1990 to 2010. This compares with 16.3 percent in Britain from 1959 to 2009. In most other countries, I.P.O. underpricing averages above 20 percent.
What explains this widespread phenomenon? There are a number of overlapping and nonexclusive theories:
Information Asymmetry
The most prominent explanation and the one with the most empirical support is that I.P.O. underpricing occurs because of informational asymmetry.
The information asymmetry theory assumes that the I.P.O. pricing is a product of information disparities.
This theory takes a variety of forms, but the most influential one was put forth by Kevin Rock almost a quarter-century ago. He theorized that uninformed investors bid without regard to the quality of the I.P.O. Informed investors bid only on the offerings they think will gain superior returns. But with weak I.P.O.’s only uninformed investors will bid and lose money. The losses are so great that the uninformed investors will eventually leave the I.P.O. market.
If you were an economics major, you might recognize this problem as a “lemon theory” — named after George Akerlof’s famous paper on how used cars are priced when information is uncertain.
The underwriters, however, need the uninformed investors to bid since informed investors do not exist in sufficient number. To solve this problem, the underwriter reprices the I.P.O. to bring in these investors and ensure that uninformed investors bid. The consequence is underpricing.
This theory has found empirical support in papers that have found that when investment banks can allocate shares in greater measure to informed investors, the underpricing is reduced since the compensation needed to draw uninformed investors is lower.
Underpricing has also been found to be lower when information about the issuer is more freely available so that uninformed investors are at less of a disadvantage.
Another informational-based theory for I.P.O. underpricing is known as informational revelation. This theory centers on the book-building process, the mechanism by which an underwriter builds a book of potential investors and the prices and number of shares they are willing to purchase.
The book-building process is intended for the underwriter to assess demand and obtain information from potential buyers about what price buyers are willing to pay. In order to incentivize investors to disclose sufficient information about the price they believe is appropriate, underwriters allocate fewer shares to potential purchasers who bid low.
But underwriters still discount the stock to incentivize aggressive bidding and to ensure that the bids are not even lower since the more bids there are, the more information is revealed about the appropriate price for the stock. Issuers accept this underpricing because it allows underwriters to better gauge a higher sale price. This theory too has found empirical support in the academic literature.
A third strand of the informational asymmetry theory asserts that underpricing is associated with the weakness of the issuer. The underpricing is intended to compensate the purchasers for this weakness. This theory has found weak evidential support.
Investment Banking Conflicts
The investment bank conflict theory, the one Mr. Nocera supports, posits that investment banks arrange for underpricing as a way to benefit themselves and their other clients. There is some mixed evidence to support this argument.
A number of papers have found that investment banks do respond to appropriate incentives to reduce underpricing. Higher I.P.O. commissions have been found to reduce underpricing. At least one paper has found that underpricing is reduced by more than 40 percent when an American bank and American investors are involved. This is attributable to the higher underwriting fees that American investment banks charge.
In addition, the greater the underwriter’s stake in the I.P.O. through ownership of the offered shares, the less underpricing, though there is conflicting evidence on this point. Papers have also found that underwriters who incorrectly underprice their business do lose the chance for future I.P.O.’s.
Managerial Conflicts
The managerial conflict theory posits that management is the primary cause of the underpricing. In its principal form, the manager conflict theory postulates that management creates excessive demand for I.P.O. shares in order to ensure that management can sell their holdings after a contractual 180-day lockup for a higher price.
Alternatively, management allows underpricing to ensure that there are many purchasers of the shares. This means there are no large shareholders created by the I.P.O., shareholders who may be more incentivized to replace management. There is not much evidence to support either form of this theory.
Litigiousness and Regulation
This theory posits that the underpricing is because of American securities laws that impose strict liability on the issuer and underwriter for material misstatements and omissions made in connection with the I.P.O. The underwriter deliberately underprices the I.P.O. to ensure that even if there is such a misstatement or omission the purchasers do not have a claim since these failures are priced in the I.P.O. This theory has not found much support primarily because regulatory schemes in other countries are much laxer yet I.P.O. underpricing happens there as well.
Behavioral Explanations
These theories have gained attention in the wake of the technology bubble. One form of this theory posits that either institutional investors or managers gain from taking advantage of retail shareholders who act irrationally or otherwise against their economic interests. And that both institutional shareholders and managers therefore underprice I.P.O.’s to lock in these gains. A variation of this theory posits that it is the institution that allows this underpricing as a result of its own inability to recognize the loss. There is uncertain evidence for these behavioral theories, but they do help in explaining extreme rises like LinkedIn’s.
And these are but a few of the competing theories for I.P.O. underpricing. They may explain I.P.O. underpricing of 10 percent to 20 percent, but they don’t explain the extreme underpricing of a debut like LinkedIn’s.
Mr. Sorkin discusses some reasons why this may be appropriate, including a need to show a successful I.P.O. rather than a price drop and the fact that LinkedIn may gain by selling its shares later at a higher price.
These may be the reasons, or perhaps Mr. Nocera is right. But I have my own theory that overlaps a bit with Mr. Sorkin’s.
If LinkedIn had sold the same number of shares as it did last week at about $100 per share, it would have made an extra $200 million or so. But this assumes that there were enough investors willing to buy shares at that level. LinkedIn and the other shareholders sold less than 10 percent of the firm’s outstanding shares. A sale at $100 a share would have reduced demand and certainly wouldn’t have given the company the publicity it did.
Now, LinkedIn can wait and sell shares later at this higher price, gaining more money in the aggregate.
The company, meanwhile, received national publicity for its Web site, something that may be worth the tens of millions of dollars alone, if not more.
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