Initial Public Offerings

Signaling theories are other theories of underpricing focus on another type of asymmetric between firms and investors. These theories assume that it is selling entrepreneur who posses superior information about the value of the IPO firm. In order to overcome adverse selection, companies with favourable prospects are interested to signal their value and thereby convince potential investors to buy shares.

Early papers on with signaling models in Leland & Pyle (1977), cited in Brau ,et al (2005) Schindelei & Perotti (2002),  argued that selling insider shares and selling a large portion of the firm in the IPO served as negative signals related to equity retained at initial share issues. Managers of profitable companies intend to convey information about their quality to outsiders: retaining equity might be a signal of high quality.

Other signaling models include Welch (1989), Allen and Faulhaber (1989) and Grimblatt and Hwang (1989) models which suggested that firm underprice initially to let investor realize larger proceeds from secondary issues. They have it that pricing initial offerings at a discount is a credible signal of firm quality (cited in Schindelei & Perotti, 2002). Other potential signals of IPO pricing and risk include firm age and other size. According to Delbor & Sullivan (2005), this implies that greater uncertainty will accompany an offer by younger firms.

Firm age may also proxy for managerial experience, which may be particularly important in an extremely competitive industry A theoretical model of IPO pricing at privatization is proposed by Perotti (1995). This explanation suggests that underpricing and equity retention serve the goal of signaling commitment of the selling government to a privatization policy without future redistribution of asset value (Scindele & Perotti, 2002). Other models of underpricing include:

The market feedback hypothesis: this model according to Ritter (1998), where book building is used investment bankers may underprice IPOs to induce regular investors to reveal information during the pre-selling period, which can then be used to assist in pricing the issue. According to this hypothesis, investment banker compensates investors through underpricing, as a way of inducing regular investors to truthfully reveal their valuations.

“IPOs for which the offer price is revised upwards will be more underpriced than those for which the offer price is revised downwards” (ibid). The Bandwagon hypothesis: The IPO market may be subject to bandwagon effect if potential investors pay attention not only to their own information about a new issue, but also whether other investors are purchasing bandwagon effects may develop. In this case, if an investor sees that no one else wants to buy, he or she may decide not to buy even when there is favourable information.

In order to prevent this from happening, an issuer may want to underprice an issue to induce the first few potential investors to buy, and induce a bandwagon, or cascade, in which all subsequent investors want to buy irrespective of their own information (ibid). The lawsuit avoidance hypothesis: in this model it is posited that in order for the issuing firm to avert law suit for the fear of committing an offence by overpricing its issues, it would decide to underprice it.

According to Ritter (1998), since the securities Act of 1933 makes all participants in the offer who sign the prospectus liable for any material omissions, one way of reducing the frequency and severity of future lawsuits is to underprice. Underpricing the IPO seems to be a very costly way of reducing the probability of a future lawsuit. The ownership dispersion hypothesis: In this instance, issuing firms may intentionally underprice their shares in order to generate excess demands and so be able to have a large number of small shareholders.

This disperses ownership will both increase the liquidity of the market for the stock, and make it more difficult for outsiders to challenge management (ibid). The Prospect theory: in this theory it is seen that when issuers are pleasantly surprise with the amount they can raise in the IPO (i. e. their new-found personal wealth) they are not significantly concerned with the underpricing and therefore it exists (Loughran & Ritter, 2001, cited in Brau et al 2005). Three theories on phenomenon of underperformance of IPOs are identified by Ritter (1998):

1. The divergence of Opinion hypothesis: the argument here is, investors who are most optimistic about an IPO will be the buyers. If there is a great deal of uncertainty about the value of an IPO the valuations of optimistic investors will be much higher than those of pessimistic investors. As time goes on and more information becomes available, the divergence of opinion between optimistic and pessimistic investors will be narrow, and consequently, the market price will drop. 2.

The Impresario hypothesis: This hypothesis argues that the market for IPOs is subject to fades and that IPOs are underpriced by investment bankers (the impresarios) to create the appearance of excess demand, just as the promoter of a rock concert attempts to make it an ‘event’. It is predicted by this hypothesis that companies with the highest initial returns should have the lowest subsequent returns. There is some evidence of this at the long run, but in the first six months momentum effects seem to dominate.

The Windows of Opportunity hypothesis: Due to normal business cycle activity, one would expect to see some variations through time in the volume of IPOs. The windows of opportunity hypothesis predict those firms goes publics in high volume periods are more likely to be overvalued than other IPOs. This has the testable implication that the high-volume periods should be associated with the lowest long-run returns.


Brau, James et al (2005), “Initial Public Offerings: An Analysis of Theory and Practice” Journal of Finance (forthcoming)