Legal Institutions and IPO Puzzles

Ruoying Chen is Associate Professor at Peking University Law School and Visiting Associate Professor at the University of Chicago Law School; Saul Levmore is the William B. Graham Distinguished Service Professor at the University of Chicago Law School. This post is based on their recent article.

Initial public offerings (IPOs) are often underpriced, so that an investor in a portfolio of new equity issues can expect a substantial above-market rate of return; in the long term, prices adjust and if anything there is overpricing. The puzzling and well-known phenomenon is international in scope, and even more pronounced in Asian capital markets than in the U.S. or in Europe. An associated puzzle is the failure of auctions to displace more conventional methods of marketing new issues of equity through underwriters. Auctions of different kinds have been tried in Taiwan and in the United States, among other places, as to be expected because firms will try to avoid the implicit losses they suffer from underpricing of their new issues. In our article, published in Peking University Law Journal, we argue, first, that underpricing might serve the interests of politicians or regulators, and more importantly, that while underpricing might reflect non-transparency, it is not best solved with more regulation of IPO pricing.

If gate-keepers and regulators are ineffective or even corrupt, then markets should produce less rather than more of them. These third parties can also be expected to waste resources if they are not transparent and if the legal system does not penalize fraud. If fraud is uncontrolled, but investors do not realize that it is so, then third parties can profit by threatening firms with negative reports. In an extremely dysfunctional system, this not a problem because no one would believe the negative reports. But in a legal system with some reliability, the problems can be severe. Hence, IPO puzzles and other securities market imperfections should often be understood as reflecting problems in the legal system as a whole.

The Article proceeds to offer a novel explanation of why auctions are unlikely to be superior in the very situations where conventional underwriting (book-building) produces the most serious and costly underpricing. The argument is built around the information costs associated with rational participation in auctions as compared to fixed price markets. Conventional theories focus on asymmetric information, agency problems, and behavioral anomalies. This article begins instead with the behavior of uninformed investors who are conventionally thought to overbid and free-ride on well-informed institutional investors. These uninformed investors cannot be sure that they will be too few in number to set the price in an auction; they will therefore hesitate to participate in an IPO auction. In fact, an auction imposes more severe information costs on bidders than does a conventional fixed-price sale. When a seller announces a fixed-price, a potential buyer only needs to gather enough information to determine whether his own evaluation is above the asking price and, if not, whether the asking price falls into the lower or higher end of his evaluation range. However, an auction requires more precise knowledge because the bidders are required to name a specific price, which can only be known after a substantial investment in information, rather than mere observation as to whether one’s own estimate of value provides enough information to find the seller’s fixed price attractive. In a flawed market or regulatory environment, this information is especially expensive to acquire. Many buyers will not want to expend this effort, or sellers will need to compensate them for their efforts. Hence, auctions do not offer buyers an escape from the problem of misinformation and non-transparency, and in turn, sellers will not do better resorting to auctions. To be sure, the auction mechanism also imposes regulatory costs beyond those associated with conventional underwriting. For IPO auctions, the regulator must monitor for collusion among bidders as well as the danger that the issuer’s agent has leaked information about bids as they are received.

Auctions may eliminate some of the agency costs associated with conventional underwriting but, apparently, auctions impose comparable or greater costs on buyers, who therefore decline to participate, or require a lower initial price. When the regulatory costs are not necessarily lower than conventional underwriting regulation, regulators are also reluctant to encourage or mandate auctions for IPOs.

IPO underpricing is attractive to investors either because of its lottery-like quality or the long-term investment opportunity it offers. These investors are not dissuaded by the long-term overpricing, because they believe they can exit before the downturn. Especially optimistic investors might believe that they can repeatedly invest in a series of IPOs, selling after a time in order to conserve funds for the next new issues. In jurisdictions where margin finance is common, such tendency is the strongest. Broad participation may bring about political benefits that may be sufficient to pay off other investors, issuing firm, and regulators themselves. But broad participation can also result from investors’ investing in the aftermarket rather than the IPO market. In an untrustworthy market with little transparency, underpricing may be the best means of achieving the imagined goal of broad, democratized investment.

The complete article is available for download here.

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