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E-MailNicholas G. Crain is Assistant Professor of Finance at Vanderbilt University. This post is based on a paper by Professor Crain, Robert Parrino, Professor of Finance at the University of Texas at Austin; and Raji Srinivasan, Professor in the Department of Marketing at the University of Texas at Austin.
Setting the offer price of an initial public offering (IPO) to accurately reflect the value of a firm’s common stock creates high stakes for both the firm and its underwriters. Pricing the shares too low would result in a wealth transfer from old shareholders to new shareholders; pricing the shares too high may result in a failed issue, or poor initial returns that adversely affect the reputation of the firm and underwriter. In a new working paper, we study how information is incorporated into the price of initial public offerings.
We can think of the process of gathering and incorporating information about the value of the issuing firm in two stages. First, in preparation for the offering, the firm’s managers and underwriters perform pre-market due-diligence. Information gathered during due-diligence is used to set an anticipated price range for the offering and to write an initial prospectus. Second, the issue is marketed to potential investors. Underwriters manage this process, known as book building, to encourage well-informed investors to reveal their private information about the firm. Investors who provide valuable information are commonly awarded a higher share of the issue. Feedback from these investors is used to update the offer price.
Some view due-diligence and book building as independent means of gathering information that can substitute for one and other. As more information is discovered during due diligence and disclosed in the prospectus, less new information is gleaned from investors. Consistent with this view, Hanley and Hoberg (2010) find that the amount of non-boiler plate language contained in the prospectus is negatively correlated with the magnitude of the price change occurring during the book building process.
We suggest that the relationship between due-diligence and book building is likely to depend on the extent to which relevant information is internal or external to the firm. Underwriters have an advantage in producing value relevant information about the internal workings of the firm because of the special access they receive during due diligence. In contrast, book building surveys a large group of investors who, in the course of other trading activities, may generate external information that is relevant to the firm.
In many domains, these perspectives may be complementary. For example, during the due-diligence phase, the firm’s underwriters may help discover information regarding the firm’s product market strategy. Evaluating the value implications of such efforts requires making judgements about a firm’s customers and competitors. Outside investors should have a comparative advantage in making these judgements. Information obtained about product market strategy and disclosed in the prospectus will increase the incentives for skilled investors to acquire complementary information.
We find evidence consistent with this theory in a sample of 2,336 IPOs that were completed between 1996 and 2013. We proxy for product market information discovered during due diligence by measuring content in IPO prospectuses pertaining to each firm’s competitive environment. Our main finding is that amount of prospectus content related to competition is positively correlated with the price update which occurs during the book building process. This is consistent with our theory. It suggests that information about strategy relative to competitors is discovered during due diligence, but is not fully incorporated into the initial anticipated price range. Instead, it is incorporated based on feedback from investors during the book building process.
Theories of book building suggest that IPO offer prices will only partially adjust to feedback from investors. The intuition is that this leaves some “money on the table” to provide an incentive for investors to reveal their private information. We find a positive correlation between initial returns on the first day of trading and prospectus content about competitive environment. This suggests that investors are being compensated for providing feedback about the firm’s strategy relative to its competitors.
Our findings help shed light on several issues related to information discovery during IPOs. First, the findings provide evidence about the relative advantage of gathering information during due diligence or book building. Our main tests examined information regarding the firm’s competitors, but we would expect similar results whenever the firm is making a strategic decision that depends on a detailed understanding of factors or agents outside the firm. For example, we found similar results when examining disclosures related to the firm’s customers. Second, our findings help explain how risk is related to price updates that occur during book building. Previous studies had shown that price updates during the book-building process are related to some proxies for firm risk, but not others. Our results suggests that price updates should only occur when investors are likely to have superior information about a given risk.
The complete paper is available here.
