Why are auction based
IPOs underpriced?
Panos Patatoukas
Motivation and Research
Question
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The underpricing phenomenon of traditional IPOs is
a well established fact in the finance literature.
But what about auction based IPOs?
In theory the clearing price of a well designed
auction is virtually equal to the market price so the
first day return should be zero and underpricing non
existent.
But in reality auction offerings are not “underpricing
free”!
Why?
Summary of results
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My simple two-step experimental design yields
results consistent with auction based IPOs being
underpriced when information asymmetry is high.
It also accommodates for no underpricing when
information asymmetry is low.
Further, my experimental setting predicts that high
underpricings are accompanied by high trading
volume, price volatility and bid ask spread
Pros and Cons of an
experimental design
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Pros: the experiment allows me to investigate both the pricing
of an IPO and the aftermarket performance, volatility and
trading volume isolating the effect for example of price
support, underwriter/ issuer’s liability concerns, flipping,
marketing events etc.
Cons: To the extent that my experimental design
unreasonably abstracts from reality any results obtained
should be cautiously considered.
Auction theory Background
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The auction literature suggests that the pure common value multi unit
auction setting is susceptible to underpricing.
Further, the magnitude of the underpricing is a function of the information
asymmetry among bidders.
Introduce the winner’s curse idea in the multi unit auction setting.
Intuition: If the bidder has a positive probability of influencing the price then
he has an incentive to shade his bid.
I model the auction IPO, as a multi unit uniform price auction with pure
common values in which each bidder receives a private signal for the value
of a unit of stock and accordingly submits his demand schedule in the form
of multiple sealed bids.
Simple Experimental Design
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For the auction IPO I adopt the mechanism used in the US; a sealed
bid, uniform (descending) market clearing price auction in which bidders
participate with multiple bids
The SEC allows the auctioneer-investment banker to provide the
preliminary results of the auction in the form of private guidance to
(institutional) bidders.
The market clearing price (stop out price) is the highest price at which
the aggregated demand at least equals the supply.
In the post issue market the winning bidders are allowed to trade their
allocations and both winning and losing bidders are allowed to
participate. The post IPO market is designed as an open cry double
auction.
My experimental design allows for two scenarios, high and low
information asymmetry, corresponding to the low and high precision (ε)
of the bidders’ privately received signals.
Hypotheses
My simple experimental setting provides a realistic
reflection of the auction based IPO setting in the US
and allows me to test the following two hypotheses:
 H1: Auction based IPOs can be underpriced and the
underpricing is more likely to surface when the
information asymmetry is high (low signal precision).
 H2: The trading volume and price volatility is high
(low) when the information asymmetry is high (low);
high underpricings are followed by high TV and PV
Experimental results: Overview
Table1: Overview of all treatments
Round 1
Round 2
low precision
high precision
low precision
high precision
Auction price
14
12
15
17
First day close
16
12.1
16.2
17
True value
16
12
16
17
Pro rata
82.47%
61.07%
67.80%
64.52%
First day return
14.29%
0.83%
8.00%
0.00%
Underpricing
14.29%
0.00%
6.70%
0.00%
Volume
56
43
57
44
Trading time (in sec.)
200
200
180
150
Volatility
0.623
0.109
0.441
0.745
Average Bid Ask Spread
2.543
0.680
1.807
1.478
Experimental results
Round 1, low signal precision
Experimental results
Round 1, low signal precision
First day of trading
Round 1 High Information Asymmetry
price
198
186
168
163
141
141
141
137
135
73
73
73
73
69
45
45
45
44
0
17.5
17
16.5
16
15.5
15
14.5
14
13.5
13
Experimental results
Round 1, high signal precision
Experimental results
Round 1, high signal precision
First day of trading
Round 1 Low Information Asymmetry
14.5
14
13.5
13
12.5
price
12
11.5
11
10.5
18
0
17
1
16
6
15
6
15
4
15
1
14
0
13
4
13
3
10
9
85
68
62
40
0
10
Experimental results
Round 2, low signal precision
Experimental results
Round 2, low signal precision
First day of trading
Round 2 High Information Asymmetry
17.5
17
16.5
16
15.5
15
14.5
14
13.5
price
15
9
14
6
14
4
13
0
11
2
99
99
83
81
72
66
43
43
43
43
35
0
13
Experimental results
Round 2, high signal precision
Experimental results
Round 2, high signal precision
First day of trading
Round 2 Low Information Asymmetry
18.5
18
17.5
17
16.5
16
15.5
15
14.5
price
99
93
92
82
74
73
69
63
57
29
29
29
29
29
29
29
0
14
Conclusions
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This paper adopts a simple model of pure common values
with private affiliated signals in the setting of multi unit sealed
bid auctions & provides experimental evidence that auction
based IPOs can be significantly underpriced when information
asymmetry is high.
High underpricings are accompanied by high trading volume,
price volatility and bid-ask spread.
If the current mechanism adopted for the auction IPOs is
prone to underpricing then the blame is not on the investment
bankers that carry out the auction offerings, but on the
structure of the “game” that delivers the underpricing.
The quest for the most efficient IPO mechanism has begun...