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What causes the underpricing of auctioned IPOs?
Experimental Evidence
Panos Patatoukas, October 2007
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IPO mechanisms in the US
•
•
An IPO is the first sale of shares in a company to the public.
Once an IPO occurs, the company will be listed on a stock exchange, and shares
begin to trade.
•
Currently there are two mechanisms for IPOs in the US: the book-building and the
auction-based method.
In both mechanisms, the main role of the underwriter is to price and allocate the
shares of the issuer.
The key difference of auctioned from book-built offerings is the mechanism under
which the underwriter carries out his role:
•
•
1.
2.
In the book-building mechanism the underwriter prices and allocates the new issue
with complete discretion.
In the auction mechanism the underwriter has limited discretion, both the pricing
and allocations are market driven since both are determined in a uniform price
sealed bid auction where all winning bidders pay the clearing price.
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The underpicing phenomenon
•
An issue is under (over) priced if the price received by the issuer in the
primary market is lower (higher) than the price of the same securities in the
secondary market.
•
The underpricing phenomenon traditionally refers to the short-term
performance of book-built IPOs and is typically measured by the “pop” in
the new issuer’s stock price within the first few days of trading.
•
The auction mechanism offers the promise of limiting underpricing. The
argument is that the clearing price of a well-designed auction is virtually
equal to the market price so the first day return should be zero .
•
The question that surfaces is whether auctioned IPOs are, in fact,
underpricing-free.
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Auctioned IPOs are not
underpricing-free
• In the US, over the period 1999-2007, the mean first day returns of
completed auction-IPOs are +14.27%.
• In France, over the period 1992-1998, auction IPOs experience on
average +9.70% returns on the first day of trading.
• The average underpricing level is +4.5% for auction-IPOs
conducted on the Tel Aviv Stock Exchange from 1993-1994.
• Auctioned deals completed from 1993 to 2001 in Japan experience
on average +11.40% first day pop.
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US Treasury auctions
• The auction IPO mechanism is based on a model similar
to that used by the US Treasury.
• Uniform price Treasury auctions also appear to be
associated with underpricing since the average price
received by the Treasury is less than the price of the
same securities in the secondary market.
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Motivation
• Theories to explain the underpricing of “traditional” IPOs usually
examine the relations between the three actors of an IPO: the
issuer, the underwriter and the investors.
• Explanations which rely on the underpricing benefits to the issuer
and/or the underwriter are not relevant for auctioned IPOs since the
issue’s price and allocation is determined by investors in an auction
and not by either the issuer or the underwriter.
• The empirical finding that auctioned IPOs are underpriced
poses a puzzle.
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Research Question
• Empirically investigate the causes of the underpricing of
auctioned issues.
• My research question cannot be empirically evaluated
with field data (at least for the time being).
• In order to investigate the causes of the underpricing of
auctioned IPOs I develop a computerized laboratory
market that enables me to test hypotheses grounded on
economic theory.
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The demand reduction effect (1)
•
Vickrey (1961) demonstrates that in single-unit, uniform-price, sealed-bid
auctions the bidder’s dominant strategy is to truthfully bid his valuation and
thus uniform price auctions are allocatively efficient and maximize the
seller’s revenue.
•
Vickrey also points out that the uniform-price auction is not expected
to be demand-revealing if bidders have multi-unit demand, as in the
case of securities auctions.
•
When a bidder desires multiple units there is a positive probability that his
bid on the second, or later units will be pivotal in determining the price that
he pays on all units that he wins.
•
So the bidder has an incentive to bid less than his true valuation on later
units in order to reduce the price he pays on the earlier units.
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The demand reduction effect (2)
• The demand reduction effect “predicts” that the issue will be
underpriced even if the signals generating process is common
across investors (information homogeneity).
Signals’ noise:
• As the noise in the signals generating process increases bidders have an
incentive to behave more strategically (Kagel, 1995) and potentially exhibit
more demand reduction.
Number of Bidders:
• As the number (N) of investors’ increases the probability that any given
investor will be the pivotal bidder decreases and the demand reduction
incentives decline.
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The marginal bidder hypothesis
• (H3) In a market setting where all investors are symmetrically
informed about the pure common value of the securities for
sale, auctioned IPOs are underpriced and the underpricing is
ceteris paribus (i) increasing in the noise of the signals
generating process and (ii) decreasing in the number of bidders
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Pilot Results (1)
Noise
True Price
Clearing price
Closing Price
% Deviation
of CP from TP
Round 1
1
$18.7
$17.6
$18.6
-5.88%
Round 2
2
$13.2
$12.3
$13.8
-6.82%
Pilot Results (2)
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$18.8
$18.6
$18.4
$18.2
$18.0
$17.8
$17.6
$17.4
$17.2
$17.0
0
58 102 57 75 50
55 56 55
75 69 74 100 82 85 93 133 131
Transaction Prices in Aftermarket
Transaction Prices
FR Price = $18.7 & k=1
Clearing Price=$17.60
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Pilot Results (3)
15
14.5
14
13.5
13
12.5
12
11.5
14
2
14
0
13
9
12
3
76
76
67
64
54
49
44
0
11
Transaction prices in aftermarket
Transaction Prices
FR Price=$13.7 & k=2
Clearing Price=$12.3
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Concluding Thoughts
Consistent with the marginal bidder hypothesis:
1. the issue can be underpriced even if all investors are
symmetrically informed.
2. the issue is more (less) underpriced when the noise in the
common signals generating process is higher (lower).
What about ?
• Experience & Learning effects.
• Asymmetric Information Structure
• Price bubbles or false equilibria in the aftermarket.
• Speculative bidding in the primary market
• Merits of running pilot experiments