Is money really left on the table? The role of regular investors in IPO pricing

• Published date: 01 June 2022
• Author: Manuela Geranio,Camilla Mazzoli,Fabrizio Palmucci
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/eufm.12357

DOI: 10.1111/eufm.12357

ORIGINAL ARTICLE

Is money really left on the table? The role

of regular investors in IPO pricing

Manuela Geranio

1

|Camilla Mazzoli

2

|Fabrizio Palmucci

3

1

Department of Management, University

of Bergamo, Bergamo, Italy

2

Dipartimento di Management,

Università Politecnica delle Marche,

Ancona, Italy

3

Department of Management, University

of Bologna, Bologna, 40126, Italy

Correspondence

Fabrizio Palmucci, University of

Bologna, Via Capo di Lucca, 34, Bologna,

BO40126, Italy.

Email: f.palmucci@unibo.it

Abstract

We study how ongoing relationships between lead

underwriters and institutional investors affect initial

public offering (IPO) pricing. By introducing a new

approach, we find that stronger relationships reduce

the partial adjustment of the offer price, leaving ‘excess

underpricing’that favors regular investors, especially

in hot IPOs, while generating an agency cost for is-

suers. At the same time, stronger relationships lead to

higher offer prices, since they reduce information

asymmetries and uncertainty in the primary market.

This ‘excess price adjustment’creates value for issuers.

Taken together, these two apparently contradictory

results reveal a win‐win outcome for issuers and

regular investors.

KEYWORDS

initial public offerings, information asymmetries, regular

investors, repeated interactions, underpricing

JEL CLASSIFICATION

G23, G24, G31

Eur Financ Manag. 2022;28:651–692. wileyonlinelibrary.com/journal/eufm

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2022 The Authors. European Financial Management published by John Wiley & Sons Ltd.

We thank the editor (John A. Doukas), an anonymous referee, the participants at the seminar at Carroll School of

Management at Boston College (2018), at the European Financial Management Conference (2019) and at the SFA

Conference (2019). We are particularly grateful to Jonathan Reuter, Yakov Amihud and Kathleen Hanley, for their

helpful comments and suggestions. All errors or omissions are our responsibility.

1|INTRODUCTION

Underwriters are the initial public offering (IPO) players ultimately responsible for the

pricing and allocation of shares in the bookbuilding method. Ideally, they should fairly price

and allocate the shares in a way that serves the interests of both the issuing firms and

investors.

In the last decade, regulators and financial authorities have taken up concerns about un-

derwriters’unfair behavior in IPOs: in particular, the growing concentration in the investment

banking and mutual fund industries threatens to produce an exclusive club that favors its own

interests at the expense of both investors outside of the club and issuers.

1

Indeed, the under-

pricing and opacity of traditional IPO procedures foster firms’interests in alternatives to tra-

ditional bookbuilding, particularly direct listings and special purpose acquisition vehicles

(SPACs), which have gained a non‐negligible market share (SPACs represented around 50% of

the US IPO market in 2020, as reported by Gahng et al., 2021).

However, bookbuilding remains the predominant method of going public around the world

and will probably retain its supremacy in the near future. On the one hand, direct listings are

less expensive but only viable for large and well‐known firms that need less support from

underwriters; on the other hand, SPACs are eventually an even more expensive way of going

public than a traditional IPO (Gahng et al., 2021).

In addition, opacity and underpricing might be just part of the story: issuers could benefit

from staying with more traditional, bookbuilt IPOs more than one might expect. In this paper,

we show that underwriter–investor relationships create a win‐win outcome for both issuers and

investors.

The academic literature has studied bookbuilt IPOs with regular investors from two

perspectives: information production, supported by bookbuilding theory, and agency‐based

opportunistic behavior. These two streams of literature have debated for years to investigate on

the overall effects of the underwriter‐investors relationships.

The bookbuilding literature stems largely from the seminal contribution of Benveniste and

Spindt (1989, henceforth BS), who theorized that regular investors are rewarded for providing

truthful information with larger allocations in the current IPO, as well as priority in the

allocation of future underpriced IPOs. BS provided a rationale (Theorem 1) for the partial

adjustment—introduced by Ibbotson et al. (1988) and empirically demonstrated by Hanley

(1993)—of the offer price based on the information collected by the bookrunner, which gives

rise to underpricing for investors. At the same time, when regular investors are involved in an

IPO, BS expected such underpricing to be smaller, to the benefit of the issuer (Theorem 2).

While the existence of a partial adjustment has been subject to empirical investigation, the

literature has not directly tested BS's Theorem 2 (i.e., how the partial adjustment is related to

the presence of regular investors).

1

In particular, US Financial Industry Regulatory Authority (FINRA) Rule 5131—approved by the U.S. Securities and

Exchange Commission (SEC) in 2010—prohibits quid pro quo in the allocation of shares in an IPO. More recently,

European and UK regulators have also compelled investment banks to implement disclosure policies, to address

conflicts of interest in IPO markets: the Markets in Financial Instruments Directive II regulation in January 2018

introduced by the European Union requires bookrunners to keep a written record to justify the rationale adopted in the

allocation policy of an IPO offer. Similarly, in 2016, the UK Financial Conduct Authority revealed the potential for

conflicts of interest in the allocation of shares in IPOs and declared that underwriters should manage these potential

conflicts of interest appropriately, including the implementation of allocation policies.

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This paper adds to the literature by demonstrating the existence of a win–win outcome for

issuers and regular investors and by directly measuring and quantifying the partial adjustment

as related to established underwriter–investor relationships. More specifically, we test whether

and how the strength of such relationships leads to variation of the partial adjustment: all else

being equal, a larger partial adjustment would result in lower underpricing (benefiting the

issuer), as predicted by BS, while a lesser partial adjustment would result in ‘excess under-

pricing’

2

(favoring regular investors, as first suggested by Reuter, 2006). This last result, if

confirmed, would contribute to the agency‐based literature, which has highlighted the op-

portunistic behaviors that underwriters adopt in terms of preferential allocation to regular

investors, either in exchange for analyst coverage (Degeorge et al., 2007) or in a quid pro quo for

brokerage commissions (Fjesme, 2019; Jenkinson & Jones, 2009; Reuter, 2006). Different from

this literature, which is mainly based on IPO allocations, our intent is to add evidence on the

effects that repeated interactions have on IPO pricing. In particular, we study how

underwriter–investor relationships affect the costs that issuers sustain in terms of IPO pricing.

To the best of our knowledge, only Binay et al. (2007) have studied the pricing issue;

however, given their methodology, they found that institutional investors’propensity to par-

ticipate repeatedly in IPOs led by the same underwriter is positively related to the underpricing

level. The authors’evidence is not enough to conclude that any agency cost is dumped on the

issuer. Moreover, we find that their results are likely driven by between variation and are, then,

not robust to a time‐variant specification of the model. Deeper investigation of the partial

adjustment mechanism is needed to draw any conclusion about the impact of regular investors

on the costs borne by issuers. This is precisely the contribution of our paper.

Based on a sample of 2552 US IPOs between 1997 and 2016, our methodology allows us to

provide clear evidence that stronger relationships between underwriters and funds are asso-

ciated with a smaller partial adjustment, which results in excess underpricing that suggests an

agency cost paid to regular investors to the detriment of issuers. This result contradicts BS's

Theorem 2, in that the underpricing is larger (instead of smaller) than expected in the presence

of regular investors. We also document that such excess underpricing is more likely in hot

3

IPOs than in cold ones. We also find evidence that stronger relationships have a positive effect

on the offer price (an ‘excess price adjustment’consistent with BS Theorem 1 and related

bookbuilding theory), favoring issuers.

We conclude that the agency‐based opportunistic behaviors and information production

supported by bookbuilding theory are not mutually exclusive, as previously argued by

Jenkinson et al. (2018). Offering a deeper and new perspective to the literature, we demonstrate

the coexistence of excess underpricing and excess price adjustment, which suggests that issuers

and regular investors share the benefits of stronger relationships. More specifically, we

maintain that this sort of win‐win outcome for issuers and regular investors is the result of the

value creation that originates from regular investors providing better information and thereby

reducing uncertainty in IPO pricing (Bajo et al., 2016; Bhattacharya et al., 2020; Chuluun,

2015). Our findings are robust to different specifications of the relationship measures.

We also propose a quantification of the aforementioned effects: the informative function

played by relationships in the primary market is responsible for an excess price adjustment (i.e.,

an increase in the price adjustment) of 2.62% on average; at the same time, we find evidence

2

In excess with respect to the expected underpricing, given the level of price adjustment. The latter is defined here as

the percentage difference between the offer price and the midpoint of the initial filing price range.

3

We define an IPO as hot if the underpricing is higher than the median underpricing, and as cold otherwise.

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