* I would like to thank Frank Dobbin, Christopher Marquis, Peter ...
underwriters price IPOs in a two-stage process. In the first stage, only certain institutional investors—primarily hedge, mutual, pension, and private equity funds—negotiate with issuers to determine offer prices through the underwriter mediated order collection and allocation (bookbuilding) process. Behavioral theorists designate these institutional investors as rational investors. Underwriters recommend an indicative price range incorporating the IPO discount to approach investors with, and issuers either acquiesce or negotiate the price range with the lead underwriter. Once the price range is agreed upon, meetings with institutional investors (roadshow) commence and bookbuilding demand informs the determination of the final offer price to institutional investors. 10 This final offer price can be priced above, within, or below the price range, representing the first-stage return outcome. After underwriters complete this first stage allocating and selling the offering to institutional investors, the stock begins trading on the general market, and retail investors (sentiment investors for behavioral theorists) can purchase shares from these institutional investors or from the lead underwriter in the second stage of IPO pricing. The first-day return is the increase in share price from the offer to the closing price on the first day of trading (i.e., the difference between the two stages of pricing, or the second-stage return outcome). IPO first-day returns averaged 21.4 percent from 1990 to 2008, costing issuers a cumulative total of $122 billion, or on average $6.4 billion a year. Figure 1 shows the average first-day returns and cost of “underpricing” over the time period of this study. [Insert Figure 1] 12
As discussed earlier, IPO pricing is of keen theoretical import to price theorists precisely because the second-stage outcome (first-day returns) purges the returns of all neoclassical explanatory factors. With the failure of EMH to explain IPO underpricing, economists have attempted to offer explanations that explain second-stage returns while recognizing that pricing above the range (first-stage returns) is the key determinant of such returns (Ritter and Welch 2002). The failure of economists to investigate first-stage return outcomes is telling, as behavioral theories have little to say about pricing above the range. Indeed, non-Bayesian investor models cannot explain first-stage return outcomes as they only involve rational investors in the first stage. 11 Non-SEU issuer models, however, might be able to explain pricing above the range, as non-rational issuers may be seeking underpricing both in the second stage (first-day returns) as well as in the first stage (pricing above the range). In other words, just as second- stage outcomes purge returns of changes to systematic risk exposure and new information, isolating non-neoclassical explanatory factors; so too, first-stage outcomes purge returns of non- Bayesian investor factors, isolating issuer and underwriter motives as the key explanatory factors. The following table summaries the explanatory factors isolated by each stage of IPO pricing. [Insert Table 1] Underwriters have a vested interest in first-day returns and actively conduct institutional work to ensure the realization of first-day returns in the IPO market. While investment banks earn less on the underwriting fee with increased first-day returns as fees are always a percentage of the offer price, they more than make up for reduced fees in increased stabilization trading 13
! ! 15! Table 9: Venture Capital-co