* I would like to thank Frank Dobbin, Christopher Marquis, Peter ...
while espousing EMH, predicts that underpricing may be necessary to align the interests of underwriters with issuers and may also represent the failure of shareholder monitoring (Jensen and Meckling 1976; Fama and Jensen 1983). Most analysts utilize the presence of large pre-IPO institutional shareholders as a proxy for lower agency and monitoring costs; thus private-equity backed issuers should exhibit lower underpricing. Economists, however, disagree on how underpricing actually affects post-IPO ownership dispersion and monitoring (Zingales 1995; Booth and Chua 1996; Brennan and Franks 1997; Mello and Parsons 1998; Stoughton and Zechner 1998; Field and Sheehan 2004; Zheng and Li 2008). Analysts also disagree as to whether underpricing is a substitute for litigation costs, either as a form of insurance or deterrence (Ibbotson 1975; Tinic 1988; Alexander 1993; Drake and Vetsuypens 1993; Lowry and Shu 2002). If first-day returns were a substitute for litigation costs, companies especially exposed to litigation risk would exhibit higher underpricing in a bid to please investors and avert lawsuits. Also, information asymmetry predicts that the reputation of knowledgeable backers (underwriters and institutional investors) certifies the quality of the issuer to the broader market, reducing first-day returns (Carter and Manaster 1990; Carter, Dark and Singh 1998). Behavioral finance relaxes either the assumption of Bayesian updating or rational SEU preferences, claiming that groups of actors are universally biased or non-rational in the same manner (Hirshleifer 2001; Barberis and Thaler 2003). Investor models within behavioral finance rely on the presence of non-Bayesian investors, generally referred to as “noise traders” or “sentiment investors.” In particular, Baker and Stein (2004) demonstrate that sentiment investors can dictate prices by driving rational investors out of the market due to short-sale constraints. These sentiment investors are prone to sentiment (non-rational optimism or pessimism in pricing) and underweighting information relevant to DPV intrinsic values, violating Bayes’ 8
theorem (Odean 1998; Kaustia and Knüpfer 2008). When sentiment levels are high, these non- Bayesian sentiment investors increase both market liquidity (trading volume) and prices beyond rational levels, as rational investors cannot short sell the overpriced shares. 6 Derrien (2005) builds on the work of Miller (1977), Benveniste and Spindt (1989), De Long et al. (1990), and Welch (1992) to model how underwriters price IPOs in the presence of sentiment investors in France. Derrien hypothesizes that underwriters rationally maximize profits, consisting of the underwriting fee as a percentage of the offer price (first-stage price outcome) less the cost of price support post-IPO. In the model, underwriters buy the offering from the issuer for resale to two groups of investors with different price predictions, rational and sentiment. Underwriters themselves do not know the intrinsic value of the issuer, so they conduct a two-stage IPO process, soliciting price predictions from the group of rational investors first. Rational investors must be enticed to disclose private information on their estimation of the intrinsic value of the issuer, so underwriters price the offering below the irrationally inflated price predictions of sentiment investors. Given such a model, the offer price to rational investors (first-stage price) increases with investor sentiment, but usually does not reach the price predictions of sentiment investors, thus explaining the persistence of first-day returns. 7 Furthermore, issuers are not upset with this underpricing, since the offer price is priced above the intrinsic value of the firm, or the predicted price by rational investors (Purnanandam and Swaminathan 2004). Finally, rational investors are happy to sell the shares to sentiment investors on the first day of trading for a quick profit. I will discuss in the “Underwriting Returns” section how U.S. IPO practices violate this model’s core assumptions. Nevertheless, this model represents one of the most complete sentiment investor accounts of IPO first-day returns and has been extended to explain long-run IPO 9
! ! 11! Operating Cashflow (standar
! ! 13! (0.436) (0.433) Positive Ea
! ! 15! Table 9: Venture Capital-co