Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Advanced Corporate Finance

Lecture 22: Initial Public Offerings
Underpricing II

Alexander Schandlbauer

1 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Outline

1 Introduction

2 The model

3 Underwriter’s bargaining power

4 Best-efforts and firm-commitment contracts

5 Conclusion

2 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Introduction

Why new issues are underpriced::

Rock (1986) provides one explanation for underpricing in IPOs
I Focuses on IPOs using the firm commitment offer system
I Explains the underpricing as being a result of . . .
But what if the book-building mechanism is used instead?
I Is there a reason for choosing between different types of IPO
mechanisms?
Benveniste and Spindt (1989) try to come up with answers
I They explain underpricing with book-building
∗ Argue that underwriters obtain bargaining power in a multi-period
game which they can exploit to reduce underpricing
I They relate the degree of asymmetric information costs to the
choice of IPO mechanism

4 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Benveniste and Spindt (1989)

How investment bankers determine the offer price and
allocation of new issues

Underwriters
I try to factor as much information in to IPO prices as possible
I solicit indications of interest from investors
Problem: Investors have no incentive to reveal positive
information before the stock is sold
The underwriter uses the book-building method to collect
information to price the IPO shares
I ...
I ...
I ...
By choosing suitably the rule relating the offer price and share
allocation to investors’ indications of interest, an underwriter can
induce investors to reveal their information

5 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Underpricing a consequence of book-building

Underpricing is a natural consequence of book-building: (premarket

auction)
IPO offer prices must be set low to provide profit to compensate
investors for revealing positive information
The amount of compensation required depends on how much
investors may expect to profit by hiding the information
This depends directly on the extent to which withholding positive
information results in a lower expected offer price
An investor has less incentives to bid low for an issue he values
highly if doing so jeopardizes his allocation

6 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

The model

A private firm wants to sell Q shares

Future cash flows to these shares are Ṽ
Both the issuing firm as well as the investors have some
information about the mean of Ṽ : V̄
Risk neutral investors and rf = 0 implies that
I price of shares equals E[Ṽ /Q] = V̄ /Q

Two types of investors:

I Regular
∗ participate regularly in the IPO market
∗ there are H regular investors
I Occasional
∗ only participate occasional
∗ there are many occasional investors
Both types have some information relevant to the expected value
of the issuing firm’s cash flow

8 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Investors’ information
Regular investors:
Each regular investor has one piece of private information
I the information is either “good” or “bad”
I has an equal marginal impact on the value of the stock
If h of H report good information, the expected price is

Ph = A − (H − h)α
where A is the price if h = H, and α is the marginal effect of information
on the expected price of the issue
Occasional investors:
Independent of regulars’ information
Let λ, with E[λ]=0, represent the effect of occasional investors’
information on price
Conditional on all information (reg.+occ.) the value of the stock is

E[Ph,λ ] = Ph,λ = A − (H − h)α + λ

10 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

The market

The market proceeds in two stages:

Stage 1: Premarket
I Regulars can bid
Stage 2: Aftermarket (open market)
I Occasional investors can bid
When regulars bid in the premarket, they take their expectations to the
price in the aftermarket into account, Ph,λ
Assume:
A.0 Aftermarket price: full-information-revealing equilibrium price
I price reflects all the private information of reg. and occ. investors
A.1 Regular investors’ investment preferences are identical. Any investor is
willing to purchase up to q̄ shares at a price ≤ Ph,λ
A.2 Regular investors’ demand just exhaust the issue, H q̄ = Q
A.3 Regular investors’ information is independent. Let p = probability regular
investor has good information

12 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Probabilities
Regulars have an information advantage in the premarket
I They have a better estimate than the underwriter and the firm
I Index the state of the premarket by the total number h of pieces of
good information possessed by regulars
Let πh denote the unconditional probability that h investors have
positive information, i.e. probability of state h
 
πh ,

A regular’s conditional probability of h given he has good info

 
0 H −1
πh−1 , ph−1 (1 − p)H−h , h = 1, . . . , H
h−1

A regular’s conditional probability of h given he has bad info

 
0 H −1
πh , ph (1 − p)H−1−h , h = 0, 1, . . . , H − 1
h
14 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Reservation price
A regular’s premarket reservation price is his conditional
estimate of the aftermarket price
A regular’s premarket reservation price, if he has good info:
H−1
X
Pg = πh0 Ph+1
h=0

A regular’s premarket reservation price, if he has bad info:

H−1
X
Pb = πh0 Ph
h=0

Note [Blackboard]

Pg − Pb = α

α . . . marginal ex ante value of a regular’s information

15 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

What is going on

Assume: all underwriter’s info was communicated to the market

The underwriter asks regulars about their information
I In practice, investors express mild or strong interest at different
prices within the underwriter’s proposed range
I In this model, the process is simplified by assuming that regulars
simply declare if they have a good or bad piece of information
The described mechanism for selling shares is simple, yet it
explains (perhaps) why book-building works
The non-binding orders are used in setting the final offer price
Must set up a mechanism such that regulars truthfully report
information
I Apply the revelation principle
∗ agent must be willing to participate
∗ agent has no incentive to lie

17 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Offer price and allocation

OP&A

Notation:
Pho . . . Offer price when h regulars indicate their information is
good
qg,h . . . The share allocated to a regular investor indicating good
info, when h − 1 others indicated good (state h)
qb,h . . . The share allocated to a regular investor indicating bad
info, when h others indicated good (state h)

Each regular chooses the indication of interest (OP&A scheme)

if indicating good
if indicating bad
because the offer price and allocation depend on the investor’s
indication and all other regular investors’ indications

18 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Summary of OP&A schedule given h

OP&A schedule given h:
Allocation to each g: qg,h
Allocation to each b: qb,h
Total shares sold in premarket: hqg,h + (H − h)qb,h


Sales in aftermarket: Q − hqg,h + (H − h)qb,h
Expected proceeds

Ph Q − hqg,h + (H − h)qb,h + Ph0 hqg,h + (H − h)qb,h




= Ph Q − (Ph − Ph0 ) hqg,h + (H − h)qb,h

Assume that the objective in choosing an OP&A schedule is to

maximize the expected proceeds of the issue:
Underwriter: only needs to settle how much to presell
Given one wants to sell Q̃ shares in the premarket, choose the
OP&A to maximize the proceeds
19 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

The objective function

H
X
πh Ph Q − (Ph − Pho ) hqg,h + (H − h) qb,h



o
max
Ph ,qg,h ,qb,h
h=0

subject to
H−1
X H−1
X
πh0 Ph+1 − Ph+1
o
πh0 ((Ph − Pho ) + α) qb,h


qg,h+1 ≥
h=0 h=0

hqg,h + (H − h) qb,h ≥ Q̃, h = 0, . . . , H

Pho ≤ Ph , h = 0, . . . , H
0 ≤ qg,h ≤ q̄, h = 0, . . . , H
0 ≤ qb,h ≤ q̄, h = 0, . . . , H − 1

20 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment
The Investors
contracts
The market
Conclusion
Probabilities and prices The premarket

Proceeds-maximizing OP&A schedule

Theorem 1
For a given presales level, Q̃, the proceeds-maximizing OP&A schedule
will have the following characteristics:
qg,h = q̄ for every outcome h
Pho = Ph for every h such that hq̄ < Q̃
Underpricing occurs in states where hq̄ ≥ Q̃
Expected proceeds from the issue are
H    
X p 
πh Ph Q − α max Q̃ − hq̄, 0
1−p
h=0

Interpretation:
The expected underpricing is necessary (the cheapest way) to induce
regulars to reveal good information if they have it
This underpricing gets smaller if qb,h (allocation to regulars declaring b)
is minimized
The best way to underprice is to do it when regulars with good
information get something out of it, i.e. when q̄h ≥ Q̃
21 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Underwriter’s bargaining power

If regulars are expected to profit from an IPO, underwriter can

use this in a multi-period game
Induced bargaining power can be used to convince regulars to
accept an overpriced issue, such that

(Pho − Ph )qb,h ≤ L,

where L is the present value of future profits

Result: less underpricing is necessary to induce truth telling

Theorem 2
For a given minimum of presales, an underwriter can provide unconditionally
higher proceeds to an issuing firm by giving priority to regular investors

23 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Best-efforts and firm-commitment contracts

In firm-commitment, the underwriter is guaranteeing the sale

Hence, this gives the underwriter incentives to set (low) price,
such that entire issue is sold in premarket
Incentive to allocate more (than in Theorem 1) to investors
indicating “bad”
In best-effort contract, the underwriter is not guaranteeing the
issue
Hence, less incentive to sell to investors with bad information
But best-efforts contracts also entail greater proceeds
uncertainty than firm-commitment contracts.
The choice of contract is influenced by three factors:
I α, which measures the value of investors’ information
I The risk aversion of the owners of the firm going public
I The issuer’s financial needs

25 / 27
Introduction The model Underwriter’s bargaining power Best-efforts and firm-commitment contracts Conclusion

Conclusion

Benveniste and Spindt (1989) show how underpricing can be

explained using the book-building method
In contrast to Rock (1986) information asymmetry is present in a
premarket
Underpricing is the cheapest payment to investors with good
information, such that they truthfully report, when they are
approached by the bank (underwriter)
Underwriter can exploit a multi-period game to decrease the
underpricing

27 / 27