Initial Public Offering
Initial public offerings (IPOs) are transactions in which businesses publicly sell their common stock within an inefficient market. In the IPO market, sellers often have more company information than buyers and insider trading is considered legal. The day in which the IPO begins trading, the stock price is likely to close higher than its original value in an attempt to sell the stocks in aftermarket trading. Within the aftermarket trading is where the value reflects the true stock price, as buyers and sellers bargain transactions. A benefit of IPOs is that they grant liquidity to company owners and raise company capital. Taking a company public is when daily operations are overseen by corporate officers who are monitored by shareholder-appointed board of directors.
Selling shares in the aftermarket can be referred to as spinning. The term spinning defines IPOs that are immediately sold in the aftermarket and are spun for a quick profit. As firms try to prevent their willingness to participate in underpricing, they may hire a lead underwriter with a highly ranked analyst. This process is known as analyst lust hypothesis. Both the spinning hypothesis and the analyst lust hypothesis are associated with the changing issuer objective function hypothesis. First-day returns create low-frequency movements in underpricing that is less common than hot issue markets. The change in underpricing is known as the changing risk composition hypothesis. The hypothesis states that riskier IPOs are underpriced more often than less-risky IPOs. IPOs are underpriced as a way to entice investors to participate within the market. The realignment of incentives hypothesis is similar to the changing risk composition hypotheses in that its ownership changes instead of pricing relations in average underpricing.
Market efficiency is when stock price values are determined by all publicly available information. According to the efficiency market hypothesis, no one investor has the ability to outperform the stock market based on private information. Consequently, stock values are equally priced because of market efficiency. Furthermore, market efficiency requires investors to use their skills and knowledge to interpret the information to achieve profitability.
Market inefficiency creates undervaluation for investors looking to buy into the market. Additionally, it creates overvaluation in which investors can sell. An inefficient market opposes an efficient market by stating that stock prices are not priced accurately and deviate either above or below their true value.
The hypothesis states that issuing firms are willing to accept underpricing when they hold constant the level of characteristics and managerial ownership. Within the changing issuer objective function hypothesis issuers are more likely to leave money on the table considering they place more attention and value on hiring a lead underwriter. Consequently, they are less concerned with avoiding underwriters with a history of excessive underpricing. This method of doing business is referred to as analysts lust hypothesis.
IPO proceeds are functions based on the choices of underwriters and auction and bookbuilding contracts. The changing issuer objective function hypothesis states issuers may put weight on proceeds from future sales and side payments instead of IPO proceeds. Within the changing issuer objective function issuers hire prestigious underwriters who charge by leaving more money on the table. Decision-makers of the issuing firms pay the price because they receive side payments and positive analyst coverage.
To launch an IPO, company’s work with investment banking firms as advisors and underwriters. As an underwriter, the bank purchases the IPO shares from the company and distributes the shares to the market. Underwriters advise issuers on pricing decisions. When an underwriter receives compensation for their recommendation, it creates an incentive to recommend a lower offer price. Bookbuilding is used to price and allocate IPOs. If there is an excess demand for shares, underwriters make the decision to whom to allocate those shares. With bookbuilding, underwriters can allocate who receives hot IPOs. Money on the table is when underwriters have influence over venture capitalist and issuing firm executives. Allocating IPOs allows for underwriters to continually underprice stocks. Decision-makers gain profits in their personal accounts when hot IPOs are allocated to them.
A hot IPO is considered an IPO that is expected to spike in price immediately upon trading. Spinning creates incentives for issuers to select bankers who underprice. The term spinning was formed when the underwriters for the firms allocated hot IPOs to brokerage accounts. The analyst lust hypothesis states that the coverage of analyst is an important factor when choosing a lead underwriter. Considering underwriters are not paid high fees for providing analyst coverage, issuers pay via the cost of underpricing. However, a concern with the analyst lust hypothesis is that it does not consider conflict of interest between managers and pre-issue shareholders, which could benefit pre-issue shareholders in situation where the analyst coverage produces higher market value.
Dr. Elijah Clark (December 31, 2022). Initial Public Offering (IPO) [Web log post]. Retrieved from https://elijahclark.com/initial-public-offering-ipo/