Hi Aboubakr,

IPO underpricing has been deliberate in many cases even when the promoters know that the intrinsic value of their shares is greater but it is not always for earning gains after listing. There is another aspect to it. In developing & emerging economies, where capital is much in demand, there are many companies competing for the scarce capital & promoters fear that their shares will not attain the minimum subscription required by legislation & issue may fail, if their shares are perceived as costly by the public. Hence, they deliberately underprice their shares to make them an attractive buy for the public which views them as attractive return opportunities. When the issues are ill-timed (i.e. when market is in doldrums & there is flight of capital away from the market) there have been evidences of companies not attaining minimum subscription & promoters colluding with merchant bankers & using dubious practices to attain minimum subscription. Hope it provides an alternative perspective to this issue.

Thanks Ms Chelawat, your comment was very insightful, the scarcity of capital probably justifies the extreme underpricing of IPO which is commonly observed in the emerging markets. As matter of fact, most of theoretical works has been insufficient in explaining the extreme underpricing observed in some of the emerging markets such as China, may be a variable proxies the scarcity of capital would remove some of the ambiguity around it.

However, the underpricing has been documented even when the capital is abundant, we've seen companies with high profile going public when the market is hot.

I will also answer no to your question. I hope you know IPO funds go to issuer and gain in market price goes to shareholders (subscriber) so IPO issuer not necessarily be get rich. I agree with Ms Chelawat point, is the case in most of the underpricing. Also underpricing is used to boost image of the company in financial markets for future funding needs.

Mr Salah U-Din

Yes you are right that subscribers also would realise huge profits in the first trading day. But these investors in most of cases are not ordinary investors, there are some questions about how the IPO shares are allocated among the investors, in the bookbuilding method the underwriter has the discretion in the allocation of IPO shares, and here the underwriter may has bias toward certain investor, many studies find that the underwriter deliberately underprice the offer price of the IPO, then allocate the big slice of IPO shares to a favored client, in contrast the underwriter reduces the cost of the issue and increases his profits through the trading commissions he acquires from his favored clients, especially if the client is an institutional investor. I agree that this is not always the case, but it still raise some questions about the credibility and the transparency of the IPO process.

Yes, I agree with you that the credibility & transparency of the IPO process is questionable in many cases. But, the share allocation process, even through book-building mode differs from country to country. In our country, the underwriters do not have absolute discretion over the allotment process, so favouring one client & resulting in a large profit to him through IPO underpricing is not possible. Firstly, our regulator has specified limits on the maximum percentages that can be allocated to retail investors, institutional investors & high net worth non-institutional investors. Besides, the Board of directors has to get the allocation methods approved by the regulator & exchange & the allocation has to be in accordance with the approved method. I guess, it is different in your country & hence, variations may be found from country to country in the reasons for IPO underpricing. I think a case by case approach would make things more clear.

This is a very simplistic explanation. Things are not black & white as is made out to be.

Thanks again for your well informed comment Ms. Chelawat

The legal and the institutional environment, which differ from country to another, has a significant role in the underpricing. Some of studies on international variance in the level of IPO underpricing have documented that. But even countries with strict IPO regulations have extreme underpricing, some countries do not grant the underwriter full discretion such as China in which the allocations are conducted through lottery, but the underpricing there still extremely high. The underwriters and the issuers are very smart beside the informational advantage they have, so they can find ways to circumvent the laws. In the US the underwriters have full discretionary power if the method used is the bookbuilding, that's why these practices are very common there, especially during the tech bubble

The IPO underpricing is one the most ambiguous market anomaly that it pertains to variety of factors, legal issues, the investors' base, the firm-specific issues, the underwriters' issues. Its complexity has been so difficult to overcome empirically and it could be almost impossible to find complete answers to it.

Mr. Emmanuel, I know that the IPO process is so complex that it is not so easy to break it down, but its complexity is what makes it questionable.

Yes, and it is this complexity which makes it a very good subject for research. There is plethora of research on this subject identifying the variables determining pricing of new issues & the variations across regions & over time. No matter how many papers have tried to explain the IPO pricing, there is still scope for more convincing work, which comprehensively identifies all factors influencing IPO pricing.

I think one of the explanations might be its being "initial". Because there is no absolute intrinsic value, and there is no market value yet for the IPOs, investors are more skeptical in investing IPOs. So the first price is determined by such psychological factors as underpriced. Findings say that human nature focuses on negative signals more than positive ones. This also may pull the price well below the probable intrinsic value because of lack of a reference such as market value.

Thanks for your comment prof. Murat

I agree with you that intrinsic value is so subjective, but I still think that insiders and the institutional investors have informational advantage over other investors. Some firms, before going public, may speculate on the firm's value referring to their counterparts in the business, or according to the growth potentials. The behavioral finance has provided some answers to the issue of IPO underpricing. However, it has been inadequate to explain it as whole.

Thanks again

I am not sure this discussion is helping much so I will try and focus the issues a little better. For IPOs in general they must be underpriced if investors are rational and risk averse. While IPOs generate a premium on listing, the variation in first day and short term returns is very high and as such a rational investor will require a return higher than the market in order to be willing to take the risk. There are also hazards in subscribing for IPOs because large institutions with the best research get the highest allocations and smaller investors who miss-price them find they get large allocations when they overvalue the shares and small allocations when they price them correctly. The pricing will also depend on the motivations for the IPO. Some are compliance issues where existing shareholders are looking for a future market for their shares, some have private equity firms looking to sell down their holdings. Some are small offerings designed to establish a price for the shares in advance of larger capital raising in the future. Some are to raise capital for expansion or to repay debt. Each has its own characteristics and pricing strategies and this complexity is lost if you simply lump IPOs together. The pricing is determined by various means and it typically involves institutional investors providing pricing indications as to volumes they will purchase at various prices. Those who participate in price discovery generally get preferential placements as a reward. This varies from country to country and studying the details of the process in the markets being evaluated is enlightening. As to the idea of IPO pricing being a scam. These are financial markets you are talking about and in financial markets the standard mode of behaviour is to gain the maximum advantage over other market participants by any legal means possible. While occasionally the bounds of what is legal or ethical are broken, generally underwriters will avoid these situations and they should be the exception rather than the rule. Those who sell shares into an IPO can be expected to maximise their wealth in the process and this is a standard function of financial markets in a capitalist economy. Those who don't like this should avoid IPOs. Underpricing is a combination market conditions and listing strategy, and it is only by understanding both you will come to understand IPO pricing. Those of us who invest in IPOs do so because we obtain, or hope to obtain, a higher return than we can achieve by investing in shares which are already listed. If there was not this expectation of superior return we would invest elsewhere. The premium on listing is determined by the balance between the expected underpricing and the risk. IPO subscribers want the lowest price relative to perceived value. Issuers want the highest price, moderated by the effect this will have on future capital raising or sell down of shares by existing share holders. Most research on IPOs is not particularly enlightening because does not adequately encompass the complexity of the problem and tends to use linear statistical relationships such as regression when often the process needs to first be dealt with using different types of relationships, for example digital logic gates which follow the process. Investors can and do consistently profit from investing in IPOs by diversifying risk over multiple IPOs and researchers want to find out how they do it will only succeed if they broaden their perspective. Simply looking at the literature and hoping to find an angle which has been missed will not advance knowledge on the subject except by sheer luck. Most of what is known about IPOs in known by practitioners not academics.

Thanks Mr Pinfold for taking time to enrich this discussion

In most of cases of IPO underpricing the balance between the risk factors whether it's endogenous or exogenous is broken, that is the bone of discussion in most of IPO underpricing studies. In fact it would have not got this great deal of attention by researchers if the pricing is well balanced. The underpricing some times is so extreme and researchers have not been able to be justify it even when considering the legal and institutional differences beside the traditional views, the explanations based on asymmetric information has been reasonable but recently it has been found inadequate, as pointed out Welch and Ritter (2002) in their review of IPO theories and activities. Any one has the right to question the way this topic has been explored empirically, but the contribution the researchers have done so far can not be undermined, the practitioners are not transparent about this issue and they usually hold information, it is the researchers' job to unfold what has been covered. The risk associated with the subscription to IPO may apply only to group of investors usually the uninformed ones, but the well informed investors such as the institutional investors do not subscribe unless they know they are going to be rewarded with huge profits exceed the expected risk by miles. Uninformed investors, on the other hand, their expectations may fall short because they are not as adept as the institutional investors in term of risk measuring. The institutional investors by nature hold and buy shares over a short period of time, this allows them to sell their holdings before deteriorating in the long run which is the case in the post-market performance of many IPOs, I understand that this is the way the market works and using the word "scam" may be was a bit inconvenient and generalises the issue, but some times it looks unfair especially if you are in the other end. I would have agreed with you if the offer price is completely justified by the hazards the subscribers would endure, but the underpricing has gone a way far beyond that. Note that the IPO is most of the time oversubscribed, so it can be said that the IPO underpricing is in favor of the investors, however the shares are not justly distributed between the investors, this unfairness only become an issue when the institutional investors started taking over the stock markets worldwide, especially after the global financial crisis. Against this backdrop, one could relate the underpricing to this factor. Finally I respectfully disagree with you that issuers wanting a higher offer price, because many studies show that the issuers are the ones who were pushing the offer price down.

Agree with your statement 'many studies show that the issuers are the ones who were pushing the offer price down'. It is true even though there are institutional differences in allocation process from country to country & in some countries, underwriters do not have full discretion over the allocation process. This is because underwriters benefit from underpricing but not necessarily in the form of listing gains. They receive indirect rewards from underpricing. Underpricing significantly reduces their marketing costs as public laps up the issue when it finds it attractive. Also, some mutual fund managers, etc.. pay higher commissions for increasing their probability of allotment in hot IPOs, especially where allocation to QIBs is on highest bid basis. This result in increase in commission revenue for the underwriter. Also, a large price-jump on listing day results in the IPO being branded "successful" by the media & it adds to the reputation of the underwriter. The benefits of underpricing seem to outweigh the opportunity cost of underpricing for the underwriters. And, last but not the least, issuers also gain from high prices on listing day, as is evident from many studies which show shift from institutional holding to individual holdings on listing day.

Academics have found that I.P.O. underpricing is ubiquitous. Jay Ritter has documented underpricingover the years. According to Professor Ritter, the average underpricing for I.P.O.’s in the United States was 14.8 percent from 1990 to 1998, 51.4 percent from 1999 to 2000 and 12.1percent from 2001 to 2009.

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Deal Professor

Over the last 50 years, I.P.O.’s in the United States have been underpriced by 16.8 percent on average. This translates to more than $125 billion that companies have left on the table in the last 20 years.

I.P.O. pricing is also a worldwide phenomenon. In China, the underpricing has been severe, averaging 137.4 percent from 1990 to 2010. This compares with 16.3 percent in Britain from 1959 to 2009. In most other countries, I.P.O. underpricing averages above 20 percent.

What explains this widespread phenomenon? There are a number of overlapping and nonexclusive theories:

Information Asymmetry

The most prominent explanation and the one with the most empirical support is that I.P.O. underpricing occurs because of informational asymmetry.

The information asymmetry theory assumes that the I.P.O. pricing is a product of information disparities.

This theory takes a variety of forms, but the most influential one was put forth by Kevin Rock almost a quarter-century ago. He theorized that uninformed investors bid without regard to the quality of the I.P.O. Informed investors bid only on the offerings they think will gain superior returns. But with weak I.P.O.’s only uninformed investors will bid and lose money. The losses are so great that the uninformed investors will eventually leave the I.P.O. market.

If you were an economics major, you might recognize this problem as a “lemon theory” — named after George Akerlof’s famous paper on how used cars are priced when information is uncertain.

The underwriters, however, need the uninformed investors to bid since informed investors do not exist in sufficient number. To solve this problem, the underwriter reprices the I.P.O. to bring in these investors and ensure that uninformed investors bid. The consequence is underpricing.

This theory has found empirical support in papers that have found that when investment banks can allocate shares in greater measure to informed investors, the underpricing is reduced since the compensation needed to draw uninformed investors is lower.

Underpricing has also been found to be lower when information about the issuer is more freely available so that uninformed investors are at less of a disadvantage.

Another informational-based theory for I.P.O. underpricing is known as informational revelation. This theory centers on the book-building process, the mechanism by which an underwriter builds a book of potential investors and the prices and number of shares they are willing to purchase.

The book-building process is intended for the underwriter to assess demand and obtain information from potential buyers about what price buyers are willing to pay. In order to incentivize investors to disclose sufficient information about the price they believe is appropriate, underwriters allocate fewer shares to potential purchasers who bid low.

But underwriters still discount the stock to incentivize aggressive bidding and to ensure that the bids are not even lower since the more bids there are, the more information is revealed about the appropriate price for the stock. Issuers accept this underpricing because it allows underwriters to better gauge a higher sale price. This theory too has found empirical support in the academic literature.

A third strand of the informational asymmetry theory asserts that underpricing is associated with the weakness of the issuer. The underpricing is intended to compensate the purchasers for this weakness. This theory has found weak evidential support.

Investment Banking Conflicts

The investment bank conflict theory, the one Mr. Nocera supports, posits that investment banks arrange for underpricing as a way to benefit themselves and their other clients. There is some mixed evidence to support this argument.

A number of papers have found that investment banks do respond to appropriate incentives to reduce underpricing. Higher I.P.O. commissions have been found to reduce underpricing. At least one paper has found that underpricing is reduced by more than 40 percent when an American bank and American investors are involved. This is attributable to the higher underwriting fees that American investment banks charge.

In addition, the greater the underwriter’s stake in the I.P.O. through ownership of the offered shares, the less underpricing, though there is conflicting evidence on this point. Papers have also found that underwriters who incorrectly underprice their business do lose the chance for future I.P.O.’s.

Managerial Conflicts

The managerial conflict theory posits that management is the primary cause of the underpricing. In its principal form, the manager conflict theory postulates that management creates excessive demand for I.P.O. shares in order to ensure that management can sell their holdings after a contractual 180-day lockup for a higher price.

Alternatively, management allows underpricing to ensure that there are many purchasers of the shares. This means there are no large shareholders created by the I.P.O., shareholders who may be more incentivized to replace management. There is not much evidence to support either form of this theory.

Litigiousness and Regulation

This theory posits that the underpricing is because of American securities laws that impose strict liability on the issuer and underwriter for material misstatements and omissions made in connection with the I.P.O. The underwriter deliberately underprices the I.P.O. to ensure that even if there is such a misstatement or omission the purchasers do not have a claim since these failures are priced in the I.P.O. This theory has not found much support primarily because regulatory schemes in other countries are much laxer yet I.P.O. underpricing happens there as well.

Behavioral Explanations

These theories have gained attention in the wake of the technology bubble. One form of this theory posits that either institutional investors or managers gain from taking advantage of retail shareholders who act irrationally or otherwise against their economic interests. And that both institutional shareholders and managers therefore underprice I.P.O.’s to lock in these gains. A variation of this theory posits that it is the institution that allows this underpricing as a result of its own inability to recognize the loss. There is uncertain evidence for these behavioral theories, but they do help in explaining extreme rises like LinkedIn’s.

And these are but a few of the competing theories for I.P.O. underpricing. They may explain I.P.O. underpricing of 10 percent to 20 percent, but they don’t explain the extreme underpricing of a debut like LinkedIn’s.

Mr. Sorkin discusses some reasons why this may be appropriate, including a need to show a successful I.P.O. rather than a price drop and the fact that LinkedIn may gain by selling its shares later at a higher price.

These may be the reasons, or perhaps Mr. Nocera is right. But I have my own theory that overlaps a bit with Mr. Sorkin’s.

If LinkedIn had sold the same number of shares as it did last week at about $100 per share, it would have made an extra $200 million or so. But this assumes that there were enough investors willing to buy shares at that level. LinkedIn and the other shareholders sold less than 10 percent of the firm’s outstanding shares. A sale at $100 a share would have reduced demand and certainly wouldn’t have given the company the publicity it did.

Now, LinkedIn can wait and sell shares later at this higher price, gaining more money in the aggregate.

The company, meanwhile, received national publicity for its Web site, something that may be worth the tens of millions of dollars alone, if not more.

The price of equity stock at the Initial Public Offering (IPO) is a highly technical issue - which transcends reputation of the entity prior to "going public", reputation management, operating performance, asset & liability management, quality of the balance sheet, management, capital market regulations, the external consultants engaged in the deal and of course whether the issuing house underwrite the IPO issue. Apparently, for the reasons of "first time outing" there is tendency for the issue or stock price to be under-quoted; there is also the marketing theory of penetrating pricing strategy and in some climes there could be some possibility of scam, which within a decade, the company to went to the stock market shut down. Regulators should monitor such events.

In conclusion, it can be seem as the nature of an IPO pricing system but there can be situation, scam was intended and that has happened in some sovereigns

Underpricing is a marketing theory pricing strategy .It can also be regarded as a risk avation by the under writers to some extent but it often misused by dishonest underwriters .

Thanks Chris and Gardner for your replies

Your comments were absolutely spot on, the possibility of misconduct in some of the initial offerings should not be overlooked and need to be investigated.

Boubekeur Baba Check the events studies in order find whether this effect is pre-available effect.