Initial Public Offering Discount and Competition
21 Pages Posted: 7 Dec 2005 Last revised: 8 Oct 2013
Lacking examples of IPO mechanisms that are open to the public and priced competitively, previous studies could not determine what size discount, if any, is efficient. We test and reject the hypothesis that underpricing is efficient or consistent with competition by comparing two consecutive pricing mechanisms on the Tel Aviv Stock Exchange: A standard investor-driven auction constrained by pre-announced maximum and minimum prices, replaced by a uniquely competitive auction in which a maximum price is banned. The switch from fixed pricing to unconstrained auction pricing leads to important changes: Rationing and herding disappear along with the binding maximum price, improving the access of uninformed investors to strong issues while decreasing their exposure to the winner's curse attached to weak issues; the quality of pricing increases by the elimination of the underpricing bias and increased pricing accuracy beyond that bias, and by increased price sensitivity to IPO-unique factors. There is evidence that underwriter fees moderately increase, apparently in compensation for a higher risk, while services performed for those fees remain unchanged. Consistently, early trading reveals no evidence of deterioration in the IPO's efficiency as a screen for weak issues. Jointly, these changes demonstrate that the price discount dominating the fixed-pricing mechanism is neither competitive nor efficient. The introduction of competitive pricing increases the efficiency of IPOs by improving the quality of pricing and by removing an implied tax on companies going public.
Keywords: IPO mechanism, IPO competition, IPO price discount, IPO initial return
JEL Classification: K22, L14, D44, G14, G24, G28
Suggested Citation: Suggested Citation