Investment Banking Issues: Why Do IPOs Get Underpriced?

Every year investment bankers help several companies raise capital from the markets. They help these companies in issuing securities and accessing more funds. The issue is that when these companies access the capital markets, they are often growing at a phenomenal pace. This means that these firms have a lot of projects where they want to make investments.

However, traditional sources of funding, such as promoter’s equity as well as bank loans, are unable to meet their funding needs. Hence, the firms often access the capital markets in a hurry.

It has been empirically proven that when these companies sell their securities, they often price themselves less. This means that there is significant underpricing at play when IPO’s are issued. This means that the companies issuing securities are leaving money on the table! It is amazing that such a trend is emerging despite the fact that capital markets all over the world are competitive, and hence any pricing discrepancies should immediately get corrected.

In this article, we will understand why IPOs are often underpriced and the role that investment bankers play in it.

There have been formal studies that have been conducted by many organizations to help zero down the reason behind the underpricing of IPOs. The four major reasons that have been listed in these studies are discussed below:

1. Monopoly of Investment Bankers: Many studies have argued that since investment banks had a monopoly on the underwriting of shares, the issues were being underpriced. This is because the investment banker has an incentive to underprice the shares. If the price of shares is sold below the market price, then the investment banker has a higher probability that they will be able to sell all the shares easily. However, if the issue is fairly priced, there is always a chance that all the shares might not be sold off at once.

   Hence, pursuant to the underwriting clause, the investment bank will have to hold on to some of the shares on their books. This would mean that their own capital gets locked, and they have to undertake the risks. This is the reason that investment bankers deliberately underprice their shares. Investment bankers have been arguing that this is incorrect. This is because it is not true that they hold a monopoly over the underwriting of shares anymore.

   Ever since the Glass Steagall Act has been repealed, commercial banks, foreign banks, and a wide variety of institutions have the ability to underwrite shares. Hence, the competition amongst various underwriters should ideally eliminate the underpricing of shares.

2. Protection from Lawsuits: Investment bankers have another incentive to underprice the IPOs. The regulations related to securities issues in many countries make the investment bankers liable for any type of misinformation and the financial losses arising from the same.

   Hence, if it is proven in court that the investors were sold an overpriced issue, the investment bankers could face a huge liability.

   To counter this, investment bankers inherently assume that the directors of the selling company are not giving them 100% correct information. Hence, they deliberately lower the valuation and keep a spread for themselves and underprice the shares. This is so that even if adverse information is found out, later on, the investment bankers can still argue that even with new information, the issue is not overpriced, and hence, they shouldn’t be liable to pay damages to the shareholders.

   However, the fact remains that in order to protect themselves from the lawsuits, the underwriters do have an incentive to provide a lower valuation to the shares.

3. Information Asymmetry: Another reason which has been mentioned by many studies is the fact that huge information asymmetry exists during an IPO. When an IPO process is announced, the investors are buying into a relatively unknown commodity.

   The business of the company has been private until then, and hence their financial performance is also not disclosed to the public. The IPO process does make it mandatory to disclose financials for the past few years. However, there is still a huge information asymmetry. This is the reason that the bidding shareholders always bid a lower price. This is because they will bid on many IPOs on average. Some issues will turn out to be overpriced.

   Hence, to be conservative, investors bid a lower price on an IPO. The selling company is also aware of this issue. However, they do not seem to protest because once the IPO has been issued and found to be worthwhile, the investing community provides a better valuation to the subsequent public offerings. Hence, it can be said that underpricing is a kind of premium that the company has to pay to induce the investors to bet their money on an unknown company.

4. Insider Outsider Theory: The insider-outsider theory assumes that underpricing is the best strategy given the asymmetry. This is because if the issue is underpriced, insiders will buy it because they know its true value. At the same time, outsiders will buy it thinking that it is at least the fair value.

   When the market corrects and prices rise, both insiders, as well as outsiders, stand to gain. On the other hand, if the issue is overpriced, then neither insiders nor outsiders would want to buy it.

The bottom line is that even though the underpricing of IPOs might seem like an anomaly, it is not. Deliberately underpricing IPOs is a strategy that has been used by many companies as a marketing tool for their issues.