Reasons for an IBank intentionally underpricing an IPO

rrrrr01First day pop = successful deal successful deal = other companies on the sideline want to play other companies on the sideline want to play = positive ipo environment positive ipo environment = fees

Very true. Pricing an IPO exactly correct would be talked about as a failure on CNBC. They would say something about low demand. Underprice an offering for that pop and all of a sudden Baidu/Linkedin are officially the shit.

So several reasons:

1. It's very difficult to figure out the "true" value to get it priced perfectly...but even if you could:

2. Ibanks that offer the IPO can do an overallotment option or green shoe, which allows the underwriter to increase the offer size by 15%. This way the firm nets a greater profit and the ibank also gets a healthy spread.

3. If the company decides to reissue stock, it's easier to sell new shares if the IPO was underpriced than over.

4. If overpriced, ibanks buy back shares...which decreases everybody's profits.

Hope this helped.

IPO pricing is a bit of a balancing act...you want to price the issue high enough so that the company thinks it is getting fair value but low enough so that the market deems it to be a fair value as well. "Successful" IPOs shoot up on day 1,day 30, etc. bc the market thinks there is enough inherent value to warrant a higher stock price.

IPOs need to be underpriced to some extent. The company going public has no history of filings, earnings calls, or research whereas the comps that help price it have that history. That's why IPOs usually have a 15%-20% discount built in. If the stock trades up an enormous amount in the first trading days then the company and bankers do realize that some money might have been left on the table. It still isn't the worst thing though as most IPOs only sell a small piece of ownership and the price gain attracts publicity for the stock in the WSJ, CNBC, etc.

In order to generate demand for the IPO from investors the shares need to be discounted from "fair value" otherwise their would be little to make investors want to buy on day 1 vs. day 30 of the stock trading. Similar for debt with an OID discount.

You don't want it to be too underpriced though, because if it shoots up a ton the next day, the company will think it left money on the table and could hold it against you when it comes to future offerings...and other companies contemplating IPOs will surely notice that too and might be more inclined to go to another bank.

Thanks, everyone! This is why WSO rocks :)

liquidity

In general, yes, the price in the primary market is set at a discount. This is for several reasons:

1) For most IPOs, the underwriter/investment bank is committed to purchasing unsold shares and would thus be taking a large risk in pricing too high (taking into consideration that investors will price the security different from the investment bank)

2) The primary market is led by a small number of large investors whose yays or nays make or break a deal (which leads to the idea that Wall Street 'knows' whether a deal will be good or not). Because of this, selling to the primary market is mostly a relationship business, which requires providing a good return to those large investors to create excitement about an offering without which a deal is basically dead. It is also true that IPOs in which the intial price set pre-roadshow is raised by pre-IPO leads to price appreciation post-IPO, whereas when the initial price set pre-roadshow is lowered by pre-IPO, no price appreciation occurs post-IPO (i.e. no excitement created because of overvaluation by investment bank)

3) During roadshows, investment banks ask potential investors what valuation they are arriving at, which they use to adjust their own price. If investors reveal their true valuation and the investment bank did not provide at least a decent return (discount to the value provided), then investors would - in the future - never give the true valuation and would instead discount expecting that their returns would be erased. Economics then dictates that in the long run, especially where investment banks work with many of the same investors, that investors should tell the truth and investment banks should discount.

Therefore, yes, in general, there is a discount in the primary market. For a normal investor (you, or a trader), it may seem that investing in all the IPOs would be a guaranteed profit because of the discounting, but it is only the case in theory. In actuality, investment banks reward the investors with which they have long-term working relationships with the 'good' deals, while pushing the 'bad' deals to others. So, for an investor, even if you wanted to purchase IPO shares, there would only be free shares (and you would only be provided shares) for IPOs where the price is expected not to appreciate greatly post-IPO. Although the research shows a great return for IPOs in general, then, you could not trade IPOs indiscriminately and make money.

Great post, Mr. White! Thanks.

Well, it's not really sold at a "discount," it really tends to be sold to the primary buyers at a near-real price. The problem is that when new IPO's come out, there's a huge survival bias (Everyone remembers Google, no one remembers the Vonages), so when the institutions that initial buy the stock go to the market to sell, there is a huge demand by people that want to get "rich" off IPO's. This is why if you take the price after the first day of trading, there is on average a -7% return. Whereas if it were truly discounting, and the price after the ~15% bump were the true price, returns should be equal to a benchmark.

I don't know where you are getting your IPO first-day return of -7%. Ibbotson shows 18% raw return on an equal-weighted index for first-day return from 1960-2006. It also doesn't make sense to not discount when selling to the primary market. If you think about the risk-reward for such a transaction, it would be impossible to get initial investors to buy if it were sold at near-real price. As I stated above, it also doesn't make any sense in terms of risk-reward for the bank, nor does it make economic sense for both parties in the long-run. However, nobody said that discounting was always set at 15% - the 15% is an off-hand number that is an ex-post average, and as with all averages/statistics, it is not a predictive result nor will any returns be exactly predicted by that average.

eh, I'm going by what my foundation of financial markets teacher said, he was some famous dude so I believed him. Maybe it has something do with how different IPOs are weighted (perhaps he was going by sheer number of IPO's instead of market cap, which would presumably lower return). Are you sure Ibbotson didn't based it on initial price, not on end of first day? Also I'm not sure of end of first day is the best guess, since I think it peaks a lot at opening. But you could be right, I'm just going by the second source of my teacher...but he really beat in the point to never buy IPO's during first day of trading, and had a bunch of graphs.