In a law journal note titled “The Seller’s Curse and the Underwriter’s Pricing Pivot: A Behavioral Theory of IPO Pricing,” author Patrick Corrigan considers various theories advanced to explain IPO underpricing. Given that so many venture and private equity investors are finding alternatives to the traditional IPO model, whether through direct listings or SPACs, and pointing to IPO underpricing as one of the ways in which the traditional IPO model is “broken,” new academic theories are well worth consideration. Corrigan calculates that from 1980 to 2016, as a result of IPO underpricing (the difference in the trading price of an IPO stock at the close of the first day and the IPO price to public), corporate issuers have foregone approximately $155 billion in offering proceeds. The author notes that there is an informational disadvantage for IPO issuers. The underwriters engage in discussions with institutional investors as part of the IPO roadshow and bookbuilding process. While current FINRA rules require that the underwriters share with the IPO issuer a report of indications of interest, the author contends that the underwriters will still have an informational advantage. The underwriters will have had bilateral discussions with investors. To address this perceived problem, the author suggests a “written auction.” The note discusses the other popular theories explaining IPO underpricing, including the principal-agent theory wherein the underwriter acts as the issuer’s agent. An auction approach would limit the extent of the agent’s decisions, since the pricing and allocation decisions would be based on the auction. Another explanation of IPO underpricing is the “winner’s curse,” which posits that underpricing compensates uninformed IPO investors who are subject to adverse selection in IPO markets. Compensation theories explain that underpricing compensates underwriters that provide equity research coverage after the IPO. The author also discusses the pricing dynamics in IPOs of “sophisticated issuers,” in which there is overpricing. The paper concludes by setting out a number of regulatory changes that would have as their objective leading to more accurate IPO pricing. First, he suggests the imposition of a mandatory fiduciary duty on underwriters to act in the best interests of issuers. This would make it costlier for underwriters to impose any underpricing. He also suggests limiting pre-IPO short selling by the underwriters to address overpricing, as well as requiring disclosures in the IPO prospectus of any open short position. The note is available here.
