How Investment Bankers Determine the Offer Price and Allocation of New Issues

Investigates how investment bankers use indications of interest from client investors to price and allocate new issues. Investors who buy initial public offerings (IPOs) can achieve sizable early returns. Recent research rationalizes this apparent contradiction to market efficiency as a response to asymmetric information; but this research ignores how information frictions bear on IPO marketing. This work analyzes underwriters' IPO marketing and shows how the information it yields is used in IPO pricing and allocation. By means of this access to investors, underwriters can reduce IPO underpricing. Develops a model of the premarket as an auction constructed to induce asymmetrically informed investors to reveal what they know to the underwriter. The model consists of a private firm offering a fixed fraction of its future cash flows and a population of investors, each of whom has a single piece of information, and market that proceeds in two stages. Two types of information frictions and two sets of rules for auctions are identified. Underpricing is a natural consequence of the premarket auction. IPO prices must be set low to provide compensatory profit to investors for revealing information. By selling repeatedly to the same investors, the underwriter can reduce required underpricing and change the rules of the auction in favor of the issuing firm. The analysis yields a number of empirical implications: that new issues will be underpriced and that priority in distribution will be given to the underwriter's regular investors. Also finds that the type of underwriting contract is affected by the tension between an underwriter's likeliness to pre-sell an issue and an issuing firm's desire to obtain the greatest proceeds. The decision to use a firm-commitment or best-efforts underwriting contract reflects the desire to control the choice of rules. The former promotes underpricing; the latter reduces underpricing for firms facing high price uncertainty