Essay Sample: What Is the Reason for IPO Underpricing?

According to Tian and Megginson (2007) IPO underpricing is the pricing of the IPO below its market value. When the issuing firm decides to issue shares it hires an underwriter whose work is to manage the long and complicated process. The work of the underwriter is also to determine the issue price, and this allows for the issuer and the underwriter to work together. The two articles Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan by Arikawa and ImadEddine (2010) and The Agency Costs of Teamwork by McClane (2015) do not define what IPO underpricing is, but they expound on reasons for underpricing and how to counter some of the challenges that are experienced during this process. Though the two articles concentrate more on the issue of agency problems and the costs that arise during the process, the only key terms that are used in both articles is the Initial Public Offer (IPO).

The article Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan provides evidence on the causes of underpricing of the IPO using data from Japanese venture capital market. From the data, the article presents the agency problem between the issuing firms and the underwriters as the main cause of the underpricing. According to their study, Arikawa and ImadEddine (2010) find out that the initial returns tend to decrease when the lead writers subsidiary is the venture capital and when the lead underwriter prefers investing in the issuing firm directly rather than through the limited partnership fund. On the other hand, the authors also found out that initial return increases when the underwriter used is among the top three security firms. This according to the authors means that the underpricing is severe each time the underwriting firm has a larger bargaining power (Tian and Megginson, 2007). These findings from the data used to support the articles hypothesis that any equity investment done by the underwriters for the issuing firms helps in improving the placement between the issuing firm and the underwriter, which in turn helps in increasing the offer price. Moreover, according to the findings, the major reason for IPO underpricing is the agency problem created by the issuers and the underwriters.

From the two articles, it is clear that the underpricing puzzle of IPOs has got a number of explanations. For example in the article Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan offers the basis for testing the hypothesis that the underpricing difficulties is caused by the agent-principal problems. For example, the sample period from the Japanese milieu covers a period when the venture capital had the option to invest through directly as a shareholder or by using a partnership fund as an agent (Elston and Yang, 2010). This gives the authors the opportunity to investigate the effect direct investment has on the issuing firms. In another example, the article Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan shows a strong relationship and comparisons when the venture capital uses either the underwriters or the issuing firms to invest in the IPO. From the findings, all the top three underwriters have venture capital subsidiaries that play a principal role in the Japanese venture capital market. This in turn allows the authors to investigate whether a direct investment by the underwriter with the issuer can resolve the issues the underwriting firms have with the issuers and reduce the agent-principal problems that are faced by the issuing firms that have a weak or no bargaining power above the offer price given by the underwriter (Jiang and Li, 2013).

According to Booth (2014), this article is not able to provide evidence that the venture capital has any impact on the initial first-day return. In addition, even after the authors take into account the improbabilities of the issuing firm they are still not able to find any positive correlation between underpricing and the bargaining powers of the underwriting firm (Tian and Megginson, 2007). This shows that there are major agent-principal problems faced by the firms that deal with large underwriter firms that have stronger bargaining powers. However, this article is able to bring out the concept that the underpricing decreases when the affiliated venture capital invests the internal monies they get from the underwriters (Adjasi, Osei, and Fiawofiye, 2011). Consequently, the authors also found out that the result from this scenario only holds when the investors consider the possibilities that the investment decisions being made are not random.

On the other hand, the article The Agency Costs of Teamwork assumes that teamwork gives better results and provides better deals when the issuing firms issue the IPOs McClane (2015). This article is in support of the notion that agency problems bring more harm than good and should be eliminated and resolved (Dalziel, White, and Arthurs, 2011). From the article The Agency Costs of Teamwork and Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan, this is true as agency problems increase agency costs which are significant between the underwriters and the issuing companies. The agency costs increased due to the agency problems experienced between the underwriters and the issuing firms according to the article The Agency Costs of Teamwork occurs for two reasons. First, as teamwork is regularly executed, it is likely to minimize conflicts from the team members that is the underwriters and the issuing firm though it is important to handle dissent amicably in order to optimize the outcomes Liu and Ritter (2011). Secondly, since team members entering the deal serve the issuing firm, team cohesion masks the elusive but vital ways in which the interests of the teams diverge especially those that come from the issuing firm. The significance of these agency costs in the capital markets though substantial in light of the expected benefits is a question that requires more research so as to come up with a better theoretical answer (Miller, 2010).

In this regard, the article The Agency Costs of Teamwork provides an empirical and theoretical analysis of the agency costs that arise from team deal making through the use of IPO transactions as a case study. This article shows the importance of having an intermediary who is the lawyer in such deals. This is because their presence carries little-noticed but substantial costs that in most cases are likely to offset the benefits that come when parties in the deal-making familiarize among themselves. To stress more on this theory, the authors of this article drew their findings from interviews conducted by practitioners and also analyzed data from 2,265 IPO deals. They also examined the possible negative effects of team dynamics in the IPO deals by looking into the collaborations lawyers had with each side of the deal team members that often take the issuing company public.

The article Venture Affiliation with Underwriters and the Underpricing of Initial Public Offerings in Japan is therefore also able to support the hypothesis that any equity investment in the issuing firm that is done by the underwriters improves the placement between the issuing firm and the underwriter and this, in turn, increases the offer price of the IPO. In view of this, the agent-principal problem is considered the major reason that leads to the underpricing of the IPO. On the other hand, the article The Agency Costs of Teamwork stresses on the importance of intermediaries in conducting the IPO deals so as to reduce the agency problems that affect the offering and the returns the issuing firm is likely to get from the investment. The analysis from the article The Agency Costs of Teamwork despite showing the importance of familiarity between the bankers and lawyers in promoting teamwork and reduction of completion time for the deal, it is also associated with systematic negative costs for the issuing company such as security litigations and greater levels of IPO underpricing (Moran and Pandes, 2010). The authors also analyzed the implications their findings had for the fiduciary law, the rules governing the lawyer ethics as well as the norms by which the IPO deals are made.

Despite the extensive study that attempts to explain the reasons for the IPO underpricing, this topic still remains a global phenomenon. There are several theories that try to explain this phenomenon to researchers like Arikawa & ImadEddine (2010) and McClane (2016) being on the forefront. For example, theories that are based on information asymmetry tend to suggest that the issuers deliberately underprice their IPOs for various reasons. Firstly, they may underprice so as to signal the quality of the IPO to the investors with the hope that it will be costly for the low-quality issuers in the market to mimic. Underpricing of the IPOs also helps in tackling the problems of adverse selection. The other importance of underpricing of IPOs is the fact that uninformed investors do not benefit fully because they always get a greater percentage of the overpriced shares which makes them stop participating in the process, and thus the importance of addressing these issues through underpricing.

In some theories, the authors suggest that banks or investment firms only adjust the prices of the IPO whenever they receive progressive information about the value of the IPO (Schenone, 2009). They wait this long simply because they want to leave money aside that will reward investors that threaten to reveal the information they have about the issue, as well as threatening to access future investment deals for the banks or investment firms that do not compensate or reward them for the information. Other studies suggest that banks only underprice the IPOs when their reputation is at stake. When new public offers are made by the banks they also tend to lower the prices of the IPOs to reduce the legal liability they are likely to incur as leverage for price declines. It is also evidenced by Busaba and Chang (2010) that underpricing of the IPOs ensure that the aftermarket trading increase in volumes. This, in turn, increases the revenues the investment banks make when they take full responsibility as market makers for the IPO firms. There are also benefits that come from underpricing IPOs as it increases the confidence and loyalty the clients have with the exchange bank and this helps the bank have hope for continued business in the future. Though these explanations show benefits only to the investment firms, it is still not clear why the issuing firms approve the underpricing. These reasons, therefore, showcase the reasons for the agency problem between the issuing firms and the underwriters as each party wants to benefit from the IPO (Boulton, Smark, and Zutter, 2010).

There are also other explanations on why underpricing is done. These are based on the information ownership and production which in most cases benefits the issuing firms. These include the need for the issuing firm to have an added dispersed ownership which can only be achieved through underpricing of the IPO. This allows the issuing firm in persuading the investors to produce the information they have about the IPO and also in buying the shares. Dispersed ownership helps in increasing the liquidity of the issuing firm as well as the aftermarket trading (Agathe, Sannassee and Brooks, 2002). It also helps the existing owners of the company to retain control. This explanation besides predicting a positive relationship between aftermarkets an...