Underpricing refers to the phenomenon of abnormal first-day returns from initial public offerings (IPOs). Without doubt, any US investor would agree that one day-returns of 11.4% on average are exceptional and a worthwhile investment. Since then many studies have proven that it is a persistent phenomenon and also occurs on markets all over the world. The most puzzling question for scientists is why companies are leaving this money on the table and do not set an offering price that reflects the market demand at the offering date. The main focus of this paper is whether and how the findings of past research, primarily conducted for the US market, apply to the German IPO market. As a result, both investors and issuers shall receive practical implications for their decision-making within the IPO process. This study comprises a brief description of some important theoretical aspects that shape the price setting of an IPO. It focuses on business valuation as it is the basis for setting the price of an IPO. Furthermore, the most common price setting mechanisms are explained. Past research results and theories with regard to IPO underpricing will be outlined and put into relation to the upcoming analysis. This also includes the long-run performance of IPOs and deals especially with the question of whether IPOs are systematically overvalued by investors and, if so, why. The empirical analysis consists of a deduction of influencing variables and an applying theoretical model. Finally, OLS results will be presented and interpreted, which also includes practical implications for both, issuers and investors.

Kapitel 3.2, The Winner’s Curse Hypothesis: The winner’s curse hypothesis has been described first by Rock. He argues that unexpectedly strong demand for shares results in rationing. Assuming that some investors have an informational advantage, the less informed ones will be worse off. Rock also explicitly considers institutional investors as informed and retail investors as uninformed. When informed investors are more likely to buy shares when they are underpriced, then excess demand will be higher when there is more underpricing. While the uninformed investors will receive only a fraction of the most desirable new issues, they will receive the whole order for the least desirable ones. This is meant to be the winner’s curse: They get all the shares they have asked for only, because the informed investors don’t want them. Faced with this problem, less informed investors will only submit orders if, on average, IPOs are underpriced sufficiently to compensate them for the bias in the allocation of new issues. From this results that IPOs on average need to be underpriced in order to attract enough investors. In contrast to Rocks’ explanation are the findings of Hanley and Wilhelm. They find that institutional investors receive large proportions of IPOs for which pre-market interest is strong but almost equally for which pre-market demand is weak. Thus, for some reason it does not seem that institutional investors are able to use their informational advantage. The following market feedback hypothesis presents a theory that implicates why this may be the case, based on underwriter power. 3.3, Market Feedback Hypothesis: Benveniste and Spindt argue that investors initially have no incentive to reveal positive information about their demand since they know that it affects the offering price. This means that if they reveal strong demand, the offer price will rise which is to their disadvantage. Thus the underwriter needs to set the offering price low enough to provide profit in order to compensate investors for revealing positive information. Positive information here means information about their demand. On the other hand, investors have less incentive to bid low for an issue they value high if doing so threatens their allocation. In that context, Benveniste and Spindt argue that underwriters are able to reduce underpricing by repeatedly selling to the same investors. It is possible because investors who are given regularly priority in IPO allocations earn abnormal returns. In return, the bank has then the power to menace investors to reduce an allocation in the future. This mechanism can be used to induce regular investors to be forthright with their information in the premarket. Even if these mechanisms may be applicable to practice, evidence has not been found, yet. Thus, it is not known, whether or to which extent this explanation affects the degree of underpricing. 3.4, Bandwagon Hypothesis: Ritter argues that the IPO market is possibly subject to bandwagon effects. He assumes that if potential investors also pay attention to whether other investors are purchasing, bandwagon effects may develop. This means that if an investor sees that no one else wants to buy, she or he may decide not to buy even when there is favorable information. Thus, an issuer may want to underprice an issue to encourage the first few potential investors to buy, and induce a bandwagon in which all subsequent investors want to buy independent of their own information. One may argue that this theory is based on irrational investor behavior. This is not necessarily true. Investors who observe the behavior of others can be seen to be rational as in fact their profit depends on the behavior of other investors. If they don’t see anybody buying, this may lead them to the conclusion not to invest in this particular IPO. However, it is questionable whether it can be assumed that investors, especially those who know the fair value of the asset, base their decision solely on the behavior of others. Both assumptions have not been proven, so far. 3.5, Lawsuit Avoidance: Tinic argues that the possible negative consequences of overpricing IPOs may enhance issuers to underprice, instead. He argues that issuers may face potential legal liabilities that overwhelm the overpricing of an offering. Another threat may be that the market demands a higher risk premium on future security offerings. In fact, for the US market, section 11 of the Securities Act of 1933 demands from investment bankers to conduct ‘due-diligence” investigations in order to avoid liability for false, misleading or omitted information in the registration statement about the prospects of the issuer. The law allows a purchaser of a stake in an IPO to sue anybody who has signed the registration statement, in order to recover from losses. This includes the issuer but also its advisors. Similar regulations exist for the German market and are ruled in §§ 44 et seq. of Börsengesetz (BörsG) and § 13 of Verkaufsprospekt-gesetz (VerkaufsprospektG). The basic statement behind these regulations is that the parties involved in the issue have to pay recovery of losses to investors for incorrect prospectus information. As a result, underpricing may be seen as an indirect insurance cost for legal liabilities, if this relationship could be proven. 3.6, Signalling: Welch developed a model based on the assumption that the company itself has the best information about its future cash flows. This leads to an asymmetric information problem as investors do not have this information. In order to overcome the asymmetric information problem, the company wishes to signal the true value of the firm by offering shares at a discount and by retaining some of the shares of the new issue in its own portfolio. By doing so, the company will be able to achieve higher prices at seasoned offerings. For ‘low-quality” firms, on the other hand, applying underpricing for the above mentioned reasons would be pointless. Assuming that between the IPO and a seasoned offering the true quality of the firm will be revealed, low-quality firms have no incentive to underprice when they know that they cannot achieve the superior cash flows. Allen and Faulhaber come up with a similar model by assuming that high-quality firms forego a lower IPO price for a more favorable interpretation of future high dividends resulting in a higher stock price in the aftermarket. On the contrary, owners of a low-quality firm know their expected performance and the resulting valuation. They know that they could not recoup the initial loss from underpricing and for that reason cannot afford to signal. The advantage for a high-quality firm to signal its quality is that they will be able to sell a higher fraction of the firm and thus increase their funds. However, empirical research reveals that companies with the highest underpricing perform worst in the long-run. Even if this seems contradicting to the two explanations above, it is not necessarily the case. The resulting question here is rather whether ‘low-quality” firms need or wish to underprice, that even more than ‘high-quality” firms, but for different reasons.

• Underpricing

• Overvaluation

• first-day return

• IPO

• price setting

Justyna Dietrich, M.Sc., was born in 1984 in Jaslo (Poland). After finishing school in Germany, she decided to study Business Administration (B.A.) at the Berlin School of Economics and Law, majoring in Finance & Accounting in 2009. These studies allowed the author to deepen her knowledge in financial markets resulting in the successful graduation in International Finance (M.Sc.) in 2010, also at the Berlin School of Economics and Law. While still studying, she also gained several years of practical experience in the IT sector. After graduation, she commenced her work in a business consulting company specializing in the financial industry. With a keen interest in Behavioral Finance and Strategy, the author decided to reflect IPO underpricing respectively from these two points of view.