News and Events

Why are IPOs Underpriced? Evidence from Japan’s Hybrid Auction-Method Offerings

Initial Public Offerings of common stock are sold at prices that offer initial investors returns on the first day that average around 18 percent. These high initial returns have puzzled academic scholars for many years. Why is it, they ask, that issuers are willing to leave so much money on the table? Many theories have been developed to explain the puzzling practice, but U.S. evidence is incapable of discriminating among most of the theories.

Richard Smith on the Claremont Graduate University’s Drucker School faculty, and Director of the School’s highly ranked Financial Engineering Management Program—along with co-authors Kenji Kutsuna and Frank Kerins—use Japanese evidence to help resolve the paradox. They document discretionary underpricing and partial adjustment of IPO prices in the public offer tranche of Japan’s hybrid auction regime, a regime where: investor information differences are not important; roadshows are not held; preferential allocations are negligible; institutional investing is low; and the public offer tranche cannot fail. The fact that high initial returns arise in circumstances that are so different from those in the U.S. indicates that many of the existing theories are not necessary to explain underpricing.

In the paper, “IPO Underpricing and Partial Adjustment When Investors Are Atomistic and Uninformed: Evidence from Japan’s Hybrid Auctions,” which is forthcoming in the highly regarded Journal of Financial Economics, the authors consider a broad range of competing hypotheses about underpricing and partial adjustment, and reject those based on asymmetric information or pricing to reflect long-run value. They find that Japan’s auction-method evidence is most consistent with an implicit contract to allocate risk related to initial mispricing where, in exchange for guaranteeing a minimum price, the underwriter participates indirectly in upside performance through its relationships with investors and its ability to attract future business. The results raise important questions about interpretations of IPO underpricing in the U.S.

Kenji Kutsuna is a professor at Kobe University and a visiting scholar at the Drucker School this year. Frank Kerins is a former member of the Drucker School faculty.