Leaving Money on the Table – Good or Bad for the IPO?

What is “Money on the Table” for an IPO?

On an average, the IPOs (Initial Public Offerings) worldwide are underpriced and the underpricing is typically referred to as “Leaving Money on the Table”. The term comes from the game of Poker where a player, despite having a better hand, is bluffed by the opponent into folding the cards and thereby loosing the pot of money on the table.

Leaving money on the table has negative connotations carrying the import of a deal that is less financially beneficial than expected or possible. Most IPOs are underpriced, thereby leaving huge sums of money on the table[1].

Fixed Price offerings used to suffer from underpricing on an average and book-building mechanism of price discovery of IPOs was touted to address this problem. But evidence shows that even book-building results in a lot of money left on the table, leading to underachievement of price discovery mechanism. A lot of studies have been undertaken to understand the underpricing and it’s still a hot topic.

Underpricing – Deliberate loss or unintended heartburn

An underpriced IPO means that the firm and pre-IPO shareholders are shortchanged as they are getting less money for the offer than they actually deserved. Various studies show that pre-liberalization; the underpricing was more than 100% and post-liberalization, even after reduction, its still around 80% on an average which means that firms are loosing on a lot of money in IPOs on account of this imperfect price discovery. Some firms like Google[2], adopted Dutch auction path for better price discovery, thereby leaving less money on the table; but not many firms are willing to go that path. Is underpricing really bad? And why is it that pre-IPO shareholder aren’t so upset about it? This is a real puzzle regarding IPOs which this article will try to analyze.

The first question to ask here is why do people make a beeline towards the IPOs? They obviously expect a lot of money left on the table which they can profit from by first buying the shares at lower price in IPO and then selling them at higher price in the first couple of days when the stock hits the market. The underwriters frequently underprice the IPOs to help the big investors in this fashion.

Figure 1: Indian Stock Market - Levels of Underpricing evident from the performance of IPOs

Most studies of the Indian stock market confirm that on an average, the underpricing of IPOs in Indian stock markets has been higher than what we see abroad[3]. A study by Arwah shows that from a sample of 1357 IPOs declared on BSE over a period of 1989-95, 4.5% of shares were fairly priced, 10% were overpriced while whopping 85.5% were underpriced! But the report also shows that after SEBI took over the regulatory role for IPOs, in the post-liberalization era, there has been a fall in the returns to around 80% levels which is still pretty huge.

So, it’s not difficult to see why IPOs are hot amongst new and old investors that are willing to sell the stock in a very short time frame. But what happens to the long term investors and the firm itself? Aren’t they loosing money as well as control by the way of underpriced IPO? What about the underwriters, who too, loose good profits if they underprice the issue? Moreover, the firms are not getting long-term investors but greedy profiteers with leveraged positions[4] which results in fast selling leading to wild price swings in the stock price during the initial days. Considerable research has been undertaken to explain why underpricing is not necessarily a bad thing for the all the players involved.

Studies say, that managers and long-term owners of the firm not only look at the shares that they are selling in the IPO, but also the shares that they retain. In case of underpricing, the shares that they retain give a quantum jump to their wealth. Underpricing serves two fundamental purposes. The actual price of the IPO shares is generally held by some large institutional investors. Underpricing is the cost that IPO issuers pay to extract this information from underwriters and institutional investors through the book-building process. This is the “Information Extraction Theory” of underpricing as suggested by Benveniste and Spindt’s 1989 study of IPOs. Underpricing is also employed to attract the uninformed investor to participate in the IPO offer for better price discovery.

Theory and Reality bears out advantages of underpricing

Apart from the theory of Information Extraction, there are some other prominent theories that explain underpricing and bring out its advantages.

Allen and Faulhaber, in their Signaling Hypothesis theory (1989), tried to explain underpricing by suggesting that good firms like to convey their better future prospects to investors by underpricing and allowing investors to make good profit from their stock. This increases the chances of those investors paying a higher price in future offerings[5] and the underwriter getting more business in future.

Another reason for underpricing is protecting the reputation of the players by playing safe. Study by Huges and Thakor (1992) confirm this theory. If the stock price immediately falls after IPO issue, it harms the reputation of merchant bankers and underwriters alike and may also invite legal and regulatory scanning of the IPO issue. To avoid this risk, underwriters deliberately underprice the issue. Recent example of this is Empee Distilleries while an earlier similar example is Bharti Televenture IPO. The price of both stocks went down after listing and the reputation of people involved in the IPO got a severe beating. Mutual funds exposed to those stocks had to go public, explaining reasons for their investment in these stocks.

A firm gains not only from the share price at the time of IPO but also from increased volumes of trading that happens long after the IPO is over. Loughran and Litter (2003) suggested the Prospect Theory of underpricing. They tried to explain underpricing by showing that the firm’s owners expect the prospect of higher trading price when they go for heavy underpricing, resulting in an increase of their wealth. Hopefully, this increase offsets the losses that they might have incurred due to underpricing. It encourages after-market trading as well as benefits the owners for a longer duration[6].

There is another, more subtle, reason for underpricing. In his study, Sherman (2005) attributes the preference of book-building over auction to the perception that book-building is less risky[7]. The fallout of the book-building process is underpricing as per Information Extraction Theory. So, it’s the price-discovery model that is dictating the underpricing, leading to a scramble for allotment that we see in the Indian stock market, with most IPOs being oversubscribed.

Now how can the firms prevent the insider trading on the launch of the IPO so that price of the shares does not take a southward dip? One way is to enter into lock-up contracts with the underwriters, insiders and big investors so that the insiders and investors can’t sell the stock within a stipulated period of time[8] and don’t indulge into flipping of IPO shares. This mechanism merely delays the inevitable i.e. when the lock-up period expires, there is likely to be downward pressure on the stock. But at least it makes the big investors think slightly long-term and stay invested in the firm for a longer period rather than walking away by picking the money left on the table as soon as possible. This helps the firm and the already existing long-term investors.

The underwriters also gain from underpricing in two ways. They can easily find big investors without incurring huge marketing costs and their brokerage arm can negotiate higher commissions from these big investors. Also, oversubscription often results in exercising the “Green Shoe” option by the underwriters which means that already an overallotment of upto 15% of original number of shares offered. This implies that due to this overallotment, the underwriters get a larger fee since a larger number of shares are involved.

Conclusion – Money on the table good for long-term health of the IPO

Keeping all these theoretical aspects in mind with corroborating real-world evidence, we can safely conclude that underpricing the IPO is beneficial for the firm and existing shareholder in the long-term. It certainly pays not to be greedy for short-term and leave something on the table for the investors.

Also, when the demand is likely to be higher, owners of the firms leave more money on the table in the hope that this will give them more gains by way of increase of their wealth long-term via their holdings in the firm than the immediate loss through underpricing. In case demand is likely to be sluggish, they negotiate aggressively on the price and leave little money on the table.

The underwriters gain indirectly from the underpricing by way of saving marketing costs and increased commissions. The retail investors anyway benefit from underpricing and carry a good impression about the company which the firm can encash in future issues. Hence overall, it seems that IPO underpricing is not necessarily a bad thing and there are certainly some not-so-obvious gains from being charitable and leaving money on the table.

Additional Notes as Cited in the blog:
[1] Money Left on the Table = Nos of Shares Issued * (First Day Market Price – IPO Offer Price)
[2] Google’s IPO was perhaps the most hyped IPO to go the Dutch auction way despite the real risk of undersubscription, where every bidder was treated with equality and no special preference was given to institutional investors. Some of the important objectives of going the Dutch auction way were: (i) avoid leaving any money on the table, (ii) get the maximum possible price of their shares from the market and (iii) get a larger number of quality retail investors who wish to stay invested long-term. Google was quite successful in all these objectives with its IPO.

[3] Indian Stock Market is different from stock market in most other countries, including US, in the sense that comparatively, a large number of retail investors (at least 25%) participate in the IPO price discovery as primarily uninformed investors.
[4] People with leveraged positions are those who are buying shares with borrowed money, in the hope of selling them soon enough, booking profits and repaying the borrowed amount.
[5] Oversubscription of IPO is not a very credible signal of underpricing but is a strong signal neverthless. This has been borne out in a study by Pande Alok and Vaidyanathan R where they considered 55 IPOs listed on NSE in the 2004-06 timeframe.
[6] There is some kind of corruption involved here as hinted in the Prospect Theory. The managers typically get the ownership of a lot of shares in the IPO and directly gain from underpricing. Because of this, they end up promoting the practice of underpricing.
[7] Auctions run the risk of undersubscription while book-building ensures enough informed investors participating in price discovery. Google was able to survive the auction path because it was a well known brand name at the time of IPO.
[8] Minimum duration is 90 days and no ceiling on the limit.