When private firms reach a certain stage in their development they face the issue of going public. This implies a greater dispersion of their equity and listing of shares on the stock exchange. The terms and procedure for going public in EU countries are based on the EC 79/279 Directive introducing a number of requirements pertaining to the capital of the firm, to its profitability, and to the dispersion of its equity. Since private firms do not usually satisfy the dispersion requirement, an initial public offering (IPO) of shares is required to offer new shares to the public. IPOs are designed in collaboration with an underwriter who usually assumes the risk of the issue. A prospectus presenting data on the firm and its prospective development as well as the specific uses of the offering proceeds is issued. Underwriters’ commission is a percentage on the gross proceeds of the offering ranging from 4% to 8%.

The central issue in IPOs is the determination of the offering price, i.e. the price at which shares will be offered to the public. Standard techniques in security analysis are used in order to approximate the ‘correct’ price, i.e. DCF, earnings multiples or book value multiples. The output of such techniques is highly dependent on their input, which is based on the subjective opinion of the analyst(s). Independent of the stage of development of the firm and the regulatory environment, all IPOs across countries and time share one characteristic – underpricing. The offering price is on average lower than the post-listing market price. Underpricing leaves money on the table for initial investors, i.e. those who buy stock in the offering and resell it once the shares are listed on the Stock Exchange. Underpricing is therefore equivalent to positive initial returns.

This underpricing phenomenon has given rise to a considerable body of theoretical and empirical work in finance. From all the alternative theories on IPO underpricing two highlight the way theoretical understanding of the phenomenon may lead to important improvements in the IPO process and its regulation. The objective is to identify ways of minimizing initial returns to permit firms to collect the maximum proceeds from the offering.

Underwriting is highly regulated: first, underwriters cannot price discriminate between investors and second, underwriters have to allocate the issue even-handedly. Therefore underwriters have no discretion in pricing and allocation. Assume that the public is divided in two large groups, informed investors and uninformed investors so that informed investors cannot fully subscribe the offerings. When ‘good’ offerings are launched then informed investors apply, whereas when ‘bad’ offerings are launched the market has only uninformed investors. If the underwriter allocates the issue fairly when the issue is over-subscribed, i.e. when the demand for shares exceeds the offering, uninformed investors will end up with more ‘bad’ shares in their portfolio than informed investors. This is referred to as a ‘winner’s curse’ situation. As a result uninformed investors will have negative returns on average and will flee the market for IPOs. Since it is underwriters who will be hurt, they will price shares in IPOs on average at a discount. This ‘winner’s curse’ approach is based on the work of Rock (1987), Beatty and Ritter (1987).

But underwriters could seek to improve on their assessment of the firm’s value in a way that ensures all shares are offered at their ‘correct’ price. This could be achieved by conducting a pre-market investigation on the price a number of important investors would offer and the quantity of shares they would be willing to buy. This is known as ‘book-building’ where underwriters organize road-shows presenting the company’s current and prospective situation and collect non-binding offers from the participants.

There are two important incentive incompatibilities that make the result of such an attempt elusive. These incompatibilities arise from the lack of pricing and allocative discretion of the underwriter. Prospective buyers will be unwilling to share their true assessment of the company’s value with the underwriter if they have no interest in doing so. In fact, their interest is to mislead the underwriter by claiming that the company value is even lower since this may reduce the offering price. Prospective buyers have an incentive to undervalue their assessment and the underwriter has no means, in terms of either price or quantity or both, to make a sincere assessment. Even if prospective buyers were sincere in giving a true assessment and sharing information with the underwriter – despite their counter-incentive – the underwriter would now have an incentive to set a higher offering price pretending that he has been driven to revise his initial assessment after having collected unexpectedly optimistic non-binding offers. The book of non-binding offers is not public.

The Greek Privatization Programme, which took place in the 1990s, provides an illuminating example. In 1992 the Greek Government decided to privatize the Greek Telecommunications Company (OTE). The company was incorporated and a pre-market investigation was conducted, including road-shows abroad with international investors, where the prospective situation of the company was presented by an underwriting pool. The results were disappointing as the pre-market investigation revealed a lack of interest from international investors indicated by low price offers. Three years later, with an amendment offering Greek underwriters allocative discretion on an over-allotment option on 2% of the issue, a new attempt was made which led to a successful IPO of the company, its listing on the Athens Stock Exchange and a successful offer of sale of another 10% of the State’s stake in the company through the stock market. The only difference between the aborted attempt and the successful one was this tiny piece of allocative discretion.

Deregulating the IPO environment will not necessarily lead to zero underpricing. But if more underwriter discretion were allowed there would probably be less underpricing. The international evidence on this point is very suggestive. In a less restrictive institutional environment for IPOs some money will be left on the table for initial investors, just the necessary money to motivate the information-sharing activity of underwriters in the pre-market. This is the second theory on underpricing based on the work of Benveniste and Wilhelm (1989, 1990).

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George Papachristou is a Senior Lecturer, Department of Economics, Aristotle University of Thessaloniki