Journal of Financial Economics 24 (1989) 3

awrence Boston College, Chestnut Hill, MA 02167, USA

au1 Uniuersi[v of North Carolinu, Chapel Hill, NC 27599-3490, USA

Received October 1988, final version received August 1989

We investigate how investment bankers use indications of interest from their client investors to price and allocate new issues. We model the process as an auction constructed to induce asymmetrically informed investors to reveal what they know to the underwriter. The analysis yields a number of empirical implications, including that new issues will be underpriced and that distributional priority will be given to an underwriter’s regular investors. We also find that tension between an unde.rwriter’s propensity to presell an issue and an issuing firm’s desire to obtain maximum proceeds affects the type of underwrit;ng contract chosen.

ctio

The sizable early returns earned by investors who buy initial public equity offerings (IPOsj have puzzled financial researchers for at least a decade. Recent research has attemptc,! to rationalize the persistence of this apparent

ntradiction to market efficiency as a r onse to asymmetric information. ut, so far, this research has largely ignor how informational frictions bear

on the marketing of IPQs. In practice, underwriters solicit indications of interest from investors as part of their efforts to factor as much information as possible into IPO prices. In this pdper, VV~ analyze underwriters’ ing process and sh how the information it yields is used i allocating an IPO. e conclude, contrary to the hypothesis

olmstrom (1980), that by using their access to inves information, underwriters can reduce

*We would like to thank Narayana Kocherlakota, (the editor), and participants at semin University of Michigan, Boston College, Federal Reserve Bank of Chicago, the Fe tion meetings for their useful comments. support from the Ranking

/89/$3.5Oc 1989, Elsevier Science

J.F.E.- E

344 L. M. Benveniste and P.A. Spdndt, Investor information and 6PQ pricing

Two kinds of informational frictions affect IPO pricing. One arises because issuing firms are likely to be asymmetrically well informed about their own

usiness situation. This asymmetry can afl’ect pricing because i incentive to misrepresent themselves to potential investors as than they actually are. Overcoming this type of asymmetry is the motive for

th and Smith (1986) and Smith (1986) call the certification role for ers.

ock (1986) has suggested another potentially important informational nvestors are likely to be asymmetrically well informed about factors

outside the issuing firm. They may, for example, have superior information about an issiring firm’s competitors. They also may have rivate information about certain characteristics of an issuing firm that the firm cannot convey credibly; the quality of management is an example. In view of these inhibi- tions, setting the sales price for an IPO is problematic; neither the issuing firm nor its underwriter can know precisely what the market’s valuation of the stock will be.

The basic difficulty facing an underwriter wishing to collect information useful to pricing an issue is that investors have no incentive to reveal positive information before the stock is sold. B such information to them- selves until after the offering, investors c to benefit; they would pay a low initial price for the stock and then could sell it at the full information price in the postoffering market. To study how these incentives may be overcome, we model the premarket as an auction, conducted by the under- writer, in which investors understand how their indications of interest affect the offer price and the stock allotments they receive. By suitably choosing the rule relating the offer price and share allocation to investors’ indications of interest, an underwriter can induce investors to reveal their information.

As in all auction design problems, our analysis has two stages. In the first stage, we identify sets of rules for tr&nslating the indications of interest into an offer price and allocation schedule that will induce investors to disclose positive information - by indicating strong interest - if they have it. The underwriter’s advantage, and most of our empirical implications, derive from this stage of the analysis. In the second stage, we determine the set of rules that yields the best expected outcome for the issuing firm.

We show that underpricing is a natural consequence of the premarket auction: IPQ offer prices must be set low to provide profit to compensate investors for revealing ositive information. The amount of compensation required depends on ho much investors may expect to profit by hiding the

ormation. Clearly, this depends directly on he extent to which withholding sitive information results in a lower expecte offer price. On the other hand, investor has less incentive to bid low for an issue he or she values highly if

his or her allocation. This is especially true if the ce is fully revealin

L. M. Benveniste and P.A. Spindt, I’nvestor ~n~ar~~at~a~~

In principle, issuing firms c without employing an underwriter.

underpricing by se we are able to qu

proceeds - that can be realized b firm, which deals regularly in IPOs, selling repeatedly to the same inve the auction in favor of the issuing firm. In who regularly are given priority in IPO allocations by an investment This gives the investment banker a lever - namely, the threat to reduce an investor’s allocation priority in future - that can be used to induce regular investors to be forthright with their information in the premarket. Thus the investment banking firm’s leverage over its client investors can be used to reduce expected IPO underpricing.

Other empirical implications derived from the solution to the auction design problems are:

Underpricing is directly related to the ex ante value of investors’ informa- tion. Underpricing is directly related to the level of presales. Investment bankers give regular priority to tbc same investors. Underpricing is directly related to the level of interest in the premarket.

The final choice among incentive-compatible rules relating indications of interest to offer prices and allocations is complicated by the basic tradeoff of early sales for more significant underpricing. A tension arises because under- writers tend to prefer maximum presales, whereas issuing firms want to maximize proceeds.

In the last section of the paper, we argue that the desire to control the choice of rules is relevant in the decision to use a firm-commitment or best-efforts underwriting contract. Under a firm-commitment contract, con- trolling interest in the issue belongs to the underwriter, whose incentive is to presell the whole offering. This incentive promotes underpricing. the greater is the ex ante price uncertainty about the offering, the stronger is the underwriter’s incentive to presell the whole issue. Thus firms facing the most price uncertainty are most adversely affected by the underwriter’s incen- tive to presell under firm-commitment contracts.

To remove the underwriter’s incentive to pre underpricing, firms facing high price uncertainty underwriting contract. The cost of t proceeds are more uncertain under a can be reduced by stipulating a underwriter’s incentive to prese

346 L. M. Benveniste and P.A. Spindt, Investor information; and IPO pricing

bias in the choice of underwriting contract: firms facing more price uncer- tainty, and whose IPOs will therefore be most severely underpriced, are more likely to choose best-efforts contracts, whereas those whose owners are most risk-averse are more likely to choose firm-commitment contracts.

Observing that some investors may be asymmetrically well informed about the prospects of an IPr3, Rock (1986) deduced that underpricing could result from a kind of ‘lemons’ problem because informed investors withdraw from the market when an issue is overpriced. Provided that the issuer allocates shares even-handedly, in the sense that orders from all investors, informed or uninformed, have an equal chance of being filled, uninformed investors are more likely to receive their full allocation if the issue is overpriced - which is to say, the issuing firm is low quality - than if the issue attracts demand from informed investors. This analysis rests heavily on the assumptions that the issuer cannot acquire information from the informed investors in advance, and that the allocation of shares does not distinguish informed from uniformed investors. Our analysis suggests that the expected proceeds of an issue may be higher if both the offering price and the allocation are determined using information solicited from investors through premarket indications of interest. The practical fact that offer prices of IPOs are not determined until investment bankers have analyzed premarket results suggests that offer prices are affected by investor interest.

In firm-commitment offerings, as we have noted, underwriters have incen- tives to presell the whole issue, which leads to greater underpricing. To counter these incentives. issuing firms may elect best-efforts contracts, which involve greater proceeds uncertainty. Rock’s (1986) and Ritter’s (1985) models pro- duce testable implications about the use of minimum-sales constraints in best-effort contracts that dif!& from those we develop here. In Ritter’s (1985) analysis, minimum-sales constraints serve to insure uninformed investors against the lemons problem; thus, underpricing should be inversely related to the size of the constraint. Our analysis, in contrast, suggests that minimum-sales constraints are designed to reduce proceeds risk by forcing some amount of preselling, so underpricing should be directly related to the size of the constraint.

ur results complement the monitoring theory presented by Smith (1986) ooth and Smith (1986). If, as we suggest, an underwriter’s business

ith a core of regular investors, their insiders is tied

L. M. Benveniste und P.A. Spindt, Investor information and IPO pricing

Several other theories of underpricing have ture. Examples include the signaling theories o Grinblatt and Hwang (1989), and Welch (1989b), and the lawsuit avoidance theory of Ibbotson (1975) and Tinic (1988). Such influences indeed may be operative; the theory we present here does not necessarily contradict these hypotheses. However, we are interested specifically in how investment bankers elicit information from investors during the preselling period, and how this information is used to establish an IPO’s offer price and allocation. These questions are not answered by the other theories cited.

3. e model

We first consider the situation faced by a single corpxption making an initial public offering. In the next section, we expand the model to account for underwriters’ long-term relationships with their investors.

I Our basic model consists of a private firm offering a fixed fraction of its future cash flows for sale, and a population of investors. WLether the new funds will be used for additional projects or owner diversif Aon, the future cash flow for sale is summarized as a random variable I? Borkj &he firm making the offer and the investors in the model have some info:rl;$Aon about the mean value of I/. The firm decides to sell off V in Q shares. The marginal investor is assumed to be risk-neutral, so the price of fhe >:“i’ering should be equal to the expected present value of V/Q.

We d.istinguish two types of investors - regular and :,7,:e,asional - to capture in the model the real-world fact that some investors pi*‘, Ib ‘i I j fate regularly in the II?0 market while others participate only occasion&$ “Piere are H regular investors and many occasional investors. Both types C2iv~ some information relevant to the expected value of the issuing firm’s CY& Wow.

For simplicity, we assume that each regular . ; G i et,or has one piece of information that is either ‘good’ or ‘bad’. F,ac .:GCC of information has an equal (absolute) marginal impact on the stock”:. v%a~ To reflect this, we write the expected price (which already incorpor::*~~~.t ~~‘EES underwriter’s information) conditioned on the information of all 12 ~gaz,iar investors in the form

P,=A-(H-h)ar.

348 L. M. Benveniste und P.A. Spindt, Tnvestor information and IPO pricing

the value of the stock is

P. h ,=A-(H-h)a+X,

where h is a random variable with mean zero that represents the effect of occasional investors’ information on price.

e market proceeds in two stages. In the first, the issue is premarketed to regular investors. In the second, the market is opened up to occasional investors. We model the market this way to reflect the fact that only regular

0 investors are targeted in the premarket. Implicitly, this market structure that the cost of conducting an all-inclusive premarket is prohibitive. regular investors offer to buy in the premarket, they factor in their

expectations about what the aftermarket price of the stock will be. the assumption that the aftermarket price reflects all the private info all regular and occasional investors, i.e., that the aftermarket price is a full-information-revealing e uilibrium price. We also assume that:

(A.l) Regular investors’ investment preferences are identical. Each regular investor is willing to purchase up to q shares at a cost not exceeding his or her expectation of the aftermarket value of the stock.

(A.2) Regular investors’ demands just exhaust the issue; that is, Hq = Q.’

(A.3) Regular investors’ information is independent. Each regular investor has probability p of having a piece of good information and probability 1 - p of having a piece of bad information.

hatever the auction strut:ture of the premarket, regular investors’ re- sponses will be based on theii- subjective valuations il:f the stock and their expected profits. ecause each knows his or her own information, regulars have an advantag in the premarket. In our model, regulars use their private information to compute subjective estimates of the aftermarket price that are

ior to those of the underwriter and the issuing firm. reser : this, we index the state of the premarket by the total number h

ieces of good information possessed by regulars. Unconditionally, the ability of state h is q,, where

ph(l -p)H-h.

oint of any regular who iece of good informa-

g rationing in the premarket, i.e., the case Hq > Q, to streamline ck (‘69861, include rationing, but the results would remain the

L.. M. Benveniste and P.A. Spindt, Investor information and IPO pricing 349

tion, state h, h = I,. . .,

from the vantage probability of sta

phjl _.,)H-1-h.

regular’s premarket reservation price is his or her conditional est the aftermarket price. The reservation price of a regular who has a good information is

and the reservation price of a regular with a piece of bad information is

H-l

The empirical significancc’of the model parameter QL is apparent from these expressions for regulars’ premarket expectations. ecause Pg - Ph = (Y, cr repre- sents the marginal ex ante value of a regular’s information. The more valuable private information relevant to the aftermarket price of the stock is, the greater Q will be.

To market an IPQ, an underwriter first conducts its own analysis of the issuer’s prospects and estimates an offer price range. The underwriter then creates a ‘road show’ designed b solicit information about the ma that the underwriting firm tells 5vestors everything it kno Thus, the potential for price sig

The term indications of int prices that underwriters solic Investors may, for example, express within the underwriter’s proposed range, or orders at prices outsi the final offer price.

tions.

350 L. M. Benoeniste und P.A. Spindt, Investor information and IPO pricing

e volume of premarket orders at fa<e value, most I oversubscribed. veryone understands the rules of t

and investors tend to overstate their true interest, expecting t only a fraction of their indicated interest.*

the premarket indications of interest, the underwriter infers positive and negative on that can be used to determine the offer price and

n our model, we represent this process in reduced form that regulars who participate in the premarket auction simply

t they have a good or bad piece of information. That is, we abstract the question of how the underwriter infers information from the indica-

tions of interest.3 ssuming regulars are truthful in declaring their informa- tian, the underw er can compute the true conditional estimate for the aftermarket equilibrium price. The rub is to make sure that regular investors

eir information truthfully. the following notation in discussing the offer price and allocation

A) schedule conditioned on the premarket indications of interest.

ph” = offer price when h regulars indicate their information is good (state h),

qg,h = shares allocated to an investor who indicates good in the premarket when h - 1 others indicated good (state h),

qb,h = shares allocated to an investor who indicated bad in the premarket when h others indicate good (state h).

Shares that are not allocated in the pTemarket are assumed to be sold in the aftermarket at the full-information price.

a& regular investor in the premarket chooses his or her intiication of in our model amounts to declaring either g (good) or b (bad). are also aware that declaring g or b amounts to choosing

between two OP A schedules, because the offer price and allocations depend n and other investors’ declarations.

n view of the revelation r’rinciple of arris and Townsend (1981), we need schedules that induce regulars to participate truth-

s will satisfy two conditions: first, vestor who has ion must expect to profit more by

that other investors also indicate rofit accruing to an investor who unces it, is the expected return

that all of the IPOs it oversubsctibed in the

the model tractable, but e:ttending

L. M. Benveniste and P. A. Spindt, Investor information end IP 351

between the premarket and the afte

H-l

h=O

n the other hand, the investor with a piece of good informati indicates bad information will be allocated a b portio reflect one less piece of good information. Such an

H-l

?r,‘o%+,- y,“h,k h =o

To induce this investor to be truthful, (1) must exceed (2). Using the fact that P h+l = a + Ph, we conclude that an investor with a piece of good information will truthfully declare g in the premarket if

H-l H-l

dph+l - p;+l)qg.~+l 2 +h(tph- p;) + dqb h* 1 (3) h =o h=O

Thus, the model conforms to the intuition suggested in. the introduction: investors with good information have to be induced, by excess early returns, to revcal it (through strong indications of interest). The size of the profits depends on the allocations they might receive if they expressed weak interest, i.e., announced bad information.4

Second, investors must be assured of nonnegative expected profits from any premarket order they make because underwriters cannot force investors to participate. Thus,

The following list summarized the outcomes that would result in state h from a particular choice of OP&A schedule based on the premarket indica- tions of interest:

Allocation to each g = qg, h9

ected proceeds = b, h)*

4To be complete, we should verify also that declare g. This is immediate because announci

egative expected profit.

e to ates

352 L. M. Benveniste und P.A. Spindt, Investor information and IPO pricing

In calculating the expected state h proceeds, we have assumed that the ted value of X is zero and that shares not allocated in the premarket are

in the aftermarket. tive in choosing an A schedule based on the premar interest is to maximize the expected proceeds of the issue, the

unc’!erwriter needs only to settle on how much gf the issue to presell. Suppose, for example, that it is decided that at least Q shares should be sold in the premarket. Conditioned on Q, the proceeds-maximizing A schedule can

mong the solutions to (there are several degrees of etting offer prices):

aximize H q,(PhQ- (P,-P,O)(hqg,~+ (H-h)q,,& A.=!)

subject to

H-l H-l

%(Ph+* - P,o,&?,,h., 2 7r;((Ph- pho) + (Y)qb h, . h =o h=O

qg h_1+(H--h)q/, +fj, h=O,.=-3, . 7

h = 0,. . . , M,

h = l,..., H,

h=O,...,W-1.

nt appendix, we prove:

1. For a speci$ed level of presales, 0, the proceeds-maximizing schedule relating indications of interest to the offer price and share

will have the following characteristics:

= ij jor every outcome h, h such that hq <

in states where ha 2 the issue are

L. IV. Benveniste und r A. Spila Investor inforination and IPO pricing 353

Proof. See appendix.

heorem 1 also implies th regulars who in be allocated the remaining - hq shares in constraint (3), which is binding, gives expected

The intuition behind Theorem 1 is compelling. Expected underpricing arises to provide incentives for regulars to reveal good information. ecause the level of profit is determined by the allocation to regulars who deck ing is minimized by giving priority to regulars who declare R. targeted a’i regulars with good informatiom most effectively by unde when all regulars who declare g receive allocations - that is Hn a model with more types of information, underpricing would be directly related to the quality of information?

The following empirical implications flow from Theorem 1:

Underpricing is directly related to the ex ante marginal value of private information. Underpricing is directly related to the level of presales. Underpricing is minimized if priority is given to orders from investors who indicate good information. Underpricing is directly related to the level of interest in t

The first implication is difficult to test directly because a good proxy for the

asures of uncertainty, such as the of disclaimers in the prospectus. implication. The third implication could be teste

?o analyze Rack’s (1986) environment, we A SC le WQ

354 L. M. Berweniste und P. A. Spindt, Investor information and TPO pricing

premarket as is practical. This way, it will be possible to allocat _- small quantities to investors who indicate low interest while of the issue w en the indications of interest are unifo

taming the sale

e have so far ignored a major contribution an underwriter can make $0 the marketing process by repeatedly selling I OS and giving priority in Ae allocation to his regular investors. Loosely eaking, an underwriter provides regular investors with fairly significant profits by including them in his list of regulars. These ts can be used occasionally to induce investors to take a badly received off the underwriter’s hands. Informally, the underwriter holds out the threat that if an investor refuses to purchase the issue at hand, he will be blackballed in future allocations and thus be denied the profits accruing to regular investors in I

e can quantify the eirect of this additional power on the proceeds of an by augmenting the model presented above. In particular, here we view the

single issuing firm described in the last section as one in a sequence of issuing firms using the same underwritpr. From the present vantage point, neither the investors nor the underwriter know for sure which firms will be going public in the immediate future. ut they all will form some expectatibsn of the profit from participating as regular buyer of future issues. For the moment, we simply represent the expected fututre profit to a regular as L. Because L derives from expectations about the underpricing of future issues, there is a required equilibrium consistency between the expected profit to a regular from ea e address t’his issue below.

lue of future participations in I OS into the analysis has the effect of permitting the underwriter to expect investors to purchase shares of the current issue even if by doing so they take a loss, provided that the loss does not exceed the present value of future expected profits. This alters the

straint required to induce investors indicating low interest to ir allotted shares. The new condition [compare with (4) above] is

ossibility that investors who indicate low interest in the uces the incentive for

formation to lie.

2 A.h9 h=O

L. M. Benveniste and PA. Spindt, hvestor in~~~rnatiQn and PPO pricing 355

lower than when the issue can be

regulars with some positive profit on average so that

unconditionally by the proceeds from an underwritten offering. This is state formally in the following theorem:

Theorem 2. For a given minimum of presales, an underwriter can provide unconditionally higher proceeds to an issuing firm by giving priority to investors.

Unlike an issuing firm, an underwriter can pool new issues. This benefits issuing firms because it offsets, to some extent, the informational a possessed by investors. ut underpricing is not eliminated because incomplete; not all issu are presented to the market at the same analysis suggests that underwriters do the next best thing by using their regular investors?

Theorem 2 establishes a clear role for underwriters that complements other . services - such as the monitoring described by Smith (1986) and Smith (19%) - they provide. Underwriters’ distribution channels reputations for certifying that inside information is disclose an underwriter certifies a new issue, he risks the value of his channels. An underwriter who fails to maintain his reputation for monitoring diligently will lose his regular investors and the future rents he could earn from his distribution channels.

Condition (6) constraining the premarket underwriter using his levera the underwriter can expect can be shown that the empirical imphcatio

‘William Blair 81. Co. indicates that it

356 L. IV, Besweniste crnd P.A. Spin& Investor information and IPO pricing

s, investors for out ir underwriter’s se our

d the value of information (a), r rssuing stock, will determine the

a&et allocation and offer price schedule. the notation as simple as possible, we assume that issuing fir ed by a one-dimensional random variable f with a distn

function &Q. The schedule for each firm f will be denoted as

which must satisfy conditions (5) and (6). egular investors do not know in advance what their information about a

e. Ex ante, regulars face a probability p of having good information on any fS and their expected profit from f’s issue is the weighted average

H-l H-l

lrh’(~+(Ph/-po.f))qh/.h+(1-P) h=O h=O

which equals

or consistency, Id must equal the present value of all future profits, i.e.,

L= Ef(uf)/r, (7)

w&e r is the constant interest rate. Expected future profit is the present value paying Ef(uf >, because there will be an infinite sequence of

athematically verifying that eq. (7) can be satisfied is straightfor- creases, the necessary profit from :ach firm’s issue decreases.

reased, the right side of (7) decreases and the two will cross nveniste and Spindt (1989) we demonstrate that eq. (7) can

hich the schedules are endogenously chosen.

L. M. Benvenrste and A. Spin& Investor in~~~~atien and I$0 pricing 357

is strategy to increa s wit

firm-commitment others, the underwriter purchases all shares not e offer price. This gives investment b kers incentives to sell the e

issue in the premarket, which they do much of the time. The incentive to presell the whole issue motivates under-writ low-interest investors than he wo otherwise, The underwriter’s propensity to presell the whole issue is strongest facing the greatest ex ante price uncertainty, i.e., firms with large ar.

One way to counter this effect is to include in the underwriting contract a Green Shoe provision, which gives the erwriter the option to ac then sell) additional shares once the is sold. A Cree underwriter to cover overallotments, and this is the t including the provision. But our analysis suggests that the means of reducing underpricing: it limits the amount of stock an underwriter has an incentive to presell, but leaves him the option to distribute a larger amount when demand is high. Thus, allocations to vestors indicating low interest can be lower when a Green Shoe is included

Another means to counter underwriters’ incentive for issuing firms to elect best-efforts underwriting offering is like a consignment sale: the underwriter markets the issue, but he is not bound to purchase any shares remaining unsold at the close of the offering period. While best-efforts contracts contain less incentive for underwriters to presell whole issues, they also entail greater proceeds uncertainty than firm- commitment contracts. Proceeds uncertainty can be limited by stipulating a minimum-sales-constraint clause, which specifies a threshold quantity of the stock that must be sold during t offering period; if sales fall sho threshold, the offer is withdrawn. owever, minimum-sales constraints tend to reactivate underwriters’ incentives to presell.

These considerations suggest that the choice of contract is influenced by three factors. First, which measures the most adversely affected by underwriters’ incentives under fir contracts to wholly presell issues. Thus, high-a firms are more best-efforts contracts i and thereby limit dnd

358 L. M. Benveniste and P.A. Spindt, Investor information and IPO pricing

he second factor influencing the ch aversion of the owners of the &In going public. $&$.Edelker asd

e suggested t.hat one benefit

are guaranteed by the investment b the price an issuer must pay to obtam are less likely to sell under a firm-commitment contract.

he third factor has to do with the issuer’s financial ne lit to raise new funds for expansion. Such firms

nimum levels of proceeds to meet their needs. Firm-commitment contracts can guarantee adequate funds.

In Benveniste and Spindt (1989), we formally set up and solve the allocation design problem faced y a private firm whose risk-averse principals wish to take the firm public. e find that the solution is characterized by a level of

resales that increases with the level of risk aversion. e also find that when firms can choose the presales volume, underpricing can be reduced for high-at firms, because firms can choose lower levels of presales to investors expressing low interest. Thus, not surprisingly, highly risk-averse owners and low-cw firms are most likely to choose firm-commitment contracts.7

elch (1989b) finds evidence that underpricing of best-efforts IPOs is irectly related to the minimum-sales constraint, a hypothesis suggested by the

theory sketched out here. Welch also demonstrates that proxy variables related to the level of premarket activity, such as the time it takes for an issue to sell out, are directly related to underpricing. Thus as our theory predicts, efforts for an early sale seem to be related to the level of underpricing.

e develop a theory of underwriting that explains the existence of under- W FS as institutions th improve the economic eticiency of the initial public equity offerings market. e begin by studying the marketing problem

g to sell equity claims on itself for the first time. naturally as a cost of compensating investors with

ue of the stock for truthful disclosure of onstrate that an underwriter can use

ts to reduce unde ricing and thus acquisition process.

g high-yield bonds has many similarities t example, investment bankers premarket

customers. The analysis presented here yields a rich crop of empirLal predictions about

the IPO market. Some of these correspond to already catalogued stylized facts about IPO prices. For example, the analysis predicts a selection bias in the choice of underwriting contract that results in lower average underpric firm-commitment offerings than of best-efforts offerings; Chalk and (1985) and Ritter (1985) have already re orted results confirming this tion. But other predictions of the model, particularly those relating the degree of underpricing to the level of interest in the preqiarket, have yet to be tested directly.8

Proof of Theorem I. From the definitions of Q and q’,

Ml -P) HP 77h =

H-h fl; and ?Th+i = -

h+=+

for h = 0,. . . , - I. Using these identities an qh

l

H = 0, we can rewrite the term

‘One suggestive finding that u erpricing is positive:y relate rices is provided by Sternberg (I

360 L. M. Benveniste and P.A. Spindt, Investor information and IPO pricing

pears in the objective functio

l)¶g.h+l+ 0 --PNPh - h=O -

, constraint (3) will bind. sing the eq. (3) and noting that we can rewrite (8) as

H-l

t&h + t1 -P)(p, - pho)qb hl, 9

ch simplifies to

H-l

fl (9

To maximize expected proceeds, the underwriter must minimize (9). He can do this by minimizing qh, h, and setting Pt = Ph whenever qb, h > 0. To minimize qb, h, the underwriter should allocate as much as possible to regulars who

icate g and allocate the remaining shares to regulars who indicate b. The expression for expected proceeds given in the statement of the theorem is

erived by substituting these results into the objective function.

eorem 2. Suppose that ( “, g{, & q)( ), } satisfies the necessary schedule without the use of future leverage. If Q > 0, n be raised by e > 0 without violating condition (7) in eeds in state h = 0. Our result will follow if prices in be raised by 6 > 0 without violating conditions (6)

us, we must verify that

1- Q&h+1

H- 1

2 -6)4, tc%O~ 1 9

!l = 1

E. Benveniste cmd P.A. Spindt, Investor information alod IPO pricing 361

reveal it.

rice ca the inducement for regulars wit

Allen, Franklin and Gerald R. Faulhaber, 11987, Signaling by underpricing in the IPO ma&et, Unpublished manuscript (Wharton School, University of Pennsylvania, Philadelphia, PA).

Baron, David P. and Bengt Holmstrom, 1980, The investment banking contract for new issues under asymmetric information: Delegation and the incentive problem, Journal of Finance 37, 1115-1138.

Beatty, Randolph P. and Jay R. Ritter, 1986, Investment banking, reputation, and the underpric- ing of initial public offerings, Journal of Financial Economics 15, 213-232.

Benveniste, Lawrence M. and Paul A. Spindt, 1989, Bringing new issues to market: A theory of underwriting, Unpublished manuscript (Federal Reserve Board, Washington, DC).

Booth, James R. and Richard L. Smith, 1986, Capital raising, underwriting, and the certification hypothesis, Journal of Financial Economics 15261-280.

Chalk, Andrew J. and John W. Peavy, 1985, Understanding the pricing of initial public offerings, Unpublished manuscript (Southern Methodist University, Dallas, TX).

Harris, Milton and Robert Townsend, 1981, Resource allocation under asymmetric information, Econometrica 48,33-64.

Ibbotson, Roger, 1975, Price performance of common stock new issues, Journal of Financial Economics 2.235-272.

Mandelker, Gershon and Arthur Raviv, 1977, Investment banking: An economic analysis of optimal underwriting contracts, Journal of Finance 32.683-694.

McDonald, John G. and Bertrand C. Jacquillat, 1974, Pricing of initial equity issues: The French sealed-bid auction, Journal of Business 47, 37-47.

Ritter, Jay R.. 1985, The choice between firm commitment and best efforts contracts, Unpublished manuscript (University of Pennsylvania, Philadelphia, PA).

Rock, Kevin, 1986, Why new issues are underpriced, Journal of Financial Economics 15,187-X2. Smith, Clifford W., 1986, Investment banking and the capital acquisition process, Journal of

Financial Economics 15, 3-29. Stemberg, Theodore, 1989, Bilateral monopoly and the dynamic properties of initial public

offerings, Unpublished manuscript (University of California at Berkeley, Berkeley, CA). Tinic, Seha M., Anatomy of initial public offerings of common stock, Journal of Finance 43,

789-822. Welch, Ivo, 1989a, Seasoned offerings, imitation costs, and underpricing o? initial public offerings,

Journal of Finance 44.421-449. Welch, IVO 1989b, An empirical test of competing contract choice predictions of a winner’s curse

and a preselling model of IPO auctioning, Unpublished manuscript (University of Chicago, Chicago, IL).