Should Federal Law Regulate Short Selling by Underwriters in IPOs? Lessons from a New Behavioral Theory of IPO Pricing

By | October 22, 2019

Courtesy of Patrick M. Corrigan

Since 1980, the average stock price of IPO firms has popped about 18 percent over the offering price on the first day of trading. This well-known phenomenon constitutes the basis of the IPO underpricing puzzle. Snapchat and its selling stockholders, to take one example, left almost $1.75 billion on the table in the company’s IPO.

However, it is often overlooked that IPO initial returns are extremely variable. While IPOs that pop in the after-market garner attention, almost a third of U.S. IPOs are overpriced. If investors bought at a discount in Snapchat’s IPO, investors paid a $617 million premium in Uber’s IPO after the price traded down more than 7 percent on the first day. Underwriters also reportedly make trading gains by short selling overpriced IPOs like Uber’s and Facebook’s. How should we understand a transaction structure that produces both underpriced Snapchat-type IPOs and overpriced Uber-type IPOs? And what does the answer imply for federal broker-dealer regulation?

In my new article, “The Seller’s Curse and the Underwriter’s Pricing Pivot: A Behavioral Theory of IPO Pricing,” I develop a theory that explains mean IPO underpricing, high initial return variability, and the dominance of the standard IPO contract. According to the theory, underwriters use the standard IPO contract to extract rents from the issuers that fail to foresee their vulnerability to underpricing under the traditional IPO process, while effectively bribing the more sophisticated issuers to keep using the inefficient contract.

The two dominant explanations in the academic literature for mean IPO underpricing is that mean underpricing persists due to information asymmetries or underwriter conflicts of interest. But neither of these theories predicts the systematically large share of overpriced IPOs, like Uber’s IPO. Moreover, transactional lawyers know that it would be surprising if information frictions or agency costs led to a systematic first-day price pop in IPOs because sophisticated parties can bargain around such first-order market frictions. Indeed, the standard IPO contract exacerbatesrather than mitigates these frictions. Why don’t issuers anticipate their vulnerability to IPO underpricing and bargain for a transaction structure that is reasonably designed to maximize their proceeds?

My analysis posits that some issuers are naïve in the sense that they engage a bank to underwrite their contemplated IPO without anticipating the incentives or capacity of their underwriter to impose underpricing down the road at the pricing negotiation. The idea of a naïve issuer may seem implausible. However, the behavioral finance literature has documented systematic managerial mistakes in other contexts, and there is good qualitative evidence that at least some naïve issuers have completed IPOs. At a minimum, it’s worth working out the implications of a theory that posits naïve issuers and testing the predictions of the theory against observations.

Consider a simple market in which all issuers are naïve. Two contractual features enable underwriters to increase their share of the negotiable surplus in an IPO. First, underwriters receive a specific veto right over an IPO until the parties agree to an offering price. Second, the offering price is negotiated shortly before an IPO, at which point issuers have already made considerable investments in the IPO process. In other words, underwriters maximize their payoffs by obtaining the contractual right to hold up IPOs precisely when issuers are most vulnerable. This, in fact, describes the features of the traditional firm-commitment IPO. At the pricing negotiation, issuers using the standard IPO contract are willing to accept any amount of underpricing that does not exceed their perceived costs of delaying or canceling their IPOs. The hold-up problem is exacerbated if the book-building process gives underwriters an information advantage in the pricing negotiation.

You might think that more sophisticated issuers (who spot the exploitation in the standard IPO contract) would demand a more efficient contract, and that naïve issuers would then demand the same contract.

In an environment with both sophisticated and naïve issuers, four interesting and non-intuitive results occur. First, underwriters offer the same firm commitment and book-building contract to all issuers. Second, underwriters maintain a strategy of underpricing the IPOs of naïve issuers. Third, in the IPOs of sophisticated issuers, underwriters pivot to a strategy of exploiting investors by overpricing IPOs. Finally, underwriters over-allot these overpriced IPOs and make a trading gain when they repurchase shares at the lower market price.

Why don’t sophisticated issuers defect to a more efficient contract? Under the traditional IPO process, they receive a cross subsidy from naïve issuers which enables them to sell stock at a premium. Uber, for example, sold almost $8 billion of stock at an 8% premium relative to the price at the close of the first day of trading, corresponding to $617 million in additional proceeds.

The model predicts that accurately pricing IPOs is not an objective of underwriters. A key result is that underwriters maximize their payoffs by deliberately pivoting between under- and overpricing strategies. The kicker is that the traditional IPO transaction structure gives underwriters the capacity to manufacture mispricing by holding up IPOs on the sell side and, on the buy side, threatening to reward or punish investors in future IPOs. The behavioral theory, therefore, predicts both Snapchat-type underpriced IPOs and Uber-type overpriced IPOs, and it is the only theory of IPO pricing to do so.

So, what does all of this mean for federal broker-dealer regulation? A central feature of the standard IPO contract is that underwriters have the option to short sell (over-allot) IPOs. This is the mechanism that aligns the interests of underwriters and sophisticated issuers to overprice an IPO. The securities laws permit such short sales in connection with securities distributions, and they do not require underwriters to disclose their total short position. While the securities laws require underwriters to disclose pure stabilizing transactions to the market, the SEC’s regulations instead permit underwriters to shroud their short covering transactions. The regulatory scheme, therefore, makes it impossible for investors to ever know an underwriter’s short position or its trading profits in the aftermarket.

My analysis produces the non-intuitive result that changes to SEC regulations restricting underwriter short selling in IPOs would not only help reduce IPO overpricing but might also mitigate IPO underpricing. If overpriced IPOs are no longer profitable, sophisticated issuers might demand accurately priced IPOs, and this might require underwriters to adopt more efficient transaction structures in those IPOs. But this development might educate naïve issuers about their vulnerability and induce market-wide adoption of more efficient transaction structures.

One report stated that Uber’s underwriting syndicate made around $200 million in trading profits by short selling Uber’s IPO. A different report indicated that underwriters in Facebook’s overpriced IPO in 2012 made over $100 million in trading profits. My work suggests that banning these types of pre-IPO short positions or even requiring enhanced disclosure of short positions would lead to more accurate pricing and efficiency gains in IPO markets.

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