"The pricing of IPOs has received much attention in the corporate finance literature over the years. Discuss the pricing of IPOs and also the consequent market behaviour from initial issue through the expiration of any lock-up period. Your discussion in the essay should deal with both the theoretical and empirical foundations with regard to the tests used in the empirical literature. The analysis should include reference to reasons for either under pricing or over pricing and also the possible approaches to potentially identify the correct market price."
Introduction.
The first thing that the large majority of academic papers on IPOs do, is point out the apparent persistent historical underpricing of stock being floated on the market. Having a quick look at table 1, we see that this trend has certainly not faded over the last 20 years, with massive amounts of money left on the table, both in absolute as well as in relative terms.
It is therefore not surprising that the topic of so-called IPO underpricing has drawn the attention of many financial researchers, who have developed a range of theories over the last 35 years, and have subsequently held these against empirical light.
In this essay, we not only look into the most developed of these theories and their empirical counterparts, but also examine why there is a strong incentive not to overprice, which in some cases might directly lead to underpricing. Using recent research, we also look into the motivation and length of IPO lock-ups, and their potential link with underpricing. Our overall conclusion is that private information, the role of the underwriters and agency cost concerns, together form the driving force behind IPO underpricing and lock-up periods, although there are few silver bullets to be found in this complex matter.
The unlikely case of an overpriced IPO.
As noted above, our main focus will be on the theories and empirical findings surrounding IPO underpricing. Before doing so, we wish to also bring forward some theoretical models and empirical results that deal with the absence of potential overpricing; in light of exhaustively analysing IPO pricing.
We start with the work surrounding the (implicit) price support offered by IPO underwriters. Price support entails keeping the market price of a good higher than the competitive equilibrium level, and in this case means that the underwriter persistently quotes a high bid price in the short term period after the IPO. The SEC, by many seen as the leading financial regulator in world, has always classified price support as market manipulation ( in e.g. SEC Release No. 2446), but has explicitly exempt it from the anti-manipulative provisions of the 1934 Act, provided it does not breach the condition set-forth. In case of an IPO this means that underwriters (i) can only support the price for a limited amount of time (ii) cannot stabilize the price above the offer price (iii) need to explicitly disclose the possibility of price support in the pre-IPO prospectus. [1] While Benveniste, Busaba, and Wilhelm (1996) see price support as a put option given to institutional investors on the assets they bought to reward them for revealing their private information during the pre-issue period; Hanley, Kumar, and Seguin (1993) argue that these stabilization efforts are aimed at disguise overpriced IPOs from investors by temporarily inflating the share price.
Lewellen (2006) finds that underwriters build up a large inventory of a low demand ('cold') IPO on the first day of trading: [2] an observation consistent with price support, and similar to that of Ellis, Michaely, and O'Hara (2000) and Aggarwal (2000). This makes that share prices of newly IPOed companies are very rigid at and under the offer price, as it requires large selling pressure to bring about a price decline, indicating the price support is effectively present in the market.
The link then between the presence of strong price support and absence of strong overpricing is quite evident: as the underwriter puts his money where his mouth is, he stands to lose both the former and the latter, if an overpriced IPO boomerangs back; and therefore by protecting himself, he protects his clients. This idea is further supported by Chowdhry and Nanda (1996) who develop a model in which price support is used alongside underpricing, as to reduce the losses incurred by uninformed investors and persuade them to invest in the IPO. Hanley, Kumar, and Seguin (1993) also model the underwriter's incentive problem directly, and show that through stabilization promises on the secondary market, the primary market gains in fairness vis-à-vis (uninformed) investors; formalizing and extending Smith's (1986) conjecture that price stabilization represents a bonding mechanism.
Empirical research, however, shows that this price support is often not expensive, and thereby weakens the idea that the underwriters stand to lose considerably if they overprice IPOs. Aggarwal(2000) and Ellis, Michaely, and O'Hara (2000) find that the underwriters do in fact offer price support to IPOs, but that through combining a short position and their over-allotment option [3] this is often without a high risk/cost to them. The idea is as follows: by overselling the issue (taking the short position) up to 15% of the offered shares, the underwriter covers himself; if the price drops, he covers his short position by buying in the secondary market -accommodating the selling pressure- and not exercising the option, if the price rises, he covers his short position by exercising his over-allotment option.
Most underwriters logically only take a limited short position, due to risk of a price increase, with a reported average short position of 17.1% (i.e. a naked short position of 2.1%). (Aggarwal (2000)). This makes that in the event of strong price pressure, underwriters "are not able to provide effective price support unless they take a long position and hold inventory of the stock" (Aggarwal (2000), p. 1081). We thus see that price support might act against excess overpricing, as price stabilization can become costly in that case. Recent research also shows that "short selling is both non-trivial and an integral part of the IPO price process on the first trading day" (Edwards and Hanley (2007), p. 11); which, in our opinion, will make the price supporters extra cautious for potentially overpricing the IPO.
Moving on, other research has found additional reasons to suspect that there is little incentive to overprice new stock issuances. Booth and Smith (1986) argue that the role of the underwriters is to certify that IPO shares are not overpriced, in the light of using reputational capital to guarantee product quality. The model shows that underwriters who overprice IPOs, subsequently lose market share in the market for new issuances; a result that is empirically confirmed by Dunbar (2000), for both underpricing as well as overpricing.
Lowry and Shu (2002) add another important consideration why there is a strong incentive not to overprice an IPO: the risk of litigation and its associated costs. [4] They find that "consistent with the deterrence effect of underpricing, there is evidence that firms that engage in more underpricing significantly lower their litigation risks" (Lowry and Shu (2002), p. 333). The authors also point out that apart from high indirect cost such as reputation and wasted management time, litigation also bring with it a high direct cost of on average "11% of the total proceeds raised. Notably, some of the cases settle for considerably larger amounts. For example, in four cases the settlement amount exceeds 35% of proceeds raised, and in one case the settlement amount is nearly 50% of proceeds" (Lowry and Shu (2002), p. 310). These numbers should also incentives the underwriters to be precautious, given that "in the case that the IPO firm does not have sufficient funds to meet all the damage payments, the plaintiffs can recover the rest from the other parties, including the underwriter" (Lowry and Shu (2002), p. 319).
The above three cases of potentially costly price support, potential damage to the underwriters' businesses and the high legal cost of potential litigation, form, both jointly and separately, good arguments to avoid overpricing an IPO altogether, as shown theoretically as well as empirically.
IPO underpricing: theory, empirics and implied solutions.
After having discussed the theory and empirics behind the likely absence of overpriced IPOs, we move to analyzing IPO underpricing and its possible remedies. Empirically speaking, underpricing has been a persistent, though volatile trend in the IPO market. Using the same data source as used for table 1, [5] we see that in the USA the underpricing discount has averaged ca. 19%, a considerable amount by any standard. This average discount has tended to fluctuate strongly: from 21% in the 1960s, to 12% in the 1970s, 16% in the 1980s and 21% in the 1990s. The four years after 2000 saw an average 40% discount, something Ljungqvist (2007) see as "reflecting mostly the tail-end of the late 1990s internet boom"; with the last decade seeing a more moderate 12%, as can be seen in table 1. Very similar trends can also be found for IPOs outside the USA. [6]
These market trends sparked a large theoretical literature in the 1980s and 1990s that has since tried to rationalize IPO underpricing, with empirical research confronting this theories with the available market data. Ljungqvist (2007) divides this research into four categories; namely asymmetric information, institutional reasons, control considerations, and behavioural approaches. The asymmetric information theories are often seen as the most established ones. We will shortly present these first three theories, their empirical validity and the measures they imply to come to a (more) correct market price. We do not discuss the behavioural finance aspect of IPO pricing, given that it is still very infant, with more work needed (Ljungqvist (2007), p.417).
Asymmetric information
Asymmetric information based models evolve about the idea that some key party to the IPO transaction, be it the issuing firm, and/or the underwriters and/or the investors buying the stock, know(s) more than the other(s), and will use this knowledge to its/their advantage. The asymmetric information theories are often seen as the most established ones, and are themselves categorizable again into four categories: winner's curse based, information revelation based, principal-agent based, 'underpricing as a signal of firm quality'-based. These models and their ensuing empirical 'verification' form a very large body of research, which we will try to present as thoroughly as possible with the limited space at hand.
winner's curse based models
Probably the best-known asymmetric information model is that of Rock (1986) which evolves around the so-called winner's curse, and which builds on Akerlof's (1970) lemons problem. The information discrepancy in this case lies between two types of investor classes: informed vs. uninformed. This makes that informed investor only bid on the attractively priced offers, while the uninformed investors cannot discriminate between attractive and non-attractive offers. In this setting the uninformed investors suffers from the winner's curse: in unattractive IPOs they obtain all the stock they have bid for, while the informed investors absorb part of the shares if the IPO is in fact attractively priced. In the extreme case that all underpriced IPOs are swept away by the informed investor, the uninformed investor are left with a return of maximum 0%, as they can only have access to correctly priced and overpriced issuances.
If the demand from the advantaged investor(s) is insufficient to absorb all attractive offerings, an assumption made by Rock, the primary market is reliant on the uniformed investors' continued presence. This makes that conditional expected returns need to be 0% or higher for the uninformed parties, to guarantee their presence; which makes that each IPO needs to be underpriced, in expectation. While this does not take away the fact that that informed investors will make above average returns, as they now use their knowledge to invest in the most underpriced IPOs, the uninformed investors will not have an expected negative return.
An important factor in this that underpricing benefits issuers collectively, due to the ensured necessary participation of the uninformed investors; but that individual issuers have the incentive to underprice their IPO too little, as underpricing is a clearly a cost to them. Beatty and Ritter (1986, p. 214) show "that any investment banker who 'cheats' on the underpricing equilibrium by persistently underpricing either by too little or by too much, will be penalized by the marketplace" The idea is that if they underprice too little, the uninformed investors will stay away from the market, which leads to lose of future underwriting commissions for the investment banks, as there will be less new IPOs. Excessive underpricing, on the other hand, will lead to lose of market share in the underwriting market. Or in other words, as a repeat player the investment bank keeps all the individual issuers in line with the underpricing equilibrium to ensure that their business does not dry-up.
From an empirical point of view there has been much research done to see if the above theories and ideas hold. The difficulty all of this research shares is that asymmetric information is not something which is directly observable, and that therefore it is assumed that certain parties have better information and/or that some market settings are able to make information more homogeneously available.
A first example of this research evolves around institutional vs. retail investors. Hanley and Wilhelm (1995), for example, find that there is little evidence that institutional investors benefit from their assumed superior knowledge, because "the favored status enjoyed by institutional investors in underpriced offerings appears, however, to carry a quid pro quo expectation that they will participate in less-attractive issues as well" (Hanley and Wilhelm (1995), p. 239). Subsequent work by Aggarwal, Prabhala, and Puri (2002) draws exactly the opposite conclusion: IPO investments are more profitable to institutional investors than to retail ones, largely due to the fact that the former are allocated more stock in those IPOs that are most likely to be underpriced, and in fact are.
Another empirical approach to Rock's theory is conducted by Michaely and Shaw (1994), who compare two markets with substantially different degrees of information homogeneity. The authors argue that institutional investors avoid IPOs of so-called MLPs (master limited partnerships), for a string of tax reasons. Assuming, once again, that there is asymmetric information between institutional and retail investors, the absence of institutional investors on the MLP market implies that there is in fact homogeneous information on that market; which in turn mitigates the need for underpricing by the issuer. The authors find that the average underpricing in their sample of 39 MLP IPOs (concluded between '84 and '88) is −0.04% vs. 8.50% for non-MLP ones over the same period, a result which is very consistent with the predictions made by the asymmetric information theory.
Looking into the empirical research surrounding Beatty and Ritter's work, we repeat the conclusion of Dunbar (2000) that investment banks benefit most from not overpricing and/or excessively underpricing IPOs, which is thus in line with the theory proposed. In similar vein, Nanda and Yun (1997) analyse the impact of under-/overpricing of IPOs on the market value of the lead-underwriter, and find that "overpriced offerings are associated with a decrease in lead-underwriter market value significantly in excess of estimated direct costs. For moderately underpriced offerings, however, underwriter wealth effects are positive" (Nanda and Yun (1997), p. 39).
The self evident solution is to reduce asymmetric information, mitigating the need to underprice. From a theoretical point of view, the proposed methods to reduce informational asymmetries are quite straightforward, and come down to using (i) a prestigious underwriter (e.g. Booth and Smith (1986), Carter and Manaster (1990), Michaely and Shaw(1994)) and/or (ii) a reputable auditor (e.g. Titman and Trueman (1986)). The idea is that reputable underwriters/auditors will only want to connect their name to high-quality issuances; to come to this decision they need to thoroughly analyse the firm, which, post factum, disincentives other parties to acquire costly extra information, weakening the winner's curse.
In practice, however, it seems not that simple, and results vary for different periods analysed. A good example is Beatty and Welch (1996), who find that the sign of the relation has switched for the early 90s vis-à-vis the 70s and 80s, indicating that more prestigious underwriters are associated with higher levels of underpricing in the later period. The reason for this switch of sign are still debated, with some research focussing on possible endogeneity bias (e.g. Habib and Ljungqvist (2001)) leading to a wrong sign, while others (e.g. Loughran and Ritter (2004)) find that underwriters try to enrich themselves and/or their clients, and have lowered their criteria, with a higher average risk profile as result.
A final interesting contribution in light of the theoretically proposed alleviation of asymmetric information, was done by Habib and Ljungqvist (2001), who base their work on Smith and Booth's (1986, p. 267) idea that "the underwriter will incur direct costs of certification only to the point where marginal cost of certification equals marginal benefit so that net issue proceeds are maximized". Using a large sample of US-based IPOs from 1991 to 1995, they find that at the margin, each dollar spent on promoting the quality of the issue reduces the issuer's wealth loss by 98 cents, indicating that issuer maximizes the collected funds, as marginal promotion cost equals the marginal gain of reduced wealth loss.
information revelation based models
The above discussion about asymmetric information implicitly assumes that there are pro-rata allocation rules in place, which in many countries have been replaced with a so-called bookbuilding method, the latter giving more discretion to the underwriters when it comes to allocation. Under bookbuilding the underwriters polls the investors about their interest in the IPO, and uses this information to set the price. If there is -as Rock assumes- asymmetric information, eliciting this information and using it to set the correct price becomes possible for the underwriters. It is fairly obvious that disclosing positive information to the underwriter is not incentive-compatible; as it is highly likely that this will result in a higher offer price, reducing the profit of the informed investor. The actual incentive is quite the opposite: all investors are induced to actively misrepresent positive information, in hope of talking the price down. Underwriters are thus faced with the challenge of designing a mechanism that incentivises investors to reveal their true information, by making it in their best interest to do so.
Research by Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991) shows that bookbuilding can be such a mechanism, if certain conditions are met. They show that a scheme under which investors who bid aggressively -revealing their favourable information- get a disproportionately large part of the newly issued shares, does in fact help underwriters set a 'correct' higher price, but only if there is still money left on the table. There is thus a clear trade-off between allocation and return, where truth telling is induced if the increase in rate of allocation is higher than the decrease in return.
Empirically, there are two interesting trends to be discussed. Firstly, the direct test of the theoretical models; and secondly, the analysis of the so-called 'partial adjustment phenomenon'. When it comes to directly testing the proposed theory, the fact that most of this data is highly confidential forms a really barrier. Nevertheless, we see that Cornelli and Goldreich (2001, 2003) and Jenkinson and Jones (2004) were both able to acquire this information. Two clear drawbacks are that in both cases the sample size is quite small, and also that these results are bank specific; making the results far from robust and/or generalizable. While Cornelli and Goldreich's results support Benveniste and Spindt's (1989) theory, Jenkinson and Jones's results "cast doubt upon the extent of information production during the bookbuilding period". (Jenkinson and Jones (2004), p. 2309). It is widely accepted that the dissimilarity in sophistication with which these two banks carry out their bookbuilding, contributes largely to this discrepancy. Using a less direct approach with publicly available, aggregated data, Aggarwal, Prabhala, and Puri (2002, p. 1423) find their results to be "consistent with the book-building hypothesis of Benveniste and Spindt (1989)"
Secondly, there has also been interesting empirical research into the 'partial adjustment phenomenon'. The idea is that positive feedback from the market is only partially absorbed into the price, as to reward the truth tellers for their honesty by still underpricing the IPO, as discussed above. Hanley (1993, p. 1423) finds that "the mean initial return for firms going public at a price above the anticipated range is 20.7%. Offerings that decrease the offer price to below the lowest anticipated price quoted in the preliminary prospectus have an average initial return of 0.6% [...] The remaining issues, representing offerings within the anticipated range, have an average initial return of 10.0%". This result makes clear why investors are willing to give up some of their information in return for a bigger allocation. Lowry and Schwert's (2004) research also shows that there is a positive and statistically significant link between offer price revisions and short term returns, although they question the economical significance of this effect.
principal-agent based models
While the previous two reasons for underpricing focused on the role of (informed) investors in this subject, the principal-agent theory in this matter deals with the relationship between the issuers and their underwriters. While the earlier theories proposed, most notably by Baron and Holmström (1980) and Baron (1982), only dealt with the direct relationship between issuer and underwriters and the latter's effort in selling the IPO; more recent models focus on a much richer setting, most notably Biais, Bossaerts, and Rochet (2002) who combine Baron's work (1982) with that of Benveniste and Spindt's (1989), and come to a model of collusion between the informed investors and the underwriter. This newer approach deals best with the two biggest market concerns, which have articulated themselves ever more strongly since the dot-com bubble; namely (i) rent-seeking behaviour of underwriters, whereby (informed) investors use side-payments to the underwriters to make sure they receive a large allocations of underpriced stock (ii) so-called 'spinning', whereby investment bankers allocate underpriced stock to the managers of other companies, in the hope of securing their (future) investment banking business. Both these practises are of course pure and simple fraud. [7]
An interesting to way to tests these agency issues is to compare IPOs where there is little to no informational asymmetry between the issuer and the underwriter. Two of the most prominent cases are (i) the case of underwriters owning an equity stakes in the IPO company, and (ii) a company underwriting its own IPO.
The first case was analyzed by Ljungqvist and Wilhelm (2003), with support for the problem of principal-agent issues, as they found that the greater the underwriter's equity holding is, the lower first-day underpricing returns are. However, Muscarella and Vetsuypens' (1989) research showed that investment banks' IPOs underwritten by themselves, have the same level of underpricing as other issuances. The problem with this approach is that there are not that many IBs taking themselves public, as the small sample size (38 observations) of this analysis shows.
The solution to this principal-agent problem has been discussed from both a theoretical and an empirical point of view. Theoretically, Biais, Bossaerts, and Rochet (2002, p. 143) find that the optimal method to mitigate collusion "is similar to auction-like IPO procedures used in the U.K. (offer by tender) and in France (offre à prix minimum)", with the optimal pricing function being decreasing in the quantity allocated to retail investors. This procedure not only induces informed investors to tell the truth to the issuer; but also lessens the winner's curse, given that when the underlying value is low and the underwriters allocate a large amount of shares to the uninformed retail investors, the price is low. Empirically, two solutions are tested: that of increased monitoring, and that of better contract design. The first solution is analyzed by Ljungqvist and Wilhelm (2003), who show that if there is a larger incentive for internal decision-makers (e.g. share ownership of the CEO of the issuer) to monitor the underwriters, underpricing is significantly reduced. The second one by Ljungqvist (2003), who analyses what the effect is of making the underwriter's compensation more sensitive to the issuer's initial valuation, and finds "that contracting on higher commissions in U.K. IPOs leads to significantly lower underpricing" (Ljungqvist (2003), p. 2).
'underpricing as a signal of firm quality'-based models
A last form of asymmetric models makes the issuer the better informed party. Welch (1989), Allen and Faulhaber (1989), Grinblatt and Hwang (1989) and Chemmanur (1993) have all proposed the same logic behind high-quality underpricing: high quality firms will undertake a (small) underpriced IPO, and afterwards use a so-called 'seasoned equity offering' (SEO) to find the rest of the desired funds. The idea is that money left on the table at the IPO is recouped from the easy SEO, as investors have been informed about quality of the firm post-IPO; low quality firms will not follow this tactic, as they will not be able to recoup the money initially left on the table from a SEO, if their true quality is found out by then. [8]
Empirical evidence for these models is quite weak, to say the least. Jegadeesh, Weinstein, and Welch (1993) find that the likelihood of using a SEO and its size both increase in IPO underpricing, but that, although statistically significant, the relationship has weak economic significance. Michaely and Shaw (1994) results show that the decision on how strongly to underprice is not significantly related to a SEO decision, and vice versa; in stark contrast with the proposed theory. A final interesting empirical observation is made by Spiess and Pettway (1997), who focus on pre-IPO shareholders (insiders) who sell personal shares at the IPO, and find that in half of all IPOs this is done, with no difference for (more) underpriced IPOs. This makes them conclude that "insiders appear not to value the suggestions of the signaling [sic] models as they do not wait to realize the benefit of their underpricing signal".
Institutional explanations for underpricing
When looking into institutional reasons behind IPO underpricing, three cases are often quoted: litigation risk, price support and taxes. [9] When discussing the unlikely case of IPO overpricing, we already discussed how litigation risk and price support probably induce underpricing. We now also look at how taxes come into play. While there are no specific theories surrounding these ideas, empirical research has unearthed some interesting trends linking capital gains and income tax to the level of underpricing. Two interesting papers are worth mentioning in this respect. Firstly, Rydqvist (1997) analyzes Swedish IPOs and the effect of the 1990 change in Swedish tax laws, which made that income was no longer more heavily taxed than capital gains. The author argues that pre-1990 there was a large incentive to compensate employees with appreciating assets -e.g. heavily underpriced shares- rather than with straightforward income, and that the tax synchronization removed this incentive. In support of this idea, he finds that underpricing fell from an average of 41% in 1980-1989 to a much lower 8% in 1990-1994.
Secondly, Taranto (2003) argues that U.S. tax law incentives senior managers with stock options to underprice IPOs, given that the 'fair market value' for options exercised in conjunction with an IPO is the offer price, rather than the real initial trading price. This makes that they increase the part on which they pay (lower) capital gain taxes, and decrease the part on which they pay (higher) income taxes. Lowry and Murphy (2007) however find that there is no evidence for such relationship.
Perhaps Ljungqvist (2007, p. 408) puts it the most diplomatic, when stating that "it is unlikely that tax alone can explain why IPOs are underpriced, the tax benefit from underpricing may help explain the cross-section of underpricing returns".
Control considerations for underpricing
Given the promising, though nascent contributions of control oriented research to the field of IPO underpricing, we decide to present only the two most acclaimed and diametrically opposed papers. The first one is by Brennan and Franks (1997), who argue that underpricing leads to managerial entrenchment and increasing agency costs by avoiding monitoring by large shareholders. Using a sample of 69 IPOs in the UK, they not only show "that underpricing is used to ensure oversubscription and rationing in the share allocation process so as to allow owners to discriminate between applicants for shares and to reduce the block size of new shareholdings"( Brennan and Franks (1997), p. 391), but also that "there is a low level of hostile takeovers in the period of up to ten years after the IPO" "( Brennan and Franks (1997), p. 392), a trend the authors view as an indication that underpriced IPOs lead to entrenchment due to wider shareholder dispersion.
The opposing view comes from Stoughton and Zechner (1998), who argue that issuers actually underpice to make sure that they have large, well-monitoring shareholders. If the shareholders are too small and dispersed none of them will have the incentive to monitor, and issuers would have to underpice anyway, as shareholders will anticipate higher agency costs. Convincing institutional shareholders to buy quantities which they deem sub-optimal at the original price, but which will induce them to thorough monitoring, has a lower cost than, ex ante, compensating a large shareholder base for potential agency problems. It is of course essential that the issuer/underwriter (s) can actually favour institutional investors in the allocation.
It is clear that both ideas are in flat contradiction with each other, making further research into his matter far from superfluous.
The lock-up period
In this last part we shortly look into so-called IPO lock-ups: what they are, what the motivation behind them is and what their potential link with underpricing is.
Bartlett (1995) explains that "the Selling Securityholders agree that, without your (the investment bank's) prior written consent, the Selling Securityholders will not, directly or indirectly, sell, offer, contract to sell, make any short sale, pledge or otherwise dispose of any shares of Common Stock or any securities convertible into or exercisable for or any rights to purchase or acquire Common Stock for a period of 180 days following the commencement of the public offering of the Stock by the Underwriters", and notes that this provision "prevents a surplus of stock hitting the market all at once".
While it is easy to understand what a lock-up is and what its direct effects are, the motivation to use them is less straightforward. We start by presenting the two main conflicting views, before looking into research which not only tries to consolidate both views, but also links it to underpricing.
Brav and Gompers (2003) explore three motivations behind imposing lock-up period, namely (i) a signalling solution to an asymmetric information problem, (ii) moral hazard alleviating measure and (iii) rent extraction by the underwriting investment banks, and find only reason to believe that moral hazard issues are at play in the 2,794 U.S. IPOs they analyse, with signalling reasons being explicitly ruled out. Brau, Lambson and McQueen (2005) revisit this question theoretically and empirically, and find quite the opposite. The authors make three interesting observations: (i) their theoretical model supports signalling theory, as lock-ups force "insiders to not only put their money where their mouth is but to keep it there as well" (Brau, et al. (2005), p. 529) (ii) they argue that Brav and Gompers's evidence for both discarding signalling considerations is far from watertight and (iii) they hypothesize and find that " l ock-ups should be shorter when a firm is i) more transparent and/or ii) more risky" (Brau, et al. (2005), p. 519). The main weakness of this work is it does not consider moral hazard, and therefore cannot accept or reject its influence.
Yung and Zender (2010) try to consolidate both views, and link the lock-up process to underpricing. The first thing they proclaim is that the length of the l ock-up period in an IPO is chosen to solve either a moral hazard or an asymmetric information problem, with the choice depending upon firm characteristics; which makes that there is need for "an identification strategy by which firms may be separated based on which of the frictions, moral hazard or asymmetric information, is likely to be the dominant consideration for the length of the l ock-up provision". In order to separate the two different types, they use three characteristics of IPO firms that have been shown to serve a certification role in the literature: (i) whether the IPO firm had pre-IPO venture capital financing, (ii) the reputation of the underwriter, and (ii) firm size. By doing so they make sets of moral hazard (characterized by high reputation underwriters or large firms) versus asymmetric information firms (characterized by low reputation underwriters or small firms), with the important note that while asymmetric information may induce underpricing in both groups, the focus here is on the factor that influences the lock-up period; or in other words, lock-up period and underpricing are two different dependent variables.
The authors find strong support for the hypothesis that while asymmetric information plays a significant role in the underpricing in both groups, it only has a significant influence on the lock-up period in the 'asymmetric information subset'. This idea is enforced in two ways: (i) the correlation between underpricing and lock-up length, which is absent in the moral hazard set and positive in the asymmetric information set (ii) 2SLS regressions [10] , with the second method indicating that asymmetric information variables only have a significant influence on lock-up length in the matching sets, and moral hazard variables only having a significant influence on lock-up length in the moral hazard sets. In short, Yung and Zender (2010) find strong indication that asymmetric information influences underpricing, and in some cases also has a significantly, 'positive' influence on the length of lock-up period, although the latter can also be imposed because of moral hazard consideration.
Conclusion
In this essay we have presented and analyzed the persistent underpricing of IPOs. After analyzing three possible reasons for the abse overpricing
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