IPO analysis Guru: Ivo Welch

Finance professor Ivo Welch has an excellent ''resource page" of IPO data, literature and links on his website. One feature is an assessment of the twin phenomena of short-run underpricing and long-run underperformance of new issues. On the first point, Welch notes that the typical IPO underpricing the return from the offer price to the price when the market starts trading is about 10%, an astonishing figure for an average daily return. He asks why issuers "leave so much money on the table" and suggests a number of reasons:

When applying for shares in an IPO, you will typically get all the shares you requested if it is overpriced you are a victim of the winner's curse. But when an IPO is underpriced, you will only get shares on rare occasions, especially if you are not a favored client of the underwriters. As a result, you come out down on average and are unlikely to apply for shares in a fair-priced offering. So to get you to participate at all, issuers set a lower price, and while it appears that the average IPO leaves money on the table, the typical investor cannot profit from it.

Issuers like to donate some money to investors since they may want to return later for further funds. Investors will remember how good a deal they got with the IPO.

Underpricing solicits information from investors about their potential interest. Why would investors tell underwriters they like an offering unless they know that by doing so, the underwriter will give them more shares for a better price?

If one important investor defects, maybe all investors will follow. Hence, to ensure the first investor does not defect, it is better to play it safe and underprice.

There is an agency problem for the issuer: because underwriters naturally prefer easier to harder work (especially when the price is high, which makes selling difficult), it is best to make selling a little easier for them and underprice.

While IPOs can be very profitable for institutions with relatively short investment horizons and which have access to them at their offer price, this is rather like a quick payback for early support. For in the longer term, new issues are not attractive investments. A significant body of evidence indicates that on aggregate, they have underperformed the market, typically 3050% below comparable companies over three- to five-year periods. A study by Tim Loughran and Jay Ritter discusses some of that research and presents their own findings, which confirm IPOs' poor performance.

How can this long-run underperformance be explained? Welch explores the two most prominent explanations, the first of which is that corporate managers are smarter than the market and thus good at timing, taking advantage of overpriced stock. The second is that managers manipulate earnings, past and forecast, dressing IPOs up for sale. While analysts advising investors should spot these exaggerated figures, they are paid by firms in the business of selling IPOs.