Yale School of Management What causes the underpricing of auctioned IPOs? Experimental Evidence Panos Patatoukas, October 2007

Yale School of Management IPO mechanisms in the US An IPO is the first sale of shares in a company to the public. Once an IPO occurs, the company will be listed on a stock exchange, and shares begin to trade. Currently there are two mechanisms for IPOs in the US: the book-building and the auction-based method. In both mechanisms, the main role of the underwriter is to price and allocate the shares of the issuer. The key difference of auctioned from book-built offerings is the mechanism under which the underwriter carries out his role: 1.In the book-building mechanism the underwriter prices and allocates the new issue with complete discretion. 2.In the auction mechanism the underwriter has limited discretion, both the pricing and allocations are market driven since both are determined in a uniform price sealed bid auction where all winning bidders pay the clearing price.

Yale School of Management The underpicing phenomenon An issue is under (over) priced if the price received by the issuer in the primary market is lower (higher) than the price of the same securities in the secondary market. The underpricing phenomenon traditionally refers to the short-term performance of book-built IPOs and is typically measured by the “pop” in the new issuer’s stock price within the first few days of trading. The auction mechanism offers the promise of limiting underpricing. The argument is that the clearing price of a well-designed auction is virtually equal to the market price so the first day return should be zero. The question that surfaces is whether auctioned IPOs are, in fact, underpricing-free.

Yale School of Management Auctioned IPOs are not underpricing-free In the US, over the period , the mean first day returns of completed auction-IPOs are %. In France, over the period , auction IPOs experience on average +9.70% returns on the first day of trading. The average underpricing level is +4.5% for auction-IPOs conducted on the Tel Aviv Stock Exchange from Auctioned deals completed from 1993 to 2001 in Japan experience on average % first day pop.

Yale School of Management US Treasury auctions The auction IPO mechanism is based on a model similar to that used by the US Treasury. Uniform price Treasury auctions also appear to be associated with underpricing since the average price received by the Treasury is less than the price of the same securities in the secondary market.

Yale School of Management Motivation Theories to explain the underpricing of “traditional” IPOs usually examine the relations between the three actors of an IPO: the issuer, the underwriter and the investors. Explanations which rely on the underpricing benefits to the issuer and/or the underwriter are not relevant for auctioned IPOs since the issue’s price and allocation is determined by investors in an auction and not by either the issuer or the underwriter. The empirical finding that auctioned IPOs are underpriced poses a puzzle.

Yale School of Management Empirically investigate the causes of the underpricing of auctioned issues. My research question cannot be empirically evaluated with field data (at least for the time being). In order to investigate the causes of the underpricing of auctioned IPOs I develop a computerized laboratory market that enables me to test hypotheses grounded on economic theory. Research Question

Yale School of Management The demand reduction effect (1) Vickrey (1961) demonstrates that in single-unit, uniform-price, sealed-bid auctions the bidder’s dominant strategy is to truthfully bid his valuation and thus uniform price auctions are allocatively efficient and maximize the seller’s revenue. Vickrey also points out that the uniform-price auction is not expected to be demand-revealing if bidders have multi-unit demand, as in the case of securities auctions. When a bidder desires multiple units there is a positive probability that his bid on the second, or later units will be pivotal in determining the price that he pays on all units that he wins. So the bidder has an incentive to bid less than his true valuation on later units in order to reduce the price he pays on the earlier units.

Yale School of Management The demand reduction effect “predicts” that the issue will be underpriced even if the signals generating process is common across investors (information homogeneity). Signals’ noise: As the noise in the signals generating process increases bidders have an incentive to behave more strategically (Kagel, 1995) and potentially exhibit more demand reduction. Number of Bidders: As the number (N) of investors’ increases the probability that any given investor will be the pivotal bidder decreases and the demand reduction incentives decline. The demand reduction effect (2)

Yale School of Management The marginal bidder hypothesis (H3) In a market setting where all investors are symmetrically informed about the pure common value of the securities for sale, auctioned IPOs are underpriced and the underpricing is ceteris paribus (i) increasing in the noise of the signals generating process and (ii) decreasing in the number of bidders

Yale School of Management Pilot Results (1) Noise True Price Clearing price Closing Price % Deviation of CP from TP Round 1 1 $18.7$17.6 $ % Round 2 2 $13.2$12.3 $ %

Yale School of Management Pilot Results (2)

Yale School of Management Pilot Results (3)

Yale School of Management Concluding Thoughts Consistent with the marginal bidder hypothesis: 1. the issue can be underpriced even if all investors are symmetrically informed. 2. the issue is more (less) underpriced when the noise in the common signals generating process is higher (lower). What about ? Experience & Learning effects. Asymmetric Information Structure Price bubbles or false equilibria in the aftermarket. Speculative bidding in the primary market Merits of running pilot experiments