How Investment Bankers Determine the Offer Price Andallocation of New Issues

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’ectpricing 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 inhibitions, 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 such information to theminformation before the stock is sold. B 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 underwriter, 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...