Corporate Finance
Market Microstructure
Microeconomics

Corporate Finance
Investments
Financial Markets

October 1996 (Orals) Microeconomic Theory, Industrial Organization
May 1995 (Written) Microeconomic and Macroeconomic Theory

The Effect of Public Information on the Timing and Pricing of IPOs

Professor Dirk Bergemann
Professor Benjamin Polak
Professor Arturo Bris

December 2001

B.Sc. (Honors) University of Manitoba, Statistics and Economics, May 1994

SSHRC Doctoral Fellowship, 1997-1999
Graduate School Fellowship, Yale University, 1994-1998
Natural Sciences and Engineering Research Council of Canada, Summer Fellowship, 1994
Robert Hogg Scholarship, University of Manitoba, 1993

Teaching Assistant, Portfolio Theory, Yale University, Spring 2000
Head Teaching Assistant, Corporate Finance, Yale University, Fall 1999
Teaching Assistant, Corporate Finance, Yale University, Fall 1998
Teaching Assistant, Intermediate Microeconomics, Yale University, Spring 1997

Research Assistant for Professor Smiley Cheng (Statistics), University of Manitoba, 1994.

Worked on a project to derive the theoretical and simulated density functions for a class of random variables.

"The Effect of Uncertainty on the Underpricing of IPOs," mimeo, Yale University, 2001.

"The Coordinating Role of Public Information in Hot Market IPOs," mimeo, Yale University, 2001.

"The Timing of Initial Public Offerings: A Real Option Approach," mimeo, Yale University, 2000.

"The Determinants of Static and Dynamic Capital Structure Choice," mimeo, Yale University, 1998.

This dissertation examines the influence of publicly observable information on the timing and pricing of IPOs. The specific definition of public information used is the market prices of firms from the IPO firm’s industry. By analyzing how market prices affect the supply of, and the demand for, IPOs, the chapters provide some unique insights into how and why ‘hot issue’ markets arise. The reliance on public information makes the contribution distinct from prior theoretical work, which has focused on the effect of asymmetric information between the different participants in the IPO process.

In the first chapter, The Timing of Initial Public Offerings: A Real Option Approach, I develop a dynamic model of the going-public decision that is based on the premise that investors value a private firm using observable and stochastic market prices. The model is unique in that it allows the value of the firm to change over time due entirely to external factors. By treating the going-public decision as a real option, the model explicitly incorporates the opportunity cost associated with undertaking the IPO today as opposed to some future date. This additional cost of going public, the timing option value, ensures that the firm will wait for a positive price shock before going public. The model predicts that an IPO should occur after a run-up in the industry valuation. The benefit of waiting dictates that an IPO would never occur after market values fall. The paper proposes an explanation for the clustering of IPOs near market valuation peaks that relies only on firms exercising their timing option optimally, without assuming asymmetric information between the firm and investors.

The real option approach is extended to seasoned equity issues. Each issue is a sale of a unique fraction of the total ownership claim of the firm, and is associated with its own timing option. Each option is independent of all others, and the firm has only one opportunity to sell each set of shares. All equity issues should occur after abnormal returns to the stock price. The real option approach to equity issuance provides a basis for thinking about dynamic capital structure choices. The timing option value is an additional cost a firm must explicitly consider when comparing the costs of issuing equity versus an alternative security.

The influence of public information on the demand for shares in an IPO is studied in the second chapter, The Coordinating Role of Public Information in Hot Market IPOs. This chapter argues that the "rules of the game" for the way bookbuilt IPOs are conducted, and the public signals generated by previous IPOs, increase the probability that an IPO becomes ‘hot’. Intentionally underpricing offerings that attract strong interest makes coordination among investors desirable. A high public signal acts as a coordinating device because each investor believes other investors will submit large buy orders in the IPO, and will choose to buy as well. During a hot market public information can dominate private, and IPOs that produce low private signals can still be successful. The disproportionate influence of public information provides an explanation for why small changes in market conditions can lead to large swings in the demand for, and consequently the volume of, IPOs. The probability of an IPO becoming hot depends critically on the IPO rules. Reducing intentional underpricing and allocating shares more equitably lowers the incentive to buy and the probability of a hot offering. The bookbuilding method may be more conducive to generating hot markets than alternative IPO mechanisms.

The final chapter, The Effect of Uncertainty on the Underpricing of IPOs, examines whether ex ante uncertainty over the firm value will lead to underpricing when the IPO is sold by the "book-building" method. The argument by Beatty and Ritter (1986) that underpricing increases with uncertainty was shown only for the fixed-price selling method. The model includes a price setting mechanism for both the primary and secondary markets. The secondary price is a function of all private information, and may not equal the true asset value. The payoff to investors participating in the IPO is determined by an uncertain initial market price, not the true value. Selling the shares in the primary market represents a transfer of risk to investors. By acquiring this risk investors insure the issuer against an adverse market reception to the offering. The premium for this insurance is the intentional underpricing. The issuer will generate information in the primary market that increases the precision of the estimate for the initial market price, reducing the necessary underpricing. When all private information is revealed in the primary market there is no uncertainty over the initial market price. Intentional underpricing is eliminated. When residual uncertainty remains, underpricing will increase in the ex ante uncertainty over the value. The model shows that underpricing due to uncertainty is not a necessary feature of bookbuilt IPOs, and suggests that underwriters can reduce the cost of going-public by requiring IPO investors to submit specific limit orders.