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Theories of IPO Pricing and Grading

Though the literature available on IPO pricing is abundant in number, the extent of literature related to grading of IPOs is very limited.

Winner’s Curse Hypothesis: Rock’s (1986) asymmetric information theory (also called winner curse hypothesis) is most high-ranking model that has been developed to explain the inconsistencies in the newly issued IPOs. Rock’s model is based on two key assumptions: two kinds of investors, those who have the knowledge about the true value of the firm and those who are completely unaware about the true value of the firm. Informed investors are cognizant of the future prospects and will only attempt to buy when the issue is under-priced whereas uninformed investors don’t have any idea about under-pricing and over pricing of issues, and therefore don’t differentiate between issues. Uninformed investors due to lack of knowledge usually get negative Initial Returns. They get all the shares they want of the poor issues and they get small fraction of good issues. Due to this adverse selection problem, the uninformed investors will exit the market unless IPOs are sufficiently under-priced on average to compensate them for their informational handicap.

Information Gathering Theory: Benvenistc and Spindt (1989) introduced the “Information gathering theory” and stated that underpricing is a way to convince informed investors to disclose private information about the demand for shares in the pre-selling phase. In the IPO market, lead managers consult clients before setting offer price in prospectus. Lead managers may intentionally underprice an IPO, to attract more and more clients. The Demand Information is gathered during the pre-selling phase, which forms the basis for pricing the issue. So the merchant bankers play game with many of their large clients.

Signal Theory: Allen and Faulhaber (1989) said that underpriced new issues leaves a good impression in Investor’s Mind. Firms tend to convey their quality to investors by offering their shares at relatively lower values and subsequent adjusting for the loss in their seasoned offering.

Kam C. Chan and Yung Ling Lo in their article credit ratings and long-term IPO performance found that there is a reduction in information asymmetry when there is a provision of credit ratings prior to IPO which helps in improving market efficiency. There is reduction in information risk and price discounts by the increase in disclosure through credit ratings. IPOs are more positively perceived by outside Investors when they have a credit rating as compared to those who don’t have any credit ratings. The market reactions for rated IPOs are more trustworthy and rapid while the long-term performance is insignificant because of reduction in the information asymmetry.

The findings of Heng (Hunter) An, and KamC.Chan in Credit ratings and IPO pricing of the analysis of U.S. common share IPOs from 1986- 2004, suggests that rated IPOs underpriced significantly less than the unrated IPOs. Credit rating levels have a very slight effect on IPO underpricing. IPO firms with high credit ratings are not necessarily underpriced less than those with low ratings. Credit ratings reduce the degree of price revision during the book building process. Credit ratings also reduce the aftermarket volatility in the post-IPO period.

Mandatory IPO grading: Joshy Jacob and Sobesh Kumar Agarwalla find that grades do influence both the institutional and retail demand for IPOs. The demand from QIBs is weaker for the relatively low grade IPOs, compared to the high grade or ungraded IPOs. The demand from retail investors forungraded IPOs appears to be positive relative to  both low and high grade IPOs. The weaker demand for the low grade IPOs, compared to the ungraded IPOs, tentatively suggests a guidance role for the IPO grade in the case of the retail investors. Information content of IPO grading by Deb. S. S. and Marisetty V. B (2010) found that IPO grade influences both the retail as well as institutional investor‟s subscription levels.

Grading, transparent books and initial public offerings by Khurshed et al. (2011) establish that IPO grading is not significant in the retail demand. It is found that QIBs demand is weaker for low-grade issues.

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