Stock markets enable firms to `go public' in a reasonably efficient manner, usually by means of an initial public offering (IPO) of their equity. Firms go public to raise new equity finance to facilitate future investment; to enable the original owners of the firm to realize some of their investment; to gain future access to additional equity finance via secondary issues; and to participate more fully in the mergers and acquisitions process.

In Discussion Paper No. 427, Research Fellow Tim Jenkinson notes first that new equity issues in the UK, the US and Japan are all typically priced at a discount to their subsequent trading price. This involves a transfer of wealth from a firm's original owners to the purchasers of the IPO, which may be regarded as an indirect cost of issuing equity finance, in addition to the direct costs (legal fees, underwriting commissions, taxes and accountancy costs), which are themselves substantial.
Jenkinson compares the extent of underpricing and the operation of equity markets in the three countries over the period 1985-8, and he finds that in normal trading conditions UK IPOs were underpriced by rather less than those in the other countries: the average UK IPO rose in price, relative to the market, by around 7% by the end of the first trading week, compared to around 10% for the US and as much as 55% for Japan.
Jenkinson also compares the direct costs of going public in the UK and the US. For a relatively small IPO (raising up to $10m), these costs absorb around 15% of the proceeds in the US and around 10% in the UK. There are substantial economies of scale in issuing an IPO, however, so the corresponding costs for a US IPO raising more than $100m are around 7% of the proceeds.

Jenkinson uses these international data on new equity issues to test some of the more popular theories as to why IPOs are systematically underpriced: that firms choose to have their shares underpriced initially in order to leave a good taste in investors' mouths if they ever want to raise additional equity finance in the future; or firms may signal their quality to potential investors by underpricing their IPOs. Theoretical models of the latter case assume that the owners of the firm possess private information indicating its prospects superior to that of potential investors, and that in the secondary offering the firm will sell additional shares at a price that more accurately reflects the true value of the firm.

Jenkinson uses data on all secondary equity issues in the UK from 1985 to the end of 1989, to show only 18 (or 9%) firms that conducted an IPO via a full listing in London between 1985 and 1988 had returned to the equity market by the end of 1989 and that the mean period between the IPO and secondary equity offering for these firms was nearly two years. The further information that would have emerged over such a long period should have reduced any informational asymmetries substantially, and it is hard to imagine how any `good taste' could remain in investors' mouths after such a long time. Moreover, those companies that did conduct secondary equity offerings were not, on average, particularly underpriced at their IPOs. This evidence throws considerable doubt upon `signalling' theories of IPO underpricing, and the systematic underpricing of new issues therefore remains something of an anomaly.

Initial Public Offerings in the UK, USA and Japan
T J Jenkinson

Discussion Paper No. 427 (AM)