At a CEPR lunchtime meeting on 24 September, Tim Jenkinson compared the pricing of initial public offerings (IPOs) for the UK, the US and Japan. Dr Jenkinson is Fellow and Tutor in Economics at Keble College, Oxford, and a Research Fellow in the Centre's Applied Microeconomics programme. His talk was based on CEPR Discussion Paper No. 427, `Initial Public Offerings in the UK, USA and Japan', published as part of the Centre's `International Study on the Financing of Industry', funded by the Anglo-German Foundation, the Bank of England, the Commission of the European Communities, the Esmée Fairbairn Charitable Trust, the Japan Foundation, Lloyds Bank and the Nuffield Foundation. Financial support for the meeting was provided by the Economic and Social Research Council. The opinions expressed by Dr Jenkinson were his own, however, and not those of the above funding organizations nor of CEPR, which takes no institutional policy positions.

Jenkinson argued that an important function of stock markets is to enable firms to `go public' in a reasonably efficient manner. Firms usually obtain a stock exchange listing at the time of the initial public offering (IPO) of their equity. Firms go public for a variety of reasons: to raise new equity finance to facilitate future investment; to enable the original owners of the firm to realize some of their investment (thus serving as an important `exit route' for the entrepreneur); to gain access to additional equity finance in the future via secondary issues; and in order to participate more fully in the mergers and acquisitions process, as their shares become more widely acceptable as a means of payment.

Jenkinson noted that IPOs in the UK, the US and Japan are typically priced at a discount relative to their subsequent trading price. Some of the most spectacular examples in the UK have been privatizations, and the large discounts observed on IPOs in Japan have had both economic and political repercussions. In the wake of the Recruit Cosmos IPO, they have led to the introduction of new rules to regulate the market. Selling shares in a firm at less than their market value entails a transfer of wealth from the original owners to the purchasers of the shares at the IPO. Such underpricing may be regarded as an indirect cost of issuing equity finance, in addition to direct costs of going public (legal fees, underwriting commissions, taxes and accountancy costs), which are also substantial.

Under current regulations in the UK, the public are invited to subscribe for shares directly, which necessitates a lag between pricing and allocation, while in the US and Japan, an IPO is typically distributed via a broker, who will enter into a commitment to buy a certain number of shares, so that the price can be set at the last moment in order to take into account any last-minute market movements.

Jenkinson reported, however, that over the period 1985-8 in normal trading conditions UK IPOs were underpriced by rather less than those of 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. Also, the UK experienced a `hot issue' period between the `Big Bang' and the October 1987 crash, during which average new-issue underpricing rose to about 25%.

Jenkinson also compared the direct costs of going public in the UK and the US and found that for a relatively small IPO (raising up to $10m) these costs would absorb around 15% of the proceeds in the US (largely in the form of the selling commission due to the brokers), compared to around 10% in the UK, where the distribution system does not require large selling commissions. There are substantial economies of scale in making an IPO, however, so that the corresponding costs of raising more than $100m are around 7% of the proceeds in the US. Jenkinson argued, however, that the proposed changes to the rules governing IPOs in the UK in particular the proposed `Intermediaries' Offer' will present firms with an important new option when deciding if and how to go public, by encouraging a new form of share promotion and retail distribution through brokers.

Jenkinson presented the results of using these international data on new equity issues to test some of the more popular theories as to why IPOs are systematically discounted. In particular, he rejected the `winner's curse' explanation, which suggests that a discount is necessary in order to induce relatively uninformed investors to participate in IPOs. This is because informed investors will only participate in the market if the price of an IPO is set below the true value of the firm. As a result, uninformed investors are likely to be rationed in their demands for underpriced IPOs (witness the over-subscription of some privatizations), but they find that their bids for overpriced IPOs are met in full: hence the winner's curse. The only way to encourage uninformed investors to enter the market is to price IPOs, on average, at a discount. The evidence for the UK does not fit this theory well: Jenkinson found that placings which are sold only to institutions, who should be considered as informed investors are discounted by 50% more than offers for sale which are offered to the general public.

Jenkinson also found that there is little evidence to support the view that firms might choose to have their shares offered at a discount in order to signal their quality to potential investors. According to such arguments, a discounted IPO might leave `a good taste in investors' mouths' should they want to raise additional equity finance in the future. Jenkinson noted that data on all secondary equity issues in the UK over the period 1985-9 show that 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 on the prospects of the firms that would have emerged over such a long period should have considerably reduced any informational asymmetries, and it is hard to imagine that any good taste would still be lingering 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, since the mean underpricing was 12.2% for the sample as a whole, but only 8% for the firms that returned to the market; and 8 of the 18 companies were actually overpriced when they went public.