Credible Underwriting and Reputation: Non-Contradiction of Higher IPO Underpricing

Abstract

Suppose IPO underpricing increases with underwriters' reputation. This study demonstrates higher underpricing is compatible with higher credibility of underwriting by reputable underwriters. Consistent with stated inference, increase in valuation uncertainty risk, and severity of adverse selection problems induces greater dampening of IPO underpricing in populations of reputable underwriters. A formal model provides theoretical support for optimality of dampening of underpricing in response to increase in combination of adverse selection problems and valuation uncertainty risk. In presence of study findings, credibility of underwriting, equivalently reputation of underwriters cannot be unambiguously inferred from underpricing levels. Formal theory and empirical findings show a risk parameter derived from the Fama-French HML (high minus low book-to-market) factor is a good proxy for intertemporal variations in severity of adverse selection problems and valuation uncertainty risk.