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...le, of which $9 million would have been his. Now he should be mad: he has been diluted, and there is no offsetting good news. In fact, his $117 million ex post holding of Netscape is below the $121 million he had expected a few 8 weeks earlier. We conjecture that he would be much more upset at the investment bankers for leaving $32.5 million on the table in this scenario than he was when $151 million was actually left on the table, but accompanied by the good news that his wealth had increased by 350% in a matter of weeks. This intuitively plausible feeling can be formalized. Prospect theory [Kahneman and Tversky (1979), Shefrin and Statman (1984)] is a descriptive theory of choice under uncertainty, and is not based upon normative postulates about the way people should behave. Each individual has a value function, which is similar to a utility function, but the value function is defined in terms of gains and losses, rather than levels. The value function is illustrated in Figure 3. The value function is concave in gains and convex in losses, with the function being steeper for small losses than for small gains (loss aversion). In the context of going public, gains and losses are computed relative to the pri...

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...e in this component of his pre-tax wealth in the course of a few weeks. So at the same time that he discovered that he had been diluted more than necessary due to the large amount of money left on the table, he discovered that his wealth had increased by hundreds of millions of dollars. Would many people be upset if they found themselves in this situation? Most of the time that there is a large stock price runup, the offer price has been increased above the file price range. The empirical pattern that the first day return is related to the revision 3 in the offer price was first documented by Hanley (1993). IPOs where the offer price is revised upwards see much higher first-day price jumps, on average, than those where the offer price is revised downwards. The magnitude of the difference is large: issues where the final offer price is below the minimum of the file price range have average first-day returns of 4%, whereas those that are priced above the maximum of the file price range have average first-day returns of 32%. The received wisdom among academics for why this partial adjustment exists is based upon the Benveniste and Spindt (1989) model of IPO underpricing. This dynamic information a...

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...7, we show the average firstday return by month for the same period as in Figure 6. For the March 1991 to August 1998 10 Maksimovic and Unal (1993), however, do not find predictability when examining the first-day returns on the IPOs of mutual financial institutions converting to stock ownership. The offer price for these IPOs must be approved by regulators. 13 period, the first-order autocorrelation of monthly average first-day returns is 0.50 (p-value = 0.0001), and the second-order autocorrelation is 0.18 (p-value = 0.089). This persistence has been previously documented in the literature (Ibbotson and Jaffe (1975), Ibbotson, Sindelar, and Ritter (1994)). Not surprisingly, there is contemporaneous correlation of monthly average firstday returns and the average revision in the offer price during a month. The contemporaneous correlation coefficient is 0.77, which is significantly different from zero with a p-value of 0.0001. 6.b. The dynamic information acquisition and prospect theory predictions There are a number of alternative explanations for why underwriters do not fully adjust the offer price to information about the state of demand. These theories are not mutually exclusive. The Benveniste-Spindt (...

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... below, one-half within, and one-quarter above the file price range. Since our sample includes only completed deals, withdrawn offerings, most of which would have been priced below the minimum, are not reflected in the proportions. Figure 1 presents a histogram of the first-day returns. During 1990-1998, less than 1.0% of IPOs doubled in price on the first day (the proportion has been much higher after 1998). Sixteen percent of IPOs close the first day at the offer price, a feature widely attributed to stabilization activities on the part of underwriters [see Hanley, Kumar, and Seguin (1993), Jenkinson and Ljungqvist (1996, p. 76), and Aggarwal (2000)]. 6 3. The partial adjustment phenomenon Table 2 illustrates the “partial adjustment phenomenon,” first documented by Hanley (1993). In this table, we categorize IPOs on the basis of the final offer price relative to the original file price range. Table 2 reports that the average IPO left $9.1 million on the table, a number that works out to an aggregate of over $27 billion in 1990-1998.3 For those IPOs priced below the file range, the mean amount is $1.5 million, and the median amount is only $0.2 million. For those priced within the file range, the mean is $6.4 ...

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...nward revisions from month to month. Indeed, we can compute the average percentage change from the midpoint of the file price range to the final offer price each month. The first-order autocorrelation of this series of monthly observations is 0.61 (p = 0.0001), and the autocorrelation at two lags is 0.28 (p = 0.0075). Information about previous first-day returns, which of course is public information, can be used to predict the average first-day return in a month. In Figure 7, we show the average firstday return by month for the same period as in Figure 6. For the March 1991 to August 1998 10 Maksimovic and Unal (1993), however, do not find predictability when examining the first-day returns on the IPOs of mutual financial institutions converting to stock ownership. The offer price for these IPOs must be approved by regulators. 13 period, the first-order autocorrelation of monthly average first-day returns is 0.50 (p-value = 0.0001), and the second-order autocorrelation is 0.18 (p-value = 0.089). This persistence has been previously documented in the literature (Ibbotson and Jaffe (1975), Ibbotson, Sindelar, and Ritter (1994)). Not surprisingly, there is contemporaneous correlation of monthly average firstd...

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...erring, due to the red letters on the cover page identifying it as preliminary) is then distributed to potential investors. The firm may file further amendments as well. The S.E.C. mandates that the final offer price must be within a range of 20% below the minimum to 20% above the maximum of the latest file price range. Our use of 15 trading days (three weeks) is a minimal measure of the length of time between the setting of the original file price range and the offer date. 12 return is 18.5%. The ability of recent market movements to predict first-day returns has been documented for decades [Logue (1973, Table 1), Hanley (1993, Table 3), Benveniste, Wilhelm, and Yu (2000, Table 3)].10 Thus, underwriters do not fully adjust the offer price with respect to public information. Indeed, the evidence suggests that there is very little adjustment of the offer price with respect to market movements. The difference in average value-weighted market returns between our top and bottom categories in Table 3 is 5.52%. The difference in average first-day returns is 8.47%. Following market rises, issuers leave more than twice as much money on the table as following market declines ($12.7 million versus $5.6...

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...t return is the only publicly available information, we derive a first-order autocorrelation coefficient in the vicinity of 0.1 to 0.2. Although positive, these values are noticeably below the empirical coefficient of 0.50. In our analysis, we do not include publicly available information about industry returns. The extreme underpricing of many internet IPOs in 1999, at the same time that most non-internet IPOs are not severely underpriced, indicates that industry factors are economically important. Inclusion of lagged industry returns would undoubtedly increase the predicted autocorrelation. Lowry and Schwert (2000) document that there is much more of an adjustment downwards following market declines than upwards following market increases. In Panels B and C of Table 5, we confirm this. Panel B reports regression results for IPOs following market declines. The coefficient of 1.51 (t-statistic of 4.58) on the market return in row 2 shows that 21 when the market declines by 1%, the offer price is cut by 1.51%, on average. Panel C reports regression results following market increases. The coefficient of 0.50 (t-statistic of 1.80) on the market return in row 2 shows that the offer price is increased only min...

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... on the table. When demand is unexpectedly weak, issuing firms negotiate more aggressively, leaving little money on the table. The structure of the rest of this article is as follows. Section 2 describes the data used. Section 3 describes the partial adjustment phenomenon. Section 4 provides a prospect theory explanation for why issuers aren’t upset. Section 5 presents an explanation of why underwriters intentionally underprice IPOs, on average. Section 6 addresses the question of why offer prices 1 In a Wall Street Journal article on an S.E.C. probe of mutual funds overpaying on commissions, Lucchetti (1999) states “Other fund executives point out that higher commissions can be justified by… the access they can provide to initial public stock offerings.” 2 The objective function of the investment banker can be viewed as benefiting from underpricing, provided it is not carried to an extreme (see Beatty and Ritter (1986) and Dunbar (2000)). If certain conditions are satisfied, models with intertemporal maximization problems predict that some issuers may want to intentionally underprice. These models, however, do not account for dynamic price adjustment between the file price range and the final off...

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...better about two gains than about one gain of twice the size. Because of the convexity of the value function for losses, two related losses will be integrated. But for a gain and a loss, whether the individual feels better by integrating or segregating the events depends upon their magnitudes. The lines demarcating the integrate and segregate regions of the second and fourth quadrants in Figure 4 are below the 45 degree line because of the loss aversion feature of prospect theory. By 6 The June 29, 1999 IPO of e-Loan is described in the cover story of the Sept. 6, 1999 issue of Business Week [Hof (1999)]. In the article, company president Janina Pawlowski boycotts the pre-IPO dinner sponsored by the lead underwriter, Goldman Sachs, because she and the other members of the management team are upset with Goldman for choosing a $14 offer price. In the face of strong demand (the offer was oversubscribed 26 times) following the roadshow, the issuers had argued for a $16 offer price at the pricing meeting. The original file price range was $11 to $13, so this seems to be inconsistent with our prospect theory explanation. But the key is that management anchored not on the $12 midpoint of the file p...