Do Underwriters Create Value for Issuers by Subjectively Determining Offer Prices?

Many existing theories attempt to explain initial public offering (IPO) underpricing by suggesting that underwriters purposefully set offer prices below market value. These theories implicitly assume that underwriters have perfect foresight and can, with complete accuracy, place a value on issuing firms. This chapter evaluates this assumption by comparing offer prices set by underwriters to prices from three objective, valuation-based approaches. Relative to these estimates, the offer prices chosen by underwriters result in lower levels of underpricing, suggesting that the prices underwriters select are actually value creating for issuing firms in that they reduce the opportunity cost of issuance. Within these existing theories, there is an implicit assumption that underwriters possess perfect foresight, meaning that they are able, with certainty, to determine the fundamental, or market, value of an issue. It is also commonly believed, and admitted, that underwriters make subjective adjustments to estimated values in order to select a final offer price. If the assumption of perfect foresight is correct, then these adjustments, given the average positive levels of underpricing that exist, suggest that underwriters actually reduce proceeds to issuing firms by purposefully offering issues at below market value.