A New Test of the Signaling Theory of IPO Underpricing

Abstract

This study leverages on a new model of IPO signaling theory in Obrimah (2017a) to develop an empirical algorithm that enables tests of signaling theory within which the incentive to signal private information is a conditional, as opposed to an unconditional incentive. Suppose comparable high or low quality firms issue new public equity in close proximity, with high quality issuers choosing to signal private information. Empirical results show signaling of private information by high quality issuers enables positive post IPO price drift. Consistent with quality rationales for signaling of private information, conditionally identified signalers are characterized by significantly smaller SEO underwriting and gross spreads or higher SEO underpricing in relation to non-signaling lower quality issuers. Consistent with predictions of prior models of IPO signaling theory, the empirical algorithm yields larger SEO proceeds for signalers in relation to non-signalers. Comparisons of forecast power show the conditional formulation of signaling incentives far outstrips unconditional formulations at predicting SEO activity. Combined, empirical findings indicate formulation of signaling incentives as conditional as opposed to unconditional incentives in Obrimah (2017a) renders IPO signaling theory, hitherto discredited by empirical findings in Jegadeesh et al. (1993), a viable theory for explaining cross-sectional differences in IPO underpricing.