Is underpricing a deliberate choice? Evidence from Germany

Abstract

This study tests whether underpricing is subject to the controlling shareholder group's discretion in a sample of German IPOs from 1997 to 2002. This question is important since previous researchers (Allen and Faulhaber (1989), Welch (1998), Grinblatt and Hwang (1989), Brennan and Franks (1997) and others) have relied on the assumption that underpricing is a deliberate choice. Regression results indicate that control by insiders has a positive impact on underpricing. Additionally, if insiders are in control, the relative marginal costs of underpricing that are borne by them have a negative impact on the extent of underpricing. In contrast, for outside block holders, no significant relation exists. This paper introduces the issuer's insurance hypothesis as a potential explanation for this result. These findings are robust to a 3SLS estimation of underpricing and relative marginal cost of underpricing, and are also robust to different definitions of control. Furthermore, underpricing has a simultaneous negative impact on the marginal cost of underpricing at the IPO, suggesting that insiders adapt to an expected level of underpricing. Overall, the results indicate that insiders are trading off the extent of underpricing with its potential costs, which implies that underpricing is a deliberate choice and that ownership and control issues matter for the extent of underpricing.