Initial Public Offerings and Underwriter Reputation

TLDR

IPO returns compensate uninformed investors for the risk of trading against superior information, and lower risk reduces the incentive to acquire information, leading to fewer informed investors. The study examined returns earned by subscribing to equity initial public offerings (IPOs). IPOs with more informed investor capital demand higher returns, while prestigious underwriters—indicating higher informed activity—are linked to lower‑risk offerings and consequently lower IPO returns.

Abstract

This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of "informed" activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns.