Initial Public Offerings: Going By The Book

In the U.S., and increasingly in other countries as well, IPO securities are marketed to investors in a process known as “book‐building”—one that amounts to polling institutional investors to establish a demand schedule for the issue and then allotting stock to individual investors according to the strength of their professed interest. Although book‐building methods require use of discriminatory tactics that have attracted strong criticism from investors and regulators, this article defends such practices by demonstrating that book‐building is more efficient than alternative methods. It effectively allows issuers to increase the net proceeds of their offerings by making better use of information about market demand conditions. In the process of explaining the efficiency of the book‐building method, this article also offers a plausible explanation for a phenomenon that has long puzzled economists: the systematic underpricing of IPOs. The key to the success of a book‐building effort lies in the use of a strategic pricing and allocation policy designed to offset the investor's incentive to understate his or her interest in an IPO. By committing to favor investors who provide strong indications of interest with relatively large allocations of underpriced shares, the investment bank can limit the distortion of investor's incentives in bidding and so increase the level of proceeds the issuing firm can expect to generate from its IPO.