IPO Pricing Theory: Underpricing, Hot Issue and Long-Run Returns

IPO underpricing — the tendency for IPO shares to trade significantly above the offer price on day one — is a persistent global phenomenon. The theoretical explanations include: information asymmetry (issuers underprice to compensate investors for the risk of adverse selection), signalling (high-quality issuers underprice to signal their quality, planning to recoup the ‘money left on the table’ through higher valuations in secondary offerings), and litigation risk reduction (underpricing reduces the probability of post-IPO lawsuits alleging that the offer price was inflated). The average first-day return for Hong Kong IPOs is approximately 5-10%, lower than the US average of 15-20%, reflecting the role of cornerstone investors in price discovery. For founders, underpricing represents dilution — they sell shares at below the market-clearing price. For investors, underpricing is the reward for bearing the risk of buying into an untested public company. The optimal level of underpricing from the issuer’s perspective is ‘enough to create a stable aftermarket but not more than necessary’ — a famously difficult balance to strike.