Underpricing, Institutional Investors and the JOBS Act

Underpricing in IPOs, which is the first day stock price return, is a significant cost to the issuers of raising capital. The money left on the table also attracts attention from different financial players such as institutional investors and big underwriters for its profits and commissions. This paper reviews two hypotheses for IPO underpricing, the general information asymmetry theory that ‘underpricing’ is a consequence of investors needing to be compensated for uncertainty about the quality of the firm, and the more practical underwriter-institutional investor collusion that may explain the increase in underpricing in recent years. By studying underpricing in the context of the JOBS Act, a natural policy experiment that significantly reduces IPO disclosure requirement and yet increases the communication between institutional investors and issuers, I find that the JOBS Act increases the overall IPO underpricing 18 months after it was passed in 2012 compared to the same period before, in line with the traditional adverse selection phenomenon. However, empirical analysis shows underpricing also increases correspondingly with the rise in proportional shares of institutional investors in post-Act period, which supports the collusion hypothesis. The overall conclusion shows strong side effect of JOBS Act in terms of increasing underpricing to issuers and as a result more lucrative underwriting business.