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Diversification of Investor's Expertise in IPOs

Bourjade, Sylvain (2002): Diversification of Investor's Expertise in IPOs.

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Abstract

In most Initial Public Offerings (IPO) in the world, the underwriter selects syndicate members and uses the information of their investors' clientele to set the offering price. The objective of this paper is to develop a model of the "book building" process in which the formation of the syndicate is an endogenous decision variable. More specifically, I will examine in which cases the lead underwriter will benefit from selecting syndicate members with different investors clientele characterized by a specific line of expertise. I model the fact that different investors have different lines of expertise in assuming that the uncertainty about the value of the shares has two dimensions. One may think about those two dimensions as information elicited from retail and institutional investors. Another interpretation may be that the first dimension is an industry-specific information and the second one, information from a local underwriter. A lead underwriter may also value both particular information about the issuer and indications of interest from key institutional investors coming from previous relationships of a syndicate member. In previous IPO's models with one dimensional uncertainty about the value of the shares, the underwriter must underprice shares to extract information from investors. Informational rents are therefore concealed to these investors in order to induce them to reveal their information and this results in underpricing. In this multi-dimensional context, I prove that it is not always optimal for the decision-maker to acquire all available information about the value of the shares. When deciding which syndicate's organization she wants to implement, the underwriter faces a trade off between the cost of extracting information and the informational efficiency. I show that it is optimal for the lead underwriter to select syndicate members having investors' clienteles with different lines of expertise when she faces a great informational problem, when she values more price accuracy, when the firm going public is more transparent, riskier, and when the capacity of the retail investors increases, which is consistent with the empirical evidence.

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