The under-pricing of initial public offerings (IPOs) has puzzled researchers for decades. First-day returns average around 15 percent, translating into billions of dollars left on the table by issuers and picked up by investors allocated shares in the IPO.  The literature has found support for two broad theories explaining this phenomenon.  One is an informational theory, where investors “earn” allocations by providing valuable information during the IPO process and by engaging in helpful behavior such as holding shares long-term.  The other is a quid pro quo theory, where investors are granted allocations as payback for generating non-IPO related commissions to the underwriters.  Evaluating these two theories has important implications for regulatory policy.  If the under-pricing serves an economic function, regulators should recognize this informational role when considering reforms to IPO markets and not focus exclusively on preventing quid pro quos.

In a new paper, we explore how investor feedback before book-building influences IPO pricing and allocations, finding that precise, optimistic feedback narrows the price range and drives the offer price upward.  Our findings shed light on the historically opaque role of early investor engagement in shaping IPO outcomes, providing strong and novel support for informational theories.

The seminal work of Benveniste and Spindt (1989) proposes that underwriters address information asymmetry by compensating investors with under-priced shares in exchange for revealing their private valuations of those shares. This “information revelation” theory suggests that discretionary allocations – unavailable in auctions and direct listings – serve an important information-gathering function. However, empirical support for the hypothesis remains inconclusive, primarily because researchers have examined book-building data only (i.e. the collection of demand bids during the two weeks before IPO pricing) and relied on indirect proxies such as price-limited bids to measure information revelation (Cornelli and Goldreich 2001; Jenkinson and Jones 2004). This has prompted questions about the timing and mechanisms of information exchange in IPOs (Jenkinson and Jones 2009) and has led researchers to conjecture that some degree of information revelation is likely to occur before book-building begins (Jenkinson and Jones 2004; Jenkinson, Morrison et al. 2006).   Recent work provides indirect support for this conjecture (Jenkinson et al. 2018; Gustafson et al. 2023) but data limitations have meant that the content and impact of pre-book-building interactions remain largely unobserved.

In our paper, we address this gap in the literature by examining an extensive private dataset of informational interactions that occur before book-building, during a two-week phase unique to European IPOs known as pre-deal investor education (“PDIE”).  This phase begins when the IPO goes live, typically after testing-the-waters meetings have concluded and before the price-range prospectus is published (see Figure 1 below).  The other significant feature (and key point of difference with U.S. practice) is that PDIE begins with a wide dissemination of analyst reports on the IPO firm, establishing a valuation range, and thus stimulating investor interest.  These twin factors, research dissemination and PDIE, mean that Europe is an ideal laboratory to study pre-book-building interactions.[1]

Figure 1:  European and U.S. IPO timelines and the PDIE phase

We exploit the richness of our data to address two major questions. First, does information revealed by investors during PDIE influence IPO outcomes?  Second, are investors rewarded for this early information disclosure through favourable share allocations?

Our European sample reveals extensive investor outreach during PDIE. On average, over 680 investors are contacted per IPO. More than 72 percent of them are located outside the issuer’s home country.  Nearly 80 percent of contacted investors express their views on the IPO’s prospects. These views include both qualitative feedback (e.g. opinions on the issuer’s strengths, weaknesses, market risks, and timing preferences) and quantitative feedback (e.g. the intention to submit bids during book-building and the size of such bids). Additionally, about 25 percent disclose their valuation of the issuer. We also have comprehensive data on investor bidding during book-building and on share allocations at the end of book-building.

To address potential endogeneity concerns, we use a two-stage selection model with an instrumental variable. Our instrument – the introduction of new direct airline routes between underwriter and investor locations – provides exogenous variation in the likelihood that information will be shared. The economic logic is straightforward: Shorter travel times facilitate face-to-face meetings between underwriters’ analysts and investors without directly affecting IPO outcomes. First-stage results confirm that direct flight connections increase the probability of valuation feedback by approximately 7 percentage points.

We first ask whether information revealed by investors before book-building influences IPO outcomes. We find investor engagement during PDIE substantially improves pricing precision: A one standard deviation increase in contacted investors narrows the book-building price range by 2.15 standard deviations; a one standard deviation increase in the fraction providing feedback narrows the width by 1.52 standard deviations.  This effect is economically meaningful, representing a reduction in pricing uncertainty that translates to more efficient capital allocation. Equally important, PDIE participation does not produce merely cheap talk. Investors who provide feedback are 12 percent more likely to submit bids during book-building, and their bids are systematically larger than those from non-contacted investors. Furthermore, we find the effect of PDIE feedback extends beyond the setting of the range.  Our evidence suggests that it helps shape the final IPO price even after accounting for book-building demand, deal characteristics, and market conditions.  These results highlight the unique value of PDIE feedback in improving pricing efficiency even after book-building phase, lending strong support to the information revelation theory of IPO pricing.

We then ask whether investors are rewarded for providing PDIE feedback. We find that they receive significantly higher “normalized rationing” (i.e. the relative scale-back of each investor, see Cornelli and Goldreich 2001) than those not contacted. Moreover, among the contacted investors, those who provide feedback and disclose valuations, and especially those who put higher values on the shares, secure the most generous allocations.  We also confirm that such allocations are more profitable.  This is important since larger allocations may feature more prominently in IPOs exhibiting lower expected first-day returns, potentially offsetting the economic benefit of such allocations.

Our main contribution is to introduce PDIE into the literature examining the impact of information on IPO pricing. We add pre-book-building interactions to the list of important determinants of the IPO information paradigm. These include informative prospectuses (Hanley and Hoberg 2010) that are plainly written (Loughran and McDonald 2014) and contain some proprietary information (Boone et al. 2016), advertising spending (Grullon et al. 2004), media coverage (Liu et al. 2014), SEC comments letters (Lowry et al. 2020), the use of investor-relations consultants (Chahine et al. 2020), press releases (Dambra et al. 2023), prospectus dissemination (Gustafson et al. 2023), senior executives’ language and tone during roadshows (Blankespoor et al. 2023), and roadshow attendance (Gustafson et al. 2024).

PDIE’s unique information-sharing setting distinguishes our findings from those of other studies. Previous research has examined more general effects of pre-IPO communication through traditional media (Bajo and Raimondo 2017; Bushee et al. 2020) or new technologies (Welch 2022).   Since we focus on private information revealed by investors, our paper relates more closely to studies showing the value of in-person access to managers (Green et al. 2014; Bradley et al. 2022; Cicero et al. 2023).  In this sense, our paper contributes to the emerging field of social economics and finance, which proposes that investor sentiment is a social phenomenon influenced by how investors communicate with one another (Hirshleifer 2020).

Our results carry important practical implications for market participants and regulators. For issuers and underwriters, encouraging early-stage feedback from investors may reduce information asymmetries, improve valuation accuracy, and minimize under-pricing. From a regulatory perspective, routine early-stage investor engagement could improve market efficiency and pricing accuracy, especially in the U.S., where such practices remain limited despite being allowed under testing-the-waters provisions.

Our paper highlights the transformative role of early investor feedback in IPO pricing and allocation. It bridges theoretical gaps in the IPO literature, offers actionable insights for market participants and regulators, and redresses the balance toward information-revelation explanations of IPO pricing and away from the agency explanations that have been the focus of many recent studies.

ENDNOTE

[1] Differences between European and U.S. IPO processes are examined in the London Stock Exchange 2024 report “Superior IPO Price Discovery Mechanisms in the UK vs US”: https://www.lsegissuerservices.com/spark-insights/fpUz2dp4DFJ96MgttrPYtz/superior-ipo-price-discovery-mechanisms-in-the-uk-vs-us

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This post comes to us from Anantha Divakaruni at the University of Bergen, and Howard Jones and Emmanuel Pezier at Saïd Business School, University of Oxford.  It is based on their recent paper “Early Price Discovery in IPOs,” available here.