It’s a Good and Bad Time for IPOs

What are the incentives of an investment bank in pricing an initial public offering? There is one big obvious one. You are selling the IPO to your investor clients, the mutual funds and hedge funds and asset managers who buy the stock. You want them to be happy, because they are big repeat customers who pay you a lot of money (in trading commissions, prime brokerage, etc.) and whom you need to buy future IPOs. They want the price to be low, so that it goes up a lot, so that they can make money. So there is a big obvious incentive to price the stock low. If the banks know that the “true” value of the company—the price where it will settle after the first day of trading—is $25, they might want to price it at $15, so the people who buy it can make a lot of money.

There is another big one but it is less obvious how it cuts. You want your issuer client—the company selling the stock—to be happy, because (1) it is paying your fees for the IPO, (2) you hope it will be a repeat customer for investment banking business (though it probably won’t do another IPO), and (3) you hope that other issuers will want to do IPOs with you, so you want testimonials from happy customers. So you want the issuer to be happy. But what will make it happy? You might think that since the issuer is selling stock it will want a high price, and that is basically true; investment banks compete for IPO mandates in part by flattering companies that they will get a high valuation. Companies want to sell stock at high prices, and telling them that you can do that—and then doing it—is a way to have a good IPO business.