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Book Building vs Fixed ddd

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Benveniste and Walid Y. Busaba Source: The Journal of Financial and Quantitative Analysis, Vol. 32, No. 4 (Dec., 1997), pp. 383-403 Published by: Cambridge University Press on behalf of the University of Washington School of Business Administration Stable URL: http://www.jstor.org/stable/2331230 . Accessed: 10/09/2013 23:52

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Fixed

Price: for

An

Analysis IPOs

of

Marketing Y. Busaba*

and

Walid

Abstract We compare two mechanisms for selling IPOs, the fixed price method and American book? building, when investors have correlated information and can observe each other's sub? scription decisions. In this environment, the fixed price method is a strategy that can create cascading demand. Alternatively, an underwriter building a book aggregates investor infor? mation into the offer price. We find that bookbuilding generates higher expected proceeds but exposes the issuer to greater uncertainty, and that it provides the option to sell additional shares that are not underpriced on the margin.

I.

Introduction

A debate has arisen in the international arena regarding the best way to price and place Initial Public Offerings of Equity (IPOs). At the center of the debate is the fixed price method, which has historically been the dominant approach in the UK and its former colonies (e.g., India and Singapore) and in most of Europe. The debate has been fueled by an acceleration in the number of IPOs done in some markets and movements toward privatization that have resulted in some unusually * Trends large issues. suggest that American bookbuilding is becoming the method of choice.2 *Finance CarlsonSchool of Management, Department, Universityof Minnesota,Minneapolis,MN 55455, andFinanceDepartment, College of BusinessandPublicAdministration, Universityof Arizona, Tucson, AZ 85721, respectively. We have benefitedfrom the commentsof BhagwanChowdhry(the at Boston Jose Suay,Bill Wilhelm,and seminarparticipants referee),Jeff Coles, George Papaioannou, College, Rice University,Universityof Michigan,Universityof SouthernCalifornia,FederalReserve Bank of New York, the 1995 meeting of the Financial ManagementAssociation, the 1996 Arizona Symposium at the Universityof Arizona, the 1996 meeting ofthe WesternFinance Association, and the 1997 meeting ofthe Multinational Finance Society. ^he handlingof the IPO of SingaporeTelecommunications Pte Ltd. is a good example. Tradi? tionally, IPOs in Singaporehave been done accordingto British company law, which mandatesthat IPOs be distributedby the fixed price method (Koh and Walter (1989)). But Goldman Sachs, the global coordinator,placed approximatelyone-half of the issue using a book of orders. The rest was distributeddomestically accordingto the traditionalfixed price evenhandedmanner(The Wall Street Journal,3/4/93 (A, 10:2), 8/18/93 (A, 7:6), and 9/27/93 (B, 4D:6)). 2See, for example, "Goingby the Book,"The Economist,January 9,1993, p. 72, "The 1995 Guide to Germany,"published with the April 1995 Issue of Euromoney,and "Don't Blame Us?It's the Markets," Euromoney,May 1995. See also Loughran,Ritter,and Rydqvist (1994) for a discussion of the recent developmentsin the new equity marketsabroad. 383

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384

This paper compares the fixed price method and American bookbuilding when investors have correlated information and can observe each other's subscription In such an environment, the fixed price method is a strategy that can decisions. create cascading demand. Alternatively, an underwriter building a book attempts to aggregate investor information into the offer price before the offer is sold. We find that bookbuilding generates higher expected proceeds but exposes the issuer to greater uncertainty, and that it provides the option to sell additional shares that are not underpriced on the margin. The challenge in any offering mechanism is price discovery: at what price will the issue sell? Consider, for example, the degree of price uncertainty in the U.S. primary market. Preliminary prospectuses filed with the SEC for firm commitment offerings specify an offer price range that, on average, spans 16% around the midpoint (Hanley (1993)). The main difference between the two selling methods lies in how they address the pricing challenge. Fixed price offerings are priced without first soliciting investor interest. Investors then make subscription decisions over a period that can typically range from two weeks to two months. In contrast, an underwriter building a book solicits non-binding contingent orders (indications of interest) during road shows, that provide information for setting the final offer price.3 Our analysis builds on the market structure developed by Welch (1992), and our modeling of the fixed price method mirrors his. Welch models a fixed price offering to investors who possess equally valuable, correlated pieces of information about the true (common) after-market share value. Selling is sequential, allowing the purchasing (or subscription) decisions of early investors to be informative for, and, hence, to affect the decisions of, the later investors. As such, investors approached earlier in the selling process would inherently have greater market power and, as Welch illustrates, can generate cascades through their investment decisions. The fixed price method uniquely offers the potential to exploit this market structure (and avoid information aggregation) by pricing the issue low enough to lure early investors and generate an immediate buying frenzy. Sequential selling is also a way, as Welch argues, to avoid the winner's curse problem that uninformed investors potentially face (Rock (1986)) when subscription decisions are simultaneously made and rationing is a function of aggregate subscription. We compare the results of this pricing strategy to the results of using an The underwriter to sell the issue through bookbuilding to the same investors. underwriter, by collecting and publicizing investor information, diffuses any pos? sibility of a cascade. And he has to pay a price, in the form of issue underpricing, to induce truthful indications of interest (Benveniste and Spindt (1989)). Yet, our analysis shows that the underpricing required to create a cascade is higher than the cost required to elicit investor information. We also find, however, that pricing an issue off a book may result in an offer price below that which creates a cascade in 3The rules for allocating shares can also differ. In fixed price offerings, share allocations can be (e.g., UK (offers for sale), Finland,Hong Kong, Taiwan,and Singapore)as well as non-discretionary Italy,Japan(pre-April1,1989), Korea(postdiscretionary(e.g., Australia,Belgium, Brazil, Germany, June 1988), Sweden, Switzerland,and the US (best-effortscontracts)). See Rock (1986), and Koh and Walter(1989) for Singaporeand the UK, and Loughran,Ritter,and Rydqvist(1994) for these and the rest. Allocations are discretionaryin the bookbuildingmethod. See also Chowdhryand Sherman between differentregimes. (1996) for an analysis ofthe differencein the levels of oversubscription

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Benveniste

and Busaba

385

a fixed price offering. On the basis of these results, we conclude that the degree of price risk endogenous to the issue and the risk tolerance of the issuer are the key elements in the issuing firm's preference regarding the offering method. Additionally, we show that bookbuilding affords the issuing firm certain op? tions that are not available in the fixed price method. In particular, bookbuilding allows the issuer to exercise discretion over the offer size conditional on the out? come ofthe book. This discretion comes in two forms. First, the final issue size in are sold via bookbuilding?does U.S. firm commitment offerings?that not have to be set until after the road shows when the final offering documents, including the offer price, are filed with the SEC (Ritter (1987)). Also, firm commitment over a allotment) option that allows the offerings typically carry greenshoe (or issuance of up to 15% additional shares and can be exercised after the final offer price has been established and selling is started. We show that the option to adjust issue size permits the issuing firm to offer added shares when demand is strong, and to do so at zero marginal underpricing cost. This result is based on the observation that underpricing in bookbuilding is a required sum of money necessary to induce investors with valuable positive information to be truthful in their indications of interest. Our analysis shows that the value of the required inducement is related only to i) the effect that false indications can have on the offer price and ii) the allocation to investors falsely claiming poor information. Filling the unfulfilled demand of investors with strong interest has no effect on either of these factors and, hence, does not increase the dollar value of required underpricing. The result is that added shares are sold at full marginal value.

II.

Relation

to Other

Work

The papers of Spatt and Srivastava (1991) and Benveniste and Wilhelm (1990) show in environments different from ours that bookbuilding generates higher ex? pected proceeds than fixed price. Spatt and Srivastava work in a general auction framework in which an IPO is viewed as an indivisible good, and argue that book? building stochastically dominates the fixed price method. Benveniste and Wilhelm reach a similar result when the winner's curse is possible in an environment that admits both informed and uninformed investors (as in Rock (1986)). In both of these papers, however, sequential selling and the possibility that investors can condition their demand on the demand of others are not permitted. We admit these possibilities and, by doing so, capture the real potential for the fixed price method to generate demand cascades. As a result, bookbuilding no longer dominates fixed price. Our paper also is the first to demonstrate stochastically the option value in allowing the issuing firm to condition the offering size on the results of the book. Some markets abroad (in France, for instance) use formal auctions to sell IPOs. Both bookbuilding and fixed price, for that matter, can be viewed as special cases ofthe general class of IPO auction mechanisms available. Rock (1986), for example, modeled the fixed price method as an auction in which investors bid with their feet. To date, however, there are no general results on auctions that identify the optimal IPO selling mechanism because an IPO is divisible. (See Back and Zender

386

(1993) and Wang and Zender (1996) for analyses of auctions of divisible goods.) This paper does not attempt to solve for the optimal IPO auction. Rather, attention is focused on comparing two specific, commonly used IPO selling mechanisms. Yet we conjecture, based on Benveniste and Spindt (1989), that bookbuilding has an added advantage over any formal auction because the underwriter deals repeatedly with the same pool of regular investors and can increase revenues to the issuer by conditioning future allocations on investors' current behavior as well. The rest of the paper is structured as follows. The next section presents the basic elements of the model and Section IV develops the two competing market? ing strategies and compares their results. Section V discusses the option value of bookbuilding and Section VI analyzes the firm's preferences with regard to marketing method. The paper concludes in Section VII.

III.

The

Model

Our analysis will be carried out in a framework that most closely resembles Welch's (1992) model. This section sketches the basic elements ofthe model and includes the fundamental mathematical results that will be used later in the paper. The format and terminology will mirror those of Welch, but the notation will be closer to that of Benveniste and Spindt (1989). A. The Market Setting

In keeping with the marketing focus of the paper, our model centers on a firm selling a fixed fraction of ownership in the form of Q shares. The preliminary offering steps, such as due diligence, are assumed to be complete and all relevant information learned in the process already conveyed to the potential investors. More formally, we assume that the issuing firm knows nothing about its prospects that the potential investors do not also know. There is a total of H investors, with appetites for at most one share each, that make up the immediate market and to whom the issue must be placed to be successful. Each investor is endowed with a private signal conveying information (about the true share value) undiscovered in the due diligence period. The distinguishing marketing strategies hinge on whether or not the issuing firm (represented by its underwriter) will try to ascertain the private information of investors prior to pricing and placing the issue. The true share value, V, is assumed to be uniformly distributed between Vu and VL, where Vu > VL. This prior distribution is common knowledge, as is the issuer's reservation value Vp. Assume that Vp < VL on the grounds that private owners may be ill-diversified or alternative sources of financing may be expensive.4 We will use the same normalization as in Welch (1992), and define a corresponding unknown offering type as e = (v-vL)/(vu -vL).

4This assumption is not critical for the fundamentalresults of our paper (yet it is for Welch's cascades result), but we retainit because it makesthe exposition significantlysimpler.

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In essence, 6 simultaneously normalizes both the magnitude and variability of possible share values. It has an implied prior distribution that is uniform over the interval [0,1] with a mean of lA. The reader should note that although 6 is our focus of analysis, expressing the solution in terms of original values will provide a comparative analysis for characteristics such as the ex ante uncertainty in share value. All parties?i.e., the issuing firm, its marketing agent (referred to as the the distribution ofthe true share value. Pri? underwriter), and the investors?know vately, however, each investor costlessly observes an independently drawn signal / e {U,L}. The information content of these signals is fully captured (and ex? plained below) by the assumption that for an offering of type 6, i is drawn from a Bernoulli variable {U,L} with the probability of U being 6. So, each signal adds valuable information and in sufficient number that the signals combined can identify with high precision the true value of the shares (or equivalently, the true value of 6). Communication among investors is important because it affects their invest? ment decisions through their reservation values. In this regard, we assume, like Welch, that investors do not convey explicitly their private signals to one another, but do observe each other's purchasing decisions. Under some conditions, an in? vestor's purchasing decision may reveal his private signal and, as a result, impacts the subjective valuation of investors who follow. We also assume though, in the spirit of Benveniste and Spindt, that the underwriter can privately ask each investor about his signal and other investors cannot observe the answer.5 Investors are assumed to be risk neutral. Their reservation prices are the expected share values conditioned on their private signals and whatever additional signals they learned during the issuing process. The following subsection contains mathematical results on conditional expectations in this model that identify the relationship between reservation prices and information. Note that, formally, an investor's conditional expectation of 6 is equivalent to his reservation price. B. Mathematical Facts

Fact 1: An investor's expectation of 6, conditional on observing H signals of which h are good (i.e., U signals), is given by the following Bayesian rule, (1) 6h = E(0\h;H) = (h+l)/(H + 2).

Fact 2: Given a total of H signals, the number of good signals h can be any of H+1 possible outcomes, {0,1,2,..., H}. Based on the prior uniform distribution of 0, each outcome is equally likely with a probability of 7rh Pr(h>k;H) = = ?r(h;H) (H-k+l)7rh = and l/(H+l), = (H k +l)/(H+1),

h = 0,...,H.

5Relaxing this assumptionby allowing investorsto observe other investors'answersreduces the the same comparative proceedsfrombookbuildingbutmaintains analysisresultsbetweenbookbuilding and fixed price.

388

Since individual investors are endowed with private signals, we must con? sider how each investor perceives the distribution of signals among the remaining investors. The following results establish these subjective distributions. Fact 3: Conditional on observing a U signal, an investor believes U signals with the remaining H ? 1 investors with probability (2a) 7rfh = Y>r(h;H-l\Usigm\) on observing Pr(h;H-l\L = **+ ti\ti *) + 1) that there are h

h = 0,...,H-l.

Conditional (2b) =

<

Marketing

We can now turn our attention to the analysis ofthe two competing marketing strategies. We will start by presenting the results of doing the issue via fixed price following the approach of Welch (1992). A. The Fixed Price Method

We view a fixed price offering as an offering in which the offer price is established without first formally attempting to learn investor valuations. This characterization obviously does not preclude learning from informal discussions with and surveys of investors. Any information gleaned can be thought of as having been factored into the ex ante expectations about 6 and, hence, will have similar effects on both offering mechanisms. We assume that private information persists beyond such attempts to learn investor sentiment. investors possess pri? Establishing the offer price in this environment?when vate information?involves weighing the benefits of raising the price against the increased likelihood that the issue will not sell. We denote the offer price by P? and assume that unsold shares are worth the reservation value ofthe issuer, 6P (the normalized value of Vp). Potential investors are lined up and selling is carried out sequentially. Each investor at a time decides to purchase or not based on his reservation price. We and denote the reser? index investors by their order in line, j, where j = \,...,H, vation price and purchasing decision of each by Pj and dj, respectively. Formally, the reservation price of investor j can be expressed as a function of his signal ij and the observed purchasing decisions of the preceding j ? 1 investors, (3) Prj(ij*,dj-x,dj-2,...,dx) = E(e\ijmddj-l,dj-2,...,dl).

Investor j decides to purchase shares only if Pj > P?. The following lemma identifies when an investor's purchasing decision is informative about his signal and, hence, impacts the reservation prices of investors down the line.

and Busaba

389

decision reveals his private signal if and only if > P? > P)(Udj-X,dj-2,...,dx).

P)(U;dj_x,dj-2,...,dx)

The intuition behind the condition is simple. When (4) is met, the investor's decision depends on his signal. Hence, a decision to purchase shares at P? reflects a U signal while a decision to abstain reflects otherwise. When a point in the selling process is reached at which (4) is violated, a cascade is created as all investors down the line ignore their signals and make the same investment decision. If, for example, P? is lower than both conditional reservation prices, investor j purchases regardless of his own signal. Investory-h1, ? 1 investors, can having observed the purchasing decisions of the first j verify that (4) is not met for investor j and, as a result, cannot infer the investor's signal from his purchasing decision. He faces the same purchasing decision faced by investor j and, likewise, decides to buy shares. Similarly, all investors down the line decide to invest. If, on the other hand, (4) is violated by P? being higher than both conditional reservation prices, a negative cascade develops as investor j and others down the line refrain from investing. The incidence of cascades, therefore, can be critical for the results of an issue and the possibility of their occurrence is expected to impact the pricing decision. which all An offer price of lAor below creates an immediate positive cascade?in investors buy?since the reservation price of the first investor in line is at least /s (the 6 value conditioned on the first investor's signal being L). Symmetrically, an offer price higher than % (the 6 value conditioned on the first investor's signal being U) creates an immediate negative cascade resulting in issue failure. For offer prices such that lA <P? < 2A,the proceeds from an issue depend on the number n of investors who choose to invest in the issue. This, in turn, depends on the ordering of the signals of the investors in line, which is stochastic. At one extreme, a sufficient number of early U signals could trigger an immediate buying cascade in which all Q shares sell. At the other extreme, if the first few investors had L signals, an immediate negative cascade could occur, resulting in n equaling 0. We will let n(P?) denote the distribution of n as a function of the offer price. Expected proceeds can be formally stated as follows, E{n(P?)P? + [Q - n(P?)]6p}.

The following theorem illustrates that the proceeds maximizing pricing strat? egy involves setting the offer price at lAto create an immediate positive cascade. Theorem 1. The offer price that maximizes expected proceeds is P? = xh. n-Qat this offer price and the maximum expected proceeds are the sure value of Q/3. Proof See Welch (1992), Theorem 5, p. 707.

A simple calculation demonstrates that expected underpricing, as measured the difference between the unconditional expected share value of Vi and the by offer price of % is /e. Theorem 1 also implies that expected investor demand is sufficiently elastic at P? = xhthat an increase in price creates a drop in expected proceeds. This happens because issue failure is costly (Vp < VL) and an increase

390

in price beyond lA raises significantly the likelihood of a negative cascade. As a result, the issuer is better off with sure success. Going back to the non-normalized share values, the cascade price of lAtranslates into a price of VL + (Vu ? VL)/3, and expected underpricing becomes (Vu ? VL)/6. Simple comparative static analysis illustrates that expected un? ? VL), which measures ex ante uncertainty in the derpricing increases with (Vu offer value. Welch's Theorem 6, p. 706 shows that underpricing as a percentage of the offer price increases "when a mean-preserving spread is added to the common prior" (Theorem 3 below shows that this is also true with bookbuilding). We turn next to analyzing the results of using the bookbuilding approach to price and place this same issue. To accomplish this, we have adapted the approach of Benveniste B. and Spindt (1989) to the current framework. Method

The Bookbuilding

In building a book, the underwriter conducts a pre-offer marketing effort in which it solicits non-binding indications of interest (or pre-orders) from potential investors. The gathered indications provide an assessment of the demand for the issue that allows the underwriter to set an offer price that better reflects aggregate, or market, valuation. The issuing firm receives the gathered information before the final pricing decision, and this eliminates its informational disadvantage vis-a-vis investors. Aggregate information is also revealed to potential investors, neutralizing the power of any individual investor. But such benefits of the information gathering effort come at a cost. Investors should be induced to be truthful in re? vealing their indications of interest, as they know that these will influence the offer price. In the context of our model, we abstract from demand indications and assume that investor responses during the pre-market are simply U or L. To secure honest responses, the underwriter establishes a mechanism that conditions both the offer price and share allocations on the outcome of the book (i.e., on individual and cumulative responses), and this mechanism is fully understood and anticipated by investors. The underwriter's objective is to maximize expected proceeds, subject to investors' incentives. In light ofthe revelation principle, the underwriter restricts its attention to price/allocation schedules that induce truthful indications of interest. In our model, the outcome of the pre-market is represented by the number h of investors who revealed U. The underwriter announces this outcome to investors and then establishes a price/allocation schedule that is conditioned on both h and individual responses (all investors with the same response are treated symmetrically). At that time, all investors revise their expectation of the true issue type to #/,, and this becomes their reservation value. The following notation will be used to describe the candidate price allocation schedule: P?h = qL,h = qu,h+\ = the offer price when h of the H investors reveal U signals; the allocation to an investor who reveals an L signal when h others reveal U signals; and the allocation to an investor who indicates U when h others do the same.

Benveniste

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Before setting the underwriter's problem and solving for the optimal price/ allocation schedule, consider first the marginal value of an investor's signal. An investor misrepresenting a U signal as L drives the perceived issue type from 0h+\ to Oh. Formally, the marginal value of private information is (5) 0/h-i ? Oh =

H + 2

H +2

H +V

a decreasing function of the number of investors polled in the pre-market, H. Assuming that the after-market price will efficiently incorporate information, and that the other H ? 1 investors are truthful, the expected profit for an investor with a U signal who falsely reveals an L signal in the pre-market is H-\ (6) Y,<\e^-p?h]qL,h, h=0

where -k'his the conditional probability that h others will signal good information (derived in Fact 3). On the other hand, truthfully announcing the good information results in an expected profit of H-\ (J) I>Uft*i-n*]tt/.**h=0

Truth-telling requires that (7) be no smaller than (6). Using (5), this condition can be written as > " "" Oh-P?h +

(8)

Yt^M-^iUuMi h=0

X>* h=0

H + 2

<lL,h.

Also, since indications of interest are non-binding, the offer price can never ex? ceed the reservation price of investors (after the outcome of the pre-market, h, is revealed). That is, (9) P?h < 0h, h = 0,...,H.

The incentive compatibility constraint (8) is the source of underpricing in To the extent that investors expect to profit from understating their bookbuilding. interest in the issue, underpricing is required in some states to induce truth-telling. Determining the proceeds maximizing price/allocation schedule requires that the following problem be solved, H (10) maximize V) ** {Qh {PI'VUiJUJm} h=0 h)qLjh} (0h P?h)} , [hqu,h + (H

(8) and (9), and < < qLjh qu,h < < 1, 1, = 2, h = 0,...,H-l, h=l,...,H, h = 0,...,H.

hqu,h + (H-h)qLjh

392

Constraints (11) reflect our assumption that any investor can buy only up to one share, and the requirement that the entire issue be placed.6 The solution to this problem is described in the following theorem, Theorem 2. The maximum expected proceeds are achieved if the following con? ditions are met: 1. when h < Q, set qUjh = 1, qUh = (Q - h)/(H - h), and P?h= 0h; 2. when h > Q, set qUjh = Q/h, qLh = 0, and P?h= 6h - uh where uh is given by

E(uh) h=Q

The expected

per share proceeds that result from this strategy are given by E(P?) = V2-E(uh).

Proof. See the Appendix. This price/allocation schedule minimizes the money that should be left on the table for investors in payment for good information. Giving allocation priority in all states to investors revealing good information and underpricing only when these investors can buy the whole issue ensures that underpricing?or the payment for information?is targeted solely at investors who provide favorable pre-market Such price/allocation response. strategy, therefore, minimizes the benefit to in? vestors from falsely reporting L and, as a result, minimizes the level of underpricing required to satisfy the incentive compatibility constraint (8). Simple comparative static analysis illustrates the following two properties of underpricing. Corollary 1. For a given offer size, Q, expected underpricing decreases with H.

Proof. Substituting

As H increases, both the marginal value of information and the expected allocation to investors revealing bad information drop, reducing the expected gains from cheating (the RHS of (8)). In the limit, when the number of investors is infinite, required underpricing drops to zero.7 Corollary 2. Expected underpricing increases with (Vu ? VL).

to place less than Q shareseliminatesthe need for underpricing since 6AUowingthe underwriter the underwriter can always set qLh = 0 and drive(6) to zero. To circumventthis artificialsolution, we view Q as the minimumnumberof sharesthe underwriter needs to place for the issue to be successful. Viewing Q this way only strengthensthe cascade resultofthe fixed price method. 7Wedo not observe,however,thatunderwriters to an infinitenumberof investors.This pre-market could be explainedin the repeatedgame framework andtheirregularinvestors) (betweenunderwriters suggested by Benveniste and Spindt (1989). Also, there are direct costs that relate to the numberof investorsin the pre-marketing process.

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Proof. Using original values, the marginal value of information (5) becomes (Vu ? VL)/(H + 2), and expected underpricing, given in Theorem 2, becomes (Vu - VL)E(uh), which clearly is increasing in (Vu - VL). This result is not surprising because when ex ante uncertainty increases, the value of private information increases. Thus, the incentive to falsely reveal bad information in the pre-market rises, and the underwriter must promise deeper The following theorem underpricing to induce honest indications of interest. shows that, as in the case of cascades, underpricing as a percentage ofthe offer price increases with ex ante risk. This is consistent with the theoretical (Proposition 1) and empirical results of Beatty and Ritter (1986). Theorem 3. The ratio of underpricing ? VL). preserving spread of (Vu Proof. See the Appendix. C. Comparing the Results to the offer price increases with a mean-

The analysis above illustrates that a fixed price offering must be discounted in order to neutralize the potential adverse effect of weak early investor interest. Bookbuilding provides an alternative method for eliminating the threat of negative cascades. It allows the issuing firm to buy investor information prior to pricing and placing the issue. The following theorem compares the results ofthe two marketing methods. In Section V, we consider other potential benefits of collecting investor information prior to selling an IPO. Theorem 4. Relative to a fixed price issue, the proceeds of an issue priced and sold with a book of pre-orders will 1. have a strictly higher expected value if H > 1, but will also 2. have higher ex ante variability, if the expected proceeds maximizing strategy is followed. Proof. See the Appendix. Theorem 4 demonstrates that the cost of acquiring information in bookbuild? is lower than that of shedding the risk of negative cascades in a fixed price ing offering. Two factors underlie this result. First, the level of underpricing required in a fixed price offering is determined by the full value of the private signal of the first investor in line. In comparison, an underwriter building a book aggregates information and, hence, pays only for the marginal value of investor signals. Since investor signals are correlated, the marginal value of any of them drops with the number of signals aggregated (see (5)). Second, the payment for informa? tion in bookbuilding is further reduced by the underwriter's ability to discriminate in share allocations against investors showing weak interest. The theorem also shows, however, that the proceeds are riskier with bookbuilding because they are contingent on investor interest that is revealed in the pre-market. Also, it should be noted here that the distribution of proceeds under bookbuilding does not first-order stochastically dominate the sure cascade proceeds. For H > 2, the cascade price

394

of /a is strictly greater than, for example, 00i the offer price in bookbuilding h = 0. Theorem 4 suggests the following empirical implications. Implication 1. Average (or expected) underpricing book vs. those sold via the fixed price method.

Implication 2. Abstracting from the degree of underpricing, the absolute level of the price adjustment in the immediate after-market, or equivalently, the crosssectional variance of initial returns, is larger for fixed price offerings than for offerings sold off a book. The intuition behind Implication 2 follows from the fact that, unlike the offer price of a pre-marketed issue, the cascade offer price does not reflect investors' Hence, the price of a fixed price issue should adjust in the private valuation. after-market to incorporate such information. (immediate) The fact that firm commitment offerings in the U.S. are typically sold using bookbuilding while best-effort offerings resemble fixed price offerings provides one way to test these implications. Chalk and Peavy (1987) study a sample of IPOs from the period 1975-1982, and consistent with our first prediction, they find that average underpricing (measured by initial day return) was 19.61% for firm commitment offerings and 37.81% for best-efforts offerings. Ritter (1987) further controls for offer size and still finds similar contract effect. He also reports, indirectly consistent with Implication 2, that the time-series after-market standard deviation of returns is significantly higher for best-efforts offerings.

V.

The

Option

Value

of Bookbuilding

Our focus to this point has been on the distinctions in the cost and quality of the information garnished by the issuing firm in the two offering mechanisms. The comparison, though, has ignored the additional benefits an issuing firm can realize from the information acquired. Such benefits can be numerous, ranging from fundamental benefits in evaluating the firm's strategy (Benveniste and Busaba (1995)) to capital cost benefits, such as permitting the firm to raise additional capital at a lower cost. In this section, we demonstrate how the option to adjust offer size based on investor information provides an inexpensive method for using such information to raise additional capital. Casual observation of the IPO market and empirical work indicate that sig? nificant adjustments to the size of firm commitment offerings do take place before the final prospectus is published. Ritter (1987) analyzes the degree of price and quantity adjustments that the 1982 firm commitment issues experienced between the preliminary and final prospectuses. He reports an average change in expected proceeds of 23.8%. Likewise, Hanley (1993) documents the incidence of such pre-offer adjustments. To formalize the value of the option to adjust offer size, we now relax the assumption that this size is fixed but maintain the issuer's objective unchanged. The issuer's objective in the analysis so far has been to maximize expected proceeds But when the offer size is fixed, this objective is identical (expression (10)).

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to maximizing the expected offer price, or minimizing the expected per-share underpricing. We assume in this section that offer size can vary from a minimum of Q shares to a maximum of Q+s shares and the issuer's objective is to maximize the expected proceeds per offered share.8 For convenience, but without loss of generality (as we illustrate in footnote 9), we model the option to adjust issue size as the option to increase issue size from Q to Q + s?h,where 0 < s?h < s. Hence, s?his a choice variable that determines the optimal offer size in state h. Establishing that the option to adjust offer size has no added value in a fixed price offering is straightforward. Exercising this option during the selling process, for example, by increasing the offer size from Q to Q + s shares, is identical to choosing the larger offering in the first place. The optimal offer price when selling Q + s shares would still be the cascade price and the added shares would sell if enough investors are there. By contrast, we show below that an option to increase issue size attached to an issue done with bookbuilding can actually increase the average offer price. In fact, we suggest an optimal strategy for exercising this option and show that it effectively allows the sale of the additional shares at no discount. This strategy underlies our proposition that information acquired during a new equity issue can be used by the issuing firm to raise additional capital more cheaply. The intuition behind this result follows from the observation that the under? pricing required to ensure the success of the bookbuilding effort is determined by the value of private information, \/(H + 2) from (5), and the allocation expected by an investor who reveals weak interest. While the first factor is exogenous, a careful choice of when to increase issue size can ensure that the second factor is unchanged. In particular, if the underwriter exercises the option only to fulfill unfulfilled demand of investors with good information, the required level of to? tal underpricing need not be changed, i.e., the extra shares can be sold without increasing the expected dollar value of underpricing. To mathematically develop this intuition, we state below the underwriter's maximization problem (in which issue size is a control variable and the objective is to maximize the expected offer price), H (10') maximize {^umvh^ Vtt, h=0 {0h {6h -P?h)} ,

(8) and (9), and < < qUh qu,h< < 1, 1, = Q + s?h, h = 0,...,H-l, h=l,...,H, h = 0,...,H, h = 0,...,H.

8We believe that this objective is realistic. A counterexample will illustratewhy. Assume that an issuing firmcan get $50 million for one-thirdof its total threemillion sharesoutstanding(i.e., $50 per share). If the firm'sobjective were to maximize total proceedsfrom the issue, selling the entire 3 million shares for $51 million (or merely $17 per share)would be a dominantselling strategy.

396

Theorem 5 describes the solution to this problem, including the optimal ex? ercise strategy ofthe option to adjust offer size. Theorem 5. The maximum ditions are met: 1. expected proceeds are achieved if the following con?

optimal exercise strategy of the option to increase issue size: s?h= 0 when h < Q, ? = Q, s) when h>Q; s?h min(h schedule: optimal price/allocation when h<Q, set qUjh = 1, qL,h = (Q - h)/(H - h), and P?h= 0h, when h > Q, set qUJh= (Q + s?h)/h, qUh - 0, and P? = 0h- vh where vh is given by

2.

x v

7/

h=0

The optimal pricing/allocation strategy is identical to that derived in Theorem 2 and the underlying intuition is the same. As to the option to increase issue size, the goal behind the exercise strategy described in Theorem 5 is to allow the underwriter to increase issue size without increasing the allocations to investors indicating L. This goal is achieved by setting s?h > 0 only in states of high demand (i.e., when h > Q) in which all of the additional shares can be allocated to investors who revealed strong interest. Increasing issue size while keeping the allocation to investors with weak interest unchanged improves the outcome of the IPO to the issuing firm. As we argued earlier, the optimal exercise strategy we identify for the option keeps unchanged the expected profit from misrepresenting signals in the pre-market and, hence, the total underpricing required for truth-telling (constraint (8)). On the other hand, the issue size is increased in states of high demand when underpricing occurs and, as a result, less underpricing per share is needed.9 In fact, the additional shares sold will generate full value and, hence, will not be underpriced on the margin. We formalize this result in Theorem 6. Theorem 6. Average underpricing per share of an issue sold off a book is reduced in the presence of an option to adjust issue size. The added proceeds in each state the issue size is increased (h > Q) are 0hS?h, the full value ofthe additional shares sold. Proof See the Appendix.

Our analysis of the option to adjust issue size during the pre-market can possibly extend to the over-allotment option that is offered on virtually every IPO that is done under a firm commitment contract in the U.S. To the extent that the pre-offer indications of interest are not binding and, hence, some uncertainty 9If we interpretedQ as the expected issue size and allowed the actualsize to vary from Q ? s to Q + s, then the same result(of increasingthe averageoffer price) can be achievedby choosing an offer size below Q when demandis weak and above Q to fulfill unfulfilleddemand.

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about market demand persists beyond the pre-market, the underwriter (working on behalf of the issuing firm) can benefit from an option to adjust the offer size in the after-market. The over-allotment option permits the underwriter to short sell an added number of shares (typically 15% of the issue) at the offer price and cover the position with additional shares issued. Our analysis suggests that such an option has value to an issuing firm only if a mechanism is used in which information is acquired in conjunction with setting the offer price, such as the bookbuilding mechanism.10 If the exercise strategy we outline in Theorem 5 is used with the over-allotment option, average underpricing per share will be reduced. The optimal exercise strategy we identify is consistent with the empirical regularity that the over-allotment option is exercised more often when indications of interest are strong. Hanley (1993) studies the frequency of use of the option from 1985 to 1987 and finds that "85% of the issues with offer prices above the offer price range exercise the over-allotment option, compared to 68% and 54% for issues with offer prices within and below the offer range, respectively" (p. 243). In her study, the position of the offer price relative to the offer range is a direct measure of the level of investor demand. Benveniste and Spindt (1989) originally hinted that the over-allotment option can potentially reduce underpricing by giving the underwriter more flexibility in the allocation of shares. Our results are much stronger, however. We show that the additional shares can be sold at full value, suggesting (contrary to Hansen, Fuller, and Janjigian (1987) who view the over-allotment option as a floatation cost) that the option can provide firms with a very inexpensive source of additional capital. This feature is particularly valuable in light of the fact that between one-third and one-fourth of firms going public come back to market for new financing within three years of their IPO (Michaely and Shaw (1994)). We turn next to the comparison ofthe two competing marketing mechanisms. Section VI contains a discussion of how our results reflect on both the choice of individual issuing firms and the debate regarding the optimal method of placement.

VI.

Bookbuilding

vs.

Fixed

Price

Our analysis illustrates that the issuing firm has some control over the results of its initial public offering through its choice ofthe marketing method used to place the offering. Bookbuilding generates higher expected proceeds and exclusively provides an opportunity to sell additional shares at full value but, in the process, exposes the issuer to greater risk. In comparison, fixed price offerings priced at the cascade price guarantee the issuer certain proceeds. The certainty ofthe proceeds ofa fixed price offering sold at the cascade price is an advantage of the fixed price method that seems to have been overlooked in light of the literature's overwhelming focus on the level of proceeds. We argue 10Thereferee suggested that, because the issuer has the option to adjust issue size during the may pre-market,the formally stated over-allotmentoption that can be exercised in the after-market have other roles. One role that comes to mind stems from the possible associationbetween the overallotment option and underwriters'price stabilizationin the after-market (Benveniste, Busaba, and Wilhelm (1996) and Schultz and Zaman(1994)). Such a possible role, however,does not reduce the option's value identifiedin Theorem6.

398

below that this feature may be attractive for risk-averse about the market valuation of their issues. A. The Effect of Risk Aversion

It is straightforward to extend our analysis to apply to a risk-averse issuer whose objective is to maximize expected utility from proceeds. The optimal pric? ing strategies for both fixed price and bookbuilding are invariant to this extension. The cascade price generates certain proceeds and, hence, is consistent with maxi? mizing expected utility from proceeds. And the optimal price/allocation schedule we identified in Theorem 2 for the bookbuilding method first-order stochastically dominates any other state-contingent pricing scheme. This is because the optimal pricing schedule maximizes the offer price state by state. Although risk aversion on the part of the issuer has no bearing on the results of the marketing methods, it may affect the issuing firms' preference of the two methods. For some concave utility function, the expected utility from the sure cascades proceeds may exceed the certainty equivalence of the state-contingent the sense that Since neither strategy dominates?in proceeds of bookbuilding. bookbuilding generates higher proceeds but exposes the issuer to higher risk?the issuer's preference should be governed by the risk of its issue and the level of its risk tolerance. In this regard, we state the following: 1. firms with more price uncertainty are more likely to prefer a fixed price offering, 2. firms with greater concern for risk are also more likely to prefer a fixed price offering, and 3. firms with greater future capital needs (who benefit from the over-allotment option) are more likely to prefer bookbuilding. Predictions 2 and 3 follow from Theorems 4 and 6, respectively. Prediction 1 is less evident. Expected underpricing in both marketing methods is directly ? VL) raise the ? VL). However, increases in (Vu uncertainty proportional to (Vu cascade in the likelihood that the sure price bookbuilding proceeds, increasing only exceeds the certainty equivalence of the bookbuilding state-contingent price. As to the international debate regarding the best way to price and place an IPO, our results show that both the fixed price and bookbuilding methods can be optimal and, hence, challenge any policy that restricts the underwriting process to one method or the other. Many countries, especially former British colonies, still operate under variants ofthe British company law and require that IPOs be placed in a manner that eliminates the potential for bookbuilding. Such restrictions create inefficiencies and handicap firms that might prefer this marketing approach. B. The Effect of Issue Size and Marketing Costs

It should be noted here that the above predictions hold for otherwise identical issues and issuers. There are other, possibly dominant factors that determine the choice of marketing method. One obvious factor is cost. As the role of the under? writers in bookbuilding is rather involved, including identifying potential investors and conducting road shows, the cost ofthe process might be prohibitive for smaller

Benveniste issues.

and Busaba

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Thus, small issues are likely to be placed by the fixed price mechanism to avoid the fixed cost of bookbuilding. Ritter (1987) documents consistent simply size difference between best-efforts and firm commitment offerings. Loughran, Ritter, and Rydqvist (1994) suggest yet another reason for why smaller issues are more often underwritten by best-effort contracts. They state that, for liquidity purposes, such issues are typically placed with individual investors (rather than institutional investors), who are unlikely to possess information rele? vant for valuation. As a result, bookbuilding is not justified in these cases. VII. and Conclusion

Summary

This paper analyzes and compares the results of two commonly used meth? ods for marketing IPOs, the fixed price offer and American bookbuilding, in an equity market where investors' information is correlated and investors can have varying degrees of market power. The paper builds upon the formalization of the bookbuilding approach in Benveniste and Spindt (1989) and the modeling of the fixed price approach in Welch (1992). The analysis shows that both methods can be optimal, depending on the characteristics ofthe issuing firms, and suggests that regulation restricting the underwriting process to one method or the other may be causing inefficiencies in new equity markets. The debate in the international forum regarding the best method to sell IPOs is complicated, however, by the policy question as to whose welfare should be paramount in determining the method of placement. For example, many IPOs done in Great Britain over the past 15 years have been privatizations of nationally owned firms. Government policy there has established that citizens should benefit directly from the privatization by giving them priority in the allocation of issues and, in many cases, at promotional prices. To the extent that such equity considerations are important in the pricing and allocation decisions, our results may be of secondorder relevance.

Appendix Proof of Fact 3: The proof builds on Lemma 3 of Welch (1992) which, using our notation, derives the probability of observing h U signals in H signals given the observation of i U signals in another sample (from the same distribution) of m signals, prob(fct/sintf|;t/sinm) where C" denotes the combinations C? h = h\(H-h)V the probability that the = CH x Cm ( -^-^ of H outcomes, m+ 1 \ , ^___ j h by h, and is given by

In our case, i = m= 1, and the investor will be calculating ? 1 investors hold h U signals, remaining H n'h =prob(A;//-l|l;l)= CH~X x C1 2 ' / * ^ ^?j \ ,

h = 0,...,H-l,

400

which, upon simplification, yields the result in Fact 3. The conditional probabilities when / = 0 are similarly derived, = = C? CH ^ C? (jff[) h = 0,...,H-l.

tt?

prob(A;ff-l|0;l)

>

of irh>^

Kh+\

-7rfh n and

+ Y, *? { [hqu,h (Hh=0

h)qL,h] (0h

P?h)} ,

which appears in the objective function, as H-\ (A-l) h=0 ^ (oh+x K+l) qvMi + Y^h~ *$ qL'h

The incentive compatibility constraint (8) will hold with equality at the optimum since the underwriter does not have to underprice by more than necessary. Using (8) to substitute for the first term within brackets in (A-l), we can write (A-l) as

which simplifies

to H1 2 \H + 2 (Oh-n) qL,h-

(A-2) h=0

To maximize expected proceeds (the objective function), the underwriter has to minimize (A-2), which represents (the issuer's expected loss to cheaters or) The underwriter should minimize qL^ and should set expected underpricing. = Oh whenever q^h > 0. The price/allocation schedule detailed in the theorem P?h achieves this goal. Substituting these results into (A-2) gives the minimum total expected under? pricing,

knowing that the second term under the summation in (A-2) will always be identical and denoting to zero. Noting that underpricing occurs only in states h = Q,...,H, = we can write underpricing per share by uh 0h? P?h,

Benveniste

and Busaba

401

\ e-

Dividing through by Q, we obtain the expression for expected underpricing per share, E(uh), stated in the theorem. Substituting constraint (11) in the objective function (10) and dividing through by Q give the following expression for expected proceeds per share, H E(P?) = H

Using the proceeds-maximizing price/allocation schedule from above and noting that X^=o Kh6h = % we obtain the expression for the maximum expected proceeds per share in the theorem. Proof of Theorem 3: In the V space, the gain from cheating is (Vu - VL)[\/(H + 2)], and un? ? VL)uh. derpricing per share is (Vu Underpricing as a ratio of the offer price is uh po (Vu - VL)uh VL + (Vl,-VL)PJ, *

^""

Increasing Vu by S and decreasing VL by 6, i.e., applying a mean-preserving to the prior distribution of V, makes relative underpricing equal to ?* P?h Differentiating n (Uh\ n) (Vu-VL)uh + 28uh *

spread

VL + (VU -VL)P?h + 8{2P?h-\y with respect to 8 gives 2uhVL + (Vu-VL)uh VL)P?h+ 6 (2P?h 1)] [VL + (Vu is positive.

U"'"

Proof of Theorem 4: Part 1. We start with the H = Q case, in which pre-marketing underpricing is the highest, and then use Corollary 1 to generalize. IfH=Q, underpricing occurs = = = in one when h H H in state, Q. Substituting only Q (A-4) and dividing the share + which will be equal by Q give 2)), expected underpricing per l/(2(H to cascade underpricing, % when H = 1, but will be smaller when H > 1. In light of Corollary 1, this result carries over to the H > Q case and, hence, we can generalize. Part 2. The proof of this part of the theorem is trivial once we note that the cascade proceeds are certain, while pre-marketing proceeds are state contingent.

402

Proof of Theorem 5: The proof of the theorem builds on the proof of Theorem 2. The level of underpricing is determined by the incentive compatibility constraint (8), H-l E^t^i h=0 K+i] iv,h+\ > H-l X>; h=0 Oh-PU1 H + 2 qL,h> + l)))7r^

which, using (11') to substitute for qLth and the fact that tt^+i = (H/(2(h on the LHS, can be written as to substitute for Tr'h 2\ (A-5) ' h=l H-l 8h~Pl h=0 + 1 H + 2 (Q + S0h)-hqu,h H-h H

Maximizing (10') is equivalent to minimizing Ylh=o ^hWh P?h\>which apMinimizing this expression requires minimizing pears on the LHS of (A-5). the RHS of (A-5), satisfying the condition with equality and, at the same time, the RHS of (A-5) can be achieved by setting maximizing qu,h- Minimizing Q + s?h- hqv,h = 0 when possible (i.e., by setting qUih = (Q + S?h)/h when h>Q) and by setting P?h = 0h and minimizing Q + s?h- hqUth (by setting s?h = 0 and qu,h = 1) when h < Q. The allocation strategy outlined above grants priority to investors with U signals and, hence, is consistent with maximizing qUth. In fact, qu,h is set to the maximum of one share when h < Q. When h> Q, qu,h can be increased further ? Q), s] > 0. This will both maximize qu^ from Q/h to by setting s?h- min[(h = (Note that, (Q+S?h)/h and insure that Q+s?h hqUfh 0, in the states h=Q,...,H. because the maximum possible allocation to an investor is one share, choosing s?h such that s > s?h > h ? Q will not increase qUth and, hence, will only increase Q + s?h hqUfh and the RHS of (A-5).) To solve for the minimized level of underpricing, we denote [Oh ? P?h] by vh, substitute the solution outlined above in (A-5), and satisfy the condition with equality. This gives the following, ?(^)f>;(?^), x v ;/ h=0 x 7

(A-6,

?m{Q*so h=Q

which appears in the theorem. Proof of Theorem 6: Expression (A-6) can conveniently

be written as Q-h

h=n h=Q

h=n h=Q

x v

7/

h=o

x H-h

where v'h is the new level of underpricing per share for the original offer shares and v'l is the underpricing per share for the additional shares, assuming for the

Benveniste

and Busaba

403

moment that these two sets of shares can be underpriced differently. Because the RHSs of (A-4) and (A-6) are identical, the LHSs should be equal. Therefore, 1. if (as it should be) v'h = vjf = vh V h, then it should be that average underpricing per share in the presence of the option to adjust issue size, v, is less than that without the option, u (to show this, we let uh = u and vh = v V h, such that = + (A-4) and (A-6) hold; then, QYHqW showing E^hSp G?f=e*W clearly that v should be less than u); 2. if the underwriter sets v'h = uh V h, then it should be that v^ = 0V/i (this means that the additional shares are selling for Oh at the margin, with total added proceeds ofs?h6h in each state). References of Divisible Goods: Onthe Rationalefor the Treasury Back, K., andJ. Zender."Auctions Experiment." Review of Financial Studies, 6 (1993), 733-764. Beatty, R., and J. Ritter. "InvestmentBanking, Reputation,and the Underpricingof Initial Public Offerings."Journalof Financial Economics, 15 (1986), 213-232. Benveniste, L., and W. Busaba. "PriceDiscovery and the Option Value in Going Public." Working Paper,Boston College (1995). Benveniste, L.; W. Busaba; and W. Wilhelm. "PriceStabilizationas a Bonding Mechanismin New Equity Issues." Journalof Financial Economics,42 (1996), 223-255. BankersDeterminethe OfferPrice and Allocation of Benveniste,L., and P Spindt. "How Investment New Issues."Journal of Financial Economics,24 (1989), 343-361. Benveniste, L., and W. Wilhelm. "A Comparative Analysis of IPO ProceedsunderAlternativeRegu? latory Regimes." Journalof Financial Economics,28 (1990), 173-207. Chalk,A., andJ. Peavy. "InitialPublicOfferings:Daily Returns,OfferingTypes,andthe PriceEffect." Financial AnalystsJournal,43 (1987), 65 -69. Differences in Oversubscription and Underpricing of Chowdhry,B., and A. Sherman. "International IPOs."Journal of CorporateFinance, 2 (1996), 359-381. of InitialPublicOfferingsandthe Partial Hanley,K. W. "TheUnderpricing AdjustmentPhenomenon." Journal of Financial Economics, 34 (1993), 231-250. Hansen,R.; B. Fuller;and V. Janjigian."TheOver-allotment OptionandEquityFinancingFloatation Costs: An EmpiricalInvestigation." Financial Management,16 (1987), 24-32. Koh, F., and T. Walter."ADirect Test of Rock's Model ofthe Pricingof UnseasonedIssues."Journal of Financial Economics, 23 (1989), 252-272. Loughran,X; J. Ritter;and K. Rydqvist. "InitialPublic Offerings: International Insights." PacificBasin Finance Journal, 2 (1994), 165-199. Michaely, R., and W. Shaw. "ThePricingof InitialPublic Offerings: Tests of Adverse-Selectionand Signaling Theories."Review of Financial Studies,1 (1994), 279-319. Ritter,J. "TheCosts of Going Public."Journalof FinancialEconomics, 19 (1987), 269-281. Rock, K. "WhyNew Issues are Underpriced"Journalof Financial Economics, 15 (1986), 187- 212. Schultz, P., and M. Zaman. "Aftermarket Supportand Underpricingof Initial Public Offerings." Journal of Financial Economics, 35 (1994), 199-220. Restrictions,and Efficiency in Spatt, C, and S. Srivastava. "PreplayCommunication,Participation Initial Public Offerings."Reviewof Financial Studies,A (1991), 709-726. Wang,J., and J. Zender. "AuctioningDivisible Goods."WorkingPaper,Univ. of Utah (1996). Welch, I. "SequentialSales, Learning,and Cascades."Journalof Finance, Al (1992), 695-733.

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