Journal of Applied Corporate Finance

S P R I N G 19 9 7 V O L U M E 10 . 1

Initial Public Offerings: Going by the Book

by Lawrence M. Benveniste,
University of Minnesota, and
William J. Wilhelm, Jr.,
Boston College
INITIAL PUBLIC
OFFERINGS: GOING
BY THE BOOK
ommon sense suggests that issuing firms
C and their investment bankers would do
well to assess market demand conditions
before setting the terms of an initial
public offering (IPO) of equity. And yet one need not
look far to find examples of primary equity markets
in which few such efforts are made. For example,
U.K. fixed-price offerings advertise the number of
shares and offer price by prospectus 14 days prior to
accepting applications from interested investors. Far
from being the exception, such practices have until
quite recently been the rule in international primary
equity markets.1
In contrast, U.S. underwriters of domestic IPOs
build a book prior to finalizing the terms of the
offering. In essence, book-building involves little
more than polling institutional investors before
pricing the offering in an attempt to gauge market
demand for the issue. This demand information is
then used to determine the size, price, and allocation
of the offering. In practice, ensuring a successful
book-building effort is somewhat more complicated
than this simple description suggests. Moreover, it
generally requires use of discriminatory tactics that
have attracted strong criticism from investors and
regulators alike.
Despite such criticism, book-building methods
are now being used in most large international
*We thank participants in the Conference on the Structure and Performance
of the Primary Equity Markets at Boston College for their comments. Special thanks
to Gordon Greer, Kathleen Hanley, Steve Pierce, and Jay Ritter. Matti Keloharju
generously provided information on the recent evolution of investment banking
practices in Finland.
1. For an international survey of pricing and allocation practices, see Tim
Loughran, Jay Ritter, and Kristian Rydqvist, Initial Public Offerings: International
Insights, Pacific-Basin Finance Journal, (1994): 2.
98
BANK OF AMERICA
JOURNAL OF
JOURNAL
APPLIEDOF
CORPORATE
APPLIED CORPORATE
FINANCE FINANCE
by Lawrence M. Benveniste,
University of Minnesota, and
William J. Wilhelm, Jr.,
Boston College*
equity offerings.2 It has been suggested that the
decline of fixed-price offerings is related to recent
efforts throughout Europe and Asia to privatize
state-owned firms and the fact that many of these
firms were simply too large to sell in a single
market.3 As a consequence, privatization authori-
ties and non-U.S. investment banks were intro-
duced to book-building methods when they en-
gaged U.S. investment banks to gain access to
foreign capital. But, as we argue below, this is only
part of the explanation.
Finland offers a striking example of fixed-price
offerings giving way to book-building efforts as
some legal and regulatory obstacles to book-build-
ing practices were removed. Before 1993, foreign
ownership restrictions limited institutional invest-
ment in Finnish IPOs. Following the abolition of
these restrictions, book-building efforts were used to
place a secondary offering by Repola in which
Prospectusa subsidiary of Kansallis bank and the
leading Finnish investment bankacted as a mem-
ber of the underwriting syndicate. Prospectus went
on to lead the book-building effort for Repolas
convertible bond issue in March 1994. With this
experience, Prospectus has gone on to lead or
participate in book-building efforts for four of the six
subsequent Finnish IPOs with proceeds greater than
FIM 50 million.4
2. See Dont Blame UsIts the Markets, Euromoney (May 1995).
3. See Going by the Book, The Economist (January 9, 1993).
4. Of these six, only one, the 1995 privatization of Neste, was placed by fixed-
price methods. In this case the government was responding to a desire to heighten
domestic retail participation in the aftermath of the small number of retail investors
attracted by Merrill Lynchs 1994 book-building effort for the privatization of
Kemira.
 Presumably, the increasing popularity of book-
building practices reflects an expectation among
issuing firms that this underwriting strategy will
generate greater proceeds than existing alternatives.
In this article, we review a body of research that
stems from a 1989 study by Paul Spindt and one of
the present writers that supports this view.5 Simply
put, book-building is more efficient than alternative
methods because it makes better use of information
about market demand conditions. Even auction
methods that also condition price and allocations on
market demand conditions may be relatively ineffi-
cient because, unlike the book-building approach,
auctions generally fail to put the full power of the
investment bankers relationships with potential
investors to work for the issuing firm.
A second goal of the article is to discuss several
management strategies the issuing firm might follow
to increase the efficiency of the book-building effort.
Among other things, we suggest that being flexible
with regard to the size of the issue and lining up
alternative sources of financing can increase the
expected proceeds from the offering. Finally, we
consider several public policy issues related to the
use of book-building methods.
BUILDING THE BOOK
The book-building effort follows the registration
of the preliminary prospectus with the SEC. The pre-
liminary prospectus represents the outcome of the
investment bankers due diligence effort. Under Sec-
tion 11 of the Securities Act of 1933, the information
provided in the prospectus also serves as the founda-
tion for civil liability arising from omissions of material
facts. With the filing of the registration statement, the
firm faces a 20-day waiting period before registration
of the offering is effective. The waiting period provides
the SEC with an opportunity to review and comment
on the filing, and it may be extended if the SEC requires
amendments to the filing. If the SEC is satisfied that the
registration statement satisfies full and fair disclosure
requirements, it may accelerate the effective date of the
offerings registration. The issuing firm generally re-
quests acceleration of the effective date when notified
of SEC clearance of the registration statement.
5. Lawrence Benveniste and Paul Spindt, How Investment Bankers Deter-
mine the Offer Price and Allocation of Initial Public Offerings, Journal of Financial
Economics, (1989): 24.
6. See Beware the IPO Market, Business Week, April 4, 1994.
99
VOLUME 10 NUMBER 1
After the SEC has commented on the registration
statement and the preliminary prospectus has been
circulated among potential investors, the issuing
firms investment bank organizes a series of road
shows designed to generate interest among potential
investors. Based on these presentations and the
information in the prospectusincluding a sug-
gested price range for the offeringparticipants are
asked to provide nonbinding indications of interest
in the issue. The book is built from these expres-
sions of demand and, based on the information in the
book, the terms of the offering are finalized shortly
before distribution begins.
In contrast to the common perception that
roadshows are conducted for the purpose of pro-
viding potential investors with information about
the firm, the actual practice of building a book
suggests that roadshows provide a vehicle for the
issuing firm and its banker to acquire information
from potential investors. Determining the relative
importance of these two information flowsfrom
the banker to investors, and from investors to the
bankeris important, in part because the invest-
ment banking industry has drawn criticism for
excluding retail investors from roadshows.6 The
force of such criticism depends on the degree to
which the information provided during roadshow
presentations is substantively different from that
provided in the prospectus, and therefore even
capable of conferring an informational advantage
on institutional investors.
In principle, roadshows provide institutional
investors with an opportunity to probe management
for its assessment of the firms prospects. In practice,
the firms legal counsel tends to discourage manage-
ment from providing information beyond that in the
prospectus. Bro Uttals description of Microsofts IPO
provides a striking case in point by noting that Bill
Gates was admonished by in-house counsel to say
nothing to anybody that deviated from the prospectus
or added new information.7
Such admonitions come with good reason. For
one thing, the SEC may require revisions to the
prospectus if the substance of a public statement is
viewed as being used to stimulate market interest;8
and once such statements are incorporated into the
7. Bro Uttal, Inside the Deal that Made Bill Gates $350,000,000, Fortune, July
21, 1986.
8. George Adams and Katherine Ashton, A Global Issuers Guide to the U.S.
Minefield, Euromoney, (August 1994).
SPRING 1997
prospectus, the issuer is liable for their accuracy.9
Moreover, the SEC can use its discretion over the
acceleration of the effective date to encourage
management to refrain from divulging information
not generally available to the investing public.
To the extent these threats are sufficient to
ensure that roadshows provide little additional infor-
mation, the practice of limiting participation to
institutional investors carries little cost for retail
investors. At the same time, as we demonstrate
below, it has the benefit of streamlining the informa-
tion-acquisition process.
THE NATURE AND VALUE OF INVESTOR
INFORMATION
Since book-building is essentially a process of
polling potential investors, the benefits from this
marketing strategy depend on the extent to which
investors possess information that would be useful
in resolving the issuers uncertainty about where to
set the price. We envision such information as taking
one of two forms. The first, which we refer to as
hard information, reflects insight about the issuing
firms prospects, or the prospects of its competitors.
It may seem unlikely that an investor would have
firm-specific or industry-specific information not
held by the issuing firms management. But portfolio
managers, for example, expend considerable re-
sources on fundamental analysis, and such efforts
may lead to more objective and hence more accurate
forecasts of the issuing firms future cash flows.
Portfolio managers are also likely to have greater
access to information about a firms competitors than
the issuers management simply because the com-
peting firms are more likely to volunteer information
to a money manager considering the addition of the
firm to his or her portfolio.
Even if the command of hard information by
potential investors is negligible, each investor knows
his or her own demand for the issue. This demand,
or soft, information is valuable if for no other
reason than because in aggregate it represents the
market demand for the issue. Moreover, there is
reason to believe that some investors have market
power in the sense that their level of interest in an
9. For a detailed discussion of the liability associated with violations of Section
11 of the Securities Act of 1933 or Section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934 See Janet Cooper Alexander, The Value of Bad News in
Securities Class Actions, UCLA Law Review, (1994): 41.
10. See Beware the IPO Market, Business Week, April 4, 1994.
100
JOURNAL OF APPLIED CORPORATE FINANCE
issue can influence the demand of other investors
and thereby make or break the issue. For ex-
ample, Richard Spillane, director of research for
Fidelity Investments, the largest buyer of IPOs,
estimates that Fidelity purchases about 10% of
newly issued shares. Not only is Fidelity likely to
account for a relatively large share of the demand
for any single issue, but it is said that other institu-
tions condition their demand on Fidelitys interest
in the issue.10 Indeed, evidence of such herd-like
behavior has caused one study of IPOs to liken the
pricing process to a cascade in which the success
or failure of an issue can be determined by the
actions of a market leader.11
Evidence of Uncertainty about Price
and Offer Size
One way of evaluating the level of uncertainty
surrounding the pricing of IPOs is to examine the
width of the price range suggested in the preliminary
prospectus. Using a sample of 1,430 IPOs brought to
market between January 1983 and September 1987,
a study by Kathleen Hanley reported an average
dollar width of $1.54 (the median was $2.00).12 This
translates into a percentage spread between the
upper and lower bounds of the suggested price
range of approximately 15% (with a median spread
of 16.7%). If we take the midpoint of the suggested
price range as the investment bankers best estimate
of the per share market value prior to polling
potential investors, an estimated price of 16 1/8
would therefore yield on average a suggested price
range of 15 to 17 1/4.
If the investment banker revises the initial
estimate of the per share market value to reflect the
information implicit in investors indications of inter-
est, we should observe deviations of the offer price
from the suggested price range. Hanley finds that, for
63% of her sample offerings, such revisions are
relatively modest in the sense that the offer price lies
within the suggested price range. For 10% of the
sample offerings, however, the offer price is greater
than the upper bound of the suggested price range,
with a mean percentage deviation from the midpoint
of the suggested price range of 20.9% and a maxi-
11. Ivo Welch, Sequential Sales, Learning, and Cascades Journal of Finance,
(1992): 47.
12. See Kathleen Weiss Hanley, Underpricing of Initial Public Offerings and
the Partial Adjustment Phenomenon, Journal of Financial Economics, (1993): 34.
 Book-building is more efficient than alternative methods because it makes better use
of information about market demand conditions.
mum deviation of 78%. (In the recent Netscape
offering, for example, the offer price was set at a
100% premium above the $14 upper bound of the
suggested price range.13) Similarly, the 27% of the
sample offerings priced below the lower bound of
the suggested price range exhibit a mean revision of
22.4%, with a maximum of 50%.
Besides motivating significant price revisions,
investor indications of interest appear to produce
revisions to the offering size suggested in the prelimi-
nary prospectus. When the offer price is set above
the upper bound of the suggested price range,
Hanley finds that issuing firms increase the number
of shares offered by 10%, on average. Likewise,
negative price revisions are associated with a 10%
scaling back of the offering. In contrast, the size of
offerings priced within the suggested price range
reflect only a modest increase (1.4%) from the
suggested offer size. Taken together, the price and
offer size revisions for offerings priced outside the
suggested price range imply a revision to expected
proceeds of approximately 30%.
HOW BOOK-BUILDING WORKS
Suppose the issuing firm and investment banker
have agreed to undertake a book-building effort.
Why would potential investors cooperate by provid-
ing forthright indications of interest? The preceding
discussion suggests that both very strong and very
weak indications of interest produce substantial
price revisions. In light of this fact, potential investors
have an incentive to understate their interest in an
offering if doing so depresses the price at which they
purchase shares.
In the remainder of this section, we provide a
simple numerical example designed to illustrate how
this incentive problem can be addressed.14 The
example provides a stylized comparison of fixed-
price offerings and offerings supported by a book-
building effort. Structuring the example in this
manner allows us to see why a book-building effort
can lead to greater expected proceeds than under a
fixed-price offering.
The key to the success of a book-building effort
lies in the use of a strategic pricing and allocation
13. Even this apparently large price revision did not fully reflect market
demand conditions as the price soared above $70 during the first day of trading.
14. This example is designed to capture the essence of the analysis in Lawrence
Benveniste and Paul Spindt, How Investment Bankers Determine the Offer Price
101
VOLUME 10 NUMBER 1
policy designed to offset the investors incentive to
understate his or her interest in an IPO. By commit-
ting to favor investors who provide strong indications
of interest with relatively large allocations of
underpriced shares, the investment bank can simul-
taneously limit the distortion of investors incentives
in bidding and so increase the level of proceeds the
issuing firm can expect to generate from its IPO.
We begin by considering an issuing firm that
wishes to sell Q = 1 share of equity. Assume that
the firm and its investment banker know that the true
value of the firms share is with equal probability
either Vhigh = $10 or Vlow = $8. Thus, the investment
bankers best estimate of the per share market value
prior to undertaking the book-building effort is $9.
The firm can sell its equity to a single institu-
tional investor and/or a pool of retail investors. The
institutional investors maximum demand is Di = 1
share, and maximum demand from the pool of retail
investors is Dr = 0.7 shares. In other words, although
it may be possible to allocate the entire issue to the
institutional investor, retail demand alone will never
be sufficient to purchase the entire issue.
We capture the notion that institutional inves-
tors are well-informed by assuming the institutional
investor knows the true value of the issuing firms
share. Members of the retail pool, like the issuing
firm and its banker, know only the high and low
values and that they occur with equal probability.
Finally, we assume that the true value of the issuing
firms share becomes clear to all parties following the
completion of the offering.
Establishing a Benchmark
Before illustrating the merits of a book-building
effort in this context, it is necessary to establish a
benchmark for comparison. We capture the essence
of fixed-price strategies that determine the offer price
and allocations independent of information about
investor demand by assuming that the investment
banker makes no effort to ascertain the institutional
investors knowledge of the true value of the firm.
One strategy the investment banker might consider
is simply to set the offer price at his estimated share
value of $9. If the true value is actually Vhigh, the
and Allocation of Initial Public Offerings, Journal of Financial Economics, (1989):
24 and Lawrence Benveniste and William Wilhelm, A Comparative Analysis of IPO
Proceeds Under Alternative Regulatory Environments, Journal of Financial
Economics, (1990): 28.
SPRING 1997
institutional investor will gladly purchase the entire
offering and the banker will have left 10% of the
value of the issuing firms equity on the table for
initial investors. On the other hand, if the true value
is Vlow, the institutional investor will be unwilling to
participate in the offering.
Whats more, when the true value is Vlow, the
investment banker cannot even count on the maxi-
mum retail demand of 0.7 shares at the $9 offer price.
If retail investors recognize that the institutional
investor knows the true value of the firms offering,
they will expect to be crowded out of underpriced
offerings and offered relatively large allocations of
overpriced offerings. Faced with this winners curse,
retail investors will participate in the investment
bankers offerings only if they believe they will break
even on average.15 In this simple example, retail
investors break-even condition for participation is:
(Vhigh P)Dr[Dr / (Di + Dr)] = (P Vlow)Dr
where P is the expected offer price. The right-
hand-side of the equality is simply the loss retail
investors expect to incur assuming they receive
their full demand in overpriced offerings. Similarly,
the left-hand-side of the equality is their expected
profit from participating in underpriced offerings.
The profit expected by retail investors assuming
they are allocated their full demand is represented
by (Vhigh P)Dr. The bracketed term reflects the fact
that the offer will be rationed across both retail and
institutional investors when it is underpriced, and is
perhaps best viewed as the probability that retail
investors will be allocated the shares they demand.
When there is no threat of being crowded out by
institutional investors (Di = 0), retail investors are
allocated their full demand of underpriced shares
and (1) will be satisfied by an offer price of P =
(Vhigh + Vlow)/2 = $9, which is just the average value
of the offering.
Given our assumptions about Di and Dr, how-
ever, setting the offer price at the estimated share
value of $9 will not satisfy the condition specified
by equation (1) above. Since retail investors do not
expect to receive their full demand (because [Dr /
(Di + Dr)] < 1), their participation can be ensured
15. For the original theoretical formulation of this argument, see Kevin Rock,
Why New Issues are Underpriced, Journal of Financial Economics (1986): 15.
16. The institutional investor will not participate in the offering at a price of
$8.58 when the true price is V . Since retail demand is insufficient to cover the
low
JOURNAL OF APPLIED CORPORATE FINANCE
only if the offering is priced at a discount from the
average share value of $9. In this case, retail inves-
tors will expect to break even at an offer price of
$8.58, or nearly a 5% discount from the estimated
share value of $9.16 This discount is the benchmark
against which we will compare the outcome of a
book-building effort.
Strategic Pricing and Share Allocation
The preceding example illustrates the leverage
held by the institutional investor. Endowed with an
informational advantage, the institutional investor
can simply observe the offer price and buy only
those offerings that appear to be underpriced. The
goal of a book-building effort is to induce the
institutional investor to yield this informational ad-
vantage. Although the institutional investors coop-
eration will carry a price, the cost may be lower than
(1), the cost of leaving the institutional investors lever-
age unchecked.
In the context of our example, the institutional
investor has an incentive to represent Vlow as the true
value in an attempt to drive the offer price below the
investment bankers initial estimate of $9. Therefore,
the challenge for the investment banker is to make
a credible commitment to bidding investors that it
will price and allocate the offering in such a way that
the institutional investors expected profit from truth-
fully revealing the true value to be Vhigh is at least as
great as falsely claiming that the true value is Vlow.
This condition can be characterized as follows:
Ahigh(Vhigh Phigh) >Alow(Vhigh Plow), (2)
where the institutional investors share allocation, A,
and the offer price, P, are now dependent on his
indication of the true value of the issuing firm. Since
any profits captured by the institutional investor
(represented by the left-hand-side of equation (2))
come at the expense of the issuing firm, the invest-
ment bankers goal is to minimize the right-hand-
side of equation (2). In other words, the goal is to
minimize the cost of eliciting an honest indication
from the institutional investor when the firms true
value is Vhigh.
entire offering, we implicitly assume that the investment banker takes up the
remainder of the offering.
102
 In contrast to the common perception that roadshows are conducted for the purpose
of providing potential investors with information about the firm, the actual practice
of building a book suggests that roadshows provide a vehicle for the issuing firm
and its banker to acquire information from potential investors.
Unfortunately, the investment bankers options
are limited. For example, it appears that the right-
hand-side of (2) could be driven to zero by setting
the offer price at $10 whenever the institutional
investor indicates that the true value is $8. But, of
course, if the investment banker followed this strat-
egy, the institutional investor would be unwilling to
participate when the true value is actually $8. Thus,
in response to an indication that the issuing firms
true value is Vlow, the underwriter is forced to set Plow
= Vlow = $8.
The investment bankers only remaining lever-
age in such a case is to minimize Alow. He can do this
by committing to grant allocation priority to retail
investors when the institutional investor provides an
indication of Vlow. In other words, allocate fewer
shares (Alow = Q Dr) to the institutional investor
claiming Vlow. Since Vhigh > Plow, the expected profit
necessary to elicit an indication of Vhigh is positive.
However, the actual discount from the true price
(Vhigh Phigh) can be minimized by favoring the
institutional investor with a large allocation in re-
sponse to an indication of Vhigh. In this example, Ahigh
should then be 1 share.
Thus, following the preceding logic (Plow = Vlow,
Alow = Q Dr, Ahigh = 1), to satisfy equation (2)
requires an offer price no higher than $9.40 in
response to an indication of Vhigh from the institu-
tional investor. This in turn implies that the issuing
firms expected offer pricethat is, the price ex-
pected prior to the solicitation of investor expres-
sions of interestis $8.70 (or 0.5 $9.40 + 0.5
$8.00) if it engages an investment banker to build a
book for its offering. Comparing this to the expected
offer price of $8.58 produced by the passive ration-
ing strategy implied by equation (1), we see that
active solicitation of information from the institu-
tional investor increases expected proceeds by 1.4%.
Although this example is simplistic, it illus-
trates several features of a successful book-building
effort. First, the investment banker is able to deter-
mine that a price revision is appropriate. Despite
this knowledge, when the true value is $10, the
banker must be willing to offer shares at a $0.60
discount to ensure that institutional investors will
be forthright with their indications of interest. Fail-
ure to do so will damage the bankers credibility
17. We explore this issue at length in A Comparative Analysis of IPO Proceeds
Under Alternative Regulatory Environments, Journal of Financial Economics,
(1990): 28.
103
VOLUME 10 NUMBER 1
with investors and therefore its ability to represent
future offerings.
The expected discount, however, is not $0.60,
but $0.30the difference between the bankers
$9.00 initial estimate of the offerings true value and
the $8.70 expected offer price calculated in the
previous paragraph. This $0.30 difference, which
should be viewed as the discount required to elicit
information from the institutional investor, is consis-
tent with the large first-day average returns on IPOs.
The example also highlights the importance of
being able to allocate IPO shares among investors in
a discriminatory fashion. Ideally, the banker would
sell shares at a discount only to those investors who
provide strong indications of interest; doing other-
wise would only increases their incentive to under-
state their interest. Nevertheless, because the NASD
Rules of Fair Practice require that IPO shares be
offered to all investors at a uniform price, a discount-
ing strategy leaves money on the table for all initial
investors, independent of their indication of interest.
One feasible alternative to discriminatory pric-
ing is to discriminate in the allocation of shares.17 If
there is sufficient demand among investors who
claim to have strong interest in the issue, the problem
can be solved by a commitment to allocate the entire
issue to these investors. Investors with strong interest
will then recognize that they cannot profit by under-
stating their interest because they will simply be
excluded from the offering.
In practice, the degree of interest expressed by
investors will vary, and it is unlikely that the investor
expressing the strongest interest in the issue would
be willing to purchase the entire issue. In spite of
these caveats, the preceding discussion suggests two
keys to a successful book-building effort:
Maintain a direct link between discounts and the
strength and breadth of interest demonstrated dur-
ing the book-building effort.
Give allocation priority to investors providing the
strongest indications of interest.
Evidence of Strategic Pricing and Allocation
The existing empirical evidence suggests that
investment bankers follow these rules of thumb. For
example, in her 1993 study cited earlier, Kathleen
SPRING 1997
Hanley observes average discounts (first-day re-
turns) of 0.6% for offerings priced below the lower
bound of the suggested price range, increasing to
10% for offerings priced within the suggested price
range and 20.7% for offerings priced above the
upper bound of the suggested price range.
Allocation policies are more difficult to ex-
amine because share allocations among various
investor classes are rarely publicized. The only
concrete evidence related to investment banker
allocation policies is reported in a recent study by
Hanley and one of the present writers.18 This
study, which examined institutional and retail
investor allocations for 38 IPOs managed (or co-
managed) by a single investment bank during the
period 1983-1988, reported a 73% median alloca-
tion of shares to institutional investors for those
offerings priced above the upper bound of the
suggested price range. Consistent with the policy
of reducing share allocations to roadshow partici-
pants when indications of interest are weak,
median institutional allocations declined some-
what for offerings priced within the suggested
price range (to 70.1%), and more sharply (to
64.5%) for offerings priced below the lower bound
of the suggested price range.
The study also confirms the widely-held belief
that institutional investors dominate discounted of-
ferings; the median institutional allocation for the 24
underpriced sample offerings was 73.3%. Although
this concentration of IPO profits among institutional
investors is often considered a problem with the
primary equity markets, our research suggests that it
promotes efficiency in the book-building process.
Taking the view that discounts are provided in
exchange for information, institutional investors
should receive allocation priority over retail inves-
tors since retail investors do not participate in the
book-building process.19
Although these findings suggest that institu-
tional investors capture the lions share of the profits
associated with discounted offerings, the preferen-
tial treatment they enjoy in discounted offerings
appears to carry a quid pro quo expectation that they
will participate in less-attractive offerings as well.
This conclusion is supported both by the median
18. Kathleen Weiss Hanley and William Wilhelm, Evidence on the Strategic
Allocation of Initial Public Offerings, Journal of Financial Economics, (1995): 37.
19. Having said this, there may be circumstances under which favoring retail
investors can serve to diminish the discount necessary to obtain accurate
indications of interest. See Lawrence Benveniste and William Wilhelm, A
104
JOURNAL OF APPLIED CORPORATE FINANCE
institutional allocation for overpriced offerings of
71.6% observed by Hanley and Wilhelm and by
discussions with investment bankers suggesting that
participation in future offerings is contingent on
broad participation in past offerings. Investors who
gain a reputation for cream skimming are less likely
to be included in future offerings.
The possibility that institutional investors are
induced to participate in less-attractive offerings
should not be taken to suggest that IPOs are
unprofitable for institutional investors. To the con-
trary, IPOs are far more frequently characterized by
positive initial returns than by negative initial returns.
Moreover, the positive returns are considerably
larger, on average, than the negative returns. Thus,
membership in an investment bankers pool of
regular IPO investors should be profitable even if the
investor participates indiscriminately.
In fact, the attraction of regular participation can
be used to enhance the efficiency of the book-
building effort.20 To see why, recall that the cost of
a successful effort to the issuing firm is the expected
discount necessary to solicit accurate indications of
interest. If an investor expects future participation in
IPOs to be profitable, the threat of losing the future
income stream can be used to induce the investor to
participate in a particular offering at an expected
discount he would find unacceptably low in a one-
time-only transaction. Thus, by bundling current and
future offerings and requiring all or nothing partici-
pation from their investors, investment bankers can
reduce the cost of book-building by reducing the
expected discount necessary to elicit accurate indi-
cations of interest.
The potential for bundling current and future
offerings is perhaps the most important reason to
believe that book-building dominates other meth-
ods used to place IPOs. For example, auctions offer
alternative mechanisms for eliciting investor infor-
mation prior to pricing an issue. However, the
anonymity typically preserved by auction mecha-
nisms does not promote a relationship between the
issuers representative and potential investors, and
therefore limits the potential for bundling from
which the book-building mechanism gains an extra
measure of efficiency.
Comparative Analysis of IPO Proceeds Under Alternative Regulatory Environ-
ments, Journal of Financial Economics, (1990): 28.
20. See Lawrence Benveniste and Paul Spindt, How Investment Bankers
Determine the Offer Price and Allocation of Initial Public Offerings, Journal of
Financial Economics, (1989): 24.
 There is reason to believe that some investors have market power in the sense that
their level of interest in an issue can influence the demand of other investors and
thereby make or break the issue.
STRATEGIC CONSIDERATIONS FOR
THE ISSUING FIRM
Thus far, we have emphasized the pricing and
allocation role of the investment bank in a successful
book-building effort. There are, however, several
ways in which the issuing firm can contribute to the
effort. First, since the cost of book-building in the
form of underpricing is driven by the degree to
which some investors know more (or less) about the
firm than managers or other investors (a condition
known in the finance literature as information
asymmetry), any information management with-
holds has the potential for being discovered by some
fraction of the investor pool, and thereby creating the
distortion of incentives described in the preceding
section. Subject to the caveat that for competitive
reasons some information cannot be revealed, man-
agement should make the firm as transparent as
possible in an effort to minimize the degree to which
some investors are better informed than others.
There is also strategic value in the issuing firms
option to terminate the offering.21 Termination can
occur at any time before pricing and placement of the
issue, and it is not uncommon. For example, one
study reported that 29% of the firm-commitment
offerings registered with the SEC in a sample drawn
from the 1979-1982 period were terminated prior to
receiving SEC approval.22 To understand why a
credible threat of termination can increase the effi-
ciency of the book-building effort, recall that in the
absence of any countervailing force, investors have
an incentive to understate their interest in an issue if
doing so can lead to a lower offer price. We
demonstrated that the investment bank can mitigate
this problem by favoring investors who provide
strong indications of interest with relatively large
allocations of discounted shares.
A credible threat to terminate the offering can
have a similar effect. If investors believe that
downplaying their interest increases the likelihood
of termination, they will be less likely to do so for
issues they find attractive. It does the investor no
good to drive down the investment banks percep-
tion of the issues value if the consequence is to have
the offering terminated. Thus, any action the firm
21. The following discussion is drawn from a recent working paper by
Lawrence Benveniste and Walid BuSaba entitled, Price Discovery and the Option
Value in Going Public.
22. See Craig Dunbar, Withdrawn Initial Public Offerings working paper,
University of Pittsburgh.
105
VOLUME 10 NUMBER 1
takes to increase its reservation price for the
offering and credibly convey this information to
investors should reduce the discount necessary to
elicit truthful indications of interest.
A recent study by Christopher James and Peggy
Wier supports this conjecture by showing that firms
that secured a line of credit prior to their IPOs
experience smaller discounts than those that did
not.23 A credible source of alternative financing
establishes a reservation price for an issuing firm
because there is no need for the firm to go public on
terms less attractive than it currently faces. Having
alternative financing in place makes a firms threat to
terminate an offering more credible. Thus, James and
Wiers finding that such firms experience smaller
discounts is consistent with the idea that a credible
threat to terminate the offering can improve the
efficiency of the book-building effort.
The final strategic consideration facing the
issuing firm relates to the size of the offering. We
observed earlier that issuing firms often revise the
size of the offering in response to investor indica-
tions of interest. Perhaps equally important is the
overallotment (or Green Shoe) option whereby the
firm allows the investment bank to sell additional
shares in response to exceptional demand during the
distribution of the offering. Strategic use of the
option to alter the offer size in response to indica-
tions of interest can also reduce the expected per
share discount required to obtain accurate indica-
tions of interest.24
The reasoning is quite simple. As the example
in the preceding section illustrates, the key to
obtaining accurate indications of interest is to con-
vince informed investors that they will be provided
with a dollar profit for giving a strong indication of
interest that exceeds the profit they expect from
understating their interest. The profit captured by
informed investors is the product of the dollar
discount and the number of shares they receive.
Thus, increasing the expected allocation to informed
investors allows the investment bank to reduce the
per share discount. By increasing the size of the
offering only when demand for the offering is high,
the investment bank can provide investors who
expressed strong indications of interest with larger
23. Chris James and Peggy Wier, Borrowing Relationships, Intermediation,
and the Cost of Issuing Public Securities, Journal of Financial Economics, (1990):
28.
24. See Benveniste and BuSaba, cited above.
SPRING 1997
allocations and reduce the discount from the level
necessary in the absence of the option. Moreover, if
the additional shares are allocated only when de-
mand is exceptionally strong, there should be no
reason to allocate some fraction of the shares to
investors providing relatively weak indications of
interest. Used in this manner, the option to alter the
size of the offering does nothing to weaken the
incentives of investors to be forthright with their
indications of interest.
CHARACTERISTICS OF SUCCESSFUL
INVESTMENT BANKS
What sets the most successful investment banks
apart from their competitors? The preceding discus-
sion suggests that if the perceived quality or reputa-
tion of an investment bank is related to its book-
building success, there are several dimensions in
which high-quality banks will excel.
First and foremost, the success of a book-
building effort rests on the investment banks ability
to acquire information from potential investors.
Thus, banks that excel at book-building should have
strong relationships with the most sophisticated
investors in IPOs. Little is gained from marketing an
issue to investors who have neither significant
private information nor the market power to influ-
ence the demand decisions of other investors.
Our analysis also suggests that there are signifi-
cant economies of scale in underwriting. Banks that
underwrite more and larger offerings have greater
opportunities for the bundling of offerings described
earlier. Moreover, these same banks present a larger
expected future income stream to members of their
investor pool. We suggested earlier that each of these
characteristics provides the investment bank with
greater leverage over its investor pool. Thus, other
things equal, we would expect the most active banks
to be the most efficient in their book-building efforts.
A third important dimension of an investment
banks reputation derives from its commitment to
secondary market price stabilization for its offerings.
Under the anti-manipulation provisions of the Secu-
rities Exchange Act of 1934, investment bankers are
permitted to support the secondary market price of
IPOs by posting a stabilizing bid at the offer price.
25. See Lawrence Benveniste, Walid BuSaba, and William Wilhelm, Price
Stabilization as a Bonding Mechanism in New Equity Issues, Journal of Financial
Economics 42 (1996), pp. 223-255.
106
JOURNAL OF APPLIED CORPORATE FINANCE
Investment bankers routinely reserve the right to
support the secondary market price by announcing
they may do so in the prospectus. Moreover, our
own recent theoretical research suggests that a
credible commitment to price stabilization is closely
related to the success of a book-building effort.25
As suggested earlier, the benefits from book-
building derive from the investment bankers ability
in some cases to set the offer price above the
initially suggested price range in response to strong
indications of interest from the institutional investor
pool. Nevertheless, in such cases, completion of the
offering at a higher price also depends in part on
the investment bankers ability to persuade inves-
tors who had little interest in the issue at prices
within the suggested price range that they should
revise their expectations regarding the value of the
offering to correspond with those of investors pro-
viding strong indications of interest. But the invest-
ment banker attempting to do this faces a credibility
problem: Because the underwriting commission is a
fraction of the proceeds from the offering, the
banker has an incentive to overstate the level of
interest among institutional investors if, by so do-
ing, a higher offer price can be achieved. Thus, it is
natural for investors to be skeptical of banker claims
that the information obtained through the book-
building effort warrants a positive price revision.
Such skepticism translates into lower expected pro-
ceeds for the issuing firm as prospective investors
require larger discounts in exchange for providing
accurate indications of interest.
One solution to this credibility problem is for
the investment banker to commit capital to support
the secondary market price of an IPO. Such price
support reassures investors for two reasons: it allows
them to sell out their positions after the offering; and,
perhaps more important, it makes any attempt to
misrepresent the outcome of the book-building
effort costly for the investment bank because the
bank will ultimately be forced to repurchase over-
priced shares.
In this sense, a commitment to price stabiliza-
tion bonds the banker against raising the offer
price when it is not warranted by expressions of
demand obtained during the book-building effort.
A price stabilization commitment may also lead
 The key to the success of a book-building effort lies in the use of a strategic pricing
and allocation policy designed to offset the investors incentive to understate his or
her interest in an IPO.
investors to accept smaller expected discounts on
IPOs in exchange for the valuable put option
implicit in the stabilization commitment. The ex-
ample presented earlier demonstrated that inves-
tors require a minimum level of compensation in
exchange for providing strong indications of inter-
est. This requirement will often be satisfied most
efficiently by a bundle of expected price discounts
and a commitment to price stabilization.26
This observation highlights an important point
for managers attempting to assess the all-in costs
associated with engaging an investment bank. As-
suming that the underwriting business is competi-
tive, the expected cost of the investment bankers
commitment to price stabilization will be reflected in
the fee charged to the issuing firm. Other things
equal, banks with the strongest commitments to
secondary market price stabilization will charge the
highest fees. However, the cost of obtaining a strong
stabilization commitment may be more than offset by
an increase in expected proceeds. Thus, an issuing
firm may face lower all-in costs by paying the fee
necessary to retain a bank with a strong commitment
to secondary market price stabilization.
PUBLIC POLICY CONSIDERATIONS
In spite of, or perhaps as a consequence of,
their increasing popularity, book-building practices
have drawn increasing scrutiny and criticism. Busi-
ness Week, for example, published a particularly
critical cover article in 1994 in which the central
findings of their two-month investigation focus
on questions of fairness associated with the dis-
criminatory tactics used by investment bankers dur-
ing the IPO marketing effort.27 The general tone of
the article is perhaps best summarized by Lynn
Stout, a professor of securities regulation at
Georgetown University Law Center, who claimed
that The IPO market is definitely rigged. Its rigged
against the average investor.
Our research challenges this point of view.
The first point of contention is related to the
belief that excluding retail investors from roadshows
places them at a distinct disadvantage relative to
institutional investors. As we suggested earlier, the
burden this places on retail investors depends on
26. Ibid.
27. See Beware the IPO Market, Business Week, April 4, 1994. See also The
Wall Street Journal, October 31, 1995, p. C1.
VOLUME 10 NUMBER 1
the degree to which substantive information is
revealed during roadshows. But since the risks
associated with revealing new information are sub-
stantial, it seems likely that retail investors generally
miss little more than the issuing firms sales pitch.
If so, there is little cost to excluding retail investors
and potential efficiency gains in the investment
bankers effort to acquire information from institu-
tional investors.
At the distribution phase, investment banks are
often criticized for favoring institutional investors
with relatively large allocations of discounted shares.
The preceding discussion suggests, however, that
such criticism is misplaced if the purpose of the
book-building effort is to acquire information and if
allocations of discounted shares are the medium of
exchange. Few would argue with the notion that as
a class institutional investors are better-informed and
have more market power than retail investors. If this
were not true, a competitive opportunity would exist
for banks to pursue more aggressively the perspec-
tive of retail investors prior to pricing issues.
Since we observe no such efforts in practice, our
research leads us to believe that favoring institutional
investors in IPOs promotes efficiency in the market
by leading to more accurate pricing. Individual retail
investors contribute little to the process of price
discovery, and therefore they warrant little consider-
ation in the allocation of IPOs. On the other hand,
retail investors can and do participate in the IPO
market through ownership of mutual and pension
funds. Perhaps the more legitimate focus of criticism
in the allocation of IPOs are those retail investors,
such as former Congressman Thomas Foley, who
receive favored treatment yet seemingly contribute
little to market efficiency in return.
Finally, it is claimed that penalty bid systems
provide a means of discriminating against retail
investors during secondary market price stabiliza-
tion efforts. Penalty bids are in essence incentive
schemes designed to discourage initial investors
from immediately selling or flipping their shares in
the secondary market.28 In our view, however, a
commitment to price stabilization can substitute for
price discounts as compensation for investor infor-
mation. If this is true, it is inefficient to provide the
commitment indiscriminately. Penalty bids are one
28. See The Wall Street Journal, December 29, 1993, p.C1.
107
SPRING 1997
means of extending the stabilization commitment
selectively. Once again, if retail investors are not
providing information used in pricing the offering,
they have no claim to compensation.29
CONCLUSION
The aim of this article has been to offer an
economic rationale for the book-building method of
29. This argument holds as long as the cost of stabilization is ultimately borne
by the issuing firm. However, if some investors in the secondary market do not
realize that the bank is supporting the secondary market price, it may be possible
to shift the burden of price stabilization to these naive investors by selling them
repurchased shares at a premium over their true value. Thus, the legitimacy of
LAWRENCE BENVENISTE
is Professor of Finance at the Carlson School of Management at
the University of Minnesota.
108
JOURNAL OF APPLIED CORPORATE FINANCE
marketing IPOs. In most cases, the fundamental
problem facing the issuing firms management and
current owners is to minimize the fraction of firm
value given away in the form of price discounts
from the firms true value. Our research suggests that,
relative to marketing strategies that involve little
effort to assess investor sentiment prior to pricing the
issue, a book-building strategy can reduce this cost
of going public.
discriminatory application of penalty bids depends on the transparency of the
market. For a more detailed discussion of this issue, see Lawrence Benveniste,
Walid BuSaba, and William Wilhelm, Price Stabilization as a Bonding Mechanism
in New Equity Issues.
WILLIAM WILHELM
is Associate Professor of Finance at Boston Colleges Wallace E.
Carroll School of Management.
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