When Bookbuilding Meets IPOs

Abstract

Bookbuilding, the dominant offering mechanism for IPOs in the U.S. and other markets, is controversial because of the power it gives underwriters over IPO allocations. Critics point to the fact that allocations could be abused to generate kickbacks for underwriters while proponents argue that allocation power could improve pre-market price discovery. We examine the effect of varying underwriter power over IPO allocations in the Indian IPO market, exploiting its natural variation due to regulatory changes. When underwriters control allocations, bookbuilding is associated with lesser underpricing, but this effect quickly dissipates when regulations bar allocation discrimination. Using a proprietary dataset of IPO books, we find that allocation discrimination is pervasive, economically significant, and is used to differentiate between institutional investors based on hard information in bids, issue and bidder characteristics and soft information possessed by underwriters. Our evidence supports bookbuilding theories in which discretion in allocation helps in pre-market price discovery.