Ljunqvist and Wilhelm: Prospect theory and IPOs

In trying to explain IPO underpricing, Loughran and Ritter (2002, RFS) suggested that CEOs may not be concerned about leaving money on the table in IPOs because the losses are netted against the rises in stock price in the secondary market.

Ljunqvist and Wilhelm now test this and find that it seems to hold. How do they do this?

From my class notes:

"Let's talk about grocery stores for a while.
Q. Why do stores try to keep their customers happy?
A. Happy customers are less likely to go to the competition."

If you follow that, you have the idea behind the Ljunqvist and Wilhelm paper. They examine when firms change investment bankers following IPOs. They find that when the CEO wealth increases significantly in the IPO process (and hence presumably the CEO is a 'happy customer'), the firm is more likely to stick with the same underwriter, even if there was significant underpricing in the IPO.

In more technical language, the idea that the CEO is less concerned about what is left on the table because (s)he is making money anyways is essentially prospect theory.

Prospect theory is the idea that how we are thinking about something affects our decision making and our utility from various events. The idea was is generally credited to Daniel Kahneman and Amos Tversky in 1979 (thanks Wikipedia!)

Thus, the idea is that even if you did not sell the firm for as much as you could have in the IPO process (you left money on the table), you are not upset because you made money on the deal--true not as much as you could have, but more than you did have).

In the authors' words:

"In contrast to Krigman, Shaw, and Womack (2001), we find that IPO firms are more likely to switch underwriters after the IPO when our behavioral proxies suggest that they were dissatisfied with the IPO underwriter’s performance. This difference arises because we measure dissatisfaction along the lines of Loughran and Ritter (2002) rather than focusing on underpricing. The finding by Krigman,Shaw, and Womack of significantly less underpricing among firms switching underwriters does not persist when we include the behavioral proxies for decision-maker satisfaction.

From the investment bankers' perspective, it pays to keep the customers happy. Not only are happy customers less likely to change companies, but they are also willing to pay higher prices!

"...underwriters appear to benefit from behavioral biases in the sense that they extract higher fees for subsequent transactions involving satisfied decision-makers. Thus, satisfaction with the IPO outcome is associated with both a reduced likelihood of switching underwriters after the IPO and paying higher fees for SEO underwriting services."

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=485302
http://www.afajof.org/Pdf/forthcoming/prospecttheory.pdf

Yeah I know this one reviewed before, but since I will be using it in class I figured I would check on it again and if I found it interesting the second time, maybe some of you will too! And additionally, the review is a bit longer than it was before and the paper is slightly different.

FTR I guess I was not the only one who liked it, the paper is now accepted in the Journal of Finance. :) Congrats!
http://www.afajof.org/Pdf/forthcoming/prospecttheory.pdf