IPO Underpricing**Thanks for helpful comments go to Martijn Cremers, Espen Eckbo, Roger Edelen, David Goldreich, Tim Jenkinson, Ron Masulis, Jay Ritter, Ann Sherman, Seha Tinic, and William J. Wilhelm.

When companies go public, the equity they sell in an initial public offering tends to be underpriced, resulting in a substantial price jump on the first day of trading. The underpricing discount in the United States averaged more than 20% during the 1990s, implying that firms left considerable amounts of money on the table. What explains this phenomenon? This chapter reviews the principal theories that have been proposed to explain IPO underpricing and discusses the empirical evidence. Theories of underpricing can be grouped under four broad headings: asymmetric information, institutional, control, and behavioral. The key parties to an IPO transaction are the issuing firm, the bank underwriting and marketing the deal, and the new investors. Asymmetric information models assume that one of these parties knows more than the others, and that the resulting information frictions give rise to underpricing in equilibrium. Institutional theories focus on three features of the marketplace: litigation, banks’ price stabilizing activities once trading starts, and taxes. Control theories argue that underpricing helps shape the shareholder base so as to reduce intervention by outside shareholders once the company is public. Finally, behavioral theories assume the presence of ‘irrational’ investors who bid up the price of IPO shares beyond true value. Broadly speaking, the empirical evidence supports the view that information frictions have a first-order effect on underpricing. At the same time, the enormous variation in the extent of underpricing over time raises doubt in some people’s mind whether information-based explanations on their own can account for the huge amounts of money left on the table in hot markets, such as the internet bubble of 1998–2000. Arising from this debate, there is continued interest in behavioral explanations, cross-country tests that exploit interesting institutional differences, conflicts of interest within investment banks, and the use of auctions to market and price IPOs.