Final answer:
Underwriters may underprice IPOs to ensure a successful launch and minimize risk. Agency problems arise due to misaligned interests between company insiders and underwriters, who prioritize a smooth IPO process. Information asymmetry also contributes to underpricing, with underwriters potentially having more market insight.
Step-by-step explanation:
Underwriters may underprice IPOs due to agency problems for several reasons, primarily associated with the interests and information asymmetries between the underwriters, company insiders, and potential investors. Management of small companies may be inclined to pursue an IPO as a way to raise funds and provide liquidity. However, such companies typically face challenges in commanding a high stock price initially because of the perceived risks and the fact that the company is not fully established. Investors may not be willing to pay much for stock in a company with little to no track record.
Moreover, because underwriters serve as intermediaries in IPOs, they may prefer to underprice the shares as a way to ensure a successful IPO and manage their reputation. Underpricing can create excess demand for the stock, which leads to a higher likelihood of the IPO being fully subscribed, minimizing the risk for the underwriters. Additionally, underpricing can result in a first-day 'pop' in stock price, which can be interpreted as a successful IPO by the market, but this can be at the expense of the issuing company, which might not raise as much capital as it potentially could have.
Agency problems occur when there is a misalignment of interests between the shareholders (principals) and the managers or underwriters (agents). The underwriters stand to gain from a successful and smooth IPO process, which can sometimes take precedence over achieving the highest possible price for the shares. This can be viewed as a form of agency cost, where the company does not maximize its potential capital due to the interests of the underwriter. Furthermore, information asymmetry is an issue as well, where underwriters may have more relevant information about the market appetite and appropriate pricing than the company insiders. This dynamic can lead to underpricing if the underwriters are overly cautious or prioritize quick sales over price maximization.