Journal of Corporate Finance 56 (2019) 267–281

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Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin

The economic role of institutional investors in auction IPOs

T
Yuechan Lua, , Taufique Samdanib
⁎

a
College of Management, University of Massachusetts Boston, 100 William T Morrissey Blvd, Boston, MA 02125, United States
b
Neff Department of Finance, College of Business and Innovation, University of Toledo, 2801 W. Bancroft, Toledo, OH 43606, United States

ARTICLE INFO ABSTRACT

JEL classification: We examine the economic role of institutional investors in auction initial public offerings (IPOs)
G15 with and without a discretionary tranche of IPO shares pledged to institutional investors prior to
G18 public filing. We find that underpricing in auction IPOs with a discretionary tranche is lower
G24 (higher) than underpricing in auction IPOs without a discretionary tranche when institutional
G28
demand for IPO shares is high (low). The findings, which hold after controlling for potential
G38
endogeneity, reveal a cost-benefit tradeoff in auction IPOs that is sensitive to institutional de-
Keywords: mand, and explain why auction, albeit commonly used for debt instruments, is rarely used for
Auction IPO
IPOs.
Discretionary allocation
IPO underpricing
Institutional investors
Quid pro quo
Winner's curse

1. Introduction

The standard methods for bringing initial public offerings (IPOs) to market are book-building, fixed-price, and auction
(Jagannathan et al., 2015). Book-building, the most popular of the three issue methods, is widely acknowledged for its superior
information production and price discovery attributes (Jagannathan et al., 2015; Sherman, 2005; Sherman and Titman, 2002;
Benveniste and Spindt, 1989; Benveniste and Wilhelm, 1990; Hanley, 1993; Bradley and Jordan, 2002). Information production in
book-building is superior to that in fixed-price because the underwriter in the former sets the offer price after marketing the issue to
investors and recording their demand. The underwriter in fixed price, in contrast, sets the offer price prior to soliciting demand
information from investors. Fixed-price, therefore, trades off information gathering against simplicity—fixed-price requires less so-
phistication and less information gathering effort on the part of the underwriter. Information production in book-building is superior
to that in auction because the underwriter in the former has substantial discretion over allocation of IPO shares, thereby allowing the
underwriter to incentivize “well-informed” institutional investors with favorable allocation (Benveniste and Spindt, 1989; Benveniste
and Wilhelm, 1990; Sherman and Titman, 2002). Auction, in contrast, gives little discretion to the underwriting bank and trades off
information gathering and price discovery against reduced exposure to “hidden” costs, such as compliance costs and “soft” costs
(Ritter, 2013; Gao et al., 2013). The compliance costs in book-building IPOs are associated with the impact on analyst coverage of
strict regulation—the Sarbanes-Oxley Act of 2002, whereas the soft-costs are associated with the soft-dollar commission revenue not
disclosed by underwriters with discretionary allocation power.
Given that each issue method uniquely trades off information gathering against simplicity and lower costs, a “hybrid” issue

⁎
Corresponding author.
E-mail addresses: yuechan.lu001@umb.edu (Y. Lu), taufique.samdani@utoledo.edu (T. Samdani).

https://doi.org/10.1016/j.jcorpfin.2019.02.004
Received 29 July 2018; Received in revised form 18 December 2018; Accepted 22 February 2019
Available online 05 March 2019
0929-1199/ © 2019 Elsevier B.V. All rights reserved.
Y. Lu and T. Samdani Journal of Corporate Finance 56 (2019) 267–281

method that combines the information gathering and price-discovery benefits of book-building with the relatively low costs of
auction appears to have a clear advantage over the standard issue methods (Jagannathan et al., 2015). Despite the apparent ad-
vantage, auction, whether hybrid or standard, has had little success in equity markets worldwide—new auction methods have failed
to capture a meaningful market share and existing auction methods have lost a significant market share to book-building in almost
every country where book-building was introduced (Sherman, 2005). In France, for example, book-building has all but replaced the
auction mechanism (Degeorge et al., 2010). In Japan, auction IPOs disappeared as soon as book-building was introduced (Kutsuna
and Smith, 2004). In the U.S., auction IPOs, albeit not non-existent, are rare and have an insignificant market share compared to
book-building IPOs.1 In emerging market countries, such as China and India, the regulatory authorities continue to experiment with
hybrid auction methods searching for an optimal tradeoff between information gathering and investor protection. China, for instance,
switched from a pro-rata allocation policy to a lottery system in November 2010, whereas India switched from a discretionary
allocation policy to a non-discretionary pro-rata allocation policy in September 2005, and from this non-discretionary allocation
policy to a hybrid semi-discretionary allocation policy in July 2009 (Jagannathan et al., 2015).
Motivated by the renewed academic and practitioner interest in auction IPOs—as evident from recent experiments of hybrid issue
methods in emerging markets, such as India and China (Jagannathan et al., 2015)—and the successful use of auction in credit default
swaps and government debt instruments in the US (Chernov et al., 2011), this paper explores a relatively less examined area of
auction, namely, the impact of institutional investors demand for IPO shares on IPO proceeds in auction IPOs with a discretionary
tranche of IPO shares pledged to institutional investors relative to auction IPOs without a discretionary tranche of IPO shares.
Specifically, the paper exploits the July 2009 amendment to the 2000 Disclosure and Investor Protection (DIP) Guidelines in India to
examine the impact of (non-)discretionary allocation of IPO shares in conjunction with institutional investors' demand for IPO
shares—proxied by institutional oversubscription level—on IPO underpricing—proxied by first-day return. The July 2009 amend-
ment to the DIP Guidelines essentially grants the underwriters of auction IPOs the right to arbitrarily allocate a fixed quota (15%) of
IPO shares to “anchor” institutional investors at their discretion prior to public filing, as if it were book-building. The allocation of
IPO shares to institutional investors and retail investors after public filing, in contrast, is pro rata and non-discretionary, as if it were
auction.
The results, using a data sample of 312 auctions IPOs (2005–13) in India, reveal that auction IPOs with a discretionary tranche of
IPO shares pledged to anchor institutional investors generate higher proceeds (lower first-day return) when the demand for IPO shares
from institutional investors is high, or when the IPO is “heavily” oversubscribed by institutional investors. Conversely, auction IPOs
without a discretionary tranche of IPO shares pledged to anchor institutional investors generate higher proceeds when the demand for
IPO shares from institutional investors is low, or when the IPO is not heavily oversubscribed by institutional investors. Thus, the
findings reveal a cost-benefit tradeoff in auction IPOs that is sensitive to institutional investors' demand for IPO shares. The findings
also reveal the complexity in pricing auction IPOs—as a consequence of the auction IPO proceeds' sensitivity to institutional investors'
demand—and explain why auction, albeit commonly used for debt instruments, is rarely used for new equity issues.
Jagannathan et al. (2015) examine auction IPOs in detail in countries around the world and provide an explanation for why so
many countries have tried and then abandoned the auction method in favor of other IPO methods. They argue that the “failure” of
auction IPOs in countries worldwide is neither due to issuers' lack of familiarity with the auction method nor due to the differences in
the underwriting fees. The lack of popularity of auction IPOs is instead due to the high level of bidding sophistication demanded of
investors to address the winner's curse inherent in auction IPOs. Specifically, they argue that it is difficult even for “well-informed”
institutional investors to assess the bidding strategies of “less-informed” retail investors who are likely to exacerbate the winner's curse
problem with their bidding mistakes in auctions. Jagannathan et al. (2015) posit that a competitive auction tranche which limits
participation to institutional investors and a non-competitive tranche that is open to all investors reduces the impact of bidding
mistakes made by naïve investors and at the same time increases information production, which in turn reduces IPO underpricing, or
the abnormal first-day return. They further posit that the impact of bidding mistakes on IPO underpricing is likely to be more
pronounced in auction IPOs when the number of bidders bidding for IPO shares is high than when it is low.
Acknowledging that 1) IPO underpricing in auction IPOs without information production is at least partially attributed to the
winner's curse problem facing less-informed retail investors (Jagannathan et al., 2015), 2) IPO underpricing in book-building IPOs
with information production is at least partially attributed to the quid pro quo for obtaining market demand information from well-
informed institutional investors (Aggarwal et al., 2002), and 3) institutional investors find it more difficult to shave for the winner's
curse when the demand for IPO shares in auction IPOs without discretionary allocation is high than when the demand is low
(Jagannathan et al., 2015), we conjecture that IPO underpricing due to the winner's curse in auction IPOs without anchor investment
increases with increasing demand for IPO shares, whereas IPO underpricing due to the quid pro quo is relatively less sensitive to
investors' demand for IPO shares. Further acknowledging that institutional investors are more likely to conduct due-diligence and
report information private to institutional investors to the underwriter of the IPO when the probability of favorable allocation to
institutional investors in the primary market is high (Busaba and Chang, 2010; Akron and Samdani, 2017), we conjecture that IPO
underpricing is lower in auction IPOs without anchor investment, or without the quid pro quo, than with anchor investment, or with
the quid pro quo, when the demand for IPO shares from institutional investors is low, or when the competition for IPO shares among
institutional investors is low and the impact of the winner's curse on IPO price in auction IPOs without anchor investment is low. This
implies that auction IPOs “exposed” to the winner's curse are likely to generate higher IPO proceeds (lower IPO underpricing) than
auction IPOs exposed to the quid pro quo when the demand for IPO shares from institutional investors is low and the impact of the

1
The auction IPO method was used by 25 US firms between 2004 and 2016 (www.wrhambrecht.com).

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winner's curse on IPO price is low. Conversely, auction IPOs exposed to the quid pro quo are likely to generate higher IPO proceeds than
auction IPOs exposed to the winner's curse when the demand for IPO shares is high and the impact of the winner's curse on IPO price in
auction IPOs without anchor investment is more pronounced. These conjectures are borne out by the findings in this paper.
The findings contribute to the IPO literature in general and to the auctions literature in particular by demonstrating a cost-benefit
tradeoff in hybrid auction IPOs under a policy that combines the price-discovery benefits of book-building with the low costs of
auction, and that is sensitive to institutional investors' demand for IPO shares. Jagannathan et al. (2015) examine auction IPOs in
equity markets worldwide and find that when given a choice, issuers tend not to use the auction method once they have become
familiar with the method. They posit that the auction method is less attractive to issuers because sophisticated institutional investors
find it difficult to accurately shave for the winner's curse, implying that institutional investors find it difficult to assess the impact of
naïve investors' bids on IPO share price in sealed-bid auction IPOs, when the number of potential bidders is high. They conclude that a
hybrid auction IPO mechanism which includes a competitive tranche of IPO shares pledged to institutional investors curbs the impact
of naïve investors' bidding mistakes on the IPO share price and at the same time provides the information gathering benefits of the
U.S.-type book-building IPO method. Given the scarce data on auction IPOs (Degeorge et al., 2010; Jagannathan et al., 2015),2 there
exists almost no empirical evidence, to the best of our knowledge, of the impact of institutional investors' demand for IPO shares on
IPO proceeds in auction IPOs with a discretionary tranche of IPO shares pledged to institutional investors prior to public filing
relative to auction IPOs without a discretionary tranche, thereby making ours the first study to provide empirical evidence of the
impact of institutional investors' demand for IPO shares on IPO underpricing in these two types of hybrid auction IPOs. In doing so,
our study adds to the existing literature on anchor investment (Samdani, 2017; Bubna and Prabhala, 2014).
The findings also contribute to the growing entrepreneurial finance literature examining the optimal sources of financing
available to entrepreneurs and the role of policymakers in optimizing support programs for these sources of financing (Cumming and
Groh, 2018). In the crowdfunding strand of entrepreneurial finance literature, Signori and Vismara (2018) report that the degree of
investor participation in IPOs plays an important role in the success of the IPO in that IPOs with dispersed ownership are less likely to
issue further equity, suggesting “failure”, whereas IPOs backed by qualified investors almost always raise funds through further
equity issues. In the anchor-investment strand of entrepreneurial finance literature, Espenlaub et al. (2016) report that strategic
anchor investors in the U.S., who are dedicated longterm investors, enhance IPO survival time in that IPOs with strategic anchor
investment are likely to issue further equity, whereas IPOs with short-term cornerstone anchor investment are less likely to raise
funds through secondary equity offerings. The findings in this paper add to this literature by demonstrating that a hybrid auction IPO
mechanism which includes a discretionary tranche pledged to long-term anchor institutional investors prior to public filing provides
the information production benefits of book-building. The findings, however, also demonstrate that institutional investors in auction
IPOs without a discretionary tranche contribute to information production without a quid pro quo at a relatively lower cost when the
demand and thereby the competition for IPO shares among institutional investors is low. Thus, the findings demonstrate a cost-
benefit tradeoff in the anchor investment policy of the Jumpstart Our Business Startups (JOBS) Act in the U.S., which is sensitive to
institutional investors' demand for IPO shares in auction IPOs.
The rest of the paper is organized as follows. In Section 2 we discuss the institutional context in India that is relevant to the
analysis and develop the testable hypotheses. In Section 3 we present the data. In Section 4 we present our research methodology, and
we report the results in Section 5. In Section 6 we check for robustness and we conclude in Section 7.

2. Institutional background, related literature, and hypotheses development

2.1. Institutional background

The hybrid auction–book-building IPO method, introduced to the Indian IPO market in 1999 and used for the first time by issuers
of new equity in January 2000, entails the issuing firm selecting an underwriting bank and going on a “road show” to gauge the
demand for the issue. Following the information gathering period, the underwriting bank sets an initial price range and invites bids
from investors for a period of four days prior to setting the offer price. In this regard, the hybrid auction–book-building IPO method in
India is similar to the “standard” book-building IPO method in the U.S. The two methods are different in that bids for hybrid auction
IPO shares in India are binding, i.e., bidders cannot change or cancel their bids after the offer price is set, whereas bidders in the U.S.
can retract their bids any time. The two issue methods are also different in that the offer price at which the IPO shares are allocated to
investors in the primary market in India has to be between the lower and upper bounds of the initial price range, whereas the offer
price of book-building IPO shares in the U.S. may deviate by up to 20% from the initial price range, thereby allowing the underwriter
to set the offer price closer to the price revealed in investors' bids. IPO shares in India are listed and allocated to investors twenty days
after the underwriter sets the offer price.
A unique feature of the hybrid auction-book-building method in India is that IPO shares are allocated to institutional investors and
retail investors based on pre-defined allocation quotas determined by the regulatory authority, namely, the Securities and Exchange
Board of India (SEBI). Specifically, the SEBI mandates the allocation of 50% of IPO shares to retail investors and 50% to institutional
investors. In the case that the IPO is oversubscribed, shares are allocated to investors in their respective categories on a pro-rata basis
(Brooks et al., 2014). Bidders with the highest bids are therefore allocated the largest number of shares in oversubscribed IPOs (none

2
Twelve firms, including Google Inc. and Freddie Mac, used the open auction method of going public in the U.S. between 2004 and 2016 (www.
wrhambrecht.com).

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of the book-building IPOs in the 2005–13 period in India are undersubscribed), whereas bidders with the lowest bids may not get any
shares in oversubscribed IPOs. The SEBI contends that the fixed allocation quotas to investor types in India, initially introduced to
ensure institutional participation in the otherwise retail investor dominated equity market (Bubna and Prabhala, 2011), curb un-
derwriter bias for investor type, as documented for discretionary book-building IPOs in the United States (Aggarwal et al., 2002), and
for non-discretionary auction IPOs in Taiwan (Chiang et al., 2010).
Since its introduction to the Indian IPO market in 1999, the hybrid auction–book-building method has undergone two major
changes with regard to allocation of IPO shares to investors in the primary market. The first change, introduced by the regulatory
authority SEBI in September 2005, took away the power of discretionary allocation of IPO shares to institutional investors from the
underwriter.3 The second change, introduced by the SEBI in July 2009, reinstated some of the discretionary power taken away from
the underwriter by the September 2005 policy. Specifically, the July 2009 regulatory amendment to the SEBI 2000 DIP Guidelines
grants the underwriter the power to allocate 15% of the IPO (30% of the institutional investor quota) to institutional investors, also
known as anchor investors, prior to the bidding period at the underwriter's discretion. The price at which the shares are allocated to
anchor investors is the higher of the anchor price and the offer price.
Another distinct feature of the auction IPO method in India that is relevant for this study is that the bidding phase in India is
transparent—bidders in auction IPOs in India can electronically observe bids from all bidders, at half-hour intervals, whereas bidders
in book-building IPOs in the U.S. cannot observe the bids of other bidders or learn about the allocation of shares to investors until
after the allocation process is closed (Khurshed et al., 2014).

2.2. Related literature and hypotheses development

A growing literature relates IPO underpricing to the winner's curse problem pointed out by Rock (1986).4 For example, Chowdhry
and Sherman (1996) relate IPO underpricing to the winner's curse by demonstrating that issuers in most countries, including India,
reduce the winner's curse and thereby the required level of IPO underpricing by favoring small investors over large investors. Likewise,
Sherman (2005) relates IPO underpricing to the winner's curse by demonstrating that there are advantages, i.e., reduced winner's curse
and thereby reduced IPO underpricing, to “by invitation only” auctions, whereas Biais and Faugeron-Crouzet (2002) relate IPO
underpricing to the winner's curse by demonstrating that IPO underpricing encourages bidders to reveal endowed information.
More recently, Jagannathan et al. (2015) relate IPO underpricing to the winner's curse by showing that an equilibrium bid of
winning bids and losing bids is a function of the strength of an investor's signal—the strength of a negative signal grows as the number
of bids grows. In their sealed-bid auction IPO pricing framework, the offer price is sensitive to mistakes made by less-informed retail
bidders, whereby the bidding mistakes, which are more pronounced in auction IPOs with many bidders, make it difficult for even
well-informed institutional bidders to “accurately” shave for the winner's curse. To curb the impact of the winner's curse in auction IPOs
in India, the regulatory authority SEBI requires the bidding phase in auction IPOs in India to be transparent—bidders in India can
observe the “book” being built at half-hour intervals. Khurshed et al. (2009) and Neupane and Poshakwale (2012) argue that
transparency in book-building allows retail investors in India to learn from institutional investors' bids, which diminishes the winner's
curse in Indian IPOs. We add to this argument and conjecture that, in auction IPOs without a discretionary allocation policy, in-
stitutional investors are less likely to report information when the competition for IPO shares among institutional investors is high
and the probability of favorable allocation to institutional investors is low, implying that institutional bids are less likely to have
meaningful content, or information that is helpful for valuation when the number of bids from institutional investors is high. Thus, we
conjecture that retail investors are less likely to learn from institutional investors' bids, even if the bidding process is transparent,
when the demand for auction IPO shares from institutional investors is high under a policy that does not allow the underwriter to
pledge a tranche of IPO shares to institutional investors. This implies that IPO underpricing in auction IPOs without anchor in-
vestment is likely to be higher when the number of bids is high and the winner's curse problem is more pronounced, than when the
number of bids is low and the winner's curse problem is less pronounced. Thus, we hypothesize:
H1. First-day return is higher in auction IPOs without anchor investment when the level of institutional oversubscription is high than
when it is low.
With regard to IPO underpricing under a policy that allows underwriters to allocate IPO shares to investors at their discretion, the
literature shows that IPO underpricing in IPOs with allocation discretion is a quid pro quo for obtaining market demand information
from institutional investors in the primary market. For example, Aggarwal et al. (2002) examine the impact of institutional investors'
demand on IPO underpricing in book-building IPOs in the U.S. in the period 1997–8 and find that IPO underpricing in book-building
IPOs is higher when institutional demand for IPO shares is high and lower when institutional demand for IPO shares is low, sug-
gesting that underwriters reward institutional investors with underpriced IPO shares. Aggarwal et al. (2002), therefore, conclude that
IPO underpricing in book-building IPOs is a quid pro quo for obtaining market demand information from institutional investors. In a
related study, Rocholl (2009) examines the impact of institutional investors' role in book-building IPOs and finds that institutional
investors' support in book-building IPOs with weak market demand is a quid pro quo for underpriced IPO shares. In a study of
institutional investors' role in auction IPOs, Degeorge et al. (2010) examine 19 auction IPOs completed by WR Hembrecht in the U.S.,

3
See the circular SEBI/CFD/DIL/DIP/14/ 2005/25/1 dated January 25, 2005 at www.sebi.gov.in.
4
IPO underpricing in Rock's (1989) model addresses the uninformed investors' concern for acquiring overpriced issues in a setting in which
informed investors acquire only underpriced shares.

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between 1997 and 2007, and find that institutional investors are rewarded with a large share of the deal in underpriced IPOs. Given
that allocation of IPO shares to anchor investors in India is at the discretion of the underwriter, we conjecture that IPO underpricing
in auction IPOs with anchor investment is a quid pro quo for obtaining market demand information from anchor investors, regardless
of the level of institutional investors' demand for IPO shares. IPO underpricing in auction IPOs without anchor investment, in
contrast, is, as previously conjectured, a discount for the winner's curse problem.
Acknowledging that the probability of acquiring non-discretionarily allocated IPO shares in the primary market is higher when
the demand and thereby the competition for IPO shares among investors is low (Busaba and Chang, 2010; Akron and Samdani, 2017),
we further conjecture that institutional investors in auction IPOs without discretionary allocation are more likely to reveal in-
formation when the IPO is less oversubscribed, and they are less likely to reveal information when the IPO is more oversubscribed. In
this framework, IPO underpricing in auction IPOs without discretionary allocation is neither reflective of the quid pro quo nor of the
winner's curse when the demand from institutional investors is low, whereas IPO underpricing in auction IPOs with discretionary
allocation is reflective of the quid pro quo, regardless of demand. This implies that IPO underpricing associated with the quid pro quo
and the winner's curse is lower in auction IPOs without allocation discretion than in auction IPOs with allocation discretion when the
demand for IPO shares from institutional investors is low. Thus, we hypothesize:
H2. First-day return is lower in auction IPOs without anchor investment than with anchor investment when the level of institutional
oversubscription is low.

3. Data and sample characteristics

The data for the analysis is collected from Prime Database, Chittograph, the Bombay Stock Exchange (BSE), and the National
Stock Exchange (NSE).5 The data sample consists of 312 auction IPOs listed on the BSE and the NSE between September 2005 and
December 2013. IPOs of nine “penny-stock” firms, or firms with face-values of registered IPO shares below INR10 are excluded from
the data sample. IPO listings on the smaller stock exchanges in India are also excluded from the data sample.
The data on market index returns is collected form Money Control.6 Daily market returns are computed using the BSE SENSEX
index which is the Indian equivalent of the NYSE in the U.S. In addition to controlling for IPO size, firm size, IPO price update, retail
oversubscription, and price-to-earnings (P/E) ratio, the regressions also control for auditor reputation, underwriter reputation,
venture capitalist ownership, and IPO grading by a SEBI approved credit rating agency—a grade of 1 signifies a low “quality” IPO
firm and a grade of 5 signifies a high quality IPO firm, for example, relative to the industry. The variables are defined in detail in
Appendix B. Table 1 provides the descriptive statistics for the data sample.
Panel A in Table 1 shows the statistics for 184 auction IPOs in the period September 2005—July 2009. Shares of auction IPOs in
this period are allocated to investors on a pro-rata basis. Panel B and Panel C in Table 1 show the statistics for IPOs in the period July
2009—December 2013 in which anchor investors are allocated 15% of the IPO shares at the discretion of the underwriter. Panel B
and Panel C show 50 auction IPOs with anchor investments and 78 auction IPOs without anchor investment, respectively, whereas
Panel D shows the number of IPOs and the mean values IPO characteristics by year. The mean first-day return and the mean price
update shown are highest (0.27% and 0.04%, respectively) for auction IPOs without anchor investment in the pre-July 2009 period
(Panel A) and lowest (0.07% and 0.01%, respectively) for auction IPOs with anchor investment in the post-July 2009 period (Panel
C), suggesting superior information production in auction IPOs with anchor investment. The mean oversubscription levels of both
institutional investors and retail investors are highest in the pre-July 2009 period during which auction IPOs did not include a tranche
of IPO shares pledged to anchor investors. Overall, the results in Table 1 show that it is important to control for year fixed effects in
the analysis of IPO underpricing in India.
Table 2 presents the Pearson correlations between variables used in the regressions. As documented in the extant literature,
Table 2 shows that first-day return in India is positively related to both institutional oversubscription and retail oversubscription. The
positive relations suggest that although both categories of investors tend to make similar choices with regard to IPO subscription,
indicating a generally homogenous market reaction to an IPO, institutional oversubscription is higher in larger firms and larger
issues, whereas retail oversubscription is higher in smaller firms and smaller issues. This suggests that control for firm size and issue
size are important in the analysis. Price update is greater in smaller firms and smaller issues, indicating a high degree of information
asymmetry in smaller firms and smaller issues (Benveniste and Spindt, 1989). Also consistent with the findings in the literature
(Bubna and Prabhala, 2014; Clarke et al., 2016), Table 2 shows that IPO grade is positively related to institutional oversubscription
and not related to first-day return.
Table 3 presents, for each individual subsample of auction IPOs in India, the difference in means of IPO characteristics between
auction IPOs in the top tercile and auction IPOs in the middle and bottom terciles for institutional oversubscription. High level of
institutional oversubscription appears to be prevalent in larger firms and larger issues that use the auction method of IPO without
anchor investment both in the pre- and post-July 2009 periods. In auction IPOs with anchor investment, in contrast, institutional
oversubscription does not vary significantly by firm size and by issue size. Market-adjusted first-day return and price updates are
significantly higher for auction IPOs with a high level of institutional oversubscription in the pre-July 2009 subsample and the post-
July 2009 subsample of auction IPOs with anchor investment. Interestingly, these two variables are not very different across the

5
www.primedatabase.com, www.chittograph.com
6
www.moneycontrol.com

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Table 1
Descriptive and summary statistics of auction IPOs in India (09/2005-12/2013).
Panel A (09/2005–07/2009): Number of non-anchor-backed auction IPOs = 184

Mean Median p25 p75 Std. dev.

FIRST_DAY_RETURN 0.27 0.16 −0.41 0.47 0.47

OVERSUBSCRIBED_INST (multiple) 29.48 9.30 2.30 46.22 40.52
OVERSUBSCRIBED_RETAIL (multiple) 11.57 5.59 2.19 14.41 16.37
FIRM_SIZE (million INR) 27,123 3485 1996 11,208 103,919
ISSUE_SIZE (million INR) 3590 1009 608 2150 9988
PE_RATIO 196.53 27.88 15.39 59.37 1970.34
IPO_GRADE 2.64 3 2 3 0.93
PRICE_UPDATE (fraction) 0.04 0.05 0.03 0.07 0.05

Panel B (07/2009–12/2013): Number of anchor-backed auction IPOs = 50

Mean Median p25 p75 Std. dev.

FIRST_DAY_RETURN 0.07 0.06 −0.05 0.15 0.21

OVERSUBSCRIBED_INST (multiple) 13.92 5.91 2.29 20.69 16.48
OVERSUBSCRIBED_RETAIL (multiple) 4.55 1.82 0.41 6.23 6.63
FIRM_SIZE (million INR) 40,561 18,694 7937 38,548 67,281
ISSUE_SIZE (million INR) 5914 3605 1949 7375 6530
PE_RATIO 109.03 38.60 27.27 71.68 305.09
IPO_GRADE 3.44 3 3 4 0.75
PRICE_UPDATE (fraction) 0.01 0.02 −0.01 0.04 0.04

Panel C (07/2009–12/2013): Number of non-anchor-backed auction IPOs = 78

Mean Median p25 p75 Std. dev.

FIRST_DAY_RETURN 0.09 0.04 −0.17 0.32 0.42

OVERSUBSCRIBED_INST (multiple) 7.63 0.82 0.23 1.84 20.45
OVERSUBSCRIBED_RETAIL (multiple) 5.87 3.27 1.60 7.82 7.57
FIRM_SIZE (million INR) 36,404 2144 1312 6600 182,200
ISSUE_SIZE (million INR) 3781 736 502 1650 13,335
PE_RATIO 49.63 27.04 17.06 40.65 80.17
IPO_GRADE 2.38 2 2 3 0.91
PRICE_UPDATE (fraction) 0.03 0.03 0.02 0.05 0.04

Panel D: Number of IPOs and mean values of IPO characteristics by year

Year Number of IPOs FIRST_DAY_RETURN OVERSUBSCRIBED_INT FIRM_SIZE ISSUE_SIZE_

09/2005–12/2005 9 0.27 18.98 3916 1023

2006 57 0.27 25.80 15,087 2427
2007 85 0.30 39.16 32,276 4506
2008 34 0.15 15.54 40,928 4016
2009 16 0.11 15.36 45,685 4973
2010 62 0.13 0.74 8.91 5009
2011 36 0.05 1.56 7379 1535
2012 10 0.04 8.38 50,971 5176
2013 3 0.02 3.67 17,165 3992__
Total 312

Table 1 reports descriptive statistics of 312 IPOs listed on the National Stock Exchange and the Bombay Stock Exchange in India. Panel A shows the
statistics for 184 non-anchor-backed auction IPOs (09/2005–07/2009), whereas Panel B and Panel C show the statistics for 50 anchor-backed and
78 non-anchor-backed auction IPOs (07/2009–12/2013). Panel D shows the number of IPOs and mean values by year. The variables are defined in
Appendix B.

tercile groups for auction IPOs without anchor investment in the post-July 2009 period. It is important to note that the differences in
means reported in Table 3 do not preclude endogeneity due to selection bias. In the next section, we present our research metho-
dology for the analysis of the differential effects of institutional investors' demand for IPO shares on IPO initial returns.

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Table 2
Pairwise correlations among variables used in the analysis.
(1) (2) (3) (4) (5) (6) (7) (8)

FIRST_DAY_RETURN 1
Ln(OVERSUBSCRIBED_INT) 0.40*** 1
Ln(OVERSUBSCRIBED_RETAIL) 0.46*** 0.58*** 1
Ln(FIRM_SIZE) −0.06 0.44*** −0.12* 1
Ln(ISSUE_SIZE) −0.10* 0.37*** −0.17*** 0.97*** 1
PE_RATIO −0.01 0.10* 0.09 0.10* 0.08 1
PRICE_UPDATE 0.28*** 0.26*** 0.52*** −0.16*** −0.15*** −0.01 1
IPO_GRADE −0.03 0.53*** 0.05 0.66*** 0.64*** 0.02 −0.15** 1

Table 2 presents Pearson partial correlations among variables used in the analysis of a data sample consisting of 312 IPOs listed on the Bombay Stock
Exchange and the National Stock Exchange in India between September 2005 and December 2013. The variables are defined in Appendix B. The
asterisks ***, ** and * denote significance at the 1%, 5% and 10% levels, respectively, in a t-test.

Table 3
Difference in means (t-test)
Panel A 184 non-anchor-backed auction IPOs (September 2005–July 2009)

HIGH_OVERSUBSCRIBED_INST LOW_OVERSUBSCRIBED_INST Difference t-statistics

***
FIRST_DAY_RETURN 0.53 0.10 0.43 6.828
Ln(OVERSUBSCRIBED_RETAIL) 2.78 0.91 1.87*** 11.903
Ln(FIRM_SIZE) 9.23 8.10 1.13*** 5.677
Ln(ISSUE_SIZE) 7.61 6.84 0.77*** 4.911
PE_RATIO 429.60 58.25 371.34 1.226
PRICE_UPDATE 0.06 0.03 0.03*** 5.245
IPO_GRADE 3.2 2.43 0.77** 2.483

Panel B 50 anchor-backed auction IPOs (July 2009–December 2013)

HIGH_OVERSUBSCRIBED_INST LOW_OVERSUBSCRIBED_INST Difference t-statistics

FIRST_DAY_RETURN 0.22 0.00 0.22*** 3.867

Ln(OVERSUBSCRIBED_RETAIL) 1.94 −0.21 2.15*** 5.676
Ln(FIRM_SIZE) 10.07 9.83 0.24 0.656
Ln(ISSUE_SIZE) 8.27 8.24 0.03 0.114
PE_RATIO 46.58 138.48 −91.89 −0.928
PRICE_UPDATE 0.04 0.00 0.04*** 4.246
IPO_GRADE 3.50 3.39 0.11 0.441

Panel C 78 non-anchor-backed auction IPOs (July 2009–December 2013)

HIGH_OVERSUBSCRIBED_INST LOW_OVERSUBSCRIBED_INST Difference t-statistics

FIRST_DAY_RETURN 0.21 0.07 0.14 0.920

Ln(OVERSUBSCRIBED_RETAIL) 2.27 1.04 1.23*** 3.568
Ln(FIRM_SIZE) 10.48 7.86 2.62*** 6.075
Ln(ISSUE_SIZE) 8.47 6.69 1.76*** 5.207
PE_RATIO 29.58 52.57 −22.99 −0.845
PRICE_UPDATE 0.04 0.02 0.02 1.251
IPO_GRADE 3.65 2.20 1.45*** 5.436

Table 3 provides the results of the univariate mean difference test of various IPO characteristics variables between auction IPOs with high in-
stitutional investors' demand (top tercile) and auction IPOs with low institutional investors' demand (middle and bottom tercile) listed on BSE and
NSE in India. Panel A provides the results of the differences in means between the top tercile and the middle and bottom terciles for institutional
investors' demand of 184 auction IPOs without anchor investment in the period September 2005—July 2009. Panel B provides the results of the
differences in means between the top tercile and the middle and bottom terciles for institutional investors' demand of 50 auction IPOs with anchor
investment in the period July 2009—December 2013. Panel C provides the results of the differences in means between the top tercile and the middle
and bottom terciles for institutional investors' demand of 78 auction IPOs without anchor investment in the period July 2009—December 2013.
Detailed variable definitions are provided in Appendix B. Ln signifies the natural logarithm. The asterisks ***, ** and * denote significance at the
1%, 5% and 10% levels, respectively, in a two-tailed t-test.

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4. Research methodology

4.1. Comparison across quantiles

Wilcox (2006, 2012) contend that the quantile regression approach is more informative than the linear regression approach when
examining the difference in causal effects between two independent groups. Thus, to present the differential effects of low and high
institutional investor demand on the degree of underpricing in auction IPOs in India, we employ a quantile regression approach in
which we divide our data sample into top, middle, and bottom terciles for institutional oversubscription. We then compare the impact
on the dependent variable of institutional oversubscription in the top tercile with that in the middle and bottom terciles. Our research
approach follows from that of Cornelli and Goldreich (2001) who divide their data sample into quartiles based on the size of the bid
to examine the effect of bid size on allocation of IPO shares. Our research also follows from that of Brav and Gompers (1997) who
divide their data sample into terciles to compare the average book-to-market ratio of venture-backed and non-venture-backed IPO
firms in the U.S., and that of Clarke et al. (2016) who divide their data sample of Indian IPOs into quartiles to examine the effect of
subscription patterns on initial returns. In our approach, we divide the IPO data sample into terciles to examine the differential effects
on the first-day return (proxy for IPO underpricing) of high institutional oversubscription level relative to low institutional over-
subscription level in auction IPOs with anchor investments and without.

4.2. Instrumental variable estimation

A major challenge facing researchers investigating the effects of investors' decisions and managers' decisions on firm value using
non-experimental data is to address the concerns for endogeneity due to selection bias—non-random decisions—and due to omitted
variable bias—an omitted variable correlated with both the explanatory variable and the error term—that could bias the ordinary
least squares (OLS) results. For example, an omitted unobservable variable related to institutional investors' demand for IPO shares
and IPO underpricing could bias the OLS results, whereas oversubscribed IPOs and IPOs backed by anchor investment, if they are
non-random outcomes, could exhibit a selection bias: underwriters may selectively choose to back IPOs with anchor investment;
institutional investors may selectively seek to acquire more shares in underpriced auction IPOs; and/or underwriters may selectively
underprice those IPOs for which the demand from institutional investors is high. Consistent with Khurshed et al. (2014) who de-
monstrate a positive relation between IPO grade and oversubscription rate, Brooks et al. (2014) posit that the oversubscription rate in
Indian IPOs is an endogenously determined explanatory variable of IPO underpricing in that several factors, including IPO grades,
analyst recommendation, and when-issued quotes, that appear prior to the subscription period affect the oversubscription rate, which
in turn affects IPO underpricing. Specifically, they demonstrate that higher IPO grades lead to higher subscription rates for in-
stitutional investors, which in turn leads to higher IPO underpricing. They also demonstrate, as do several other studies (see, e.g.,
Khurshed et al., 2009; Bubna and Prabhala, 2014; Clarke et al., 2016), that retail investors' bidding behavior in India is influenced by
institutional investors' bidding behavior in that retail investors follow the bidding behavior of institutional investors in the trans-
parent IPO bidding phase, which suggests that IPO underpricing in India is likely be affected directly and/or indirectly by retail
investors' bidding behavior. Overall, these findings imply that IPO grade, which is known to investors prior to the IPO bidding phase
and which affects IPO underpricing through its effect on institutional oversubscription and anchor investment is a good instrument
for the latter two variables in India. Following this line of reasoning, we address endogeneity concerns due to omitted variable bias,
selection bias, and simultaneity or reverse causality by employing an instrumental variable (IV) regression approach, as in Angrist
and Imbens (1995), in which we choose IPO grade as an instrument for institutional oversubscription and anchor investment.
A good instrument in the IV regression framework satisfies both the “relevance” condition and the “exclusion” condition (Angrist
and Imbens, 1995). The partial correlation (non-zero) between IPO grade and the potentially endogenous institutional over-
subscription variable implies that IPO grade satisfies the relevance condition. This condition is also empirically testable via OLS and
the test of the null hypothesis that the coefficient for the instrument is zero against the hypothesis that it is not. The exclusion
condition, in contrast, requires that the covariance between the instrumental variable and the error term is zero. This condition is
difficult to test because the error term is not observable. Thus, to find a good instrument, researchers focus on understanding the
economics of the question at hand. For example, Khurshed et al. (2014) argue that the primary objective of mandatory IPO grading,
or third-party assessment of the fundamentals of the IPO firm, is to reduce the asymmetric information between firm insiders and
outside investors. Given that IPO grades are based on the same parameters as those used by institutional investors in their valuation
of the IPO, the information conveyed to less-informed retail investors by IPO grade is expected to be similar to that conveyed by
more-informed institutional investors during the transparent bidding phase in Indian IPOs. Consistent with this line of reasoning,
Brooks et al. (2014) argue that IPO grade, analyst coverage, and when-issued quotes are good instruments for subscription rate
because they are known to investors prior to the subscription period and because they are expected to have information content about
the quality of the IPO and the demand for IPO shares. As such, these instruments are likely to affect the subscription rate which, in
turn, is likely to affect IPO underpricing in India. Following this line of reasoning, and the findings that IPO underpricing in India is,
for the large part, driven by institutional investors' demand (Bubna and Prabhala, 2014; Brooks et al., 2014; Khurshed et al., 2014;
Clarke et al., 2016), we posit that IPO grade is a good instrument for institutional oversubscription and anchor investment in India.
In addition to the economic rationale noted above, we examine the appropriateness of IPO grade as a plausible instrumental
variable by conducted several post-estimation statistical tests, including a test to see whether institutional oversubscription and
anchor investment are endogenous (Wooldridge, 1995).

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4.3. Kernel-based propensity score matching

To ensure that IPOs with high institutional subscription rate in our analysis of IPO underpricing are otherwise “similar” to IPOs
with low institutional subscription rate, we employ a non-parametric approach with kernel-based Propensity Score Matching (PSM)
in which we associate to the outcome (IPO underpricing) of the “treatment” IPO (IPO with high institutional subscription rate) a
matched outcome given by the kernel-weighted average of the outcome of all IPOs in the “control” group (IPOs with medium and low
institutional subscription rate). The PSM not just enables matching at the mean but also balances the distribution of observed
characteristics across treatment and control. The kernel-based PSM procedure in this way mitigates selection bias due to observable
sample differences (Rosenbaum and Rubin, 1983). The procedure, which is robust to misspecification of the functional form, is
appealing because it does not impose the identification restriction of the instrumental variable procedure.
In order to minimize exclusion of IPOs from the data sample, the kernel-weighted PSM procedure assigns weights to each firm in
the control group in proportion to its “closeness” to the matched firm in the treatment group by IPO size, PE ratio, IPO price revision,
and whether or not the IPO is certified through reputable auditors and VC participation (Heckman et al., 1998). The common support
feature of the PSM procedure excludes “treated” IPOs with propensity scores greater than the largest propensity score in the control
group. The propensity score estimated in the kernel-based PSM procedure is the predicted value from a Probit regression of the
incidence of high institutional oversubscription on common factors, namely, the size of the IPO, the IPO firm's PE ratio, the per-
centage difference between the midpoint of the initial price range and the final offer price, and IPO certification, i.e., whether or not
the IPO is audited by a reputable auditor and whether or not VCs have a stake in the IPO.

5. Analysis and results

In this section, we test the predictions of our hypotheses H1 and H2. We accomplish this by examining the effects of anchor
investment and high institutional subscription rate on first-day return in auction IPOs in India using OLS regressions based on the
following regression model:
FIRST _DAY _RETURN =
1 ANCHOR _INVESTMENT + 2 HIGH _OVERSUBSCRIBED _INST +

3 ANCHOR _INVESTMENT × HIGH _OVERSUBSCRIBED _INST +

4 POST _2009 + 5 IPO _GRADE + 6 PE _RATIO + 7 VC _OWNERSHIP+

8 AUDITOR _REP + 9 UNDERWRITER _REP + 10 Ln (ISSUE _SIZE )+

11 PRICE _UPDATE + 12 OVERSUBSCRIBED _RETAIL + (1)

The left-hand side of Eq. (1) shows the dependent variable, FIRST_DAY_RETURN, which is a proxy for IPO underpricing. The right-
hand side of Eq. (1) shows, in addition to the control variables commonly used in Indian IPO studies (Khurshed et al., 2009; Marisetty
and Subrahmanyam, 2010; Neupane and Poshakwale, 2012; Bubna and Prabhala, 2011; Brooks et al., 2014), the binary anchor
investment variable, ANCHOR_INVESTMENT, the binary high institutional oversubscription variable, HIGH_OVERSUBSCRIBED_INST,
and the interaction term, ANCHOR_INVESTMENT*HIGH_OVERSUBSCRIBED_INST. These variables are defined in Appendix B. Table 4
reports the results of the regressions based on Eq. (1).
Model 1 in Table 4 shows the results of the OLS regression with the independent variables of interest, namely, the anchor
investment variable, ANCHOR_INVESTMENT, the high oversubscription by institutional investors variable, HIGH_OVERSUBSCRI-
BED_INST, and the interaction term, ANCHOR_INVESTMENT* HIGH_OVERSUBSCRIBED_INST. Model 2 also shows the results of the
OLS regression with the independent IPO GRADE variable. Models 3 and 4 in Table 4 are extended Models 1 and 2, respectively.
Model 5 is identical to Model 3 in all aspects except for the number of observations in the data sample used in each. While the data
samples used in Model 1 and Model 3 include all observations in the period September 2005—December 2013, the data samples used
in Model 2, Model 4, and Model 5 include observations in the period May 2007—December 2013 in which IPO grading is mandatory
in India. All five regression models shown in Table 4 control for industry-fixed effects and year-fixed effects.
The coefficients for ANCHOR_INVESTMENT and HIGH_OVERSUBSCRIBED_INST reported in the extended Model 3 and the ex-
tended Model 5 in Table 4 are statistically significant and positive, whereas the coefficients for the interaction term
ANCHOR_INVESTMENT *HIGH_OVERSUBSCRIBED_INST are statistically significant and negative. Taken together, these coefficients
imply that 1.) first-day return in auction IPOs without discretionary allocation is on average 31% (Model 3) to 32% (Model 5) higher
when the IPO is heavily oversubscribed by institutional investors than when the IPO is not heavily oversubscribed, thereby con-
firming hypothesis H1, and 2.) first-day return in auction IPOs without discretionary allocation is 16% (Model 5) to 19% (Model 3)
lower than first-day return in auction IPOs with allocation discretion when the IPO is not heavily oversubscribed by institutional
investors, thereby confirming hypothesis H2. The results also show that the first-day return in heavily oversubscribed auction IPOs
with anchor investment is 20% (0.19 + 0.31–0.30 in Model 3 and 0.16 + 0.32–0.28 in Model 5), which is less than the first-day
return in heavily oversubscribed auction IPOs without anchor investment noted earlier (31% in Model 3 and 32% in Model 5).
Overall, the results support the argument and the predictions of hypotheses H1 and H2 that IPO underpricing in auction IPOs not
exposed to the quid pro quo and the winner's curse is lower than IPO underpricing in auction IPOs exposed to the quid pro quo.
The statistically insignificant coefficients for the IPO_GRADE variable reported in Model 2 and Model 4 in Table 4 support the
conjecture that IPO grade does not directly affect IPO underpricing, suggesting that the IPO_GRADE variable is a suitable exogenous
proxy candidate for the ANCHOR_INVESTMENT variable and the HIGH_OVERSUBSCRIBED_INST variable in the analysis of IPO

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Table 4
First-day return in auction IPOs in India (September 2005—December 2013).
FIRST_DAY_RETURN Model 1 Model 2 Model 3 Model 4 Model 5

Constant 0.01 −0.05 1.57*** 1.38*** 1.71***

(0.349) (0.224) (0.422) (0.371) (0.522)
ANCHOR_INVESTMENT 0.01 0.19*** 0.16**
(0.055) (0.069) (0.075)
HIGH_OVERSUBSCRIBED_INST 0.42*** 0.31*** 0.32**
(0.064) (0.067) (0.126)
ANCHOR_INVESTMENT* HIGH_OVERSUBSCRIBED_INST −0.23** −0.30*** −0.28*
(0.107) (0.113) (0.148)
IPO_GRADE −0.05 −0.07
(0.033) (0.050)

Control variables
POST_2009 −1.25*** −1.22*** −1.27***
(0.095) (0.143) 0.120
PE_RATIO −0.01*** −0.01* −0.01**
(0.001) (0.001) (0.001)
VC_OWNERSHIP −0.04 −0.02 −0.05
(0.091) (0.114) (0.119)
AUDITOR_REP 0.07 0.08 0.01
(0.071) (0.115) (0.098)
UNDERWRITER_REP 0.02 0.09 0.04
(0.045) (0.102) (0.082)
Ln(ISSUE_SIZE) −0.07*** −0.01 −0.08**
(0.030) (0.055) (0.041)
PRICE_UPDATE 0.01 −0.49 −0.38
(0.681) (1.193) (1.106)
OVERSUBSCRIBED_RETAIL 0.08** (0.032) 0.11*** (0.036) 0.07* (0.044)
INDUSTRY_FIXED_EFFECTS Yes Yes Yes Yes Yes
YEAR_FIXED_EFFECTS Yes Yes Yes Yes Yes
Adjusted R2 0.19 0.01 0.29 0.12 0.20
Observations 312 178 312 178 178

Table 4 reports the OLS regression results for the effects of anchor investment and high institutional oversubscription on first-day return in 312
auction IPOs listed on the Bombay Stock Exchange and the National Stock Exchange in India (September 2005—December 2013). Models 2, 4, and
5, exclude IPO listings prior to May 1, 2007 when IPO grading was not yet mandatory in India. The dependent variable is FIRST_DAY_RETURN. All
variables are defined in Appendix B. Robust standard errors clustered by year and industry are in parentheses below the coefficients. The asterisks
***, ** and * denote significance at the 1%, 5% and 10% levels, respectively, in a two-tailed t-test.

underpricing in India (Bubna and Prabhala, 2014; Brooks et al., 2014; Clarke et al., 2016).

6. Robustness check

Self-selection bias may cause the coefficients estimated for the effect of anchor investment and high institutional oversubscription
on IPO underpricing in the OLS regression models (Table 4) to overstate the positive/negative effect of institutional investors on IPO
underpricing in India. If firms with most/least to benefit from institutional investors in auction IPOs choose to cater to institutional
investors, the negative relation between the interaction term (anchor institutional investment and high institutional over-
subscription) and IPO underpricing may not be causal but a by-product of the selection behavior of such firms. To address the concern
for endogeneity in general and selection bias in particular, we employ a regression technique that explicitly treats the variable
ANCHOR_INVESTMENT, the variable HIGH_OVERSUBSCRIBED_INST, and the interaction term ANCHOR_INVESTMENT*
HIGH_OVERSUBSCRIBED_INST as endogenous. Acknowledging that these variables are binary, and also acknowledging that simply
mimicking a two-stage least squares (2SLS) with binary variables may not produce consistent results (Wooldridge, 2010), we con-
struct a 3-step instrumental variable regression procedure, as in Adams et al. (2009), in which the first-step consists of regressing the
potentially endogenous binary variables on the exogenous variables using Probit procedures based on the following regression
equations.

ANCHOR _INVESTMENT =
1 IPO _GRADE + 2 PE _RATIO + 3 VC _OWNERSHIP+

4 AUDITOR _REP + 5 UNDERWRITER _REP + 6 Ln (ISSUE _SIZE ) + (2)

HIGH _OVERSUBSCRIBED _INST =

1 IPO _GRADE + 2 PE _RATIO + 3 VC _OWNERSHIP+

4 AUDITOR _REP + 5 UNDERWRITER _REP + 6 Ln (ISSUE _SIZE ) + (3)

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ANCHOR _INVESTMENT × HIGH _OVERSUBSCRIBED _INST =

1 IPO _GRADE + 2 PE _RATIO + 3 VC _OWNERSHIP+

4 AUDITOR _REP + 5 UNDERWRITER _REP + 6 Ln (ISSUE _SIZE ) + (4)

The second-step of the 3-step instrumental variable procedure consists of regressing the potentially endogenous variables on the
exogenous variables and the predicted probabilities estimated from the Probit regressions in the first step. The third and final step of
the IV regression procedure, which is also the second step of the 2SLS procedure, consists of regressing the outcome first-day return
variable on the exogenous variables, namely, the IPO_GRADE variable and the predicted values.
It is important to note that the reduced form first-stage of the 2SLS procedure in the 3-step instrumental variable procedure used
in the analysis includes all the exogenous covariates used in the second-stage of the 2SLS procedure. The 3-step instrumental variable
model thus overcomes the limitations of Probit and OLS procedures that may only produce consistent estimates under very restrictive
assumptions that rarely hold in real world settings (Wooldridge, 2010). Table A1 in Appendix A shows the results of the 3-step
instrumental variable procedure.
Models 1, 2, and 3 in Table A1 are the second-stage regressions of the 2SLS procedure. The data samples used in all three
regression models in Table A1 exclude IPOs listed in the pre-May 2007 non-mandatory IPO grading period.
The results show that in auction IPOs without anchor investment, the degree of underpricing is 75% (Model 1), 91% (Model 2),
and 83% (Model 3) higher when the institutional investor oversubscription level is high than when it is low. These results are
consistent with those reported in Table 4 and offer strong support for the prediction of hypothesis H1. The statistically significant and
negative coefficients for the ANCHOR_INVESTMENT* HIGH_OVERSUBSCRIBED_INST interaction term in Models 1, 2, and 3, to-
gether with the statistically significant and positive coefficients for the HIGH_OVERSUBSCRIBED_INST variable support the con-
jecture that IPO underpricing is lower (6%, 35%, and 2% in Model 1, 2, and 3, respectively) in auction IPOs with anchor investment
than without when institutional demand for IPO shares is very high. The post-estimation robust score test results (not reported) are
statistically insignificant, implying that we cannot reject the null hypotheses that institutional oversubscription is exogenous in the
analysis (Wooldridge, 1995). The test statistics also imply and that the OLS procedure is more efficient and thereby preferable to the
2SLS procedure. The post-estimation test (not reported) for overidentification restriction indicates that there are no overidentification
restrictions in the 2SLS procedure using the four instruments, namely, the IPO_GRADE variable, and the three predicted probabilities
estimated from the Probit regressions in the first step of the three-step instrumental variable procedure. The results therefore provide
robust evidence of the impact of institutional investors' demand for IPO shares on IPO underpricing in auctions IPOs with IPO shares
pledged to institutional investors prior to public filing relative to auction IPOs without IPO shares pledged to institutional investors.
To test whether the results are robust to different endogeneity checks, we appeal to the non-parametric kernel-based PSM ap-
proach—which addresses the endogeneity concern due to observable sample differences—and we reexamine the regression results in
Eq. (1). We further address the concern for sample selection bias due to missing values—the pre-July 2009 period does not have IPOs
with anchor investment—by dividing the data sample into three groups—a group of IPOs with anchor investment in the post-July
2009 period, a group of IPOs without anchor investment in the post-July 2009 period, and a group of IPOs without anchor investment
in the pre-July 2009 period. In each group, we estimate the predicted probabilities of the treatment IPOs—IPOs with high institu-
tional oversubscription level—using Probit regressions, and we assign to the outcome of the treatment IPO a matched outcome given
by a kernel-weighted average of the outcome of the control IPOs—all IPOs with “low” institutional oversubscription level. The weight
given to the control IPOs is in proportion to the closeness between the control IPOs and the treatment IPO based on their propensity
scores, thus removing biases due to differences in covariate distributions between the treatment and the control IPOs. The results of
the regressions using the non-parametric kernel-based PSM matched samples are reported in Table A2 and Table A3 in Appendix A.
Panel A in Table A2 reports the results of Probit regressions using a sample of 184 IPOs without anchor investment in the period
2005–09, whereas Panel B in Table A2 reports the results of Probit regressions using a sample of 78 IPOs without anchor investment
in the period 2009–13. Panel C in Table A2 reports the results of regressions using a matched sample in which the weights for the
group of observations in the pre-July 2009 period and the group of IPOs in the post-July 2009 period are estimated from the predicted
probabilities. The common support feature of the PSM procedure excludes treatment IPOs with propensity scores greater than the
largest propensity score in the control group.
The results in Panel C of Table A2 show that first-day return in auction IPOs without anchor investment is 48% to 51% higher
when the demand from institutional investors is high than when it is low, regardless of whether the IPO is listed in the pre-July 2009
period in which the anchor-investment option is not available to firms going public, or the IPO is listed in the post-July 2009 period in
which the anchor-investment option is available to firms. The analysis using subsamples, therefore, addresses the selection bias with
respect to anchor versus non-anchor investment in the data sample and confirms hypothesis H1. The balancing tests (not reported)
indicate that the PSM procedure is appropriately executed.
Panel A in Table A3 reports the results of Probit regressions using a sample of 78 IPOs without anchor investment in the period
2009–13, whereas Panel B reports the results of Probit regressions using a sample of 50 IPOs with anchor investment in the same
period. Panel C in Table A3 reports the results of regressions using a matched sample in which the weights for the group of IPOs with
anchor investment and the group of IPOs without anchor investment are estimated from the predicted probabilities. The common
support feature of the PSM procedure excludes treatment IPOs with propensity scores greater than the largest propensity score in the
control group.
The coefficients for ANCHOR_INVESTMENT and HIGH_OVERSUBSCRIBED_INST reported in both Model 1 and Model 2 in Panel C
of Table A3 are statistically significant and positive, whereas the coefficients for the interaction term ANCHOR_INVESTMENT
*HIGH_OVERSUBSCRIBED_INST are statistically significant and negative. Taken together, these coefficients imply that 1.) first-day

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return in auction IPOs without discretionary allocation is on average 79% higher when the IPO is heavily oversubscribed by in-
stitutional investors than when the IPO is not heavily oversubscribed, thereby confirming hypothesis H1, and 2.) first-day return in
auction IPOs without discretionary allocation is 45% (Model 1) to 47% (Model 2) lower than first-day return in auction IPOs with
allocation discretion when the IPO is not heavily oversubscribed by institutional investors, thereby confirming hypothesis H2. The
results also show that first-day return in heavily oversubscribed auction IPOs with discretionary allocation is 71% (0.79 + 0.45–0.53
in Model 3) to 72% (0.79 + 0.47–0.54 in Model 5) on average, whereas first-day return in heavily oversubscribed auction IPOs
without discretionary allocation is, as noted before, 79%, thereby supporting the conjecture that IPO underpricing in heavily
oversubscribed auction IPOs without allocation discretion is higher than IPO underpricing in heavily oversubscribed auction IPOs
with allocation discretion. The unreported balancing tests indicate that the PSM procedure is appropriately executed. Overall, the
results reported in Table A3 are consistent with the OLS regression results reported in Table 4 and the 2SLS regression results reported
in Table A1.

7. Conclusion

In this paper, we exploit a policy change—which grants the underwriters of post-July 2009 hybrid auction IPOs in India the right
to arbitrarily pledge a fixed quota (15%) of auction IPO shares to anchor institutional investors prior to the auction—to demonstrate a
cost-benefit tradeoff in auction IPOs that is sensitive to institutional investors' demand for IPO shares. Our results show that auction
IPOs that include a tranche of IPO shares pledged to institutional investors generate higher proceeds (lower first-day return) when the
demand for IPO shares from institutional investors is high, whereas auction IPOs that do not include a tranche of IPO shares pledged
to institutional investors generate higher proceeds when the demand for IPO shares from institutional investors is low. The findings
underscore the important role played by institutional investors in auction IPOs and elucidate the complexity in pricing auction IPO
shares. This complexity, which is induced by institutional investors' demand for IPO shares, also explains why auction, albeit
commonly used for debt instruments worldwide, is rarely used for new equity issues.

Acknowledgements

We thank the editor, Douglas Cumming, and two anonymous referees for their insightful comments. We thank Mattias Nilsson for
valuable suggestions. We also thank Gary Moore, Alex Petkevitch, Kainan Wang, Chi Wan, and participants at the FMA 2018 annual
meeting for excellent comments.

Appendix A

Table A1
Instrumental variable estimation (July 2009—December 2013).

FIRST_DAY_RETURN Model 1 Model 2 Model 3

Constant 0.62 (0.462) 0.58 (0.569) 0.65 (0.744)

ANCHOR_INVESTMENT 0.22 (0.218) 0.50 (0.325) 0.25 (0.398)
HIGH_OVERSUBSCRIBED_INST 0.75*** (0.215) 0.91*** (0.349) 0.83* (0.432)
ANCHOR_INVESTMENT * HIGH_OVERSUBSCRIBED_INST −0.81*** (0.280) −1.26** (0.541) −0.85* (0.463)

Control variables
PE_RATIO −0.01 (0.001) −0.01 (0.001) −0.01 (0.001)
VC_OWNERSHIP −0.05 (0.105) −0.13 (0.168) −0.09 (0.148)
AUDITOR_REP −0.01 (0.069) 0.01 (0.081) 0.02 (0.074)
UNDERWRITER_REP −0.04 (0.133) −0.09 (0.197) −0.01 (0.159)
Ln(ISSUE_SIZE) −0.08 (0.067) −0.09 (0.084) −0.09 (0.107)
PRICE_UPDATE 2.38 (1.787) 1.69 (1.396)
OVERSUBSCRIBED_RETAIL −0.01 (0.101)
F-statistic 15.03 5.16 46.73
Observations 56 56 56

Table A1 reports the results of Instrumental Variable regressions in which the IPO_GRADE variable and the predicted probabilities estimated using
Probit regressions are instruments for the ANCHOR_INVESTMENT variable, the HIGH_OVERSUBSCRIBED_INST variable, and the ANCHOR_INVE-
STMENT*HIGH_OVERSUBSCRIBED_INST interaction term. The variables shown in the table are defined in Appendix B. Robust standard errors
clustered by year and industry are in parentheses below the coefficients. The asterisks *, **, *** denote significance at the 10%, 5%, and 1% levels,
respectively, in a two-tailed t-test.

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Table A2
Propensity score matching estimation (2005–2013).

Panel A: Probit (2005–2009): IPOs without anchor investment

HIGH_OVERSUBSCRIBED_INST Model 1 Model 2

Ln(ISSUE_SIZE) 0.57*** (0.167) 0.58*** (0.191)

PE_RATIO 0.01 (0.001) 0.01 (0.001)
PRICE_UPDATE 24.01*** (4.888) 23.40*** (5.071)
VC_OWNERSHIP −1.48* (0.854)
AUDITOR_REP −0.30 (0.551)
UNDERWRITER_REP 0.28 (0.357)
INDUSTRY_FIXED_EFFECTS Yes Yes
Pseudo R2 0.40 42
Observations 184 184

Panel B: Probit (2009–2013): IPOs without anchor investment

HIGH_OVERSUBSCRIBED_INST

Ln(ISSUE_SIZE) 0.77 (0.658) −0.01 (0.917)

PE_RATIO 0.02 (0.030) 0.04 (0.047)
VC_OWNERSHIP 34.48 (0.168) 46.62* (27.772)
UNDERWRITER_REP 2.55 (0.159)
INDUSTRY_FIXED_EFFECTS Yes Yes
Pseudo R2 0.34 0.41
Observations 78 78

Panel C: Matched sample (2005–2013): IPOs without anchor investment

FIRST_DAY_RETURN

HIGH_OVERSUBSCRIBED_INST 0.51*** (0.087) 0.48*** (0.092)

POST_2009 −0.56*** (0.105) −0.19*** (0.001)
HIGH_OVERSUBSCRIBED_INST * POST_2009 0.24 (0.150) −0.10 (0.147)
Adjusted R2 0.41 0.26
Observations 213 207

Panel A in Table A2 reports the results of Probit regressions using 184 IPOs without anchor investment in the period
2005–09, whereas Panel B reports the results of Probit regressions using 78 IPOs without anchor investment in the
period 2009–13. Panel C reports the results of regressions of a matched sample using the propensity scores estimated
in Panel A and Panel B in the period 2005–13. Robust standard errors clustered by year and industry are in par-
entheses below the coefficients. The asterisks *, **, *** denote significance at the 10%, 5%, and 1% levels, respec-
tively, in a two-tailed t-test.

Table A3
Propensity score matching estimation (2009–2013).

Panel A: Probit (2009–2013): IPOs without anchor investment

HIGH_OVERSUBSCRIBED_INST Model 1 Model 2

Ln(ISSUE_SIZE) 0.77 (0.658) 0.77 (0.658)

PE_RATIO 0.02 (0.030) 0.02 (0.030)
PRICE_UPDATE 34.48* (19.842) 34.48* (19.842)
INDUSTRY_FIXED_EFFECTS Yes Yes
Pseudo R2 0.34 0.34
Observations 78 78

Panel B: Probit (2009–2013): IPOs with anchor investment

HIGH_OVERSUBSCRIBED_INST

Ln(ISSUE_SIZE) −0.25 (0.448) −0.26 (0.463)

PE_RATIO −0.01 (0.008) −0.01 (0.008)
PRICE_UPDATE 32.86** (13.742) 32.08** (14.161)
VC_OWNERSHIP 34.48 (0.168) 0.18 (0.686)
AUDITOR_REP −0.21 (0.833)
(continued on next page)

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Table A3 (continued)

Panel B: Probit (2009–2013): IPOs with anchor investment

HIGH_OVERSUBSCRIBED_INST

INDUSTRY_FIXED_EFFECTS Yes Yes

Pseudo R2 0.39 0.40
Observations 50 50

Panel C: Matched sample (2009–2013): IPOs with and without anchor investment

FIRST_DAY_RETURN

HIGH_OVERSUBSCRIBED_INST 0.79*** (0.175) 0.79*** (0.174)

ANCHOR_INVESTMENT 0.45*** (0.083) 0.47*** (0.090)
HIGH_OVERSUBSCRIBED_INST * ANCHOR_INVESTMENT −0.53* (0.278) −0.54* (0.269)
Adjusted R2 0.33 0.42
Observations 83 83

Panel A in Table A2 reports the results of Probit regressions using 78 IPOs without anchor investment and 50 IPOs with anchor investment in the
period 2009–13. Panel C reports the results of regressions of a matched sample using the probability scores estimated in Panel A and Panel B in the
period 2009–13. Robust standard errors clustered by year and industry are in parentheses below the coefficients. The asterisks *, **, *** denote
significance at the 10%, 5%, and 1% levels, respectively, in a two-tailed t-test.

Appendix B

Variable definitions

OFFER_PRICE Price per share of the offering in the primary market.

MID_INITIAL_PRICE Initial price range of the offering in the primary market.
PRICE_UPDATE Change (%) in OFFER_PRICE from MID_INITIAL_PRICE.
FIRST_DAY_RETURN ((First-day closing price / OFFE_PRICE) —1) — SENSEX daily return).
OVERSUBSCRIBED_INST Times IPO is oversubscribed by institutional investors.
OVERSUBSCRIBED_RETAIL Times IPO is oversubscribed by retail investors.
HIGH_OVERSUBSCRIBED_INST Takes the value 1 if IPO in the top tercile for institutional oversubscription, 0 otherwise.
LOW_OVERSUBSCRIBED_INST Takes the value 1 if IPO in the middle or bottom tercile for institutional oversubscription, 0 otherwise.
ANCHOR_INVESTMENT Takes the value 1 if IPO includes anchor investment, 0 otherwise.
PE_RATIO Price-to-earnings ratio (in multiples).
ISSUE_SIZE IPO size (million INR).
FIRM_SIZE Firm size (million INR).
VC_OWNERSHIP Takes the value 1, if venture capitalists own shares in the IPO firm, 0 otherwise.
AUDITOR_REP Takes the value 1 if IPO firm audited by reputable auditors, 0 otherwise.
UNDERWRITER_REP Takes the value 1 if IPO firm underwritten by a reputable underwriter, 0 otherwise.
IPO_GRADE Grades between 1 and 5 are assigned by a SEBI approved rating agency. A grade of 1 indicates a low-quality firm and a grade of
5 indicates a high-quality firm relative to the industry.
POST_2009 Takes the value 1 if IPO is listed after July 2009, 0 if IPO listed before July 2009.

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