1 Introduction
Two of the important functions of a financial system are to facilitate risk sharing amonginvestors and capital formation by firms. The initial public offering (IPO) process performsboth functions by allowing the initial owners of a firm to raise capital by transferring andsharing some of the firm’s risk with the wider investing public. If the IPO process was fullyefficient, an IPO should maximize the issuer’s proceeds, the investors who most value theshares should receive them, and in the absence of news or private information, there shouldbe little trade after the shares are allocated. Additionally, the fact that a stock is a newissue should not influence its risk-adjusted expected returns in aftermarket trading.Relative to this benchmark, U.S. IPOs appear to be highly inefficient: post-IPO sharetrading is initially very heavy
1
, and the allocation price of U.S. IPOs is on average nearly19 percent below the closing price on the first day of trade [Ritter and Welch (2002)]. Thisunderpricing is an apparent loss to issuers who would prefer to have sold at the higherprice in the IPO aftermarket. The IPO process has other inefficiencies: allocations tendsto favor institutional investors
2
and, after the first trading day, the returns of new issuesunderperform on a market and characteristic adjusted basis for a period of time as long asthree years [Loughran and Ritter (1991), Ritter and Welch (2002)].
3
This paper presents a fully rational, symmetric information, theoretical model of IPOshare allocation and price-setting, and of trading in the IPO aftermarket. The paper is builtaround the idea that trading conditions in the aftermarket may simultaneously explain un-derpricing, underperformance, and why allocations favor institutional investors. The modelof the aftermarket is imperfectly competitive in the sense that there are some “large” in-vestors who have market power, that is their trades move prices and they account for thiswhen trading. The IPO is modeled as a bargaining game between the underwriter and theaftermarket investors: The underwriter must sell a fixed number of shares at the IPO orshortly afterwards in aftermarket trading. To do so, he sets a uniform IPO offer price andoffers take it or leave it share allocations to the investors. Any shares that go unallocated aresold by the underwriter in aftermarket trading that follows the IPO. Large investors’ market
1
Ellis, Michaely, and O’Hara’s (2000) study of NASDAQ IPO’s, found that turnover on the first tradingday is equal to 1/3rd of the turnover that a NASDAQ stock experiences over a year.
2
Institutional investors receive more favorable allocations than retail investors in the most underpricedissues.
3
There is an ongoing debate within the empirical literature concerning whether IPO underperformanceexists and whether it is statistically significant. For a discussion of these issues see Viswanathan and Wei(2004), de Jong and Dahlquist (2003), Schultz (2003), Loughran and Ritter (2000), and Brav, Geczy, andGompers (2000).
1
Leave a Comment