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You are on page 1of 40

**Long-Run Underperformance
**

Ralph Bachmann

∗

Nanyang Business School

Division of Banking and Finance

Nanyang Avenue, S3-B1A-14

Singapore 639798

ARBachmann@ntu.edu.sg

Phone: +65 6790 5000

Fax: +65 6794 6321

Comments welcome!

March 11, 2004

∗

I wish to thank Vik Nanda, Jay Ritter, Masako Ueda, seminar participants at Nanyang Tech-

nological University, and participants of the 2003 Australasian Banking and Finance Conference

in Sydney for valuable comments.

A Theory of IPO Underpricing, Issue Activity, and

Long-Run Underperformance

Abstract

We present a dynamic model of an IPO market in which ﬁrms go public to raise capital

for investment. The original shareholders have inside information with respect to the quality of

their ﬁrm’s investment opportunities, and they decide whether to go public, how much capital

to raise and invest, and how to price the IPO. Outside investors are of one of two types: some

investors know and understand even the not directly observable economic incentives of the original

shareholders, whereas all other investors learn about the IPO market only from the publicly

observable IPO market data. Market participation by the latter investors can upset the stationary

rational equilibrium and give rise to a dynamic equilibrium that is characterized by: (1) IPO

underpricing, (2) underperformance of IPO shares in the long run, and (3) cyclical variations

in IPO volume. Learning investors upset the stationary equilibrium not because of ex ante

unreasonable beliefs, but because they fail to condition their beliefs on variables that convey only

redundant information in the stationary equilibrium. The model provides a joint explanation for

the three empirically documented IPO market “anomalies,” and it yields a number of new testable

empirical predictions.

JEL classiﬁcation: D82, D83, G31, G32.

I Introduction

Financial economists have documented at least three puzzling empirical regularities in the market

for initial public oﬀerings of common stock: IPO underpricing, i.e. positive excess returns in the

short run; strong concentration of IPO activity in certain periods; and underperformance of IPO

shares in the long run.

The ﬁrst empirical evidence on IPO underpricing dates back to a study by the U.S. Securi-

ties and Exchange Commission (SEC) in 1963. A large body of subsequent empirical research

has conﬁrmed the ﬁnding that IPOs tend to be substantially underpriced in the U.S., as well as

internationally.

1

Ibbotson and Jaﬀe (1975) present evidence of the existence of “hot issue” mar-

kets, which they deﬁne as periods during which the initial performance of IPOs is exceptionally

high. Moreover, they ﬁnd evidence of a strong concentration of IPO activity in certain periods.

Loughran, Ritter, and Rydqvist (1994) report that similar patterns can be observed internation-

ally. Evidence of long-run underperformance of IPO shares was ﬁrst presented by Ritter (1991),

who also ﬁnds that underperformance was most severe for ﬁrms that went public during certain

years of high IPO activity. Further evidence on IPO underperformance in the long run is presented

by Loughran and Ritter (1995).

Much of the theoretical research on IPOs has focused on explaining IPO underpricing. Possible

reasons for underpricing include self-interested investment bankers (Baron and Holmstr¨om (1980)

and Baron (1982)), the “winner’s curse” (Rock (1986)), lawsuit avoidance (Tini¸c (1988) and

Hughes and Thakor (1992)), signaling (Allen and Faulhaber (1989), Grinblatt and Hwang (1989),

and Welch (1989)), market incompleteness (Mauer and Senbet (1992)), bookbuilding (Benveniste

and Spindt (1989)), and informational cascades (Welch (1992)). Evidence suggests also that in

some countries IPO underpricing may be due to the regulatory environment (see Loughran, Ritter,

and Rydqvist (1994)), or because the allocation of IPO shares can be used as a bribe.

One possible explanation for the strong ﬂuctuations in IPO volume is that the cost of issuing

1

See Ibbotson and Ritter (1995) for a survey of the research on initial public oﬀerings. Loughran, Ritter, and

Rydqvist (1994) focus on the international evidence.

1

equity varies across the business cycle. Choe, Masulis, and Nanda (1993) present a model in

which the business cycle causes adverse selection costs to vary over time. Adverse selection costs

are lower in periods of economic expansion which leads ﬁrms to issue equity primarily during

such times. Choe, Masulis, and Nanda also provide some evidence in support of their model.

Although their paper is about seasoned equity oﬀerings, it is conceivable that varying degrees of

asymmetric information across the business cycle also aﬀect the market for initial public oﬀerings.

Chemmanur and Fulghieri (1999) point out another possible explanation for the strong clustering

of IPOs in certain periods, namely the existence of productivity shocks that are correlated across

ﬁrms. In Maug (2001) clustering of IPOs occurs because the ﬁrst IPO(s) in a new industry

lead investors to developing a better understanding of this industry. This reduces their costs of

evaluating subsequent IPOs. Stoughton, Wong, and Zechner (2001) present a model in which the

market clearing price of an IPO conveys information with respect to the ﬁrm’s future prospects,

as well as with respect to the prospects of the entire industry. Clustering of IPOs can occur when

an IPO conveys very favorable information with respect to an industry’s growth opportunities.

Lowry (2003) investigates empirically whether the ﬂuctuations in IPO volume can be explained

by the aggregate capital demands of private ﬁrms, by the adverse selection costs of issuing equity,

or by the level of investor optimism. She ﬁnds that all three factors are statistically signiﬁcant, but

that only the ﬁrms’ aggregate capital demand and investor sentiment appear to be economically

signiﬁcant determinants of IPO volume. Lowry and Schwert (2002) report a signiﬁcant positive

lead-lag relation between initial returns and future IPO volume. They provide evidence suggesting

that this lead-lag relationship between initial returns an IPO volume may be driven by information

that is learned by the underwriter during the registration period, but that is not fully incorporated

into the oﬀer price.

If one is willing to accept the view that IPO shares tend to underperform the market in the long

run then rational explanations of this phenomenon appear hard to come by.

2

Most of the literature

on this topic therefore empirical and points in the direction of limited investor rationality and

2

Whether IPO shares really underperform the market in the long run has recently been subject to some debate.

See Brav and Gompers (1997), Eckbo and Norly (2000), and Loughran and Ritter (2000).

2

psychological ﬁnance.

3

However, one possible rational explanation is that IPO underperformance

is due to investor learning. Morris (1996) presents a model in which investors share a common

prior belief with respect to the value of IPO ﬁrms, but in which they have diﬀerent prior beliefs

with respect to the distribution of the ﬁrm values. In this setting, “speculative bubbles” can

occur, in which IPOs are sold at a price that is above each individual investor’s valuation. In such

a bubble each investor anticipates to be able to sell his shares in the aftermarket to an investor

with a higher valuation. IPOs underperform as investors learn about the true distribution of the

ﬁrm values in the long run.

The to our knowledge only theory that links all three IPO market anomalies to a single cause is

due to Ljungqvist, Nanda, and Singh (2001). They attribute all three phenomena to the existence

of a class of investors who are, at times, irrationally exuberant about the prospects of IPOs. In

their model the selling policy that is in the issuer’s best interest usually involves staggered sales.

Underpricing happens to compensate the regular (institutional) investors for the risk of losing

money on their inventory in the event that the hot issue market ends prematurely.

We propose an alternative theory that is also capable of jointly explaining IPO underpricing,

ﬂuctuations in IPO volume, and long-run underperformance of IPO shares. In our model ﬁrms

go public to raise capital for investment. IPO underpricing is a rational equilibrium outcome that

obtains as a result of the original shareholders’ personal wealth maximization under asymmetric

information. Periods of high IPO activity and long-run underperformance are attributable to the

presence of investors who learn about the IPO market based on publicly observable performance

of past IPOs.

The structure of our model is quite simple. We assume universal risk neutrality and model

IPOs as direct transactions between entrepreneurs and investors. Nature randomly creates in-

vestment opportunities that are of one of two types (proﬁtable or unproﬁtable). Each investment

opportunity is available to a single personal wealth maximizing entrepreneur who is privately in-

formed about its proﬁtability. Undertaking the investment opportunity requires an IPO to raise

3

Hirshleifer (2001) provides a comprehensive overview of the various psychological biases and their common root

causes.

3

capital for investment. Depending on the terms at which equity can be sold the entrepreneurs

decide whether to go public, how much capital to raise and invest, and how to price an IPO.

Under plausible conditions some entrepreneurs ﬁnd it optimal to augment the information that is

conveyed by their investment decisions to outsiders by underpricing their IPOs. In equilibrium,

the combination of IPO pricing and investment choice signals the quality of a ﬁrm’s investment

opportunities.

We then introduce a class of investors who learn about the IPO market only based on publicly

observable data, such as the performance of past IPOs. Intuitively, these investors are like sta-

tisticians who lack a structural model of the world, and who try to understand the IPO market

just from looking at the data. In the stationary equilibrium these investors can learn to infer the

value of an IPO from the issuing ﬁrm’s investment policy alone. The issue price of an IPO does

not convey any additional information.

Learning investors will eventually be able to infer which IPOs are underpriced, and also by

how much. However, while learning investors may eventually be able to forecast which IPOs are

underpriced, they cannot infer from the data why these IPOs are underpriced. It is consistent

with the beliefs of these investor to purchase any IPO that is issued at a price weakly below

its inferred expected value. This creates an opportunity for some issuing ﬁrms to sell equity at

a price closer to its fair value, but it also alters the incentives of those entrepreneurs that did

not previously ﬁnd it proﬁtable to go public. In our model even a slight increase in the price at

which ﬁrms can issue equity can alter the incentives of lower quality ﬁrms. This results in an

increase in IPO volume, and a sudden drop in the average IPO quality that leads to subsequent

IPO underperformance.

4

After a period of high IPO activity the IPO market reverts back to

the rational equilibrium as long-run underperformance leads the learning investors to revise their

beliefs downwards.

The main empirical implications of our model are as follows. (1) Consistent with the conven-

tional wisdom our model predicts that IPOs are, on average, underpriced, but that they under-

perform the market in the long run (if long run performance is measured based on the ﬁrst market

4

This suggests that underpricing may be a necessary condition for the absence of underperformance.

4

clearing price). (2) Long-run underperformance is limited to IPOs that take place during periods

of high IPO volume. This prediction is consistent with the ﬁndings of Loughran and Ritter (2000)

and others. (3) IPOs that take place during periods of high IPO volume underperform the market

even if long run performance is measured based on the issue price. (4) Periods of exceptionally

high IPO volume are not a market wide phenomenon, but rather limited to certain industries.

This prediction is in line with existing evidence (see, e.g. Ritter (1984)). Moreover, our model

suggests that exceptionally high IPO volume is attributable to ﬁrms that go public speciﬁcally to

raise capital for investment. (5) Consistent with ﬁndings by Lowry and Schwert (2002) our model

predicts a positive lead-lag relationship between initial returns and IPO volume. In our model,

high initial returns attract unsophisticated investors to the IPO market. Their presence allows

ﬁrms to issue equity at a higher price, which results in a subsequent increase in IPO activity. (6)

Our model predicts that periods of exceptionally high IPO volume come to an end when investors

begin to learn about the true fundamental value of these ﬁrms. (7) Finally, our model suggests

that the variance of the long run performance of ﬁrms that go public during periods of high IPO

volume should be much large than that of ﬁrms that go public during periods of low IPO activity.

The remainder of this paper is organized as follows. The model is set up in Section II.

Section III discusses the rational IPO market equilibrium in the absence of learning. Section IV

contains the analysis of investor learning and the dynamic IPO market equilibrium. Section V

summarizes the empirical implications, and Section VI concludes. All proofs are in the Appendix.

II The Model

A The Economy

Consider an economy with ﬁrms that are initially privately held by owner-managers (“entrepre-

neurs”). The distinctive feature of entrepreneurs is that they may have access to additional

physical investment opportunities, whereas the remaining agents in the economy (“investors”)

have only access to ﬁnancial market investments. All agents in the economy are risk neutral

and maximize their respective personal wealth. There are no transaction costs or taxes, and the

5

interest rate is zero.

B Firms, Entrepreneurs, and IPOs

Nature creates investment opportunities in discrete time intervals, ∆t > 0. At each point in

time, t

j

= t

0

+ j∆t, j ∈ {0, 1, 2, . . .}, nature creates a physical investment opportunity with

probability λ ∈ (0, 1). Any such investment opportunity is available only to a single entrepreneur.

An investment opportunity that opens up has to be undertaken immediately, or it ceases to exist.

We assume that ﬁrms are all-equity ﬁnanced, and that additional investment can only be

ﬁnanced by means of an initial public oﬀering (IPO) of common stock. This could be, for example,

because entrepreneurs do not have any own funds to pay for the additional investment, asymmetric

information or agency problems rule out debt ﬁnancing, and the wealth of each individual investor

is too small to allow a private equity placement.

The value of any ﬁrm’s assets in place prior to (or without) an IPO is equal to A > 0.

5

An

investment opportunity is of one of two types that we refer to as type-G (“good”) and type-B

(“bad”) respectively.

6

Firms diﬀer only in terms of their investment opportunities so that we will

refer to a ﬁrm with access to a type-G (type-B) project as a type-G (type-B) ﬁrm and to its

original shareholder as a type-G (type-B) entrepreneur.

The (expected) marginal proﬁt function of a type-T project is denoted by π

T

(I). Marginal

proﬁt functions are assumed to be continuously diﬀerentiable functions of investment with the

following properties:

7

(A1) A type-G project yields higher marginal returns on investment than a type-B project,

5

The assumption that ﬁrms do not diﬀer in terms of the value of their assets in place is a simplifying assumption

that is not crucial for our results.

6

An extension of the model to more than two types is straightforward but tedious.

7

None of these assumptions is crucial for the main results of the model. The assumptions (A1), (A2), and (A4),

are merely technical assumptions that allow us to keep the analysis simple. Even if we relaxed assumption (A3) by

assuming that both types have a positive NPV project we could obtain IPO underpricing, long-run underperfor-

mance, and ﬂuctuations in the amount of equity that is issued. However, we could not obtain ﬂuctuations in the

number of IPOs that take place.

6

irrespective of the level of investment: π

B

(I) < π

G

(I) for all I ≥ 0.

(A2) Projects exhibit decreasing returns to scale: π

T

(I) < 0 for all I > 0, T ∈ {G, B}.

(A3) Only type-G projects have a positive expected NPV: π

G

(0) > 0, but π

B

(0) ≤ 0.

(A4) Marginal gross returns on investment are non-negative. This means that marginal losses

from ineﬃcient investment never exceed the additional investment outlay: π

T

(I) > −1 for

all I > 0, T ∈ {G, B}.

The ex ante probability that an investment opportunity is type-G is equal to p ∈ (0, 1), and

the probability that it is type-B is equal to 1−p. The project type is initially private information

of the entrepreneur and it is not veriﬁable ex post.

We abstract from the existence of ﬁnancial intermediaries and model IPOs as direct transac-

tions between entrepreneurs and investors. Our assumption of universal risk neutrality implies

that entrepreneurs have no incentive to sell equity for diversiﬁcation purposes. The sole purpose

of the IPO in our model is to raise capital for investment, which means that the entire proceeds

from the issue will be invested in the ﬁrm.

8

We assume that a ﬁrm without access to a physical

investment opportunity cannot go public.

9

The value of a type-T ﬁrm that raises and invests I

dollars is equal to the expected value of its future cash ﬂows:

V

T

(I) = A+

I

0

1 +π

T

(I) dI. (1)

Conditional on a physical investment opportunity being available, an entrepreneur can make

a take-it-or-leave-it oﬀer I, α ∈ [0, ∞) ×[0, 1] to outside investors, where I denotes the amount

of capital raised and invested, and α denotes the fraction of equity retained by the entrepreneur.

The oﬀer 0, 1 represents the special case that the entrepreneur does not raise any capital and

instead retains full ownership of her ﬁrm.

8

We rule out the possibility that a ﬁrm invests the proceeds from the equity issue in marketable securities or

just holds cash. Moreover, the original shareholder’s informational advantage implies that outsiders would view

any attempt to sell more equity than necessary to ﬁnance the intended investment policy as a negative signal of

the ﬁrm quality.

9

Hence, at most one IPO can take place at any given point in time.

7

By assumption, an entrepreneur chooses the IPO that maximizes her expected terminal wealth.

As a tie breaker we assume that an entrepreneur who is indiﬀerent between her ﬁrst-best IPO and

some alternative IPO will stick to her ﬁrst-best IPO. The total wealth of a type-T entrepreneur

who manages to sell an IPO I, α is equal to the value of her retained equity,

W

T

(I, α) = αV

T

(I). (2)

An entrepreneur’s payoﬀ from unsuccessfully attempting an IPO I, α is assumed to be equal to

zero. An entrepreneur whose IPO has failed cannot approach the market again.

10

For any IPO, I, α, we can calculate the ﬁrm valuation that is implicit in the terms of the

IPO as

V

i

(I, α) =

I

1 −α

. (3)

It is clear that V

i

(I, α) need not be identical to the true ﬁrm value. If V

i

(I, α) exceeds the true

ﬁrm value then the IPO is overpriced, and if V

i

(I, α) is smaller then the true ﬁrm value then the

IPO is underpriced. Outside investors just break even on purchasing (1 −α) of a ﬁrm’s equity for

I dollars whenever the true ﬁrm value is identical to (3).

For each IPO I, α we can now ﬁnd an equivalent representation I, V

i

(I, α), where V

i

(I, α)

denotes the ﬁrm value that is implicit in the terms of the IPO. For convenience we will refer to

V

i

(I, α) in the following as “the issue price”.

Which of the two above IPO representations is going to be more convenient depends on

the questions that we will address. The representation I, α captures the entrepreneur’s trade-

oﬀ between raising more capital and retaining more equity. This representation will be very

intuitive when it comes to analyzing the decision problem of an entrepreneur. The representation

I, V

i

(I, α) emphasizes the link between investment policy and ﬁrm value. This representation

will be more intuitive when it comes to analyzing investor learning and the resulting IPO market

dynamics.

10

Neither of these assumptions is crucial for our model. Our main results would still hold if an entrepreneur could

approach the market again after a failed ﬁrst attempt to sell an IPO, or if we assumed a diﬀerent (ﬁxed) payoﬀ

from a failed IPO.

8

We assume that all uncertainty with respect to a ﬁrm’s cash ﬂows is resolved exactly periods

after its IPO. At that time, the ﬁrm value is publicly revealed to be equal to V

T

(I) +

˜

δ

T

(I), where

˜

δ

T

(I) is a random variable with zero expected mean.

11

C Investors

Investors can either purchase stocks or hold cash, but they cannot short sell IPO shares.

12

Whether

an investor decides to participate in a particular IPO depends on the terms of the IPO, and on

his belief with respect to the value of the oﬀering ﬁrm,

¯

V .

13

An investor will participate in an

IPO whenever he expects to at least break even, that is, whenever

V

i

(I, α) ≤

¯

V . (4)

A crucial assumption in our model is the existence of two types of investors that diﬀer in terms

of their knowledge and their understanding of the IPO market.

C.1 R-Investors

The ﬁrst group of investors, that we refer to as “R-investors”, are rational in the usual game

theoretic sense. These investors are assumed to have all the information about the ﬁrms with

the exception of the individual ﬁrm types. The R-investors can therefore infer each entrepreneur

type’s expected payoﬀ from every feasible strategy, which means that they understand even the

not directly observable economic incentives of the entrepreneurs. They condition their beliefs with

respect to the ﬁrm value,

¯

V

R

, on the ﬁrm’s investment policy, as well as on the fraction of equity

retained by the entrepreneur. Following (4), R-investors demand shares in an IPO whenever

V

i

(I, α) ≤

¯

V

R

(I, α). (5)

11

The only purpose of this stochastic component is to ensure that the ﬁrm type is not veriﬁable ex post. To

account for limited liability we have to assume that

˜

δ

T

(I) is bounded from below by −V

T

(I).

12

This assumption is necessary to obtain long-run underperformance of IPO shares in our model.

13

It will be more convenient to specify the investors’ beliefs with respect to the ﬁrm value (

¯

V ), rather than with

respect to the probabilities that they assign to the event that the ﬁrm is of the high type (ˆ µ).

9

Note that R-investors may alternatively be viewed as conditioning their beliefs on I and

V

i

(I, α), so that (5) may be stated equivalently as

V

i

(I, α) ≤

¯

V

R

(I, V

i

(I, α)). (6)

C.2 L-Investors

The second group of investors, that we refer to as “L-investors”, are not irrational, but they learn

about the IPO market only from the publicly observable performance of past IPOs. Intuitively,

an L-investor is like a statistician who lacks a structural model of the world, and who tries to

understand the world just from looking at the data.

We will see that L-investors may learn to predict the value of an IPO based on the issuing

ﬁrm’s investment policy alone. We therefore assume that L-investors condition their beliefs,

¯

V

L

,

on the ﬁrm’s investment policy, and that they demand shares in an IPO as long as it is oﬀered at

a price weakly below its inferred expected value,

V

i

(I, α) ≤

¯

V

L

(I). (7)

L-investors are not ignoring how much of the ﬁrm’s equity is oﬀered in exchange for the capital

that is raised in the IPO, but they diﬀer from R-investors in that they view the choice of α merely

as a pricing decision.

We will discuss the learning by L-investors in more detail in Subsection II.E, after the sequence

of events for an individual IPO has been speciﬁed.

C.3 IPO Market Regimes

We denote the number of R-investors and the number of L-investors in the economy by N

R

and

N

L

, respectively. It is crucial that we assume that N

R

and N

L

are suﬃciently large so that each

group of investors by itself can purchase all IPOs in the economy. This assumption implies that

an entrepreneur may sell the IPO to the group of investors with the highest valuation for the

shares. Depending on whether IPOs are oﬀered at a price (weakly) below or (strictly) above

the R-investors’ valuation we distinguish between two IPO market regimes that we refer to as

“regime-R” and “regime-L”, respectively.

10

. . .

t

j

+ t

j+1

−

. . .

t

j+f

. . .

V

j,j

V

j,j+1

V

j,j+f

IPO takes place. The ﬁrst market clearing

price is determined in pub-

lic trading.

Nature reveals the

true ﬁrm value.

. .. .

Underpricing

. .. .

. .. .

Long run performance

Figure 1: Time line of events for an individual IPO

Deﬁnition 1 (Regime-R and Regime-L) At time-t

j

the IPO market is in regime-R if an

IPO is oﬀered at a price weakly below the R-investors’ valuation. The market is in regime-L if

an IPO is oﬀered at a price strictly above the R-investors’ valuation.

D Sequence of Events for an Individual IPO

Up to three events can take place in our model at any given point in time, t

j

: (1) there is a public

trading session in which the market clearing prices of all ﬁrms that previously issued equity are

determined, (2) if a ﬁrm issued equity at t

j−f

then the true value of this ﬁrm’s cash ﬂows is

publicly revealed, and (3) a ﬁrm that is not yet publicly listed may undertake an IPO. To avoid

ambiguities we assume that these events take place in the aforementioned sequence. We may think

of the trading session, the revelation of the realized cash ﬂows, and the IPO taking place at times

t

j

− , t

j

, and t

j

+ , respectively. This particular sequencing implies that no new information

becomes available between the time at which an IPO is sold to investors (t

j

+), and the trading

11

session in which its ﬁrst market clearing price is determined (at t

j+1

−). Moreover, the time-t

j

market clearing prices of all publicly traded ﬁrms and the true fundamental value of any ﬁrm that

went public at t

j−f

are already common knowledge when the time-t

j

IPO is oﬀered to the public.

The time line of events for an individual IPO ﬁrm is depicted in Figure 1.

Whenever we are primarily interested in the dynamic aspects of the IPO market we will denote

the time-t

j+k

price of the ﬁrm that went public at t

j

by V

j,j+k

. For a successful IPO that takes

place at t

j

a time series of ﬁrm prices, V

j,j+k

, k ∈ {0, 1, 2, 3, . . .}, is observed. The issue price, V

j,j

,

is set by the entrepreneur, and it is identical to (3). All subsequent prices are market clearing

prices that are determined by the investors with the highest valuation for the shares. At t

j+f

all

uncertainty with respect to the true ﬁrm value is resolved, and the true ﬁrm value is publicly

revealed. Hence, we have

V

j,j+k

=

⎧

⎪

⎪

⎪

⎪

⎪

⎨

⎪

⎪

⎪

⎪

⎪

⎩

V

i

(I, α) for k = 0,

max

¯

V

L

(I),

¯

V

R

(I, α)

¸

for 1 ≤ k < , and

V

T

(I) +

˜

δ

T

(I) for ≤ k.

(8)

We measure the abnormal initial performance (i.e. underpricing) of an IPO by its stock price

performance from t

j

to t

j+1

. The long run performance of IPO shares is measured either based on

the oﬀer price (i.e. from time t

j

to t

j+f

), or based on the ﬁrst market clearing price (i.e. from t

j+1

to t

j+f

), since our model yields separate predictions for the two time horizons.

E Learning by L-Investors

We denote the L-investors’ time-t

j

belief with respect to the value of a ﬁrm that raises and invests

I dollars by

¯

V

L

j

(I). No IPO took place before t

0

, so that

¯

V

L

0

(I) denotes the L-investors’ prior

belief with respect to the value of a ﬁrm that raises and invests I dollars. We assume that this

prior is distributed according to some probability density function, g(·), with compact support.

The probability density function is assumed to be common knowledge, but the prior itself is

private information of the L-investors. The (ﬁnite) weight that L-investors assign to their prior

12

is denoted by ω

0

(I).

14

For convenience we assume that ω

0

(I) is common knowledge.

15

To formalize the updating of beliefs by L-investors we deﬁne the indicator functions

φ

j

(I) =

⎧

⎪

⎨

⎪

⎩

1 if an IPO of size I took place at t

j

,

0 otherwise,

(9)

for each j ∈ {0, 1, 2, . . .}. In addition, we deﬁne

ω

j

(I) = ω

j−1

(I) +φ

j

(I) (10)

= ω

0

(I) +

j−1

¸

0

φ

j

(I), (11)

which is the sum of the weight of the L-investors’ t

0

-prior, and of the number of IPOs of size I

that took place prior to t

j

.

L-investors update their beliefs whenever the ﬁrst market clearing price for an IPO is observed,

and whenever new information on a publicly listed ﬁrm becomes available. By assumption, the

latter is the case at t

j

if and only if a ﬁrm went public at t

j−f

. The expected development of the

L-investors’ beliefs at a given point in time therefore depends not only on the current IPO market

regime, but also on the IPO market regime periods ago.

Assuming Bayesian updating, the L-investors’ updated time-t

j

belief may be expressed as

¯

V

L

j

(I) =

ω

j−1

(I)

ω

j

(I)

·

¯

V

L

j−1

(I) +

φ

j−1

(I)

ω

j

(I)

· V

j−1,j

+

φ

j−f

(I)

ω

j

(I)

· (V

j−f,j

−V

j−f,j−1

) . (12)

The three terms in (12) represent the investors’ time-t

j−1

belief, the ﬁrst market clearing price of

any time-t

j−1

IPO, and any change in the market value of a ﬁrm that issued equity at t

j−f

due

to the arrival of new public information. Note that (12) can alternatively be stated as

¯

V

L

j

(I) =

ω

0

(I)

ω

j

(I)

·

¯

V

L

0

(I) +

j−1

¸

k=0

φ

k

(I)

ω

j

(I)

· V

k,j

, (13)

14

A weight ω0(I) = k means that the weight that type-L investors assign to their prior is equivalent to the weight

that they would assign to k independent observations.

15

Assuming that only one of the parameters that determine the L-investors’ beliefs is private information implies

that all other agents in the economy fully understand the L-investors’ beliefs after observing only a single IPO in

regime-L. This limits the number of special cases that we have to consider (see Lemma 5) without aﬀecting the

main insights that can be gained from our model.

13

which reveals that the type-L investors’ time-t

j

belief with respect to the value of a ﬁrm that

raises and invests I dollars is just a weighted average of their time-t

0

prior, and of the current

market values of all publicly listed ﬁrms that followed the same investment policy in the past.

III The Rational IPO Market Equilibrium in the Absence of

Learning: Regime-R

We begin our analysis by deriving the rational IPO market equilibrium that obtains in the absence

of learning. That is, we assume initially that the L-investors are not participating in the IPO

market. An in-depth analysis of this equilibrium can be found in a companion paper by the same

authors,

16

so that we will skip most of the technical details and some of the proofs in this section

and instead focus mainly on the intuition.

A The First-Best Outcome

In the absence of informational asymmetries a type-T entrepreneur can raise I dollars by oﬀering

1 −α

F

T

(I) =

I

V

T

(I)

(14)

of her ﬁrm’s equity to outside investors. The IPO is priced correctly (i.e. V

i

(I, α

F

T

(I)) = V

T

(I)),

so that outside investors just break even on purchasing the issue.

Since the equity is sold at the fair price, a type-T entrepreneur has no incentive to deviate

from her ﬁrst-best investment policy, denoted by I

F

T

. A type-B entrepreneur therefore does not

invest (I

F

B

= 0), and a type-G entrepreneur undertakes the NPV-maximizing investment level

that is implicitly deﬁned by π

G

(I

F

G

) = 0.

The total payoﬀ to a type-B entrepreneur is equal to W

B

(0, 1) = A, and the total payoﬀ to a

type-G entrepreneur is equal to the sum of her project-NPV and the value of the assets in place:

W

G

(I

F

G

, α

F

G

(I

F

G

)) = A+

I

F

G

0

π

T

(I) dI. (15)

16

Available from the authors, or from the Social Science Research Network at http://www.ssrn.com.

14

Both the issue price and the ﬁrst market clearing price are identical to the true (expected)

ﬁrm value. Hence, there is no underpricing, and no abnormal stock price performance is observed

in the long run.

B Equilibrium under Asymmetric Information

We assume that the ﬁrst-best outcome is not feasible under asymmetric information. That is, we

assume that the bad type’s payoﬀ from undertaking the good types’s ﬁrst-best oﬀer exceeds the

bad type’s payoﬀ from her own ﬁrst-best strategy:

W

B

(I

F

G

, α

F

G

(I

F

G

)) > W

B

(0, 1). (16)

The intuitive interpretation of (16) is that at the IPO I

F

G

, α

F

G

(I

F

G

) the bad type’s gain from

selling overvalued equity exceeds her imitation costs that arise from ineﬃcient investment.

Whenever the ﬁrst-best outcome is not feasible due to asymmetric information the good type

typically has an incentive to deviate from her ﬁrst-best investment policy to signal her type.

Lemma 1 There exists an investment level

¯

I > I

F

G

at which the good type could issue equity at

the fair price.

Lemma 1 states that, in principle, the good type could always distinguish herself from the bad

type by overinvesting to such an extend that it becomes too costly for the bad type to mimic.

However, doing so would not necessarily be optimal from the point of view of a personal wealth

maximizing entrepreneur: while the fact that the good type earns higher marginal returns on

investment than the bad type creates an incentive to signal with overinvestment, the necessity to

ﬁnance this investment with outside equity creates a counteracting incentive to underinvest.

17

The direction in which the good type adjusts her investment policy can be determined by

looking at the two type’s respective marginal rates of substitution between the fraction of retained

17

For all I > 0 the equity of a type-G ﬁrm is more valuable than that of a type-B ﬁrm since type-G ﬁrms earn

higher returns on investment than type-B ﬁrms. Under asymmetric information type-G ﬁrms are therefore faced

with higher marginal ﬁnancing costs than type-B ﬁrms.

15

equity, and the amount of capital that is raised and invested. From (2) we obtain

MRS

T

(I, α) =

∂W

T

(I, α)/∂I

∂W

T

(I, α)/∂α

(17)

= α

V

T

(I)

V

T

(I)

. (18)

Based on (17) it can be shown that the good type’s second-best strategy entails undertaking

only those investments for which its marginal gross return, V

G

(I) = 1 + π

G

(I), exceeds the bad

type’s marginal gross return, V

B

(I), by a factor greater than the ratio of the two types’ respective

marginal ﬁnancing costs, V

G

(I)/V

B

(I).

18

That is, the good type will undertake only investments

for which her marginal return on investment is suﬃciently higher than the bad type’s to compen-

sate her for her relatively higher marginal cost of outside equity capital. However, the good type

will not increase investment beyond

¯

I since this investment level is already suﬃciently informa-

tive to allow an equity issue at the fair price. The good-type’s second-best investment policy can

therefore be identiﬁed as the investment policy, I

T

, that maximizes the ratio V

G

(I)/V

B

(I) on the

interval [0,

¯

I].

19

There exists a (unique) pure-strategy equilibrium in regime-R. To be able to fully characterize

this equilibrium we need to calculate the fraction of equity that the entrepreneurs could retain

in a pooling equilibrium candidate IPO of size I, in which both ﬁrm types issue equity at the

average fair price,

α

P

(I) = 1 −

I

(1 −p)V

B

(I) +pV

G

(I)

, (19)

and the fraction of equity that a type-G entrepreneur could retain in an IPO of the same size that

is priced to prevent the bad type from mimicking,

α

S

G

(I) =

A

V

B

(I)

. (20)

18

The ratio of the ﬁrm values may be interpreted as the ratio of the two type’s respective marginal ﬁnancing

costs since both types have to give up the same fraction of equity to raise another dollar of capital.

19

Any equilibrium candidate in which the good type undertakes an investment policy I

I

= I

T

with strictly positive

probability fails the “Intuitive Criterion” of Cho and Kreps (1987): there exist an alternative IPO of size I

T

that

makes the good type strictly better but the bad type strictly worse oﬀ than the IPO of size I

I

. R-investors therefore

have to believe that a ﬁrm that oﬀers the IPO of size I

T

is of the good type, and the good type has no incentive to

undertake an IPO of size I

I

in the ﬁrst place.

16

Proposition 1 (Equilibrium in Regime-R) Regime-R is characterized by the existence of a

unique equilibrium in pure strategies. Depending on the location of I

T

on [0,

¯

I], and on the values

of α

P

(I

T

) and α

S

G

(I

T

), this equilibrium is of the following type:

20

a) If I

T

=

¯

I then the equilibrium is a separating equilibrium in which type-G signals with

overinvestment and issues equity at the fair price, I

e

G

, α

e

G

=

¯

I, α

F

G

(

¯

I), and in which the

bad type undertakes its ﬁrst-best IPO, I

e

B

, α

e

B

= 0, 1.

b) If I

T

<

¯

I and α

S

G

(I

T

) < α

P

(I

T

) then the equilibrium is a pooling equilibrium in which both

types raise and invest I

T

, and in which equity is issued at the average value: I

e

G

, α

e

G

=

I

e

B

, α

e

B

= I

T

, α

P

(I

T

).

c) If I

T

<

¯

I and α

S

G

(I

T

) ≥ α

P

(I

T

) then the equilibrium is a separating equilibrium in which the

bad type undertakes its ﬁrst-best IPO, I

e

B

, α

e

B

= 0, 1, and in which the good type signals

with a combination of investment choice and IPO underpricing, I

e

G

, α

e

G

= I

T

, α

S

G

(I

T

).

The equilibrium can be supported by the R-investors’ beliefs that a ﬁrm that defects with an out-

of-equilibrium investment policy I

= I

T

is of the bad type with probability one, and that a ﬁrm

that defects with an out-of-equilibrium IPO I

T

, α

, α

> α

e

G

, is of the good type with probability

p, and of the bad type with probability 1 − p. These beliefs are admissible under the Intuitive

Criterion of Cho and Kreps (1987).

The intuition underlying these diﬀerent types of equilibria is as follows. Case a) corresponds

to a setting in which for any level of investment the good type’s marginal return on investment

is suﬃciently higher than the bad type’s to ensure that good type always prefers a marginal

increase in equity ﬁnanced investment over issuing equity below the fair price. The cases b) and

c) correspond to a setting in which this is only initially so. The latter cases are plausible since any

investment that the good type chooses to undertake increases the ratio of the ﬁrm values, and,

hence, increases the ratio of the two types’ respective marginal ﬁnancing costs. Once I

T

has been

reached the good type’s relative disadvantage on the ﬁnancing side (vis-`a-vis the bad type) begins

20

The values of

¯

I, I

T

, and α

S

G

(I

T

), depend only on the two types’ respective marginal proﬁt functions. The value

of αP (I

T

) depends additionally on the probability distribution of the ﬁrm types.

17

to outweigh its relative advantage on the investment side. At I

T

the good type therefore prefers

issuing undervalued equity over changing the investment policy in either direction. Whether the

equilibrium in this case is a pooling equilibrium or a separating equilibrium in which the good

type issues deliberately underpriced equity depends only on the probability distribution of good

and bad ﬁrms in the economy. The pooling equilibrium exists only if the ex ante probability of

a ﬁrm being type-G is so high that α

P

(I

T

) > α

S

G

(I

T

). Otherwise the bad type prefers her own

ﬁrst-best payoﬀ over the payoﬀ from the pooling equilibrium candidate IPO. In the latter case

the good type can retain α

S

G

(I

T

) ≥ α

P

(I

T

) of the equity without being mimicked by the bad type.

Only Proposition 1.c)’s separating equilibrium with underpricing is of interest to us. We

therefore assume for the remainder of the paper that the model parameters are such that they

result in this type of equilibrium. Based on the equilibrium of Proposition 1.c) we obtain the

following properties of the IPO market in regime-R.

Proposition 2 (Issue Activity and IPO Performance in Regime-R) Suppose the equilib-

rium in regime-R is Proposition 1.c)’s separating equilibrium with underpricing. Then the IPO

market is characterized by the following properties:

(1) The ex-ante probability that an IPO takes place at any given time, t

j

, j ∈ {0, 1, 2, . . .} is

equal to λp.

(2) Any IPO that takes place is an issue I

T

, α

S

G

(I

T

) that is oﬀered by a type-G ﬁrm. The

abnormal initial performance of IPOs from the issue price to the ﬁrst market clearing price

(i.e. from t

j

to t

j+1

) is equal to

V

j,j+1

V

j,j

−1 =

V

G

(I

T

)

V

i

(I

T

, α

S

G

(I

T

))

−1 (21)

=

α

F

G

(I

T

) −α

S

G

(I

T

)

1 −α

F

G

(I

T

)

> 0. (22)

(3) No abnormal stock price performance is observed after the ﬁrst market clearing price. Hence,

there is no abnormal long run performance of IPO shares from t

j+1

to t

j+f

, but there is

positive abnormal long run performance from t

j

to t

j+f

.

18

The following subsection contains an example of Proposition 1.c)’s IPO market equilibrium

with underpricing. We will extend this example in Subsection IV.C, where we present results

from a simulation of the IPO market dynamics.

C An Example

Suppose the value of any ﬁrm’s asset in place prior to (or without) the IPO is equal to V

T

(0) = 100,

T ∈ {G, B}. The ex-ante probability that a new project is of type-G is equal to p = 0.3, and the

two types’ marginal net proﬁt functions are given by (23) and (24), respectively.

21

π

G

(I) = 2 −

I

50

(23)

π

B

(I) = −

I

175

(24)

In a world of symmetric information the good type undertakes her ﬁrst-best IPO, I

F

G

, α

F

G

(I

F

G

) =

100,

2

3

, and the bad type does not go public I

F

B

, α

F

B

(I

F

B

) = 0, 1. The corresponding ﬁrst-best

payoﬀs to the entrepreneurs are equal to W

G

(100,

2

3

) = 200, and W

B

(0, 1) = 100.

The ﬁrst-best outcome is not feasible under asymmetric information since the bad type’s

payoﬀ from the good type’s ﬁrst-best IPO exceeds her own ﬁrst-best payoﬀ:

2

3

V

B

(100) = 114

2

7

>

W

B

(0, 1) = 100. At the good type’s ﬁrst-best investment level the good type’s marginal gross

return on investment exceeds the bad type’s by the factor (1 +π

G

(100)) / (1 +π

B

(100)) = 2

1

3

,

which is greater than the ratio of the two type’s marginal ﬁnancing costs, V

G

(100)/V

B

(100) =

1.75.

22

Hence, the good type has an incentive to signal by increasing investment up to I

T

= 124.5,

at which point

V

G

(I

T

)

V

B

(I

T

)

=

1 +π

G

(I

T

)

1 +π

B

(I

T

)

=

357

202

≈ 1.767.

23

(25)

We obtain α

F

G

(I

T

) =

77,599

127,399

≈ 0.6091, α

S

G

(I

T

) =

1,400

2,523

≈ 0.4451, and α

P

(I

T

) =

129,599

295,599

≈ 0.4384.

21

Assuming linear marginal proﬁt functions keeps the calculations tractable but also implies that we have to choose

marginal proﬁt functions that violate the assumptions (A1) and (A4) for suﬃciently high levels of investment. This

is not a problem, however, since neither assumption is necessary for the existence of the equilibrium of Proposition 1.

22

V

G

(100) = 300, V

B

(100) = 171

3

7

, 1 +π

G

(100) = 1, and 1 +π

B

(100) =

3

7

.

23

VG(I

T

) = 318

199

400

≈ 318.5, VB(I

T

) = 180

3

14

≈ 180.2, VP (I

T

) = 221

2797

4000

≈ 221.7, 1 + πG(I

T

) =

51

100

= 0.51, and

1 +π

B

(I

T

) =

101

350

≈ 0.2886.

19

This implies that the bad type would mimic an IPO in which the good type raises I

T

dollars by

issuing equity at the fair price, but at the same time prefers her own ﬁst-best strategy over the

pooling candidate IPO:

α

P

(I

T

) V

B

(I

T

) ≈ 79.01 < 100 < α

F

G

(I

T

) V

B

(I

T

) ≈ 109.77. (26)

The pure-strategy equilibrium is consequently a separating equilibrium in which the bad type

does not go public, I

F

B

, α

F

B

(I

F

B

) = 0, 1, and in which the good type undertakes the IPO

I

T

, α

S

G

(I

T

) = 124.5,

1,400

2,523

, that is just suﬃciently underpriced to prevent the bad type from

mimicking. Outside investors obtain 1−α

S

G

(I

T

) of the good type’s equity in return for I

T

dollars.

This translates into an issue price of V

i

(I

T

, α

S

G

(I

T

)) ≈ 279.7, compared to a true ﬁrm value of

V

G

(I

T

) ≈ 318.5. The good type’s IPO therefore experiences an abnormal initial return of +13.87%.

The equilibrium payoﬀ to the good type’s original shareholders is equal to W

G

(I

T

, α

S

G

(I

T

)) ≈ 176.7,

and the total amount of “money left on the table” is equal to

1 −α

S

G

(I

T

)

V

G

(I

T

) −V

i

(I

T

, α

S

G

(I

T

))

≈ 17.3. (27)

Note that overinvesting up to

¯

I = 150 would enable the good type to issue equity at the

fair price: V

B

(

¯

I) = 185

5

7

, and V

G

(

¯

I) = 325, so that α

F

G

(

¯

I) =

7

13

, (1 − α

F

G

(

¯

I))V

G

(

¯

I) =

¯

I, and

α

F

G

(

¯

I)V

B

(

¯

I) = 100. However, the good type’s payoﬀ from doing so would only be equal to

W

G

(

¯

I, α

S

G

(

¯

I)) = 175, which is less than its equilibrium payoﬀ.

A graphic representation of the equilibrium is depicted in Figure 2. The three dotted curves

represent the (maximal) fraction of equity that the original shareholders can retain for a given

investment level for a good/bad/pooling IPO, so that outsiders still break even on purchasing

the oﬀer. The solid black curve represents the bad type’s iso-payoﬀ curve through her ﬁrst-best

strategy, B = 0, 1. The solid grey curves are the good type’s iso-payoﬀ curves through her

ﬁrst-best IPO, G = I

F

G

, α

F

G

(I

F

G

), and through her equilibrium oﬀer, U = I

T

, α

S

G

(I

T

). At I

T

the

good type’s iso-payoﬀ curves are tangent to the bad type’s iso-payoﬀ curves from above. Hence,

the good type prefers retaining less than the fair amount of equity over changing her investment

policy in either direction.

20

I

α

B

G

F

U

P

1

0

α

F

G

(I

F

G

)

α

F

G

(I

T

)

α

S

G

(I

T

)

α

P

(I

T

)

I

F

B

= 0 I

F

G

I

T

α

F

B

(I)

α

P

(I)

α

F

G

(I)

Figure 2: The separating equilibrium of our example: type-G ﬁrms overinvest and issue under-

priced equity (U) and type-B ﬁrms do not go public (B).

21

IV Learning by L-Investors, and Regime-L

We begin investigating what eﬀects the presence of L-investors can have on the IPO market

equilibrium by studying how their beliefs evolve as they learn about the IPO market in regime-R.

A Learning by L-Investors in Regime-R

Suppose, without loss of generality, that the IPO market starts at t

0

in regime-R. The L-investors

will then update their beliefs from t

0

to t

f−1

only based on the respective ﬁrst market clearing

prices of any new IPOs. Beginning at t

f

, L-investors will also update their beliefs whenever the

realized cash ﬂows of a ﬁrm that went public in the past are observed.

The only IPOs that take place in regime-R are IPOs I

T

, α

S

G

(I

T

) that are undertaken by

good ﬁrms. Based on the ﬁrst market clearing price, the market value of any such ﬁrm is equal

to V

G

(I

T

). Thereafter, the market value does not change until the uncertainty with respect to

the ﬁrm’s cash ﬂows is resolved. Firms that go public in regime-R are valued correctly by the

market, so that the new “information” that is contained in the realized cash ﬂows is just noise

with an expected value of zero. If the IPO market was exogenously ﬁxed in regime-R it would

therefore only be a matter of time until the L-investors learn to predict the value of IPO ﬁrms

with arbitrary precision.

Lemma 2 (Learning by L-Investors in Regime-R) Suppose the IPO market is exogenously

ﬁxed in regime-R. Then the L-investors’ belief with respect to the value of a ﬁrm that goes public

converges to the correct value:

¯

V

L

j

(I

T

)−→V

G

(I

T

). (28)

Lemma 2 could be generalized in a straightforward manner to a setting in which two or more

ﬁrm types issue equity in regime-R. In the latter setting an equilibrium investment policy would

either be undertaken by only a single ﬁrm type, in which case Lemma 2 applies accordingly, or it

would be undertaken by two or more ﬁrm types that pool and issue equity at the identical terms,

in which case L-investors would learn to forecast the average value of these ﬁrms. In any case,

22

L-investors would eventually be able to predict the value of a ﬁrm that goes public in regime-R

with the same accuracy as the R-investors.

Now recall that V

G

(I

T

) > V

i

(I

T

, α

S

G

(I

T

)), so that Lemma 2 implies that the L-investors’

valuation for IPO shares will sooner or later exceed the issue price. By assumption, the L-

investors demand shares whenever they expect to at least break even on purchasing an IPO. It is

therefore only a matter of time until the L-investors begin to participate in the IPO market.

Lemma 3 (Demand for IPO Shares) The L-investors demand IPO shares as soon as their

beliefs with respect to the value of a ﬁrm that raises and invests I

T

exceeds V

i

(I

T

, α

S

G

(I

T

)). At that

time the total demand for shares of IPOs I

T

, V

i

(I

T

, α

S

G

(I

T

)) increases from N

R

to N

R

+N

L

.

The L-investors’ participation in the IPO market is publicly observable due to the publicly

observable increase in the demand for IPO shares. While there was already excess demand for

underpriced IPOs when L-investors were absent, excess demand is even more severe now. The

increase in the demand for IPO shares reveals to the entrepreneurs that it may now be possible

to issue equity at a higher price.

Lemma 4 (Expected Payoﬀ from Raising the Issue Price) Suppose that the IPO market is

in regime-R, and suppose that the L-investors are demanding shares of IPOs I

T

, V

i

(I

T

, α

S

G

(I

T

)).

Let V

be such that V

i

(I

T

, α

S

G

(I

T

)) < V

< V

G

(I

T

). As time passes, the probability that an IPO

I

T

, V

**would succeed converges to one. The good type’s expected payoﬀ from oﬀering I
**

T

, V

**converges to the l.h.s. of (29), and the bad type’s expected payoﬀ from oﬀering I
**

T

, V

converges

to the l.h.s. of (30).

W

G

(I

T

, 1 −I

T

/V

) = V

G

(I

T

) −

V

G

(I

T

)

V

I

T

> W

G

(I

T

, α

S

G

(I

T

)) (29)

W

B

(I

T

, 1 −I

T

/V

) = V

B

(I

T

) −

V

B

(I

T

)

V

I

T

> W

B

(0, 1) (30)

It follows from Lemma 4 that it is only a matter of time until an entrepreneur will attempt

to sell an IPO of size I

T

at a price V

> V

i

(I

T

, α

S

G

(I

T

)). The ﬁrst such IPO(s) may fail since the

entrepreneurs do not know the L-investors’ t

0

-prior, so that they are uncertain with respect to

the L-investors’ exact willingness to pay. An IPO I

T

, V

**that fails reveals that the L-investors’
**

23

valuation for an IPO of size I

T

is less that V

**, but it does not lead to any updating of the L-
**

investors’ beliefs. The ﬁrst successful IPO I

T

, V

with V

> V

i

(I

T

, α

S

G

(I

T

)) marks the beginning

of regime-L.

B Regime-L

Lemma 5 (The First Successful IPO in Regime-L) Suppose the ﬁrst IPO I

T

, V

that is

successfully oﬀered at a price V

> V

i

(I

T

, α

S

G

(I

T

)) takes place at t

k

. Then this IPO’s ﬁrst market

clearing price, V

k,k+1

, is equal to

¯

V

L

k

(I

T

) ≥ V

**, and it reveals the L-investors’ t
**

0

-prior,

¯

V

L

0

(I

T

).

The abnormal initial return of the IPO is non-negative, but strictly lower than the abnormal initial

return in regime-R:

V

k,k+1

V

k,k

−1 =

¯

V

L

k

(I

T

) −V

V

≥ 0. (31)

The ﬁrst market clearing price of any IPO that takes place in regime-L is equal to the L-

investors’ valuation for the shares. Once the market has entered regime-L the market clearing

prices of any new IPOs will therefore just conﬁrm the L-investors’ beliefs. Moreover, since the

IPOs that previously took place in regime-R were valued correctly by the market no new in-

formation is expected to be incorporated in the L-investors’ beliefs for the ﬁrst − 1 periods.

Regime-L will consequently persist for a number of periods. The following proposition states the

entrepreneurs equilibrium strategies after the ﬁrst successful IPO in regime-L.

Proposition 3 (Equilibrium in Regime-L) Suppose

¯

V

L

j

(I

T

) > V

i

(I

T

, α

S

G

(I

T

)) at t

j

> t

k

. An

entrepreneur with access to an investment opportunity will then successfully undertake the IPO

I

T

,

¯

V

L

j

(I

T

), irrespective of her type. The IPO is undervalued if the issuing ﬁrm is type-G, but

overvalued if the issuing ﬁrm is type-B.

Based on Proposition 3 it is straightforward to derive the following properties of the IPO

market in regime-L.

Proposition 4 (Issue Activity and IPO Performance in Regime-L) The IPO market

exhibits the following characteristics in regime-L:

24

(1) The ex-ante probability that an IPO takes place at any given point in time, t

j

, is equal to λ.

(2) Any IPO that takes place is an issue I

T

,

¯

V

L

j

(I

T

), where

¯

V

L

j

(I

T

) > V

i

(I

T

, α

S

G

(I

T

)). The

issuing ﬁrm is of type-G with probability p, and of type-B with probability 1 − p. The ﬁrst

market clearing price of each IPO is equal to its issue price. Hence, there is no abnormal

initial performance (i.e. no underpricing) from t

j

to t

j+1

.

(3) The expected value of a ﬁrm that goes public is equal to V

P

(I

T

) < V

i

(I

T

, α

S

G

(I

T

)). The

expected abnormal long run performance (from t

j

to t

j+f

, or from t

j+1

to t

j+f

) is negative:

V

j,j+f

V

j,j

−1 =

V

j,j+f

V

j,j+1

−1 =

V

P

(I

T

)

¯

V

L

j

(I

T

)

−1 < 0. (32)

A comparison of the IPO market characteristics in the two regimes reveals the following key

diﬀerences:

(1) The expected IPO volume in regime-L exceeds the expected IPO volume in regime-R by

the factor 1/p > 1.

(2) Issue prices are higher but the (ﬁrst) market clearing prices are lower in regime-L than in

regime-R. Consequently there is less IPO underpricing in regime-L than in regime-R.

(3) On average, IPOs that take place in regime-L underperform in the long run. Based on

the ﬁrst market clearing price there is no abnormal performance of IPOs that take place in

regime-R.

A remarkable feature of our model is that IPOs have to be underpriced to avoid under-

performance long run: just a small increase in the issue price changes the incentives of some

entrepreneurs and results in a (potentially dramatic) decline in the average IPO quality. It is this

poor performance of IPOs in the long run that eventually puts an end to regime-L.

Lemma 6 (Learning by L-Investors in Regime-L) Suppose the IPO market is exogenously

ﬁxed in regime-L. Then the L-investors’ beliefs with respect to the value of an IPO ﬁrm converge

to the correct value:

¯

V

L

j

(I

T

)−→V

P

(I

T

). (33)

25

If regime-L persisted for long enough then the L-investors would again learn to predict the

value of IPO ﬁrms with the same precision as the R-investors. However, the IPO market will

revert to regime-R as soon as the L-investors’ willingness to pay for IPOs of size I

T

drops below

V

i

(I

T

, α

S

G

(I

T

)). At that time entrepreneurs with access to bad projects ﬁnd that it is no longer

proﬁtable to issue equity, and there is a sudden decline in IPO volume that is accompanied by an

increase in IPO quality.

Proposition 5 (Lack of Convergence) The IPO market does not converge to the stationary

equilibrium that would obtain in the absence of L-investors. The IPO market is therefore charac-

terized by cyclical ﬂuctuations in the IPO volume, in the degree of underpricing, and in the long

run performance of IPO shares.

That the IPO market in our model does not converge to the stationary (regime-R) equilibrium

may surprise somewhat. The reason for this lack of convergence lies in our assumptions that the

L-investors do not condition their beliefs with respect to the value of an IPO ﬁrm on the issue

price, and that they are willing to pay up to their full valuation for the shares of a new IPO.

However, for a number of reasons that are outside our model, we may not observe cyclical

variations in IPO volume within a single industry in the real world. One possibility is that investors

who do not understand the economic incentives of the entrepreneurs refrain from participating

in the IPO market after having lost a suﬃcient amount of money. Another possibility is that

investors may eventually learn that they have to condition their beliefs with respect to the value

of an IPO ﬁrm also on the issue price. In either case, no new period of high IPO volume will

be observed before a new generation of investors has entered the market. Finally, we may not

observe more than one period of high IPO activity in any single industry since the nature of the

physical investment opportunities in the economy changes over time.

C An Example (cont’d)

We now present the results from a simulation of the IPO market dynamics that was based on our

example from Subsection III.C. With respect to the parameters that have not been speciﬁed earlier

we make the following assumptions: (1) The probability that a new project becomes available at

26

any given point in time is equal to λ = 0.5. (2) The L-investors’ t

0

-prior with respect to the value

of a ﬁrm that raises and invests I

T

is equal to

¯

V

L

0

(I

T

) = I

T

. The weight that the investors assign

to this prior is equal to ω

0

(I

T

) = 30. (3) The probability distribution of the L-investors’ prior is

degenerate, with a single mass point at I

T

. This implies that the L-investors’ beliefs are common

knowledge already at t

0

. The IPO market therefore enters regime-L for the ﬁrst time as soon

as

¯

V

L

j

(I

T

) exceeds V

i

(I

T

, α

S

G

(I

T

)). (4) The true cash ﬂow of a ﬁrm is revealed exactly = 240

periods after its IPO. (5) Finally, we assume that the probability distribution of the stochastic

component of a type-T ﬁrm’s cash ﬂows (

˜

δ

T

(I

T

)) is degenerate with a single mass point at zero.

This implies that a ﬁrm’s realized cash ﬂows are always equal to its ex ante expected cash ﬂows.

We simulate the evolution of the IPO market over a total of T = 5, 000 points in time. It

may be intuitive to view each point in time as a business “day,” a 5-day period as a “week,” a

4-week period as a “month,” and a 12-month period as a “year.” With this interpretation, the

true cash ﬂow of each ﬁrm is revealed exactly one year after its IPO, and the simulation period

corresponds to a time span of 20 years and 8 months. The probability that a good investment

opportunity opens up on any given day is equal to λp = 0.15, and the probability that a bad

investment opportunity opens up is equal to λ(1 −p) = 0.35.

Our simulation resulted in the creation of 2, 541 investment opportunities, 758 of which were

of the good type, and 1, 783 of which were of the bad type. A total of 1, 017 IPOs took place,

which translates into an overall average of approximately one IPO per week.

We report the evolution of L-investors’ beliefs (Figure 3), the monthly IPO volume (Figure 4),

the IPO prices and values (Figure 5), and the underpricing and the long run performance of IPOs

(Figure 6). While we have depicted the evolution of the L-investors’ beliefs and the monthly

IPO volume for the entire simulation period, we show the issue prices and values and the IPO

performance only for a 500-day window (from t

751

to t

1,250

) to improve the clarity of the ﬁgures.

The IPO market starts at t

0

by assumption in regime-R. The ﬁrst market clearing price of

any ﬁrm that raises I

T

= 124.5 dollars in regime-R is equal to V

G

(I

T

) ≈ 318.5, so that initially

each IPO that takes place leads the L-investors to revise their beliefs upwards (Figure 3). As

soon as the L-investors’ beliefs exceed V

i

(I

T

, α

S

G

(I

T

)) ≈ 279.7, ﬁrms with access to an investment

27

¯

V

L

j

(I

T

)

t

j

V

i

(I

T

, α

S

G

(I

T

))

≈ 279.7

240

t

1,000

t

2,000

t

3,000

t

4,000

t

5,000

Figure 3: The evolution of the L-investors’ beliefs over T = 5, 000 periods.

Number

of IPOs

t

j

20λ

= 10

20λp

= 3

0

Figure 4: The number of IPOs per “month” (i.e. per 20-day period).

28

IPO Price,

IPO Value

t

j

V

B

(I

T

)

≈ 180.2

V

P

(I

T

)

≈ 221.7

V

i

(I

T

, α

S

G

(I

T

))

≈ 279.7

V

G

(I

T

)

≈ 318.5

0

t

751

t

1,250

Regime-R Regime-L Regime-R

IPO Value

IPO Price

Expected IPO Value

Figure 5: Issue prices, values, and expected values for the 500-day period from t

751

to t

1,250

.

IPO Underpricing

Long Run Performance

tj

tj

t

751

t

1,250

+13.9%

0

+13.9%

0

−20.7%

−35.6%

Regime-R Regime-L Regime-R

Figure 6: IPO underpricing and long run performance for the 500-day period from t

751

to t

1,250

.

29

opportunity are able to issue equity at a higher price. In our simulation the IPO market enters

regime-L for the ﬁrst time at t

800

. The regime shift is accompanied by a slight increase in the

issue price from 279.71 to 279.96. Even though this price increase is too small to be noticeable in

Figure 5, it implies that IPOs are now no longer signiﬁcantly underpriced, but rather signiﬁcantly

overpriced (Figure 5). The reason for this is that ﬁrms with access to a bad project now also

ﬁnd it proﬁtable to go public. The fundamental value of a bad ﬁrm that raises and invests I

T

is only V

B

(I

T

) ≈ 180.2, so that average IPO value drops from V

G

(I

T

) ≈ 318.5 in regime-R to

V

P

(I

T

) ≈ 221.7 in regime-L. However, the true fundamental ﬁrm value is not revealed until some

time after the IPO, so that the drop in the average IPO quality is not immediately noticed by the

L-investors. The market clearing prices of all IPOs that take place in regime-L are identical to

the L-investors’ beliefs. The L-investors’ beliefs therefore do not change until the ﬁrst cash ﬂows

of ﬁrms that went public in regime-L are observed (Figure 3). The cash ﬂow realizations of the

good ﬁrms that went public in regime-L will be unexpectedly high, and the cash ﬂow realizations

of the bad ﬁrms will be unexpectedly low. Based on the ﬁrst market clearing price, the expected

long run performance of good and bad ﬁrms that go public in regime-L is given by (34) and (35),

respectively.

V

G

(I

T

)

¯

V

L

800

(I

T

)

−1 =

318.5

279.96

−1 = +13.76% (34)

V

B

(I

T

)

¯

V

L

800

(I

T

)

−1 =

180.2

279.96

−1 = −35.63%. (35)

The overall expected long run performance of IPOs that take place in regime-L is equal to −20.8%

(Figure 6), which leads L-investors to revise their beliefs downwards (Figure 3). The IPO mar-

ket reverts back to regime-R as soon as the L-investors’ valuation for IPO shares drops below

V

i

(I

T

, α

S

G

(I

T

)).

The plot of the L-investors’ beliefs over time (Figure 3) reveals that the IPO market enters

regime-L at three distinct occasions, t

j

, j ∈ {800; 2, 294; 3, 831}, and reverts back to regime-R at

times t

j

, j ∈ {1, 043; 2, 536; 4, 074}. As we can see, a total of 1, 017 IPOs over a period of 5, 000

point in time does not result in convergence to a stationary equilibrium, even though there are

only two types of ﬁrms in our model.

30

V Implications

Our model applies only to ﬁrms that go public to raise capital for investment. Moreover, it

is crucial in our theory that the diﬀerent ﬁrm types are outwardly identical so that they are

indistinguishable to outside investors. Our model should therefore not be viewed as a model of

the IPO market as a whole, but rather as a model of the IPO market in a particular industry.

The following empirical predictions follow readily from our results:

Implication 1 An increase in the IPO volume in an industry is observed after a period during

which ﬁrms in this industry issued underpriced equity to raise capital for investment.

Implication 2 The prices at which IPOs are issued are higher during periods of high IPO volume

than during periods of low IPO volume. The ﬁrst market clearing prices of IPOs are lower during

periods of high IPO volume than during periods of low IPO volume. An increase in IPO volume

is accompanied by a reduction in underpricing.

Implication 3 Based on the ﬁrst market clearing price, shares of IPOs that take place during

periods of low IPO volume show no systematic abnormal long run performance. Shares of IPOs

that take place during periods of high IPO volume underperform in the long run. Based on the

ﬁrst market clearing price, the overall average long run performance of IPO shares is negative.

Note that our model does not yield any clear predictions with respect to the overall average

long run performance of IPOs if the latter is measured based on the issue price, rather than on

the ﬁrst market clearing price. However, we obtain unambiguous predictions with respect to the

long run performance of IPOs in each of the two regimes.

Implication 4 The abnormal long run performance of IPOs that take place during periods of

high IPO volume is negative, even if long run performance is measured based on the issue price.

Based on the issue price the abnormal long run performance of IPOs that take place during periods

of low IPO volume is positive.

Implication 5 The variance of long run performance is higher among ﬁrms that go public during

periods of high IPO volume than for ﬁrms that go public during periods with low IPO volume.

31

Implication 6 After a period of high IPO volume issue activity decreases as a result of poor long

run performance.

Finally, our model also suggest that IPOs in periods of high and low IPO volume are bought

by diﬀerent groups of investors. Our model predicts that IPOs that take place during periods of

high IPO volume are primarily purchased by investors who lack a deeper understanding of the

IPO market, and who invest in the IPOs only because they previously observed IPO underpricing.

However, this prediction may be diﬃcult to test.

VI Conclusion

We have presented a stylized model of an IPO market in which ﬁrms go public to raise capital

for investment. The model is capable of jointly explaining three major IPO market “anomalies”

that have been empirically documented in the literature: IPO underpricing, underperformance of

IPO shares in the long run, and strong concentration of issue activity in certain periods. In our

model, underpricing is observed even in the rational IPO market equilibrium. Some ﬁrms will

optimally use underpricing to augment the information that is conveyed by the ﬁrm’s investment

decisions to outside investors. This enables the ﬁrm to signal the proﬁtability of its investment

opportunities to outsiders, and thereby maximizes the original shareholders’ personal wealth.

Long-run underperformance and periods of increased IPO volume arise from the presence of

investors who learn about the IPO market from publicly observable IPO market data. The latter

investors upset the rational equilibrium not because of ex ante unreasonable beliefs, but rather

because they learn to forecast the value of IPO ﬁrms based on the ﬁrms’ investment policy alone,

and because they are willing to purchase any IPO that is oﬀered at a price below its inferred

value.

While long-run underperformance may otherwise appear hard to reconcile with the abnor-

mal positive returns (“underpricing”) of IPOs in the short-run, the joint existence of these two

phenomena may be explained with relative ease if underpricing is indeed used to signal the prof-

itability of a ﬁrm’s investment opportunities. Even a minor increase in the price at which ﬁrms

32

can issue equity is suﬃcient to alter the incentives of ﬁrms with lower quality investment oppor-

tunities. This results in a sudden increase in IPO activity that is accompanied by a signiﬁcant

drop in the average IPO quality that leads to subsequent IPO underperformance.

A Mathematical Appendix

Proof of Lemma 1: The good type earns higher marginal returns on investment than the bad

type. Moreover, for I > I

F

G

additional investment is unproﬁtable for either type. Hence, there

exists an investment level

¯

I > I

F

G

that the good type is still able to ﬁnance, but at which the bad

type no longer prefers the payoﬀ from the good type’s correctly priced IPO over her own ﬁrst-best

payoﬀ.

Proof of Proposition 1: It is straightforward to verify for each part of Proposition 1 that the

proposed pure strategy combination represents a perfect Bayesian equilibrium. We omit this part

of the proof an show only that the proposed equilibrium is the unique pure strategy equilibrium

that passes the Intuitive Criterion (IC).

By construction of the good type’s equilibrium oﬀer there exists no out-of-equilibrium IPO

(I

, α

), I

= I

T

, that would make the good type better oﬀ than its proposed equilibrium oﬀer,

but that is not also strictly preferred by the bad type over its own equilibrium oﬀer. The bad

type therefore cannot be ruled out a defector, and the belief that a ﬁrm that defects with (I

, α

)

is of the bad type with probability one is admissible under the IC.

Now consider an equilibrium in which the good type undertakes some IPO (I

, α

), with I

= I

T

.

No such equilibrium can pass the IC since we can construct an alternative IPO of size I

T

that

investors would be willing to purchase if it was oﬀered by the good type, and that makes the good

type strictly better oﬀ but the bad type strictly worse oﬀ than (I

, α

**). Hence, the bad type can
**

be ruled out as a defector for the IPO of size I

T

, and the good type has no incentive to stick to

its proposed equilibrium strategy in the ﬁrst place.

We have now established that the good type must raise and invest I

T

in equilibrium. In each

case of Proposition 1 it is easy to see that the good type cannot raise the issue price, relative to

its proposed equilibrium IPO. Moreover, the bad type cannot make itself better oﬀ by defecting

33

from its ﬁrst-best strategy. This concludes the proof.

Proof of Proposition 2: Proposition 2 follows jointly from our assumptions and Proposition 1.

Proof of Lemma 2: For each point in time t

k

in regime-R we have either φ

k

(I

T

) = 0, or

φ

k

(I

T

) = 1 and

V

k,j

=

⎧

⎪

⎨

⎪

⎩

V

G

(I

T

) if j − < k < j,

V

G

(I

T

) +δ

k

if 0 ≤ k ≤ j −.

(36)

Consequently, we can rewrite (13) as

¯

V

L

j

(I

T

) =

ω

0

(I

T

)

ω

j

(I

T

)

·

¯

V

L

0

(I

T

) +

j−1

¸

k=0

φ

k

(I

T

)

ω

j

(I

T

)

· V

G

(I

T

) +

j−f

¸

k=0

φ

k

(I

T

)

ω

j

(I

T

)

· δ

k,j

. (37)

As j → ∞ the ﬁrst and the third term in (37) converge to zero, and the second term converges

to V

G

(I

T

). Hence, we obtain (28).

Proof of Lemma 3: Lemma 3 follows directly from our assumptions.

Proof of Lemma 4: The probability that an IPO I

T

, V

with V

i

(I

T

, α

S

G

(I

T

)) < V

< V

G

(I

T

)

succeeds is equal to the probability that the L-investors’ valuation for an IPOs of size I

T

exceeds

V

**. The latter probability converges to one since
**

¯

V

L

j

(I

T

) converges to V

G

(I

T

) > V

for j −→∞by

Lemma 6. The results regarding the expected payoﬀs from undertaking the oﬀer I

T

, V

follow

immediately.

Proof of Lemma 5: The L-investors’ valuation for the IPO I

T

, V

**exceeds the R-investors’
**

valuation for this IPO. No new information becomes available between the time of the IPO and

the time at which its ﬁrst market clearing price is determined. The ﬁrst market clearing price is

therefore equal to the L-investors’ valuation,

¯

V

L

k

(I

T

). The L-investors’ t

0

-prior can be inferred

using (13) based on this market clearing price and on the performance of past IPOs. Finally, that

the abnormal initial return of this IPO is smaller than the abnormal initial return in regime-R

follows from that facts that

¯

V

L

k

(I

T

) < V

G

(I

T

), and V

> V

i

(I

T

, α

S

G

(I

T

)).

Proof of Proposition 3: The proof is straightforward and therefore omitted.

Proof of Proposition 4: Proposition 4 follows directly from Proposition 3.

Proof of Lemma 6: The proof of Lemma 6 is analogous to the proof of Lemma 2.

Proof of Proposition 5: This proof is done by contradiction. Suppose the economy reaches

the stationary equilibrium of Proposition 1.c). Then it follows from Lemma 2, Lemma 3, and

34

Lemma 4 that sooner or later a ﬁrm will successfully attempt an IPO at a higher price.

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38

A Theory of IPO Underpricing, Issue Activity, and Long-Run Underperformance

Abstract We present a dynamic model of an IPO market in which ﬁrms go public to raise capital for investment. The original shareholders have inside information with respect to the quality of their ﬁrm’s investment opportunities, and they decide whether to go public, how much capital to raise and invest, and how to price the IPO. Outside investors are of one of two types: some investors know and understand even the not directly observable economic incentives of the original shareholders, whereas all other investors learn about the IPO market only from the publicly observable IPO market data. Market participation by the latter investors can upset the stationary rational equilibrium and give rise to a dynamic equilibrium that is characterized by: (1) IPO underpricing, (2) underperformance of IPO shares in the long run, and (3) cyclical variations in IPO volume. Learning investors upset the stationary equilibrium not because of ex ante unreasonable beliefs, but because they fail to condition their beliefs on variables that convey only redundant information in the stationary equilibrium. The model provides a joint explanation for the three empirically documented IPO market “anomalies,” and it yields a number of new testable empirical predictions. JEL classiﬁcation: D82, D83, G31, G32.

I

Introduction

Financial economists have documented at least three puzzling empirical regularities in the market for initial public oﬀerings of common stock: IPO underpricing, i.e. positive excess returns in the short run; strong concentration of IPO activity in certain periods; and underperformance of IPO shares in the long run. The ﬁrst empirical evidence on IPO underpricing dates back to a study by the U.S. Securities and Exchange Commission (SEC) in 1963. A large body of subsequent empirical research has conﬁrmed the ﬁnding that IPOs tend to be substantially underpriced in the U.S., as well as internationally.1 Ibbotson and Jaﬀe (1975) present evidence of the existence of “hot issue” markets, which they deﬁne as periods during which the initial performance of IPOs is exceptionally high. Moreover, they ﬁnd evidence of a strong concentration of IPO activity in certain periods. Loughran, Ritter, and Rydqvist (1994) report that similar patterns can be observed internationally. Evidence of long-run underperformance of IPO shares was ﬁrst presented by Ritter (1991), who also ﬁnds that underperformance was most severe for ﬁrms that went public during certain years of high IPO activity. Further evidence on IPO underperformance in the long run is presented by Loughran and Ritter (1995). Much of the theoretical research on IPOs has focused on explaining IPO underpricing. Possible reasons for underpricing include self-interested investment bankers (Baron and Holmstr¨m (1980) o and Baron (1982)), the “winner’s curse” (Rock (1986)), lawsuit avoidance (Tini¸ (1988) and c Hughes and Thakor (1992)), signaling (Allen and Faulhaber (1989), Grinblatt and Hwang (1989), and Welch (1989)), market incompleteness (Mauer and Senbet (1992)), bookbuilding (Benveniste and Spindt (1989)), and informational cascades (Welch (1992)). Evidence suggests also that in some countries IPO underpricing may be due to the regulatory environment (see Loughran, Ritter, and Rydqvist (1994)), or because the allocation of IPO shares can be used as a bribe. One possible explanation for the strong ﬂuctuations in IPO volume is that the cost of issuing

1

See Ibbotson and Ritter (1995) for a survey of the research on initial public oﬀerings. Loughran, Ritter, and

Rydqvist (1994) focus on the international evidence.

1

equity varies across the business cycle. Choe, Masulis, and Nanda (1993) present a model in which the business cycle causes adverse selection costs to vary over time. Adverse selection costs are lower in periods of economic expansion which leads ﬁrms to issue equity primarily during such times. Choe, Masulis, and Nanda also provide some evidence in support of their model. Although their paper is about seasoned equity oﬀerings, it is conceivable that varying degrees of asymmetric information across the business cycle also aﬀect the market for initial public oﬀerings. Chemmanur and Fulghieri (1999) point out another possible explanation for the strong clustering of IPOs in certain periods, namely the existence of productivity shocks that are correlated across ﬁrms. In Maug (2001) clustering of IPOs occurs because the ﬁrst IPO(s) in a new industry lead investors to developing a better understanding of this industry. This reduces their costs of evaluating subsequent IPOs. Stoughton, Wong, and Zechner (2001) present a model in which the market clearing price of an IPO conveys information with respect to the ﬁrm’s future prospects, as well as with respect to the prospects of the entire industry. Clustering of IPOs can occur when an IPO conveys very favorable information with respect to an industry’s growth opportunities. Lowry (2003) investigates empirically whether the ﬂuctuations in IPO volume can be explained by the aggregate capital demands of private ﬁrms, by the adverse selection costs of issuing equity, or by the level of investor optimism. She ﬁnds that all three factors are statistically signiﬁcant, but that only the ﬁrms’ aggregate capital demand and investor sentiment appear to be economically signiﬁcant determinants of IPO volume. Lowry and Schwert (2002) report a signiﬁcant positive lead-lag relation between initial returns and future IPO volume. They provide evidence suggesting that this lead-lag relationship between initial returns an IPO volume may be driven by information that is learned by the underwriter during the registration period, but that is not fully incorporated into the oﬀer price. If one is willing to accept the view that IPO shares tend to underperform the market in the long run then rational explanations of this phenomenon appear hard to come by.2 Most of the literature on this topic therefore empirical and points in the direction of limited investor rationality and

2

Whether IPO shares really underperform the market in the long run has recently been subject to some debate.

See Brav and Gompers (1997), Eckbo and Norly (2000), and Loughran and Ritter (2000).

2

We propose an alternative theory that is also capable of jointly explaining IPO underpricing. and long-run underperformance of IPO shares. We assume universal risk neutrality and model IPOs as direct transactions between entrepreneurs and investors. at times. “speculative bubbles” can occur.psychological ﬁnance. and Singh (2001). Undertaking the investment opportunity requires an IPO to raise 3 Hirshleifer (2001) provides a comprehensive overview of the various psychological biases and their common root causes. IPOs underperform as investors learn about the true distribution of the ﬁrm values in the long run. In our model ﬁrms go public to raise capital for investment. but in which they have diﬀerent prior beliefs with respect to the distribution of the ﬁrm values. They attribute all three phenomena to the existence of a class of investors who are. Nanda. The structure of our model is quite simple. IPO underpricing is a rational equilibrium outcome that obtains as a result of the original shareholders’ personal wealth maximization under asymmetric information. irrationally exuberant about the prospects of IPOs. Underpricing happens to compensate the regular (institutional) investors for the risk of losing money on their inventory in the event that the hot issue market ends prematurely. The to our knowledge only theory that links all three IPO market anomalies to a single cause is due to Ljungqvist. In such a bubble each investor anticipates to be able to sell his shares in the aftermarket to an investor with a higher valuation. in which IPOs are sold at a price that is above each individual investor’s valuation. Morris (1996) presents a model in which investors share a common prior belief with respect to the value of IPO ﬁrms. ﬂuctuations in IPO volume. Each investment opportunity is available to a single personal wealth maximizing entrepreneur who is privately informed about its proﬁtability. In their model the selling policy that is in the issuer’s best interest usually involves staggered sales. Periods of high IPO activity and long-run underperformance are attributable to the presence of investors who learn about the IPO market based on publicly observable performance of past IPOs. In this setting. one possible rational explanation is that IPO underperformance is due to investor learning.3 However. Nature randomly creates investment opportunities that are of one of two types (proﬁtable or unproﬁtable). 3 .

Intuitively. It is consistent with the beliefs of these investor to purchase any IPO that is issued at a price weakly below its inferred expected value. how much capital to raise and invest. on average. underpriced. and how to price an IPO. but it also alters the incentives of those entrepreneurs that did not previously ﬁnd it proﬁtable to go public. while learning investors may eventually be able to forecast which IPOs are underpriced. Depending on the terms at which equity can be sold the entrepreneurs decide whether to go public. but that they underperform the market in the long run (if long run performance is measured based on the ﬁrst market 4 This suggests that underpricing may be a necessary condition for the absence of underperformance. (1) Consistent with the conventional wisdom our model predicts that IPOs are. The main empirical implications of our model are as follows. However. and also by how much. Learning investors will eventually be able to infer which IPOs are underpriced. In equilibrium. these investors are like statisticians who lack a structural model of the world. We then introduce a class of investors who learn about the IPO market only based on publicly observable data.4 After a period of high IPO activity the IPO market reverts back to the rational equilibrium as long-run underperformance leads the learning investors to revise their beliefs downwards. and who try to understand the IPO market just from looking at the data.capital for investment. such as the performance of past IPOs. In our model even a slight increase in the price at which ﬁrms can issue equity can alter the incentives of lower quality ﬁrms. Under plausible conditions some entrepreneurs ﬁnd it optimal to augment the information that is conveyed by their investment decisions to outsiders by underpricing their IPOs. and a sudden drop in the average IPO quality that leads to subsequent IPO underperformance. The issue price of an IPO does not convey any additional information. the combination of IPO pricing and investment choice signals the quality of a ﬁrm’s investment opportunities. 4 . they cannot infer from the data why these IPOs are underpriced. This results in an increase in IPO volume. In the stationary equilibrium these investors can learn to infer the value of an IPO from the issuing ﬁrm’s investment policy alone. This creates an opportunity for some issuing ﬁrms to sell equity at a price closer to its fair value.

This prediction is consistent with the ﬁndings of Loughran and Ritter (2000) and others. Section III discusses the rational IPO market equilibrium in the absence of learning. (6) Our model predicts that periods of exceptionally high IPO volume come to an end when investors begin to learn about the true fundamental value of these ﬁrms. (3) IPOs that take place during periods of high IPO volume underperform the market even if long run performance is measured based on the issue price. Their presence allows ﬁrms to issue equity at a higher price. All proofs are in the Appendix. The model is set up in Section II. Ritter (1984)). e. This prediction is in line with existing evidence (see. whereas the remaining agents in the economy (“investors”) have only access to ﬁnancial market investments. All agents in the economy are risk neutral and maximize their respective personal wealth. Section IV contains the analysis of investor learning and the dynamic IPO market equilibrium. high initial returns attract unsophisticated investors to the IPO market. II A The Model The Economy Consider an economy with ﬁrms that are initially privately held by owner-managers (“entrepreneurs”).g. (7) Finally. Section V summarizes the empirical implications. Moreover. but rather limited to certain industries. our model suggests that exceptionally high IPO volume is attributable to ﬁrms that go public speciﬁcally to raise capital for investment. which results in a subsequent increase in IPO activity. (4) Periods of exceptionally high IPO volume are not a market wide phenomenon. (2) Long-run underperformance is limited to IPOs that take place during periods of high IPO volume. and Section VI concludes. There are no transaction costs or taxes. In our model. The distinctive feature of entrepreneurs is that they may have access to additional physical investment opportunities. The remainder of this paper is organized as follows. (5) Consistent with ﬁndings by Lowry and Schwert (2002) our model predicts a positive lead-lag relationship between initial returns and IPO volume. and the 5 . our model suggests that the variance of the long run performance of ﬁrms that go public during periods of high IPO volume should be much large than that of ﬁrms that go public during periods of low IPO activity.clearing price).

and the wealth of each individual investor is too small to allow a private equity placement. 6 7 An extension of the model to more than two types is straightforward but tedious. Even if we relaxed assumption (A3) by assuming that both types have a positive NPV project we could obtain IPO underpricing. The value of any ﬁrm’s assets in place prior to (or without) an IPO is equal to A > 0. j ∈ {0. . B Firms. tj = t0 + j∆t. 1). and (A4). nature creates a physical investment opportunity with probability λ ∈ (0.interest rate is zero. The assumptions (A1). and IPOs Nature creates investment opportunities in discrete time intervals. Any such investment opportunity is available only to a single entrepreneur. Marginal proﬁt functions are assumed to be continuously diﬀerentiable functions of investment with the following properties:7 (A1) A type-G project yields higher marginal returns on investment than a type-B project. 5 The assumption that ﬁrms do not diﬀer in terms of the value of their assets in place is a simplifying assumption that is not crucial for our results. and that additional investment can only be ﬁnanced by means of an initial public oﬀering (IPO) of common stock. This could be. we could not obtain ﬂuctuations in the number of IPOs that take place. 1.6 Firms diﬀer only in terms of their investment opportunities so that we will refer to a ﬁrm with access to a type-G (type-B) project as a type-G (type-B) ﬁrm and to its original shareholder as a type-G (type-B) entrepreneur. long-run underperformance. are merely technical assumptions that allow us to keep the analysis simple. The (expected) marginal proﬁt function of a type-T project is denoted by πT (I). However. . because entrepreneurs do not have any own funds to pay for the additional investment. An investment opportunity that opens up has to be undertaken immediately. asymmetric information or agency problems rule out debt ﬁnancing. 6 . We assume that ﬁrms are all-equity ﬁnanced. (A2). At each point in time. . for example. None of these assumptions is crucial for the main results of the model. ∆t > 0. and ﬂuctuations in the amount of equity that is issued. or it ceases to exist. Entrepreneurs.5 An investment opportunity is of one of two types that we refer to as type-G (“good”) and type-B (“bad”) respectively. 2.}.

We abstract from the existence of ﬁnancial intermediaries and model IPOs as direct transactions between entrepreneurs and investors. B}. ∞) × [0. and α denotes the fraction of equity retained by the entrepreneur.9 The value of a type-T ﬁrm that raises and invests I dollars is equal to the expected value of its future cash ﬂows: I VT (I) = A + 0 1 + πT (I) dI. an entrepreneur can make a take-it-or-leave-it oﬀer I. the original shareholder’s informational advantage implies that outsiders would view any attempt to sell more equity than necessary to ﬁnance the intended investment policy as a negative signal of the ﬁrm quality. and the probability that it is type-B is equal to 1 − p. The sole purpose of the IPO in our model is to raise capital for investment. The oﬀer 0. 1] to outside investors. Moreover. T ∈ {G. B}. α ∈ [0.8 We assume that a ﬁrm without access to a physical investment opportunity cannot go public. The ex ante probability that an investment opportunity is type-G is equal to p ∈ (0. (A2) Projects exhibit decreasing returns to scale: πT (I) < 0 for all I > 0. at most one IPO can take place at any given point in time. 1). (A3) Only type-G projects have a positive expected NPV: πG (0) > 0. 7 . The project type is initially private information of the entrepreneur and it is not veriﬁable ex post. 1 represents the special case that the entrepreneur does not raise any capital and instead retains full ownership of her ﬁrm. which means that the entire proceeds from the issue will be invested in the ﬁrm. 9 Hence. (A4) Marginal gross returns on investment are non-negative. (1) Conditional on a physical investment opportunity being available. 8 We rule out the possibility that a ﬁrm invests the proceeds from the equity issue in marketable securities or just holds cash. but πB (0) ≤ 0. T ∈ {G.irrespective of the level of investment: πB (I) < πG (I) for all I ≥ 0. This means that marginal losses from ineﬃcient investment never exceed the additional investment outlay: πT (I) > −1 for all I > 0. where I denotes the amount of capital raised and invested. Our assumption of universal risk neutrality implies that entrepreneurs have no incentive to sell equity for diversiﬁcation purposes.

10 Neither of these assumptions is crucial for our model. α) . Our main results would still hold if an entrepreneur could approach the market again after a failed ﬁrst attempt to sell an IPO. This representation will be more intuitive when it comes to analyzing investor learning and the resulting IPO market dynamics. α is equal to the value of her retained equity. α) = I . As a tie breaker we assume that an entrepreneur who is indiﬀerent between her ﬁrst-best IPO and some alternative IPO will stick to her ﬁrst-best IPO. α) exceeds the true ﬁrm value then the IPO is overpriced. WT (I. V i (I. α) in the following as “the issue price”. α captures the entrepreneur’s tradeoﬀ between raising more capital and retaining more equity. For convenience we will refer to V i (I. where V i (I. α) denotes the ﬁrm value that is implicit in the terms of the IPO. The total wealth of a type-T entrepreneur who manages to sell an IPO I. 8 . α we can now ﬁnd an equivalent representation I. The representation I.By assumption. α) is smaller then the true ﬁrm value then the IPO is underpriced. I. and if V i (I. If V i (I. α . 1−α (3) It is clear that V i (I. V i (I. For each IPO I. An entrepreneur whose IPO has failed cannot approach the market again. an entrepreneur chooses the IPO that maximizes her expected terminal wealth. Outside investors just break even on purchasing (1 − α) of a ﬁrm’s equity for I dollars whenever the true ﬁrm value is identical to (3). This representation will be very intuitive when it comes to analyzing the decision problem of an entrepreneur. we can calculate the ﬁrm valuation that is implicit in the terms of the IPO as V i (I. α is assumed to be equal to zero. (2) An entrepreneur’s payoﬀ from unsuccessfully attempting an IPO I.10 For any IPO. α) need not be identical to the true ﬁrm value. or if we assumed a diﬀerent (ﬁxed) payoﬀ from a failed IPO. Which of the two above IPO representations is going to be more convenient depends on the questions that we will address. α) emphasizes the link between investment policy and ﬁrm value. α) = αVT (I). The representation I.

α) ≤ V R (I. α) ≤ V .1 R-Investors The ﬁrst group of investors. which means that they understand even the not directly observable economic incentives of the entrepreneurs. µ 9 .11 C Investors Investors can either purchase stocks or hold cash.We assume that all uncertainty with respect to a ﬁrm’s cash ﬂows is resolved exactly periods ˜ after its IPO. whenever V i (I. where ˜ δT (I) is a random variable with zero expected mean. It will be more convenient to specify the investors’ beliefs with respect to the ﬁrm value (V ). and on his belief with respect to the value of the oﬀering ﬁrm. the ﬁrm value is publicly revealed to be equal to VT (I) + δT (I). as well as on the fraction of equity retained by the entrepreneur. C. 12 13 This assumption is necessary to obtain long-run underperformance of IPO shares in our model.13 An investor will participate in an IPO whenever he expects to at least break even. (4) A crucial assumption in our model is the existence of two types of investors that diﬀer in terms of their knowledge and their understanding of the IPO market.12 Whether an investor decides to participate in a particular IPO depends on the terms of the IPO. rather than with respect to the probabilities that they assign to the event that the ﬁrm is of the high type (ˆ). These investors are assumed to have all the information about the ﬁrms with the exception of the individual ﬁrm types. R-investors demand shares in an IPO whenever V i (I. V R . α). To ˜ account for limited liability we have to assume that δT (I) is bounded from below by −VT (I). that we refer to as “R-investors”. They condition their beliefs with respect to the ﬁrm value. At that time. but they cannot short sell IPO shares. V . 11 (5) The only purpose of this stochastic component is to ensure that the ﬁrm type is not veriﬁable ex post. The R-investors can therefore infer each entrepreneur type’s expected payoﬀ from every feasible strategy. Following (4). on the ﬁrm’s investment policy. that is. are rational in the usual game theoretic sense.

respectively. We will see that L-investors may learn to predict the value of an IPO based on the issuing ﬁrm’s investment policy alone. This assumption implies that an entrepreneur may sell the IPO to the group of investors with the highest valuation for the shares. V i (I. C.2 L-Investors (6) The second group of investors. are not irrational. It is crucial that we assume that NR and NL are suﬃciently large so that each group of investors by itself can purchase all IPOs in the economy. α) ≤ V L (I). Depending on whether IPOs are oﬀered at a price (weakly) below or (strictly) above the R-investors’ valuation we distinguish between two IPO market regimes that we refer to as “regime-R” and “regime-L”.Note that R-investors may alternatively be viewed as conditioning their beliefs on I and V i (I. (7) L-investors are not ignoring how much of the ﬁrm’s equity is oﬀered in exchange for the capital that is raised in the IPO.E. that we refer to as “L-investors”. C. and that they demand shares in an IPO as long as it is oﬀered at a price weakly below its inferred expected value. but they diﬀer from R-investors in that they view the choice of α merely as a pricing decision. an L-investor is like a statistician who lacks a structural model of the world. so that (5) may be stated equivalently as V i (I. We therefore assume that L-investors condition their beliefs. α). but they learn about the IPO market only from the publicly observable performance of past IPOs. 10 . α)). We will discuss the learning by L-investors in more detail in Subsection II. α) ≤ V R (I. and who tries to understand the world just from looking at the data. Intuitively. after the sequence of events for an individual IPO has been speciﬁed.3 IPO Market Regimes We denote the number of R-investors and the number of L-investors in the economy by NR and NL . V L . respectively. V i (I. on the ﬁrm’s investment policy.

. (2) if a ﬁrm issued equity at tj− then the true value of this ﬁrm’s cash ﬂows is publicly revealed. and (3) a ﬁrm that is not yet publicly listed may undertake an IPO. Vj.j+1 The ﬁrst market clearing price is determined in public trading... tj+ .j+ Nature reveals the true ﬁrm value. The market is in regime-L if an IPO is oﬀered at a price strictly above the R-investors’ valuation. To avoid ambiguities we assume that these events take place in the aforementioned sequence. Underpricing Long run performance Figure 1: Time line of events for an individual IPO Deﬁnition 1 (Regime-R and Regime-L) At time-tj the IPO market is in regime-R if an IPO is oﬀered at a price weakly below the R-investors’ valuation. tj + tj+1 − . Vj.j IPO takes place.. Vj... tj . D Sequence of Events for an Individual IPO Up to three events can take place in our model at any given point in time. and tj + . tj : (1) there is a public trading session in which the market clearing prices of all ﬁrms that previously issued equity are determined. respectively. This particular sequencing implies that no new information becomes available between the time at which an IPO is sold to investors (tj + ). We may think of the trading session. the revelation of the realized cash ﬂows.. and the IPO taking place at times tj − . and the trading 11 .

Vj. The issue price. from tj+1 to tj+ ). V (I.j+k . Vj. . g(·). Whenever we are primarily interested in the dynamic aspects of the IPO market we will denote the time-tj+k price of the ﬁrm that went public at tj by Vj.}.j+k . and for ≤ k. k ∈ {0. Moreover. is observed. . we have ⎧ ⎪ i ⎪ V (I.e. 1. the time-tj market clearing prices of all publicly traded ﬁrms and the true fundamental value of any ﬁrm that went public at tj− are already common knowledge when the time-tj IPO is oﬀered to the public. The time line of events for an individual IPO ﬁrm is depicted in Figure 1. and the true ﬁrm value is publicly revealed.e. α) ⎪ ⎪ ⎪ ⎨ for k = 0. with compact support. Hence. from time tj to tj+ ).session in which its ﬁrst market clearing price is determined (at tj+1 − ). We assume that this prior is distributed according to some probability density function. 3. (8) Vj.j .e. for 1 ≤ k < . At tj+ all uncertainty with respect to the true ﬁrm value is resolved. L R ⎪ max V (I). underpricing) of an IPO by its stock price performance from tj to tj+1 . The probability density function is assumed to be common knowledge. The (ﬁnite) weight that L-investors assign to their prior 12 . since our model yields separate predictions for the two time horizons. or based on the ﬁrst market clearing price (i. and it is identical to (3). so that V0L (I) denotes the L-investors’ prior belief with respect to the value of a ﬁrm that raises and invests I dollars. For a successful IPO that takes place at tj a time series of ﬁrm prices.j+k = We measure the abnormal initial performance (i. The long run performance of IPO shares is measured either based on the oﬀer price (i. . All subsequent prices are market clearing prices that are determined by the investors with the highest valuation for the shares. No IPO took place before t0 . α) ⎪ ⎪ ⎪ ⎪ ⎩ V (I) + δ (I) ˜T T E Learning by L-Investors We denote the L-investors’ time-tj belief with respect to the value of a ﬁrm that raises and invests I dollars by VjL (I). 2. but the prior itself is private information of the L-investors. is set by the entrepreneur.

L-investors update their beliefs whenever the ﬁrst market clearing price for an IPO is observed. but also on the IPO market regime periods ago. The expected development of the L-investors’ beliefs at a given point in time therefore depends not only on the current IPO market regime.is denoted by ω0 (I). the L-investors’ updated time-tj belief may be expressed as VjL (I) = φj− (I) ωj−1 (I) φj−1 (I) L · Vj−1 (I) + · Vj−1. we deﬁne ωj (I) = ωj−1 (I) + φj (I) j−1 (10) (11) = ω0 (I) + 0 φj (I).j + · (Vj− ωj (I) ωj (I) ωj (I) . . 15 Assuming that only one of the parameters that determine the L-investors’ beliefs is private information implies that all other agents in the economy fully understand the L-investors’ beliefs after observing only a single IPO in regime-L. 1. This limits the number of special cases that we have to consider (see Lemma 5) without aﬀecting the main insights that can be gained from our model.j . By assumption.j − Vj− . 13 . 2. Assuming Bayesian updating. and whenever new information on a publicly listed ﬁrm becomes available. ω (I) k=0 j j−1 (13) A weight ω0 (I) = k means that the weight that type-L investors assign to their prior is equivalent to the weight that they would assign to k independent observations. the ﬁrst market clearing price of any time-tj−1 IPO. and of the number of IPOs of size I that took place prior to tj .15 To formalize the updating of beliefs by L-investors we deﬁne the indicator functions ⎧ ⎪ ⎨ 1 if an IPO of size I took place at tj . (12) The three terms in (12) represent the investors’ time-tj−1 belief.j−1 ) . ⎪ ⎩ 0 otherwise. Note that (12) can alternatively be stated as VjL (I) 14 = ω0 (I) · V L (I) + ωj (I) 0 φk (I) · Vk. the latter is the case at tj if and only if a ﬁrm went public at tj− .}. and any change in the market value of a ﬁrm that issued equity at tj− due to the arrival of new public information.14 For convenience we assume that ω0 (I) is common knowledge. In addition. φj (I) = (9) for each j ∈ {0. . . which is the sum of the weight of the L-investors’ t0 -prior.

and of the current market values of all publicly listed ﬁrms that followed the same investment policy in the past. III The Rational IPO Market Equilibrium in the Absence of Learning: Regime-R We begin our analysis by deriving the rational IPO market equilibrium that obtains in the absence of learning. That is. 14 . αG (IG )) = A + 16 F IG 0 πT (I) dI.16 so that we will skip most of the technical details and some of the proofs in this section and instead focus mainly on the intuition. (15) Available from the authors. αT (I)) = VT (I)). A type-B entrepreneur therefore does not F invest (IB = 0).com. so that outside investors just break even on purchasing the issue. we assume initially that the L-investors are not participating in the IPO market. or from the Social Science Research Network at http://www. The total payoﬀ to a type-B entrepreneur is equal to WB (0. denoted by IT . A The First-Best Outcome In the absence of informational asymmetries a type-T entrepreneur can raise I dollars by oﬀering F 1 − αT (I) = I VT (I) (14) F of her ﬁrm’s equity to outside investors. and a type-G entrepreneur undertakes the NPV-maximizing investment level F that is implicitly deﬁned by πG (IG ) = 0. Since the equity is sold at the fair price. The IPO is priced correctly (i. An in-depth analysis of this equilibrium can be found in a companion paper by the same authors.which reveals that the type-L investors’ time-tj belief with respect to the value of a ﬁrm that raises and invests I dollars is just a weighted average of their time-t0 prior. 1) = A.ssrn. a type-T entrepreneur has no incentive to deviate F from her ﬁrst-best investment policy. V i (I.e. and the total payoﬀ to a type-G entrepreneur is equal to the sum of her project-NPV and the value of the assets in place: F F F WG (IG .

αG (IG ) the bad type’s gain from selling overvalued equity exceeds her imitation costs that arise from ineﬃcient investment. F ¯ Lemma 1 There exists an investment level I > IG at which the good type could issue equity at the fair price. doing so would not necessarily be optimal from the point of view of a personal wealth maximizing entrepreneur: while the fact that the good type earns higher marginal returns on investment than the bad type creates an incentive to signal with overinvestment. the good type could always distinguish herself from the bad type by overinvesting to such an extend that it becomes too costly for the bad type to mimic. B Equilibrium under Asymmetric Information We assume that the ﬁrst-best outcome is not feasible under asymmetric information. Whenever the ﬁrst-best outcome is not feasible due to asymmetric information the good type typically has an incentive to deviate from her ﬁrst-best investment policy to signal her type. 15 . Hence. 1). the necessity to ﬁnance this investment with outside equity creates a counteracting incentive to underinvest. and no abnormal stock price performance is observed in the long run. Under asymmetric information type-G ﬁrms are therefore faced with higher marginal ﬁnancing costs than type-B ﬁrms. Lemma 1 states that. That is. we assume that the bad type’s payoﬀ from undertaking the good types’s ﬁrst-best oﬀer exceeds the bad type’s payoﬀ from her own ﬁrst-best strategy: F F F WB (IG .Both the issue price and the ﬁrst market clearing price are identical to the true (expected) ﬁrm value.17 The direction in which the good type adjusts her investment policy can be determined by looking at the two type’s respective marginal rates of substitution between the fraction of retained 17 For all I > 0 the equity of a type-G ﬁrm is more valuable than that of a type-B ﬁrm since type-G ﬁrms earn higher returns on investment than type-B ﬁrms. (16) F F F The intuitive interpretation of (16) is that at the IPO IG . in principle. αG (IG )) > WB (0. However. there is no underpricing.

S αG (I) = 18 A . I . 16 . VB (I) (20) The ratio of the ﬁrm values may be interpreted as the ratio of the two type’s respective marginal ﬁnancing costs since both types have to give up the same fraction of equity to raise another dollar of capital.18 That is. α)/∂α V (I) = α T . VB (I). exceeds the bad type’s marginal gross return. From (2) we obtain MRS T (I. R-investors therefore have to believe that a ﬁrm that oﬀers the IPO of size I is of the good type. and the amount of capital that is raised and invested. α) = ∂WT (I. the good type will undertake only investments for which her marginal return on investment is suﬃciently higher than the bad type’s to compensate her for her relatively higher marginal cost of outside equity capital. and the good type has no incentive to undertake an IPO of size I in the ﬁrst place. VT (I) (17) (18) Based on (17) it can be shown that the good type’s second-best strategy entails undertaking only those investments for which its marginal gross return. VG (I) = 1 + πG (I). the good type ¯ will not increase investment beyond I since this investment level is already suﬃciently informative to allow an equity issue at the fair price. 19 Any equilibrium candidate in which the good type undertakes an investment policy I = I with strictly positive probability fails the “Intuitive Criterion” of Cho and Kreps (1987): there exist an alternative IPO of size I that makes the good type strictly better but the bad type strictly worse oﬀ than the IPO of size I . αP (I) = 1 − I .19 There exists a (unique) pure-strategy equilibrium in regime-R. The good-type’s second-best investment policy can therefore be identiﬁed as the investment policy.equity. To be able to fully characterize this equilibrium we need to calculate the fraction of equity that the entrepreneurs could retain in a pooling equilibrium candidate IPO of size I. (1 − p)VB (I) + pVG (I) (19) and the fraction of equity that a type-G entrepreneur could retain in an IPO of the same size that is priced to prevent the bad type from mimicking. VG (I)/VB (I). I]. However. in which both ﬁrm types issue equity at the average fair price. that maximizes the ratio VG (I)/VB (I) on the ¯ interval [0. by a factor greater than the ratio of the two types’ respective marginal ﬁnancing costs. α)/∂I ∂WT (I.

αP (I ) . IG . α > αe . and in which the e bad type undertakes its ﬁrst-best IPO. Case a) corresponds to a setting in which for any level of investment the good type’s marginal return on investment is suﬃciently higher than the bad type’s to ensure that good type always prefers a marginal increase in equity ﬁnanced investment over issuing equity below the fair price. 1 . α . hence. IB . and that a ﬁrm that defects with an out-of-equilibrium IPO I . 1 . G The equilibrium can be supported by the R-investors’ beliefs that a ﬁrm that defects with an outof-equilibrium investment policy I = I is of the bad type with probability one. αe = I . The value G of αP (I ) depends additionally on the probability distribution of the ﬁrm types. and. and αS (I ). IB . αG (I) . These beliefs are admissible under the Intuitive Criterion of Cho and Kreps (1987). αe = G S ¯ c) If I < I and αG (I ) ≥ αP (I ) then the equilibrium is a separating equilibrium in which the e bad type undertakes its ﬁrst-best IPO. and in which the good type signals B e S with a combination of investment choice and IPO underpricing. αG (I ) . B S ¯ b) If I < I and αG (I ) < αP (I ) then the equilibrium is a pooling equilibrium in which both types raise and invest I . this equilibrium is of the following type:20 a) If I ¯ = I then the equilibrium is a separating equilibrium in which type-G signals with e e ¯ F ¯ overinvestment and issues equity at the fair price. αe = I . is of the good type with probability G p. Depending on the location of I on [0. B e IG . and of the bad type with probability 1 − p. αe = 0. The intuition underlying these diﬀerent types of equilibria is as follows. increases the ratio of the two types’ respective marginal ﬁnancing costs. I . The latter cases are plausible since any investment that the good type chooses to undertake increases the ratio of the ﬁrm values. depend only on the two types’ respective marginal proﬁt functions. αe = 0. and in which equity is issued at the average value: e IB . 17 . I]. IG . The cases b) and c) correspond to a setting in which this is only initially so. αG = I.Proposition 1 (Equilibrium in Regime-R) Regime-R is characterized by the existence of a ¯ unique equilibrium in pure strategies. Once I has been reached the good type’s relative disadvantage on the ﬁnancing side (vis-`-vis the bad type) begins a 20 ¯ The values of I. and on the values S of αP (I ) and αG (I ).

αS (I ) that is oﬀered by a type-G ﬁrm.c)’s separating equilibrium with underpricing. αG (I )) F αG (I ) − αS (I ) G > 0. Otherwise the bad type prefers her own ﬁrst-best payoﬀ over the payoﬀ from the pooling equilibrium candidate IPO. Based on the equilibrium of Proposition 1. 1. In the latter case the good type can retain αS (I ) ≥ αP (I ) of the equity without being mimicked by the bad type. . G Only Proposition 1. but there is positive abnormal long run performance from tj to tj+ . The G abnormal initial performance of IPOs from the issue price to the ﬁrst market clearing price (i. tj . Proposition 2 (Issue Activity and IPO Performance in Regime-R) Suppose the equilibrium in regime-R is Proposition 1.to outweigh its relative advantage on the investment side. 1 − αF (I ) G (21) (22) (3) No abnormal stock price performance is observed after the ﬁrst market clearing price. The pooling equilibrium exists only if the ex ante probability of S a ﬁrm being type-G is so high that αP (I ) > αG (I ).j+1 −1 = Vj. 18 . Whether the equilibrium in this case is a pooling equilibrium or a separating equilibrium in which the good type issues deliberately underpriced equity depends only on the probability distribution of good and bad ﬁrms in the economy. Then the IPO market is characterized by the following properties: (1) The ex-ante probability that an IPO takes place at any given time. from tj to tj+1 ) is equal to Vj.c)’s separating equilibrium with underpricing is of interest to us. 2. there is no abnormal long run performance of IPO shares from tj+1 to tj+ . (2) Any IPO that takes place is an issue I .j = VG (I ) −1 S V i (I . j ∈ {0. . Hence. At I the good type therefore prefers issuing undervalued equity over changing the investment policy in either direction. We therefore assume for the remainder of the paper that the model parameters are such that they result in this type of equilibrium.c) we obtain the following properties of the IPO market in regime-R.e. .} is equal to λp.

VG (100)/VB (100) = 1. αB (IB ) = 0. 1) = 100. 3 The ﬁrst-best outcome is not feasible under asymmetric information since the bad type’s payoﬀ from the good type’s ﬁrst-best IPO exceeds her own ﬁrst-best payoﬀ: 2 3 VB (100) = 114 2 > 7 WB (0. B}. We will extend this example in Subsection IV. This is not a problem. αG (IG ) = F F F 100.The following subsection contains an example of Proposition 1. 1 .6091.599 127.400 2.5.51. and αP (I ) = ≈ 0.3. where we present results from a simulation of the IPO market dynamics. and the two types’ marginal net proﬁt functions are given by (23) and (24).23 VB (I ) 1 + πB (I ) 202 F We obtain αG (I ) = 21 (25) 129. αG (I ) = 1. respectively. VB (100) = 171 3 . VP (I ) = 221 2797 ≈ 221. 1) = 100. IG . and 1 + πB (I ) = ≈ 0. C An Example Suppose the value of any ﬁrm’s asset in place prior to (or without) the IPO is equal to VT (0) = 100. At the good type’s ﬁrst-best investment level the good type’s marginal gross return on investment exceeds the bad type’s by the factor (1 + πG (100)) / (1 + πB (100)) = 2 1 . and 1 + πB (100) = 3 . 7 7 3 VG (I ) = 318 199 ≈ 318.2886. T ∈ {G.399 S ≈ 0.4451.599 295.599 77. however. The ex-ante probability that a new project is of type-G is equal to p = 0. and the bad type does not go public IB . 2 ) = 200. since neither assumption is necessary for the existence of the equilibrium of Proposition 1.c)’s IPO market equilibrium with underpricing. 22 23 VG (100) = 300. The corresponding ﬁrst-best 3 payoﬀs to the entrepreneurs are equal to WG (100.2.523 ≈ 0.21 πG (I) = 2 − πB (I) = − I 50 (23) (24) I 175 F F F In a world of symmetric information the good type undertakes her ﬁrst-best IPO. 2 . 1 + πG (I ) = 400 4000 101 350 51 100 = 0. 3 which is greater than the ratio of the two type’s marginal ﬁnancing costs.75. 1 + πG (100) = 1. the good type has an incentive to signal by increasing investment up to I = 124.4384.22 Hence.5.C.7. 19 . Assuming linear marginal proﬁt functions keeps the calculations tractable but also implies that we have to choose marginal proﬁt functions that violate the assumptions (A1) and (A4) for suﬃciently high levels of investment.767. at which point 1 + πG (I ) 357 VG (I ) = = ≈ 1. VB (I ) = 180 14 ≈ 180. and WB (0.

and in which the good type undertakes the IPO B S I . and G F ¯ ¯ αG (I)VB (I) = 100. compared to a true ﬁrm value of G VG (I ) ≈ 318. αG (I ) = 124. αG (I)) = 175.3. which is less than its equilibrium payoﬀ.400 . A graphic representation of the equilibrium is depicted in Figure 2. The three dotted curves represent the (maximal) fraction of equity that the original shareholders can retain for a given investment level for a good/bad/pooling IPO. so that αF (I) = G 7 7 13 .5. Outside investors obtain 1 − αG (I ) of the good type’s equity in return for I dollars. ¯ ¯ ¯ (1 − αF (I))VG (I) = I. αG (I ) .5. so that outsiders still break even on purchasing the oﬀer. S The equilibrium payoﬀ to the good type’s original shareholders is equal to WG (I . 1 . and through her equilibrium oﬀer. but at the same time prefers her own ﬁst-best strategy over the pooling candidate IPO: F αP (I ) VB (I ) ≈ 79. At I the good type’s iso-payoﬀ curves are tangent to the bad type’s iso-payoﬀ curves from above. The solid grey curves are the good type’s iso-payoﬀ curves through her F F F S ﬁrst-best IPO. The solid black curve represents the bad type’s iso-payoﬀ curve through her ﬁrst-best strategy. (27) ¯ Note that overinvesting up to I = 150 would enable the good type to issue equity at the ¯ ¯ ¯ fair price: VB (I) = 185 5 .This implies that the bad type would mimic an IPO in which the good type raises I dollars by issuing equity at the fair price. This translates into an issue price of V i (I . 20 . the good type’s payoﬀ from doing so would only be equal to ¯ S ¯ WG (I. the good type prefers retaining less than the fair amount of equity over changing her investment policy in either direction.7.87%. (26) The pure-strategy equilibrium is consequently a separating equilibrium in which the bad type F F does not go public. Hence. However.523 S mimicking. that is just suﬃciently underpriced to prevent the bad type from 2. U = I .01 < 100 < αG (I ) VB (I ) ≈ 109. IB . G = IG . 1.77.7. αG (IG ) . αG (I )) ≈ 176. αG (I )) ≈ 17. 1 . B = 0. αS (I )) ≈ 279. and the total amount of “money left on the table” is equal to S 1 − αG (I ) S VG (I ) − V i (I . and VG (I) = 325. The good type’s IPO therefore experiences an abnormal initial return of +13. αF (IB ) = 0.

21 .α 1 B F F αG (IG ) G F U F αG (I ) S αG (I ) αP (I ) P F αG (I) αP (I) αF (I) B 0 F IB = 0 I F IG I Figure 2: The separating equilibrium of our example: type-G ﬁrms overinvest and issue underpriced equity (U) and type-B ﬁrms do not go public (B).

so that the new “information” that is contained in the realized cash ﬂows is just noise with an expected value of zero. the market value of any such ﬁrm is equal to VG (I ). and Regime-L We begin investigating what eﬀects the presence of L-investors can have on the IPO market equilibrium by studying how their beliefs evolve as they learn about the IPO market in regime-R. or it would be undertaken by two or more ﬁrm types that pool and issue equity at the identical terms. In the latter setting an equilibrium investment policy would either be undertaken by only a single ﬁrm type. Lemma 2 (Learning by L-Investors in Regime-R) Suppose the IPO market is exogenously ﬁxed in regime-R. Thereafter.IV Learning by L-Investors. αG (I ) that are undertaken by good ﬁrms. In any case. S The only IPOs that take place in regime-R are IPOs I . without loss of generality. If the IPO market was exogenously ﬁxed in regime-R it would therefore only be a matter of time until the L-investors learn to predict the value of IPO ﬁrms with arbitrary precision. L-investors will also update their beliefs whenever the realized cash ﬂows of a ﬁrm that went public in the past are observed. Firms that go public in regime-R are valued correctly by the market. Based on the ﬁrst market clearing price. 22 . Beginning at t . that the IPO market starts at t0 in regime-R. Then the L-investors’ belief with respect to the value of a ﬁrm that goes public converges to the correct value: VjL (I )−→VG (I ). in which case Lemma 2 applies accordingly. (28) Lemma 2 could be generalized in a straightforward manner to a setting in which two or more ﬁrm types issue equity in regime-R. A Learning by L-Investors in Regime-R Suppose. the market value does not change until the uncertainty with respect to the ﬁrm’s cash ﬂows is resolved. The L-investors will then update their beliefs from t0 to t −1 only based on the respective ﬁrst market clearing prices of any new IPOs. in which case L-investors would learn to forecast the average value of these ﬁrms.

By assumption. 1 − I /V ) = VB (I ) − V WG (I . and suppose that the L-investors are demanding shares of IPOs I . the probability that an IPO I . excess demand is even more severe now. αS (I )).h. An IPO I . V i (I . Lemma 3 (Demand for IPO Shares) The L-investors demand IPO shares as soon as their beliefs with respect to the value of a ﬁrm that raises and invests I exceeds V i (I . The ﬁrst such IPO(s) may fail since the G entrepreneurs do not know the L-investors’ t0 -prior. so that Lemma 2 implies that the L-investors’ G valuation for IPO shares will sooner or later exceed the issue price.L-investors would eventually be able to predict the value of a ﬁrm that goes public in regime-R with the same accuracy as the R-investors. At that G S time the total demand for shares of IPOs I . It is therefore only a matter of time until the L-investors begin to participate in the IPO market. of (30). V converges converges to the l. αG (I )) increases from NR to NR + NL . V to the l. 1 − I /V ) = VG (I ) − S > WG (I . The good type’s expected payoﬀ from oﬀering I . of (29). αG (I )) < V < VG (I ).V would succeed converges to one. αG (I )) . While there was already excess demand for underpriced IPOs when L-investors were absent. As time passes. V i (I . VG (I ) I V VB (I ) I WB (I . αS (I )). αS (I )).s. the Linvestors demand shares whenever they expect to at least break even on purchasing an IPO. Lemma 4 (Expected Payoﬀ from Raising the Issue Price) Suppose that the IPO market is S in regime-R.h. Now recall that VG (I ) > V i (I . The increase in the demand for IPO shares reveals to the entrepreneurs that it may now be possible to issue equity at a higher price. 1) It follows from Lemma 4 that it is only a matter of time until an entrepreneur will attempt to sell an IPO of size I at a price V > V i (I .s. S Let V be such that V i (I . and the bad type’s expected payoﬀ from oﬀering I . The L-investors’ participation in the IPO market is publicly observable due to the publicly observable increase in the demand for IPO shares. so that they are uncertain with respect to the L-investors’ exact willingness to pay. αG (I )) (29) (30) > WB (0. V 23 that fails reveals that the L-investors’ .

V0L (I ). αS (I )) marks the beginning G B Regime-L that is Lemma 5 (The First Successful IPO in Regime-L) Suppose the ﬁrst IPO I . since the IPOs that previously took place in regime-R were valued correctly by the market no new information is expected to be incorporated in the L-investors’ beliefs for the ﬁrst − 1 periods. The IPO is undervalued if the issuing ﬁrm is type-G. Vk.k V ≥ 0.k+1 V L (I ) − V −1 = k Vk. The abnormal initial return of the IPO is non-negative. but it does not lead to any updating of the Linvestors’ beliefs. Then this IPO’s ﬁrst market clearing price. is equal to VkL (I ) ≥ V . Once the market has entered regime-L the market clearing prices of any new IPOs will therefore just conﬁrm the L-investors’ beliefs. but overvalued if the issuing ﬁrm is type-B. but strictly lower than the abnormal initial return in regime-R: Vk.valuation for an IPO of size I is less that V . Proposition 3 (Equilibrium in Regime-L) Suppose VjL (I ) > V i (I . The ﬁrst successful IPO I . (31) The ﬁrst market clearing price of any IPO that takes place in regime-L is equal to the Linvestors’ valuation for the shares. with V > V i (I . and it reveals the L-investors’ t0 -prior. V of regime-L.k+1 . VjL (I ) . Moreover. Proposition 4 (Issue Activity and IPO Performance in Regime-L) The IPO market exhibits the following characteristics in regime-L: 24 . αS (I )) at tj > tk . Based on Proposition 3 it is straightforward to derive the following properties of the IPO market in regime-L. αG (I )) takes place at tk . An G entrepreneur with access to an investment opportunity will then successfully undertake the IPO I . V S successfully oﬀered at a price V > V i (I . Regime-L will consequently persist for a number of periods. The following proposition states the entrepreneurs equilibrium strategies after the ﬁrst successful IPO in regime-L. irrespective of her type.

The G issuing ﬁrm is of type-G with probability p. there is no abnormal initial performance (i. (3) On average. is equal to λ. VjL (I ) . Hence. (3) The expected value of a ﬁrm that goes public is equal to VP (I ) < V i (I . and of type-B with probability 1 − p.(1) The ex-ante probability that an IPO takes place at any given point in time. It is this poor performance of IPOs in the long run that eventually puts an end to regime-L.j+1 VjL (I ) (32) A comparison of the IPO market characteristics in the two regimes reveals the following key diﬀerences: (1) The expected IPO volume in regime-L exceeds the expected IPO volume in regime-R by the factor 1/p > 1.e. Consequently there is less IPO underpricing in regime-L than in regime-R.j+ Vj. (2) Any IPO that takes place is an issue I . (2) Issue prices are higher but the (ﬁrst) market clearing prices are lower in regime-L than in regime-R. IPOs that take place in regime-L underperform in the long run. tj . The ﬁrst market clearing price of each IPO is equal to its issue price. 25 (33) . where VjL (I ) > V i (I .j+ VP (I ) − 1 < 0. or from tj+1 to tj+ ) is negative: Vj. A remarkable feature of our model is that IPOs have to be underpriced to avoid underperformance long run: just a small increase in the issue price changes the incentives of some entrepreneurs and results in a (potentially dramatic) decline in the average IPO quality. Lemma 6 (Learning by L-Investors in Regime-L) Suppose the IPO market is exogenously ﬁxed in regime-L. Based on the ﬁrst market clearing price there is no abnormal performance of IPOs that take place in regime-R.j Vj. αS (I )). Then the L-investors’ beliefs with respect to the value of an IPO ﬁrm converge to the correct value: VjL (I )−→VP (I ). αS (I )). no underpricing) from tj to tj+1 . −1 = −1 = Vj. The G expected abnormal long run performance (from tj to tj+ .

and in the long run performance of IPO shares. and that they are willing to pay up to their full valuation for the shares of a new IPO. Finally. we may not observe more than one period of high IPO activity in any single industry since the nature of the physical investment opportunities in the economy changes over time. no new period of high IPO volume will be observed before a new generation of investors has entered the market. the IPO market will revert to regime-R as soon as the L-investors’ willingness to pay for IPOs of size I drops below V i (I . With respect to the parameters that have not been speciﬁed earlier we make the following assumptions: (1) The probability that a new project becomes available at 26 . for a number of reasons that are outside our model. Another possibility is that investors may eventually learn that they have to condition their beliefs with respect to the value of an IPO ﬁrm also on the issue price. αS (I )). The IPO market is therefore characterized by cyclical ﬂuctuations in the IPO volume. we may not observe cyclical variations in IPO volume within a single industry in the real world. The reason for this lack of convergence lies in our assumptions that the L-investors do not condition their beliefs with respect to the value of an IPO ﬁrm on the issue price. That the IPO market in our model does not converge to the stationary (regime-R) equilibrium may surprise somewhat. in the degree of underpricing. One possibility is that investors who do not understand the economic incentives of the entrepreneurs refrain from participating in the IPO market after having lost a suﬃcient amount of money. However. In either case. and there is a sudden decline in IPO volume that is accompanied by an increase in IPO quality. C An Example (cont’d) We now present the results from a simulation of the IPO market dynamics that was based on our example from Subsection III.If regime-L persisted for long enough then the L-investors would again learn to predict the value of IPO ﬁrms with the same precision as the R-investors. Proposition 5 (Lack of Convergence) The IPO market does not converge to the stationary equilibrium that would obtain in the absence of L-investors.C. At that time entrepreneurs with access to bad projects ﬁnd that it is no longer G proﬁtable to issue equity. However.

and the simulation period corresponds to a time span of 20 years and 8 months. 017 IPOs took place. We simulate the evolution of the IPO market over a total of T = 5. 758 of which were of the good type. We report the evolution of L-investors’ beliefs (Figure 3). the monthly IPO volume (Figure 4). αS (I )) ≈ 279.” a 4-week period as a “month. The weight that the investors assign to this prior is equal to ω0 (I ) = 30. 000 points in time. the IPO prices and values (Figure 5). It may be intuitive to view each point in time as a business “day. the true cash ﬂow of each ﬁrm is revealed exactly one year after its IPO. (4) The true cash ﬂow of a ﬁrm is revealed exactly = 240 periods after its IPO. and the probability that a bad investment opportunity opens up is equal to λ(1 − p) = 0. The IPO market therefore enters regime-L for the ﬁrst time as soon S as VjL (I ) exceeds V i (I . The IPO market starts at t0 by assumption in regime-R. This implies that the L-investors’ beliefs are common knowledge already at t0 . ﬁrms with access to an investment G 27 . and 1.5.5. 541 investment opportunities. Our simulation resulted in the creation of 2. which translates into an overall average of approximately one IPO per week.7. While we have depicted the evolution of the L-investors’ beliefs and the monthly IPO volume for the entire simulation period. we assume that the probability distribution of the stochastic ˜ component of a type-T ﬁrm’s cash ﬂows (δT (I )) is degenerate with a single mass point at zero.250 ) to improve the clarity of the ﬁgures. so that initially each IPO that takes place leads the L-investors to revise their beliefs upwards (Figure 3).” With this interpretation.” and a 12-month period as a “year. This implies that a ﬁrm’s realized cash ﬂows are always equal to its ex ante expected cash ﬂows. A total of 1.” a 5-day period as a “week. αG (I )).35. (3) The probability distribution of the L-investors’ prior is degenerate.any given point in time is equal to λ = 0. and the underpricing and the long run performance of IPOs (Figure 6).15. (5) Finally. As soon as the L-investors’ beliefs exceed V i (I . 783 of which were of the bad type. The ﬁrst market clearing price of any ﬁrm that raises I = 124.5 dollars in regime-R is equal to VG (I ) ≈ 318. we show the issue prices and values and the IPO performance only for a 500-day window (from t751 to t1. with a single mass point at I . The probability that a good investment opportunity opens up on any given day is equal to λp = 0. (2) The L-investors’ t0 -prior with respect to the value of a ﬁrm that raises and invests I is equal to V0L (I ) = I .

28 .VjL (I ) S V i (I .e. 000 periods.000 240 t2. per 20-day period).7 t1.000 t4. Number of IPOs 20λ = 10 20λp =3 0 tj Figure 4: The number of IPOs per “month” (i. αG (I )) ≈ 279.000 t3.000 tj Figure 3: The evolution of the L-investors’ beliefs over T = 5.000 t5.

6% Regime-R Regime-L Regime-R Figure 6: IPO underpricing and long run performance for the 500-day period from t751 to t1. and expected values for the 500-day period from t751 to t1. IPO Underpricing +13.IPO Price.2 IPO Value IPO Price Expected IPO Value 0 t751 Regime-R t1.250 tj −20. αS (I )) G ≈ 279. 29 .5 V i (I .250 .9% 0 t751 Long Run Performance +13.7 VB (I ) ≈ 180.9% 0 tj t1.250 Regime-L Regime-R tj Figure 5: Issue prices. values. IPO Value VG (I ) ≈ 318.250 .7% −35.7 VP (I ) ≈ 221.

96.7 in regime-L.5 in regime-R to VP (I ) ≈ 221. αS (I )). even though there are only two types of ﬁrms in our model.71 to 279.63%. The fundamental value of a bad ﬁrm that raises and invests I is only VB (I ) ≈ 180. so that average IPO value drops from VG (I ) ≈ 318. 831}. 2. Even though this price increase is too small to be noticeable in Figure 5.opportunity are able to issue equity at a higher price. the true fundamental ﬁrm value is not revealed until some time after the IPO. VG (I ) −1 = L V800 (I ) VB (I ) −1 = L V800 (I ) 318. 017 IPOs over a period of 5. which leads L-investors to revise their beliefs downwards (Figure 3). As we can see. j ∈ {1. Based on the ﬁrst market clearing price. 043. it implies that IPOs are now no longer signiﬁcantly underpriced. and reverts back to regime-R at times tj . However.8% (Figure 6). but rather signiﬁcantly overpriced (Figure 5). The market clearing prices of all IPOs that take place in regime-L are identical to the L-investors’ beliefs. 2. The reason for this is that ﬁrms with access to a bad project now also ﬁnd it proﬁtable to go public. 3. tj . 4. 074}. The IPO market reverts back to regime-R as soon as the L-investors’ valuation for IPO shares drops below V i (I . the expected long run performance of good and bad ﬁrms that go public in regime-L is given by (34) and (35). 294. 000 point in time does not result in convergence to a stationary equilibrium.2 − 1 = −35. 536. 279. The cash ﬂow realizations of the good ﬁrms that went public in regime-L will be unexpectedly high. The L-investors’ beliefs therefore do not change until the ﬁrst cash ﬂows of ﬁrms that went public in regime-L are observed (Figure 3). j ∈ {800.2. G The plot of the L-investors’ beliefs over time (Figure 3) reveals that the IPO market enters regime-L at three distinct occasions.5 − 1 = +13. The regime shift is accompanied by a slight increase in the issue price from 279. so that the drop in the average IPO quality is not immediately noticed by the L-investors. In our simulation the IPO market enters regime-L for the ﬁrst time at t800 . a total of 1. and the cash ﬂow realizations of the bad ﬁrms will be unexpectedly low.96 (34) (35) The overall expected long run performance of IPOs that take place in regime-L is equal to −20.76% 279.96 180. 30 . respectively.

However. 31 . Shares of IPOs that take place during periods of high IPO volume underperform in the long run. but rather as a model of the IPO market in a particular industry. The following empirical predictions follow readily from our results: Implication 1 An increase in the IPO volume in an industry is observed after a period during which ﬁrms in this industry issued underpriced equity to raise capital for investment. we obtain unambiguous predictions with respect to the long run performance of IPOs in each of the two regimes. Implication 3 Based on the ﬁrst market clearing price. The ﬁrst market clearing prices of IPOs are lower during periods of high IPO volume than during periods of low IPO volume. the overall average long run performance of IPO shares is negative. shares of IPOs that take place during periods of low IPO volume show no systematic abnormal long run performance. Implication 4 The abnormal long run performance of IPOs that take place during periods of high IPO volume is negative. Note that our model does not yield any clear predictions with respect to the overall average long run performance of IPOs if the latter is measured based on the issue price.V Implications Our model applies only to ﬁrms that go public to raise capital for investment. even if long run performance is measured based on the issue price. rather than on the ﬁrst market clearing price. Based on the ﬁrst market clearing price. Implication 2 The prices at which IPOs are issued are higher during periods of high IPO volume than during periods of low IPO volume. Moreover. it is crucial in our theory that the diﬀerent ﬁrm types are outwardly identical so that they are indistinguishable to outside investors. Implication 5 The variance of long run performance is higher among ﬁrms that go public during periods of high IPO volume than for ﬁrms that go public during periods with low IPO volume. Based on the issue price the abnormal long run performance of IPOs that take place during periods of low IPO volume is positive. An increase in IPO volume is accompanied by a reduction in underpricing. Our model should therefore not be viewed as a model of the IPO market as a whole.

and because they are willing to purchase any IPO that is oﬀered at a price below its inferred value. Long-run underperformance and periods of increased IPO volume arise from the presence of investors who learn about the IPO market from publicly observable IPO market data. This enables the ﬁrm to signal the proﬁtability of its investment opportunities to outsiders. underperformance of IPO shares in the long run. However. our model also suggest that IPOs in periods of high and low IPO volume are bought by diﬀerent groups of investors. VI Conclusion We have presented a stylized model of an IPO market in which ﬁrms go public to raise capital for investment. While long-run underperformance may otherwise appear hard to reconcile with the abnormal positive returns (“underpricing”) of IPOs in the short-run. The latter investors upset the rational equilibrium not because of ex ante unreasonable beliefs. Even a minor increase in the price at which ﬁrms 32 . the joint existence of these two phenomena may be explained with relative ease if underpricing is indeed used to signal the profitability of a ﬁrm’s investment opportunities. underpricing is observed even in the rational IPO market equilibrium. and who invest in the IPOs only because they previously observed IPO underpricing. and strong concentration of issue activity in certain periods. Some ﬁrms will optimally use underpricing to augment the information that is conveyed by the ﬁrm’s investment decisions to outside investors. In our model. The model is capable of jointly explaining three major IPO market “anomalies” that have been empirically documented in the literature: IPO underpricing. Finally. but rather because they learn to forecast the value of IPO ﬁrms based on the ﬁrms’ investment policy alone. and thereby maximizes the original shareholders’ personal wealth. this prediction may be diﬃcult to test. Our model predicts that IPOs that take place during periods of high IPO volume are primarily purchased by investors who lack a deeper understanding of the IPO market.Implication 6 After a period of high IPO volume issue activity decreases as a result of poor long run performance.

α ). and that makes the good type strictly better oﬀ but the bad type strictly worse oﬀ than (I . Hence. The bad type therefore cannot be ruled out a defector. This results in a sudden increase in IPO activity that is accompanied by a signiﬁcant drop in the average IPO quality that leads to subsequent IPO underperformance. but that is not also strictly preferred by the bad type over its own equilibrium oﬀer. and the good type has no incentive to stick to its proposed equilibrium strategy in the ﬁrst place. that would make the good type better oﬀ than its proposed equilibrium oﬀer. the bad type can be ruled out as a defector for the IPO of size I .can issue equity is suﬃcient to alter the incentives of ﬁrms with lower quality investment opportunities. A Mathematical Appendix Proof of Lemma 1: The good type earns higher marginal returns on investment than the bad F type. there F ¯ exists an investment level I > IG that the good type is still able to ﬁnance. I = I . In each case of Proposition 1 it is easy to see that the good type cannot raise the issue price. α ). We have now established that the good type must raise and invest I in equilibrium. Moreover. Moreover. α ) is of the bad type with probability one is admissible under the IC. but at which the bad type no longer prefers the payoﬀ from the good type’s correctly priced IPO over her own ﬁrst-best payoﬀ. Now consider an equilibrium in which the good type undertakes some IPO (I . with I = I . for I > IG additional investment is unproﬁtable for either type. α ). Proof of Proposition 1: It is straightforward to verify for each part of Proposition 1 that the proposed pure strategy combination represents a perfect Bayesian equilibrium. No such equilibrium can pass the IC since we can construct an alternative IPO of size I that investors would be willing to purchase if it was oﬀered by the good type. relative to its proposed equilibrium IPO. the bad type cannot make itself better oﬀ by defecting 33 . By construction of the good type’s equilibrium oﬀer there exists no out-of-equilibrium IPO (I . and the belief that a ﬁrm that defects with (I . We omit this part of the proof an show only that the proposed equilibrium is the unique pure strategy equilibrium that passes the Intuitive Criterion (IC). Hence.

This concludes the proof. Finally. αG (I )). and the second term converges to VG (I ). Proof of Lemma 2: For each point in time tk in regime-R we have either φk (I ) = 0. Proof of Proposition 4: Proposition 4 follows directly from Proposition 3. Proof of Lemma 6: The proof of Lemma 6 is analogous to the proof of Lemma 2. The results regarding the expected payoﬀs from undertaking the oﬀer I . Then it follows from Lemma 2. Proof of Lemma 5: The L-investors’ valuation for the IPO I . Proof of Lemma 3: Lemma 3 follows directly from our assumptions. Proof of Proposition 2: Proposition 2 follows jointly from our assumptions and Proposition 1. we can rewrite (13) as VjL (I ) = ⎪ ⎩ V (I ) + δ G k j−1 if j − < k < j.c). or φk (I ) = 1 and Vk. αG (I )) < V < VG (I ) succeeds is equal to the probability that the L-investors’ valuation for an IPOs of size I exceeds V . The L-investors’ t0 -prior can be inferred using (13) based on this market clearing price and on the performance of past IPOs. we obtain (28). Suppose the economy reaches the stationary equilibrium of Proposition 1. Proof of Proposition 5: This proof is done by contradiction. ω (I ) k=0 j (37) As j → ∞ the ﬁrst and the third term in (37) converge to zero.j . Proof of Lemma 4: The probability that an IPO I . V immediately.j = ⎧ ⎪ ⎨ VG (I ) Consequently. Hence. and 34 . if 0 ≤ k ≤ j − . VkL (I ). Lemma 3. that the abnormal initial return of this IPO is smaller than the abnormal initial return in regime-R S follows from that facts that VkL (I ) < VG (I ). No new information becomes available between the time of the IPO and the time at which its ﬁrst market clearing price is determined. Proof of Proposition 3: The proof is straightforward and therefore omitted. and V > V i (I . V exceeds the R-investors’ follow valuation for this IPO. The latter probability converges to one since VjL (I ) converges to VG (I ) > V for j −→ ∞ by Lemma 6.from its ﬁrst-best strategy. The ﬁrst market clearing price is therefore equal to the L-investors’ valuation. V S with V i (I . j− (36) ω0 (I ) · V L (I ) + ωj (I ) 0 φk (I ) · VG (I ) + ω (I ) k=0 j φk (I ) · δk.

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