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A Theory of IPO Underpricing, Issue Activity, and
Long-Run Underperformance
Ralph Bachmann
Nanyang Business School
Division of Banking and Finance
Nanyang Avenue, S3-B1A-14
Singapore 639798
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.
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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 firms 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: someinvestors 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.
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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 Holmstrom (1980)
and Baron (1982)), the winners curse (Rock (1986)), lawsuit avoidance (Tinic (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
1See Ibbotson and Ritter (1995) for a survey of the research on initial public o fferings. Loughran, Ritter, and
Rydqvist (1994) focus on the international evidence.
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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 firms 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 industrys 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 off
er 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
2Whether 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).
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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 investors 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 issuers 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
3Hirshleifer (2001) provides a comprehensive overview of the various psychological biases and their common root
causes.
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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 firms 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 firms 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 theirbeliefs 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
4This suggests that underpricing may be a necessary condition for the absence of underperformance.
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interest rate is zero.
B Firms, Entrepreneurs, and IPOs
Nature creates investment opportunities in discrete time intervals, t > 0. At each point in
time, tj = t0 + jt, j {0, 1, 2, . . .}, nature creates a physical investment opportunity with
probability (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 firms 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 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,
5The 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.6An extension of the model to more than two types is straightforward but tedious.
7None 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.
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irrespective of the level of investment: B(I) < G(I) for all I 0.
(A2) Projects exhibit decreasing returns to scale: T(I) < 0 for all I > 0, T {G, B}.
(A3) Only type-G projects have a positive expected NPV: G(0) > 0, but 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: 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:
VT(I) = A +
I0
1 + T(I) dI. (1)
Conditional on a physical investment opportunity being available, an entrepreneur can make
a take-it-or-leave-it offer I, [0, ) [0, 1] to outside investors, where I denotes the amount
of capital raised and invested, and 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.
8We rule out the possibility that a firm invests the proceeds from the equity issue in marketable securities or
just holds cash. Moreover, the original shareholders 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.
9Hence, at most one IPO can take place at any given point in time.
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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, is equal to the value of her retained equity,
WT(I,) = VT(I). (2)
An entrepreneurs payoff from unsuccessfully attempting an IPO I, is assumed to be equal to
zero. An entrepreneur whose IPO has failed cannot approach the market again.10
For any IPO, I,, we can calculate the firm valuation that is implicit in the terms of the
IPO as
Vi(I,) =I
1 . (3)
It is clear that Vi(I, ) need not be identical to the true firm value. If Vi(I, ) exceeds the true
firm value then the IPO is overpriced, and if Vi(I,) is smaller then the true firm value then the
IPO is underpriced. Outside investors just break even on purchasing (1 ) of a firms equity for
I dollars whenever the true firm value is identical to (3).
For each IPO I, we can now find an equivalent representation I, Vi(I, ), where Vi(I, )
denotes the firm value that is implicit in the terms of the IPO. For convenience we will refer to
Vi(I, ) 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, captures the entrepreneurs 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, Vi(I,) 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.
10Neither 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.
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We assume that all uncertainty with respect to a firms cash flows is resolved exactly periods
after its IPO. At that time, the firm value is publicly revealed to be equal to VT(I) + T(I), where
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 anIPO whenever he expects to at least break even, that is, whenever
Vi(I, ) 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
types 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, VR, on the firms investment policy, as well as on the fraction of equityretained by the entrepreneur. Following (4), R-investors demand shares in an IPO whenever
Vi(I, ) VR(I, ). (5)11The 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 T(I) is bounded from below by VT(I).
12This assumption is necessary to obtain long-run underperformance of IPO shares in our model.
13It will be more convenient to specify the investors beliefs with respect to the firm value (V), rather than withrespect to the probabilities that they assign to the event that the firm is of the high type ().
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Note that R-investors may alternatively be viewed as conditioning their beliefs on I and
Vi(I, ), so that (5) may be stated equivalently as
Vi
(I, ) VR(I, Vi(I,)). (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
firms investment policy alone. We therefore assume that L-investors condition their beliefs, VL,on the firms 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,
Vi(I, ) VL(I). (7)L-investors are not ignoring how much of the firms 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 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 NR and
NL, respectively. 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. 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.
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. . .tj + tj+1
. . .tj+
. . .
Vj,j Vj,j+1 Vj,j+
IPO takes place. The first market clearingprice is determined in pub-lic trading.
Nature reveals thetrue 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-tj 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, tj: (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 tj then the true value of this firms 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
tj , tj , and tj + , respectively. This particular sequencing implies that no new information
becomes available between the time at which an IPO is sold to investors (tj + ), and the trading
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session in which its first market clearing price is determined (at tj+1 ). Moreover, 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.
Whenever we are primarily interested in the dynamicaspects of the IPO market we will denote
the time-tj+k price of the firm that went public at tj by Vj,j+k. For a successful IPO that takes
place at tj a time series offirm prices, Vj,j+k, k {0, 1, 2, 3, . . .}, is observed. The issue price, Vj,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 tj+ all
uncertainty with respect to the true firm value is resolved, and the true firm value is publicly
revealed. Hence, we have
Vj,j+k =
Vi(I,) for k = 0,
maxVL(I), VR(I,) for 1 k < , and
VT(I) + T(I) for k.
(8)
We measure the abnormal initial performance (i.e. underpricing) of an IPO by its stock price
performance from tj to tj+1. The long run performance of IPO shares is measured either based on
the offer price (i.e. from time tj to tj+), or based on the first market clearing price (i.e. from tj+1
to tj+), since our model yields separate predictions for the two time horizons.
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
VLj (I). No IPO took place before t0, so that
VL0 (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
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is denoted by 0(I).14 For convenience we assume that 0(I) is common knowledge.15
To formalize the updating of beliefs by L-investors we define the indicator functions
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
j(I) = j1(I) + j(I) (10)
= 0(I) +j10
j(I), (11)
which is the sum of the weight of the L-investors t0-prior, and of the number of IPOs of size I
that took place prior to tj.
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 tj if and only if a firm went public at tj. 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-tj belief may be expressed as
VLj (I) = j1(I)j(I) VLj1(I) +j1(I)
j(I) Vj1,j +
j(I)
j(I) (Vj,j Vj,j1) . (12)
The three terms in (12) represent the investors time-tj1 belief, the first market clearing price of
any time-tj1 IPO, and any change in the market value of a firm that issued equity at tj due
to the arrival of new public information. Note that (12) can alternatively be stated as
VLj (I) =0(I)
j(I) VL0 (I) +
j1
k=0k(I)
j(I) V
k,j, (13)
14A weight 0(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.
15Assuming 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.
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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, 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 F
T
(I) =I
VT(I)(14)
of her firms equity to outside investors. The IPO is priced correctly (i.e. Vi(I,FT(I)) = VT(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 IFT . A type-B entrepreneur therefore does not
invest (IFB = 0), and a type-G entrepreneur undertakes the NPV-maximizing investment level
that is implicitly defined by G(IFG ) = 0.
The total payoff to a type-B entrepreneur is equal to WB(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:
WG(IFG ,
FG(I
FG)) = A +
IFG
0
T(I) dI. (15)
16Available from the authors, or from the Social Science Research Network at http://www.ssrn.com.
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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 p erformance 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 types payoff from undertaking the good typess first-best offer exceeds the
bad types payoff from her own first-best strategy:
WB(IFG ,
FG(I
FG )) > WB(0, 1). (16)
The intuitive interpretation of (16) is that at the IPO IFG ,FG(I
FG) the bad types 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 > IFG 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 types respective marginal rates of substitution between the fraction of retained
17For 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.
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equity, and the amount of capital that is raised and invested. From (2) we obtain
MRST(I,) =WT(I,)/I
WT(I, )/(17)
= V
T(I)VT(I)
. (18)
Based on (17) it can be shown that the good types second-best strategy entails undertaking
only those investments for which its marginal gross return, VG(I) = 1 + G(I), exceeds the bad
types marginal gross return, VB(I), by a factor greater than the ratio of the two types respective
marginal financing costs, VG(I)/VB(I).18 That is, the good type will undertake only investments
for which her marginal return on investment is sufficiently higher than the bad types to compen-
sate her for her relatively higher marginal cost of outside equity capital. However, the good typewill 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-types second-best investment policy can
therefore be identified as the investment policy, I, that maximizes the ratio VG(I)/VB(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,
P(I) = 1 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,
SG(I) =A
VB(I). (20)
18The ratio of the firm values may be interpreted as the ratio of the two types respective marginal financing
costs since both types have to give up the same fraction of equity to raise another dollar of capital.
19Any 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. R-investors therefore
have to believe that a firm that offers the IPO of size I is of the good type, and the good type has no incentive to
undertake an IPO of size I in the first place.
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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 on [0, I], and on the values
ofP(I) andSG(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
overinvestment and issues equity at the fair price, IeG,eG = I ,
FG(I), and in which the
bad type undertakes itsfirst-best IPO, IeB,eB = 0, 1.
b) If I < I and SG(I) < P(I
) then the equilibrium is a pooling equilibrium in which both
types raise and invest I, and in which equity is issued at the average value: IeG,eG =
IeB
,eB
= I,P(I).
c) IfI < I andSG(I) P(I
) then the equilibrium is a separating equilibrium in which the
bad type undertakes itsfirst-best IPO, IeB,eB = 0, 1, and in which the good type signals
with a combination of investment choice and IPO underpricing, IeG,eG = I
,SG(I).
The equilibrium can be supported by the R-investors beliefs that a firm that defects with an out-
of-equilibrium investment policy I = I is of the bad type with probability one, and that a firm
that defects with an out-of-equilibrium IPO I,, > eG
, 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 types marginal return on investment
is sufficiently higher than the bad types 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 has been
reached the good types relative disadvantage on the financing side (vis-a-vis the bad type) begins
20The values of I, I, and SG(I), depend only on the two types respective marginal profit functions. The value
ofP(I) depends additionally on the probability distribution of the firm types.
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to outweigh its relative advantage on the investment side. At I 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 P(I) > SG(I
). 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 SG(I) P(I
) 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, tj, j {0, 1, 2, . . .} is
equal to p.
(2) Any IPO that takes place is an issue I,SG(I) 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 tj to tj+1) is equal to
Vj,j+1
Vj,j 1 =
VG(I)
Vi
(I
,S
G(I
))
1 (21)
=FG(I
) SG(I)
1 FG(I)
> 0. (22)
(3) No abnormal stock price performance is observed after thefirst market clearing price. Hence,
there is no abnormal long run performance of IPO shares from tj+1 to tj+, but there is
positive abnormal long run performance from tj to tj+.
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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 firms asset in place prior to (or without) the IPO is equal to VT(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
G(I) = 2 I
50
(23)
B(I) = I
175(24)
In a world of symmetric information the good type undertakes her first-best IPO, IFG ,FG(I
FG) =
100, 23
, and the bad type does not go public IFB ,FB(I
FB ) = 0, 1. The corresponding first-best
payoffs to the entrepreneurs are equal to WG(100,2
3) = 200, and WB(0, 1) = 100.
The first-best outcome is not feasible under asymmetric information since the bad types
payoff from the good types first-best IPO exceeds her own first-best payoff: 23
VB(100) = 1142
7>
WB(0, 1) = 100. At the good types first-best investment level the good types marginal gross
return on investment exceeds the bad types by the factor (1 + G(100)) / (1 + B(100)) = 21
3,
which is greater than the ratio of the two types marginal financing costs, VG(100)/VB(100) =
1.75.22 Hence, the good type has an incentive to signal by increasing investment up to I = 124.5,
at which point
VG(I)
VB(I)=
1 + G(I)
1 + B(I)=
357
202 1.767.23 (25)
We obtain FG(I) = 77,599127,399 0.6091, SG(I) = 1,4002,523 0.4451, and P(I) = 129,599295,599 0.4384.
21Assuming 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.
22VG(100) = 300, VB(100) = 1713
7, 1 + G(100) = 1, and 1 + B(100) =
3
7.
23VG(I) = 318 199
400 318.5, VB(I
) = 180 314 180.2, VP(I
) = 221 27974000
221.7, 1 + G(I) = 51
100= 0.51, and
1 + B(I) = 101
350 0.2886.
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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, but at the same time prefers her own fist-best strategy over the
pooling candidate IPO:
P(I) VB(I
) 79.01 < 100 < FG(I) VB(I
) 109.77. (26)
The pure-strategy equilibrium is consequently a separating equilibrium in which the bad type
does not go public, IFB ,FB(I
FB ) = 0, 1, and in which the good type undertakes the IPO
I,SG(I) = 124.5, 1,400
2,523, that is just sufficiently underpriced to prevent the bad type from
mimicking. Outside investors obtain 1 SG(I) of the good types equity in return for I dollars.
This translates into an issue price of Vi(I
,SG(I
)) 279.7, compared to a true firm value of
VG(I) 318.5. The good types IPO therefore experiences an abnormal initial return of +13.87%.
The equilibrium payoffto the good types original shareholders is equal to WG(I,SG(I
)) 176.7,
and the total amount of money left on the table is equal to
1 SG(I
)
VG(I) Vi(I,SG(I
))
17.3. (27)
Note that overinvesting up to I = 150 would enable the good type to issue equity at the
fair price: VB(I) = 1855
7, and VG(I) = 325, so that
FG(I) =
7
13, (1 FG(I))VG(I) = I, and
FG(I)VB(I) = 100. However, the good types payoff from doing so would only be equal to
WG(I ,SG(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 types iso-payoff curve through her first-best
strategy, B = 0, 1. The solid grey curves are the good types iso-payoff curves through her
first-best IPO, G= IFG ,FG(I
FG), and through her equilibrium offer, U= I
,SG(I). At I the
good types iso-payoff curves are tangent to the bad types 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.
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I
B
G
F
U
P
1
0
FG(IFG)
FG(I)
SG(I)
P(I)
IFB = 0 IFG I
FB(I)
P(I)
FG(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).
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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 t0 in regime-R. The L-investors
will then update their beliefs from t0 to t1 only based on the respective first market clearing
prices of any new IPOs. Beginning at t, 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,SG(I) that are undertaken by
good firms. Based on the first market clearing price, the market value of any such firm is equal
to VG(I). Thereafter, the market value does not change until the uncertainty with respect to
the firms 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 IPOfi
rms
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:
VLj (I)VG(I). (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,
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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 VG(I) > Vi(I,SG(I
)), 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 exceeds Vi(I,SG(I)). At that
time the total demand for shares of IPOs I, Vi(I,SG(I)) increases from NR to NR + NL.
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, Vi(I,SG(I)).
Let V be such that Vi(I,SG(I)) < V < VG(I
). As time passes, the probability that an IPO
I, V would succeed converges to one. The good types expected payoff from offering I, V
converges to the l.h.s. of (29), and the bad types expected payoff from offering I, V converges
to the l.h.s. of (30).
WG
(I, 1 I/V) = VG
(I) VG(I
)
VI > W
G(I,S
G(I)) (29)
WB(I, 1 I/V) = VB(I
) VB(I
)
VI > WB(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 at a price V > Vi(I,SG(I)). The first such IPO(s) may fail since the
entrepreneurs do not know the L-investors t0-prior, so that they are uncertain with respect to
the L-investors exact willingness to pay. An IPO I, V that fails reveals that the L-investors
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valuation for an IPO of size I is less that V, but it does not lead to any updating of the L-
investors beliefs. The first successful IPO I, V with V > V i(I,SG(I)) marks the beginning
of regime-L.
B Regime-L
Lemma 5 (The First Successful IPO in Regime-L) Suppose the first IPO I, V that is
successfully offered at a price V > Vi(I,SG(I)) takes place at tk. Then this IPOsfirst market
clearing price, Vk,k+1, is equal to VLk (I) V, and it reveals the L-investors t0-prior, VL0 (I).The abnormal initial return of the IPO is non-negative, but strictly lower than the abnormal initial
return in regime-R:Vk,k+1
Vk,k 1 =
VLk (I) VV
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 VLj (I) > V i(I,SG(I)) at tj > tk. Anentrepreneur with access to an investment opportunity will then successfully undertake the IPO
I, VLj (I), irrespective of her type. The IPO is undervalued if the issuingfirm is type-G, butovervalued if the issuingfirm 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:
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(1) The ex-ante probability that an IPO takes place at any given point in time, tj, is equal to .
(2) Any IPO that takes place is an issue I, VLj (I), where VLj (I) > Vi(I,SG(I)). Theissuingfirm is of type-G with probability p, and of type-B with probability 1 p. Thefirst
market clearing price of each IPO is equal to its issue price. Hence, there is no abnormal
initial performance (i.e. no underpricing) from tj to tj+1.
(3) The expected value of a firm that goes public is equal to VP(I) < Vi(I,SG(I
)). The
expected abnormal long run performance (from tj to tj+, or from tj+1 to tj+) is negative:
Vj,j+Vj,j
1 =Vj,j+Vj,j+1
1 =VP(I
)
VLj (I
) 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 thispoor 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:
VLj (I)VP(I). (33)
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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 drops below
Vi(I,SG(I)). 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 (contd)
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
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any given point in time is equal to = 0.5. (2) The L-investors t0-prior with respect to the value
of a firm that raises and invests I is equal to VL0 (I) = I. The weight that the investors assignto this prior is equal to 0(I
) = 30. (3) The probability distribution of the L-investors prior is
degenerate, with a single mass point at I. This implies that the L-investors beliefs are common
knowledge already at t0. The IPO market therefore enters regime-L for the first time as soon
as VLj (I) exceeds Vi(I,SG(I)). (4) The true cash flow of a firm is revealed exactly = 240periods after its IPO. (5) Finally, we assume that the probability distribution of the stochastic
component of a type-T firms cash flows (T(I)) is degenerate with a single mass point at zero.
This implies that a firms 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 p = 0.15, and the probability that a bad
investment opportunity opens up is equal to (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 ofL-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 IPOperformance only for a 500-day window (from t751 to t1,250) to improve the clarity of the figures.
The IPO market starts at t0 by assumption in regime-R. The first market clearing price of
any firm that raises I = 124.5 dollars in regime-R is equal to VG(I) 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 Vi(I,SG(I)) 279.7, firms with access to an investment
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VLj (I)
tj
Vi(I,SG(I))
279.7
240t1,000 t2,000 t3,000 t4,000 t5,000
Figure 3: The evolution of the L-investors beliefs over T = 5, 000 periods.
Number
of IPOs
tj
20= 10
20p= 3
0
Figure 4: The number of IPOs per month (i.e. per 20-day period).
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IPO Price,
IPO Value
tj
VB(I)
180.2
VP(I)
221.7
Vi(I, SG(I))
279.7
VG(I)
318.5
0
t751 t1,250
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 t751 to t1,250.
IPO Underpricing
Long Run Performance
tj
tj
t751 t1,250
+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 t751 to t1,250.
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opportunity are able to issue equity at a higher price. In our simulation the IPO market enters
regime-L for the first time at t800. 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
is only VB(I) 180.2, so that average IPO value drops from VG(I
) 318.5 in regime-R to
VP(I) 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
offirms 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.
VG(I)VL800(I) 1 =
318.5
279.96 1 = + 13.76% (34)
VB(I)VL800(I) 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
Vi(I,SG(I)).
The plot of the L-investors beliefs over time (Figure 3) reveals that the IPO market enters
regime-L at three distinct occasions, tj , j {800; 2, 294; 3, 831}, and reverts back to regime-R at
times tj, 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 offirms in our model.
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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
whichfirms 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. Thefirst 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 amongfirms that go public during
periods of high IPO volume than forfirms that go public during periods with low IPO volume.
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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 ma jor 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 firms 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 off
ered at a price below its inferredvalue.
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 firms investment opportunities. Even a minor increase in the price at which firms
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can issue equity is sufficient to alter the incentives offirms 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 > IFG additional investment is unprofitable for either type. Hence, there
exists an investment level I > IFG that the good type is still able to finance, but at which the bad
type no longer prefers the payoff from the good types 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 types equilibrium offer there exists no out-of-equilibrium IPO
(I
,
), I
= I
, 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,)
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,), with I = I.
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, and that makes the good
type strictly better off but the bad type strictly worse off than (I,). Hence, the bad type can
be ruled out as a defector for the IPO of size I, 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 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
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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 tk in regime-R we have either k(I) = 0, or
k(I) = 1 and
Vk,j =
VG(I) if j < k < j,
VG(I) + k if 0 k j .
(36)
Consequently, we can rewrite (13) as
VLj (I) = 0(I)j(I) VL0 (I) +j1k=0
k(I)
j(I) VG(I
) +jk=0
k(I)
j(I) k,j . (37)
As j the first and the third term in (37) converge to zero, and the second term converges
to VG(I). 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, V with Vi(I,SG(I)) < V < VG(I
)
succeeds is equal to the probability that the L-investors valuation for an IPOs of size I exceeds
V. The latter probability converges to one since VLj (I) converges to VG(I) > V for j byLemma 6. The results regarding the expected payoffs from undertaking the offer I, V follow
immediately.
Proof of Lemma 5: The L-investors valuation for the IPO I, 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, VLk (I). The L-investors t0-prior can be inferredusing (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 VLk (I) < VG(I), and V > Vi(I,SG(I)).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
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Lemma 4 that sooner or later a firm will successfully attempt an IPO at a higher price.
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