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A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance

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  • Matt Pritsker

Abstract

I present a fully-rational symmetric-information model of an IPO, as well as a dynamic imperfectly competitive model of the aftermarket trading that follows. The model helps explain why IPO share allocations favor large institutional investors. It also helps to explain IPO underpricing, and underperformance, and the large fees charged by underwriters. The critical assumption in the model is that underwriters need to sell a fixed number of shares at the IPO or soon thereafter in the aftermarket, but they want to avoid selling in the aftermarket because there are some aftermarket investors who have market power and can affect the prices received by the underwriter. To maximize revenue and avoid unnecessary aftermarket sales, the underwriter distorts share allocations toward those those investors who have market power, and he sets the offer price at the IPO below the aftermarket price that will prevail shortly after the IPO. In the aftermarket model, I show that there are share allocations that can generate arbitrarily high levels of return underperformance for very long periods of time. In some simulations, the distorted share allocations at the IPO generate return underperformance that persists for more than one year. The underwriter can dilute investor's market power by participating for longer periods of time in the aftermarket. By doing so, he sometimes substantially increase the revenue that is raised by the IPO issuer

Suggested Citation

  • Matt Pritsker, 2005. "A Fully-Rational Liquidity-Based Theory of IPO Underpricing and Underperformance," Computing in Economics and Finance 2005 414, Society for Computational Economics.
  • Handle: RePEc:sce:scecf5:414
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    File URL: http://repec.org/sce2005/up.12414.1107229829.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    IPO; Asset Pricing; Market Microstructure; Liquidity;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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