This paper presents a signalling model in which high-quality firms underprice at the initial public offering (IPO) in order to obtain a higher price at a seasoned offering. The main assumptions are that low-quality firms must invest in imitation expenses to appear to be high-quality firms, and that with some probability this imitation is discovered between offerings. Underpricing by high-quality firms at the IPO can then add sufficient signalling costs to these imitation expenses to induce low-quality firms to reveal their quality voluntarily. The model is consistent with several documented empirical regnlarities and offers new testable implications. In addition, the paper provides empirical evidence that many firms raise substantial amounts of additional equity capital in the years after their IPO.

We review the theory and evidence on IPO activity: why firms go public, why they reward first-day investors with considerable underpricing, and how IPOs perform in the long run. Our perspective is threefold: First, we believe that many IPO phenomena are not stationary. Second, we believe research into share allocation issues is the most promising area of research in IPOs at the moment. Third, we argue that asymmetric information is not the primary driver of many IPO phenomena.

Using a sample of both U.S. and international IPOs we find evidence of the following: IPO allocation policies favor institutional investors both in the U.S. and worldwide. Constraints on the discretion bankers exercise in the allocation of IPO shares reduce institutional allocations. Constraints on allocation discretion result in offer prices that deviate less from the indicative price range established prior to bankers ’ efforts to gauge demand among institutional investors. We interpret this as indicative of diminished information production. Initial returns, which reflect a significant indirect cost of going public, are directly related to this measure of information production and inversely related to the fraction of shares allocated to institutional investors.

IPO initial returns reached astronomical levels during 1999-2000. We show that the regime shift in initial returns and other elements of pricing behavior can be at least partially accounted for by a variety of marked changes in pre-IPO ownership structure and insider selling behavior over the period, which reduced key decision-makers ’ incentives to control underpricing. After controlling for these changes, the difference in underpricing between 1999-2000 and the preceding three years is much reduced. Our results suggest that it was firm characteristics that were unique during the “dot-com bubble ” and that pricing behavior followed from incentives created by these characteristics.

Our model of the initial public offering process links the three main empirical IPO ‘anomalies’ – underpricing, hot issue markets, and long-run underperformance – and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000 market for Internet IPOs) to the presence of a class of investors who are ‘irrational’ in the sense of having exuberant expectations regarding future performance. Underpricing and long-run underperformance emerge as underwriters attempt to maximize profits from the sale of equity, at the expense of these exuberant investors. Underpricing serves to compensate regular IPO investors for their role in restricting the supply of available shares and maintaining prices. The model is shown to be consistent with many aspects of the IPO process. It also generates a number of new empirical predictions.

We find that dual-class firms experience less underpricing than single-class firms, and we explore several hypotheses which might explain this phenomenon. Compared to single-class firms, dual-class companies have slightly higher post-IPO institutional ownership and experience fewer control events. Although dual-class firms achieve a lower underpricing cost, they trade at lower prices relative to earnings and sales than do single-class IPOs. This pricing differential, combined with evidence that dual-class managers earn higher compensation and that dual-class shares are common among media and entertainment industry IPOs, suggests that dual-class ownership structures protect private control benefits.

Conflicts of interest and efficient contracting in IPOs We study the role of underwriter compensation in mitigating conflicts of interest between companies going public and their investment bankers. Making the bank’s compensation more sensitive to the issuer’s valuation should reduce agency conflicts and thus underpricing. Consistent with this prediction, we show that contracting on higher commissions in U.K. IPOs leads to significantly lower underpricing: a one percentage point increase in the commission rate reduces the initial return by 11 percentage points, after controlling for other influences on underpricing. Moreover, we present evidence consistent with issuers choosing commission rates optimally. Overall, our results indicate that issuers and banks contract efficiently in U.K. IPOs.

This study develops and tests a theoretical rationale for the well-documented fact that IPO prices are revised only partially in response to waiting-period market returns. Rational issuers maximize the expected surplus from going public by weighing the probability of deal success against offer proceeds conditional on success. A rise in market valuations during the waiting period increases surplus, causing the issuer to seek a higher success probability. This is achieved by only partially revising the offer price. In addition to explaining other stylized facts; including unconditional underpricing and hot issues markets, several predictions of the model are born out in new empirical tests. For example, the predicted relation between withdrawal probability and waiting-period market returns leads to a sample truncation bias in empirical analyses of IPO pricing. When that bias is taken into account, the often-cited asymmetric response of offer prices to up versus down market returns disappears.

We examine the relation between litigation risk and IPO underpricing. To adjust for the endogeneity bias in previous studies, we use a simultaneous equation framework. Evidence suggests that firms employ underpricing as a form of insurance against future litigation costs. Specifically, firms with greater litigation risk underprice their IPOs by a greater amount. Further, consistent with underpricing representing a viable form of insurance, results indicate that higher underpricing significantly lowers litigation risk

meeting of the German Finance Association and seminar participants at the ESSFM 2001 in Gerzensee, and at the universities of Frankfurt and Zürich for valuable comments.