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.

Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.”

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.

A simple model is developed in the paper in which two market conditions change over time: (i) investor sentiment or price-insensitive demand; and (ii) feedback trader risk or the propensity of investors to chase trends. The model shows that these conditions partially explain the three anomalies associated with the IPO market: (i) underpricing; (ii) windows of opportunity for new issues and (iii) long-term underperformance. The model is tested using a sample of firm commitment IPOs over the 1975-1987 period. The paper finds that the predictions of the model are largely borne out in the data. 1 We thank Jay Ritter and Mike Vetsuypens, and I.B.E.S. for allowing us to use their database.

Individual and institutional investors can trade German initial public equity offerings on an as–if/when–issued basis before the start of secondary trading. Using a novel data set of pre – and post–IPO trades made by a sample of clients at a large German retail broker, the paper documents that retail investors both are willing to overpay and end up overpaying for IPOs, especially following periods of high returns in recent new issues. IPOs that are more aggressively bought by retail investors in the pre–IPO market or on the day of the IPO post higher first-day returns, but also experience lower aftermarket returns, controlling for firm characteristics such as size and book–to–market ratio. In short, sentiment – expectations about asset values unwarranted by fundamentals – drives retail purchases of IPOs and appears to have a transitory effect on prices.

Academic literature has documented for a long time the existence of important price gains in the first trading day of initial public offerings (IPOs). Most of the empirical analysis that has been carried out to date to explain underpricing through the offering structure is based on multiple linear regression. The alternative that we suggest is a rule-based system defined by a genetic algorithm using a Michigan approach. The system offers significant advantages in two areas, 1) a higher predictive performance, and 2) robustness to outlier patterns. The importance of the latter should be emphasized since the non-trivial task of selecting the patterns to be excluded from the training sample severely affects the results. We compare the predictions provided by the algorithm to those obtained from linear models frequently used in the IPO literature. The predictions are based on seven classic variables. The results suggest that there is a clear correlation between the selected variables and the initial return, therefore making possible to predict, to a certain extent, the closing price.

What role do sentiment investors play in the pricing of newly listed stocks? We derive conditions under which we can distinguish between sentiment and rational pricing behavior and test for the rationality of small investors ’ demand for new stock issues using data from pre-issue (or ‘grey’) markets in Europe. Under sentiment, the model predicts asymmetric relations between the prices at which small investors trade new stock issues in the grey market and i) the subsequent issue price set by the investment bank, ii) prices in the early after-market, and iii) the degree of stock price reversal in the long run. Our empirical results suggest that sentiment demand is present and influences the pricing of newly listed firms.

institutions We would like to thank Gennaro Bernile and seminar participants at the University of Miami and South Florida and the 2007 Financial Management Association Meetings, the CIFC conference in Chengdu for their insightful comments. We gratefully acknowledge the data provided by I/B/E/S. Any errors remain our responsibility. Equity ownership in IPO issuers by brokerage firms and affiliated research coverage We examine the relation between brokerage firms research coverage and their equity ownership in IPO issuers due to earlier venture investments. Equity ownership aligns the interest of brokerage firms and IPO issuers by inducing affiliates to provide research coverage, especially by Institutional Investor all star analysts. Equity ownership also enhances the credibility of affiliated analysts with investors and does not encourage affiliated analysts to provide booster shots to issuers ’ stock prices. The recommendations of affiliated analysts are less overly optimistic and produce larger abnormal announcement returns, especially for issuers with greater information asymmetry. Our results indicate that offering venture investment and analyst research under one roof benefits both issuers and IPO investors and does not create serious conflicts of interest between affiliated firms and investors. Our results also yield several implications for the recent NASD and NYSE rules changes regarding equity ownership of IPO firms and affiliated analysts

2007 Despite their theoretical efficiency in selling shares to the public, auctions are not the preferred mechanisms of issuers in Initial Public Offerings (IPOs). Chemmanur and Liu (2006) [WP] and Sherman (2005) [JFE 78, 615-649] provide a rational explanation for this “IPO auction puzzle ” based on the notion that issuers are not only interested in maximizing the offering proceeds, but also care about the secondary market price and thus try to induce many investors to produce information about the IPO. In this paper, we report an experimental study that was set up to test the mechanisms underlying this reasoning. Our findings strongly support the theoretical argument. If the issuer has some discretion in setting the offering price (as with bookbuilding or fixed-price offerings), he can maintain investors ’ propensity to produce information by appropriately adjusting the offering price even if information costs are high. In auctions, however, high information costs inevitably result in a low propensity to produce information. This is a consequence of investors ’ competitive bidding behavior which prevents them from recovering the costs of information production. Our results provide experimental support for the theoretical argument that an auction is not the preferable offering mechanism