Hot Markets, Investor Sentiment, and IPO Pricing

Abstract

Our model of the initial public offering process links the three main empirical IPO anomalies underpricing, hot issue markets, and long-run under performance and traces them to a common source of inefficiency. We relate hot IPO markets (such as the 1999/2000market for Internet IPOs) to the presence of a class of investors who are irrational inthe sense of having exuberant expectations regarding future performance. Underpricingand long-run under performance emerge as underwriters attempt to maximize profits fromthe sale of equity, at the expense of these exuberant investors. Underpricing serves tocompensate 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.