• Document: IPO Underpricing and After-Market Liquidity
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IPO Underpricing and After-Market Liquidity Andrew Ellul Indiana University Marco Pagano Università di Napoli Federico II, CSEF and CEPR The underpricing of initial public offerings (IPOs) is generally explained with asym- metric information and risk. We complement these traditional explanations with a new theory where investors worry also about the after-market illiquidity that may result from asymmetric information after the IPO. The less liquid the aftermarket is expected to be, and the less predictable its liquidity, the larger will be the IPO underpricing. Our model blends such liquidity concerns with adverse selection and risk as motives for underpricing. The model’s predictions are supported by evidence for 337 British IPOs effected between 1998 and 2000. Using various measures of liquidity, we find that expected after-market liquidity and liquidity risk are important determinants of IPO underpricing. The underpricing of the shares sold through initial public offerings (IPOs) is generally explained in the literature with asymmetric information about the security’s value and with its fundamental risk. For the IPO to attract sufficient interest, the issuer must leave enough ‘‘money on the table’’ to compensate investors for the uncertainty about the security’s value. How- ever, until now the literature has largely disregarded how after-market liquidity may impact on the IPO underpricing. This is a striking omission in view of the established evidence that the returns of seasoned securities include a liquidity premium. One would expect such premium to be paid also by stocks in the process of being floated. Moreover, at the IPO stage, investors do not know precisely how liquid the aftermarket will be. This We thank the editor, an anonymous referee, Walid Busaba, John Chalmers, Venkat Eleswarapu, Carlo Favero, Craig Holden, Eugene Kandel, Jonathan Karpoff, Tullio Jappelli, Alexander Ljungqvist, Andy Lo, Stewart Myers, Kjell Nyborg, Mario Padula, Lubos Pastor, Kristian Rydqvist, Jos van Bommel, and Ingrid Werner for useful discussions and comments. We also thank seminar participants at Bocconi, Indiana, MIT, Ohio State, the 2002 Yale-Nasdaq-JFM Market Microstructure Conference, the Bocconi University conference on Risk and Stability in the Financial System, the FEEM conference on Auctions and Market Design, and the FIRS Conference on Banking, Insurance and Intermediation. We acknowl- edge financial support from the Italian National Research Council (CNR) and the Italian Ministry of Education, University and Research (MIUR). This article is produced as part of a CEPR research network on The Industrial Organization of Banking and Financial Markets in Europe, funded by the European Commission under the TMR Programme (contract no. ERBFMRXCT980222). Address correspondence to Marco Pagano, Department of Economics, Università di Napoli Federico II, Via Cintia, 80126 Napoli, Italy, or email: mrpagano@tin.it. Ó The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org. doi:10.1093/rfs/hhj018 Advance Access publication January 20, 2006 The Review of Financial Studies / v 19 n 2 2006 suggests that they will not only care about expected liquidity but also about the uncertainty about it, that is, about liquidity risk. Our article fills this gap. It complements traditional explanations with theory and evidence showing that after-market liquidity is an important determinant of IPO underpricing. We provide a model showing that an IPO that is expected to be more illiquid and to have higher liquidity risk should feature higher underpricing. We model after-market illiquidity as stemming from the asymmetric information that persists after the IPO stage. Equilibrium stock returns must compensate investors for the losses expected from trading with better informed investors and for the asso- ciated risk. In the model, there are two types of private information: a signal that becomes public as soon as shares start trading after the IPO and some residual private information that is disclosed at some later date. The first type of private information creates the standard adverse selec- tion problem at the IPO stage while the second determines an adverse selection problem in the aftermarket and is reflected in the bid-ask spread. IPO underpricing will impound also the costs caused by the latter to the extent that some investors expect to liquidate their shares in the after- market. One example of these investors are the so-called flippers, who buy the stock at the IPO with a view of selling it immediately after. Such investors will require compensation for the trading cost that they expect to incur, as well as for the associated uncertainty, just as they would for a random transaction tax. The correlation between IPO underpricing and after-market liquidity should therefore be stronger in markets w

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