Equilibrium in the Initial Public Offerings Market

The critical review article, Equilibrium in the Initial Public Offerings Market, forthcoming in the Annual Review of Financial Economic,  focuses on selected topics dealing with initial public offerings (IPOs) of equity securities, emphasizing issues that are of current interest to academics, practitioners, and policymakers.

On average, the average first-day returns on IPOs in the U.S. and most other countries appear to be higher than they should be if companies were trying to maximize the amount of money being raised. I criticize the ability of popular asymmetric information-based models to explain the magnitude of the underpricing of IPOs that is observed. I suggest that the quantitative magnitude of underpricing can be explained with a market structure in which underwriters want to underprice excessively, issuers are focused on services bundled with underwriting rather than on maximizing the offer proceeds, and there is limited competition between underwriters. I explain why competition is limited, in spite of the existence of dozens of underwriters competing for deals.

Although U.S. IPOs have had average first-day returns of 18%, the distribution is right-skewed, with most IPOs having very modest underpricing, and a minority having very high underpricing. I argue that there is no empirical support whatsoever for the testable implications of the most popular academic explanation for the conditional underpricing of IPOs.

The average first-day return of 18% for U.S. IPOs is modest compared with the 156% average in China. I discuss the regulatory restrictions that have resulted in this extreme underpricing. I also point out that in the last few years the Chinese government has relaxed the regulations, allowing more freedom to market participants. As a result of these reforms, the underpricing of Chinese IPOs has been much less extreme the last few years, and is approaching the levels seen in developed capital markets.

Since the technology bubble burst in 2000, U.S. IPO volume has been low. From 1980-2000, an average of 311 operating companies went public in the U.S. per year, but since then the average has been only 102 IPOs per year. The percentage decline has been even more severe for small companies than for the general IPO market, a pattern that has alarmed venture capitalists that have historically exited many of their most successful portfolio companies by taking them public. Although regulatory burdens (Sarbanes-Oxley) undoubtedly account for some of the decline in IPO volume, I suggest that much of the decline may be due to a structural shift that has lessened the profitability of small independent companies relative to their value as part of a larger, more established organization that can realize economies of scope and speed products to market more quickly. If this explanation is correct, attempts to generate more analyst coverage of small firms or changing Sarbanes-Oxley will have little effect on IPO market activity.

In the bubble years of 1999-2000, the IPOs of many internet and technology stocks were severely underpriced. I discuss the rent-seeking practices that developed and the failure of regulators (especially the U.S. Securities and Exchange Commission) to crack down on analyst conflicts of interest and profit-sharing arrangements between underwriters and hedge funds, in spite of explicit laws and regulations prohibiting many of the practices that developed.

I also discuss the long-run performance literature. Except for the smaller companies going public, IPOs have long-run returns that are similar to those on seasoned stocks with the same characteristics. Specifically, for U.S. IPOs from 1980-2009, the average 3-year buy-and-hold abnormal return, measured from the first closing market price to the third year anniversary (or delisting date if it comes earlier) is -16.6% for companies with less than $50 million in inflation-adjusted annual sales prior to the IPO, versus +3.7% for companies with more than $50 million in annual sales.

The full paper is available for download here.