Cycles in the IPO Market

Abstract

We develop a model in which time-varying real investment opportunities lead to time-varying adverse selection in the market for initial public offerings. The model is consistent with several stylized facts known about the IPO market: economic expansions are associated with a dramatic increase in the number of firms going public, which is in turn positively correlated with underpricing. The model also makes new predictions regarding long-run IPO returns. Adverse selection is shown to be of procyclical severity in the sense that dispersion in unobservable quality across firms should be more pronounced during booms. Taking the premise that uncertainty will only be resolved (and thus private information revealed) over time, we test this hypothesis by looking at long-run abnormal returns and delisting rates. Consistent with the model, we find a) greater cross-sectional return variance and b) higher incidence of delisting during hot IPO markets.