Equilibrium Rationing in Initial Public Offerings of Equity

Abstract

Underpricing and rationing may occur in many markets, but nowhere is the debate about its cause more vigorous than in the market for initial public offerings (IPOs) of equity. This analysis contributes to the debate by showing that under-pricing is related to profits from after-market trading. Specifically, underwriters create after-market trading by pricing the issue below its market-clearing price to attract low-valuation investors, who flip shares to higher-valuation investors that are rationed during primary allocations. As the dominant market maker in the IPO, the underwriter gains trading profits and brokerage commissions from this arrangement. This theory provides a common explanation for underpricing across countries and time periods. This theory is tested using data on actual stock flipping and returns for 110 IPOs issued between May 1997 and June 1998, and time series data on U.S. IPOs during 1962-2000. These tests support the view that after-market trading affects underpricing in IPOs.