How Stock Flippers Affect IPO Pricing and Stabilization

Abstract

Stock flippers pose a problem for underwriters of initial public offerings (IPOs). They subscribe to the issue, but immediately re-sell their shares, so they create an artificial demand that overstates the true demand in the market. We model how underwriters set the offer price to maximize profits in this environment. Given the underwriter's expectation of flipping activity, we find that the choice of an offer price defines whether the issue is a cold, weak, or hot IPO. A cold IPO is under subscribed; a weak IPO is over-subscribed, but flippers cause the after-market price to decrease; and a hot IPO is over-subscribed but after-market price increases. We show that flippers have the greatest effect on weak IPOs, and provide an explanation for underwriter price support activities. In contrast to existing models of price support, we show that underwriters profit from after-market purchases, particularly if the issue includes an over-allotment option. The over-allotment option causes the underwriter to choose a lower offer price, which may lead to underpricing. We also show that price support combined with the over-allotment option provides a put option to the underwriter, not the market. These results are found to be consistent with recent empirical research on IPOs and price stabilization by underwriters.