Investor Horizon Clientele and IPO Underpricing

Abstract

We study the effect of investment horizon clienteles on the IPO market. We start from the premise – that we support with evidence – that IPO stocks are very liquid in the after-market. Therefore, short-term investors should have a higher reservation price for them than long-term investors. However, the limited potential demand of short-term investors and the firm’s incentives to have long-term investors induce the underwriter to price the issue at the reservation price of long-term investors. Rationing causes the unsatisfied demand of short-term investors to express itself in the secondary market. This generates a positive relationship between short-term investor demand and both underpricing and trading volume at the IPO. We test this intuition by constructing a geography-based measure of “local short-term demand,” which captures the cross-sectional variations in regional investor horizon clienteles. We show that short-term investors prefer more liquid stocks than long-term investors do and that the fraction of IPO holdings by short-term investors after the IPO is “abnormally” high. Consistent with our hypotheses, local short-term demand is strongly positively related to IPO underpricing and after-market trading volume.