Abstract
We are the first to set up a random search based model to describe the pre-IPO market searching and matching process between private firms with intent to sell equity in an IPO and investment banks (IB) that underwrite the issue. Due to the wide existence of the market search friction, the necessary time is required in order to form a strategic pair between a private firm and an investment bank for a successful IPO. We derive a closed-form formula for the investment bank’s share of profit from an IPO transaction at the market equilibrium. The calibrated simulation result for this value is consistent with the “ seven percent solution ” initially identified by Chen and Ritter (2000). Our model suggests that IPO underpricing is not a deterministic phenomenon but an empirical observation, the existence of which largely originates from the market-wide co-movement between the total gross proceeds of each IPO and the total number of successful IPOs.
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