Good IPOs draw in bad: inelastic banking capacity and hot markets

Working paper

We posit that screening IPOs requires specialized labor which, in the short run, is in fixed supply. Hence, a sudden increase in demand for IPO financing increases the compensation of IPO screening labor. Increased compensation results in reduced screening which encourages sub-marginal firms to enter the IPO market, further increasing the demand for screening labor and thus its compensation. The model's conclusions are consistent with empirical findings of increased underpricing during hot markets, positive correlation between issue volume and underpricing, negative correlation between issue volume and information production, and with tipping points between hot and cold markets characterized by discontinuous jumps in volume, underpricing, and issue quality. Finally, the model makes sharp and so far untested predictions relating IPO market conditions both to the fundamental values of IPO firms and to the returns to investment banks and investment banking labor.

Authors: Khanna, N; Noe, T; Sonti, R

• Publication status: Published
• Publisher: University of Oxford
• Series: Department of Economics Discussion Paper Series
• Publication date: 2008-01-01
• Paper number: 2008fe10
• Keywords: IPO; labor constraint; underpricing