414 A. Ljungqvist
of the relation between underpricing and the bank’s geographic reach (or underwriter
reputation) must be interpreted with caution. This reinforcesHabib and Ljungqvist’s
(2001)argument discussed in Section3.1, albeit on the basis of a different model of
IPO underpricing.
At a more basic level,Amihud, Hauser, and Kirsh’s (2003)analysis of demand and
allocations in Israeli IPOs supportsWelch’s (1992)prediction that demand is either
extremely low or there is oversubscription, with few cases in between.
In conclusion, Welch’s cascades model remains one of the least explored explanations
of IPO underpricing.
6.2. Investor sentiment
Behavioral finance is interested in the effect on stock prices of ‘irrational’ or ‘sentiment’
investors. The potential for such an effect would seem particularly large in the case
of IPOs, since IPO firms are young, immature, and relatively informationally opaque
and hence hard to value. The first paper to model an IPO company’s optimal response
to the presence of sentiment investors isLjungqvist, Nanda, and Singh (2004).They
assume some sentiment investors hold optimistic beliefs about the future prospects for
the IPO company. The issuer’s objective is to capture as much of the ‘surplus’ under the
sentiment investors’ downward-sloping demand curve as possible, that is, to maximize
the excess valuation over the fundamental value of the stock. Flooding the market with
stock will depress the price, so the optimal strategy involves holding back stock in
inventory to keep the price from falling. Eventually, nature reveals the true value of the
stock and the price reverts to fundamental value. That is, in the long-run IPO returns
are negative, consistent with the empirical evidence inRitter (1991)and others. This
assumes the existence of short sale constraints, or else arbitrageurs would trade in such
a way that prices reflected fundamental value even in the short term.
Regulatory constraints on price discrimination and inventory holding prevent the
issuer from implementing such a strategy directly. Instead, the optimal mechanism
involves the issuer allocating stock to ‘regular’ institutional investors for subsequent
resale to sentiment investors, at prices the regulars maintain by restricting supply. Be-
cause the hot market can end prematurely, carrying IPO stock in inventory is risky, so
to break even in expectation regulars require the stock to be underpriced—even in the
absence of asymmetric information. However, the offer price still exceeds fundamen-
tal value, as it capitalizes the regulars’ expected gain from trading with the sentiment
investors, and so the issuer benefits from this mechanism.
6.2.1. Testable implications and evidence
The model generates a number of new and refutable empirical predictions. Most obvi-
ously, the model predicts that companies going public in a hot market subsequently un-
derperform, both relative to the first-day price and to the offer price. Underperformance
relative to the first-day price is not surprising; it follows from the twin assumptions of