Publicity and the Clustering of IPO Underpricing

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Abstract
We explain why underpricing in IPOs can be large in magnitude and clustered, using a signalling model where firms have private information about their qualities (high or low). A novel feature is that a firm, if perceived by the market as high quality, benefits from the industry's publicity which is an increasing function of the amount of IPO underpricing by all high-quality firms in the industry. Two separating equilibria exist, in one no firm underprices IPO and the industry has no publicity; in the other every high-quality firm underprices IPO and the industry has great publicity. The two equilibria coexist when the industry's publicity has a strong positive effect on each high-quality firm's expected earnings. A strong industry publicity induces underpricing because it increases both the benefit for a high-quality firm to signal its quality and the temptation for a low-quality firm to mimic; to benefit from the publicity, a high-quality firm underprices its IPO to separate itself from a low-quality firm. This result is opposite to a typical externality story where the free-rider problem would reduce or eliminate IPO underpricing altogether.