Going Public

One explanation for the empirically observed underpricing of new issues is the existence of an adverse selection problem faced by uninformed investors in the presence of informed investors. Rather than excluding informed investors from initial public offerings (IPOs), we show that, if share allocation rules are set properly, then the existence of informed investors may reduce underpricing by making credible threats that, in oversubscribed offerings, allocations to the uninformed will be small unless uninformed demand levels are high. Unlike earlier models, we provide a rationale for the intermediary role played by investment bankers in IPOs. Their knowledge of the primary market participants can enhance the revenue raised by the issuer.