RFS Advance Access originally published online on April 12, 2007
Review of Financial Studies 2008 21(5):1873-1906; doi:10.1093/rfs/hhm018
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Good IPOs Draw in Bad: Inelastic Banking Capacity and Hot Markets
Michigan State University
University of Oxford
Indian School of Business
Address correspondence to Naveen Khanna, Eli Broad School of Business, Michigan State University, East Lansing, MI 48824, Michigan, or e-mail: khanna{at}msu.edu
JEL Classification: G20, G24
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Abstract |
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We posit that screening IPOs requires specialized labor which is in fixed supply. A sudden increase in demand for IPO financing increases the compensation of IPO screening labor. This results in reduced screening, encouraging sub-marginal firms to enter the IPO market, further fueling the demand for screening labor. The model's conclusions are consistent with empirical findings of increased underpricing during hot markets, positive correlation between issue volume and underpricing, and with tipping points between hot and cold markets. Finally, the model makes sharp predictions relating the IPO market to fundamental values of firms and to investment banking returns.
We wish to thank Walid Busaba, Mike Fishman, Jie Gan, Jon Garfinkel, Anand Goel, Vidhan Goyal, Gerard Hoberg, Yrjo Koskinen, Erik Lie, Ji-Chai Lin, Tim Loughran, Allen Michel, Jacob Oded, Gordon Phillips, Thomas Rietz, Harley "Chip" Ryan, Jay Sa-Aadu, Paul Schultz, Ann Sherman, Mark Taranto, Xianming Zhou, seminar participants at Baruch College, Boston University, DePaul University, Louisiana State University, MIT, Michigan State University, Notre Dame University, University of Iowa, University of Maryland, University of Michigan, University of Minnesota and the University of Western Ontario, as well as the discussants and participants at the 2005 City University of Hong Kong Corporate Finance and Governance Conference for their valuable comments and suggestions. Special thanks are extended to the Editor, Matthew Spiegel, and two anonymous reviewers for very detailed and insightful comments. The second author, Thomas Noe, would also like to acknowledge the generous support and assistance of the Tulane University and MIT, where most of the work on this paper was completed. All remaining errors are ours.