Good IPOs drive in bad: Inelastic banking capacity and persistently large underpricing in hot IPO markets

Abstract:     
In this paper, we consider the effect of labor market constraints on the Initial Public Offering (IPO) activity of investment banks. We posit that identifying IPO quality requires specialized screening labor that takes time to train. Positive shocks to economy's production frontier stimulate IPO demand. At this higher level of demand, screening labor costs must rise to clear the labor market. This results in underwriters optimally reducing screening quality, in the process encouraging firms with sub-marginal projects to also apply, further straining the screening labor market. In equilibrium, underpricing can be quite significant both because of lower quality screening and because of its role in lowering the quality of the applicant pool. Our model's predictions are consistent with empirical results such as positive correlation between IPO volume and underpricing, reduced information search per project during hot markets, and the persistence of high IPO volume in the face of increased underpricing.

Keywords: IPO, hot markets, underpricing, capacity constraints

JEL Classifications: G24

Working Paper Series