Building the IPO Order Book: Underpricing and Participation Limits with Costly Information

Abstract

This paper examines the book building mechanism for marketing initial public offerings. We present a model where the underwriter selects a group of investors along with a pricing and allocation mechanism in a way that maximizes the information generated during the process of going public at a minimum cost. Unlike previous models, we take into account the moral hazard problem that is faced by investors when evaluation is costly. Our results suggest that for firms with the most to gain from accurate pricing, the number of investors participating in the offering is larger, and underpricing will be greater. When the demand for accuracy is relatively low, the expected amount of underpricing exactly offsets the investors' costs of acquiring information. However, when the demand for accuracy is high, the expected amount of underpricing can exceed the cost of information and investors can earn rents.