Do Underwriters Encourage Stock Flipping? A New Explanation for the Underpricing of Ipos

Disagreement persists about why IPOs are underpriced on average. In part because the more popular theories?based on asymmetric information, signaling, cascades, or investor feedback?are difficult to test, we do not know how much underpricing they can explain. We develop an alternative theory that provides a simple and testable explanation for underpricing. This theory is based on the need for liquidity in the after-market. The issuer gains little if the IPO is placed successfully, but there is no trading afterwards. We show that liquidity needs give rise to an offer price and allocation that encourages some flipping of the IPO. By placing shares with flippers and rationing demand to other investors, flippers have buyers waiting for their shares, which creates after-market trading. The underwriter accomplishes this by underpricing the issue to attract low-valuation investors, who flip shares to higher-valuation investors that are rationed. The underwriter gains trading profits from this arrangement by acting as the primary market maker in the IPO. We test this theory using proprietary data on stock flipping and find significant support for this explanation of underpricing