The Journal of Finance - Vol

When IPO shares are sold sequentially, later potential investors can learn from the purchasing decisions of earlier investors. This can lead rapidly to "cascades" in which subsequent investors optimally ignore their private information and imitate earlier investors. Although rationing in this situation gives rise to a winner's curse, it is irrelevant. The model predicts that: (1) Offerings succeed or fail rapidly. (2) Demand can be so elastic that even risk-neutral issuers underprice to completely avoid failure. (3) Issuers with good inside information can price their shares so high that they sometimes fail. (4) An underwriter may want to reduce the communication among investors by spreading the selling effort over a more segmented market. CONSIDER A SCENARIO IN which an issuer is selling a new security of uncertain value, for example, an IPO (initial public offering) of stock or high-yield debt, through an underwriter. The S.E.C. has banned variable-price sales. While the value of this new security is highly uncertain to individual market participants, investors hold perfectly accurate information when aggregated. Moreover, there are many (potential) investors, and a small number of these investors can jointly determine the value of the firm (or its project) with high precision. It would seem that in this scenario underpriced offerings would succeed and overpriced offerings would fail. Nevertheless, this paper shows that, if the distribution channels of invest ment banks are limited, underpriced offerings can fail and overpriced offer ings can succeed. With limited distribution channels, it takes the under writer 'time to approach interested investors. Therefore, later investors can observe how well an offering has sold to date -or at least how successful it has sold relative to offerings previously undertaken by this underwriter. University of California, Los Angeles. I gratefully acknowledge the helpful discussions and comments of James Ang, Michael Brennan, Chris Barry (the discussant at the WFA 1990 meetings), Bhagwan Chowdhry, Kent Daniel, Milton Harris (the chairman of my Ph.D. thesis from which this paper derives), David Hirshleifer, Narasimhan Jegadeesh, Tim Opler, Jay Ritter, Ren6 Stutz, Sheridan Iltman, Itzchak Venezia, an anonymous referee, and the workshop participants at seminars at The University of California at Los Angeles, The University of Chicago, and The University of Illinois at Champaign-Urbana, INSEAD, The 5th Symposium on Money, Banking, Finance and Insurance in Karlsruhe, and the NBER. An earlier version of this paper, titled "Sequential Sales, Path Dependence and Cascades," was presented at the Western Finance Association 1990 conference. I gratefully acknowledge financial support from the Center for Finance and Real Estate and the Center for Entrepreneurial Studies, both at UCLA.