Good IPOs Draw in Bad: Inelastic Banking Capacity and Hot Markets

Abstract

We posit that screening IPOs requires specialized labor which, in the short run, is in fixed supply. Hence, a sudden increase in demand for IPO financing increases the compensation of IPO screening labor. Increased compensation results in reduced screening which encourages sub-marginal firms to enter the IPO market, further increasing the demand for screening labor and thus its compensation. The model's conclusions are consistent with empirical findings of increased underpricing during hot markets, positive correlation between issue volume and underpricing, negative correlation between issue volume and information production, and with tipping points between hot and cold markets characterized by discontinuous jumps in volume, underpricing, and issue quality. Finally, the model makes sharp and so far untested predictions relating IPO market conditions both to the fundamental values of IPO firms and to the returns to investment banks and investment banking labor.JEL Classification Codes: G20, G24; Keywords: IPO, underpricing, labor constraint † 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 discussant 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 Sloan School at MIT, where he was a visiting scholar during the period in which much of the work on the manuscript was completed. All remaining errors are ours.

Riding the merger wave: Uncertainty, reduced monitoring, and bad acquisitions

“…Therefore, it is possible that the quality of analysis of any individual merger decreases with overall merger activity. A similar mechanism is modeled in the work of Khanna, Noe, and Sonti (2009), which finds that banks reduce IPO screening in hot markets because it requires specialized labor, which is in fixed supply.…”

Corporate Fraud and Business Conditions: Evidence from IPOs

“…Our second measure of underwriters’ monitoring costs focuses on the supply side of investment banking labor markets. Khanna, Noe, and Sonti (2008) argue that the screening quality of underwriters deteriorates in hot IPO markets due to strong demand for the limited supply of specialized labor available to the investment banking industry. We compute the fraction of MBA graduates placed in the investment banking industry from Columbia Business School ( IB Hiring ) from each sample year 5 .…”

Public market staging: The timing of capital infusions in newly public firms

“…First, to the extent that human capital is limited, investors who are faced with a large volume of IPO activity might not be able to engage in appropriate levels of due diligence (Khanna, Noe, and Sonti, 2008). If this is true, the public market staging hypothesis suggests that, because the absence of proper due diligence should be associated with greater uncertainty, investors provide individual firms with less capital when the level of IPO activity is high.…”