Public Information and IPO Initial Returns: Theory and Tests

The literature shows that the first-day return in an IPO is positively related to the market return leading up to the issue. We propose a new model for this puzzling predictability by adding a public signal to the Benveniste and Spindt (1989) information-based framework. The public signal affects the equilibrium offer price through investors' incentives to truthfully reveal their private information to the underwriter and the probability that the IPO is in high demand. Analyzing 6,300 U.S. IPOs in 1983-2012, the model predictions receive strong support in the subsample of top-tier underwriters, where the order book has been shown to be informative. Moreover, controlling for the incentive effect of the model, the positive relation between the initial return and the market return disappears, effectively resolving the predictability puzzle.