A model of dynamic information production for initial public offerings

We develop a multi-period information-theoretic model of initial public offering (IPO) in the presence of an adverse selection problem that addresses both underpricing in an IPO and subsequent underperformance in the long run. In this model, information asymmetry exists among the owner of a firm going IPO, underwriter(s), informed analysts and uninformed investors. Information asymmetry between the owner and the investors is reduced through both the initial information production by some investors and the evaluations by informed analysts in the subsequent periods as new information arrives on the market. By incorporating future uncertainty, subsequent information revelation, certain firm-specific constraints and the actions of the agents, the optimal or sub-optimal actions of the agents are identified. The model explains why firms going public are underpriced at the IPO and, on average, underperform in the long run. The results are also compatible with social comparison explanations from a behavioral finance perspective.