A Rationale for Order Inflation in IPO Bookbuilding

The literature on IPO allocations assumes that investors bid their true demand in bookbuilding, or alternatively that all orders are uniformly inflated. We propose a model in which investors face uncertainty with respect to the aftermarket performance of the IPO and the number of shares they will be allocated, and adopt a mean-variance criterion to optimize their bids. We show that investors bid with varying degrees of inflation depending on their informational ties with the underwriter. Our model raises questions for policymakers and researchers who use normalized rationing (i.e. the relative scale-back of each investor) to measure allocation favouritism