Merging Activity as a Rational Explanation for the Long-Run Underperformance of IPO

The phenomena of IPO underpricing and underperformance are examined in the same rational model. In this model, underpricing is caused by the presence of uninformed investors. Low-type firms carry out an IPO under the same conditions as high-type firms. Instead of investing by themselves, the latter prefer to merge with a bidder, which entails their delisting from the market. The behavior of these firms provides a rational explanation for the underperformance phenomenon since only low-type firms remain on the market. Initial preliminary findings are consistent with the basic idea of the model. We show that when mergers occur, the monthly average return of the remaining firms is significantly negative, whereas the monthly average return is not significantly different from zero for the months without mergers. This result suggests that mergers induce a depreciation effect on the remaining firms and could be a source of underperformance.