The winner's curse and international methods of allocating initial public offerings

An interesting feature of the allocation of initial public offerings (IPOs) is that issuers in many countries tend to favor small over large investors. This occurs in the U.K., Hong Kong, Singapore, Malaysia, Indonesia, India, Thailand and Bangladesh, among other places. For example in Hong Kong between 1986 and 1992, around 85% of IPOs were allocated in a way that strictly favored smaller orders. The reason for favoring small investors over large investors is often thought to be some notion of ‘fairness’. We develop a model to show that such a policy may, in fact, be consistent with revenue maximization by the issuing firm because it reduces the adverse selection or the ‘winner's curse’ problem pointed out by Rock (1986). The intuition is that informed investors tend to place larger orders than do uninformed investors even when they have the same wealth level; this tendency is obviously stronger if informed investors tend to be wealthier than the uninformed. We derive other empirical implications of the model and relate them to the stylized facts about IPOs in various countries.