Underwriters’ allocation power and adverse selection costs in the IPO process

This study uses a unique and extensive data set of over 28.2 million investors’ applications to examine the theory of adverse selection under two distinct regulatory regimes (discretionary against mandatory clawback provision) in relation to IPO share allocation. Consistent with Rock’s (1996) theory of adverse selection, we show that, prior to the implementation of the regulation; the probability of receiving an allocation in overpriced IPOs was significantly higher than that of receiving an allocation in underpriced hot issues. However, we find that the probability of an uninformed investor receiving an allocation in an underpriced issue has increased significantly following the adoption of the mandatory clawback provision. We also report a significant increase in allocation-adjusted returns earned by uninformed investors in the period following the introduction of the mandatory clawback provision. These findings imply that the mandatory clawback provision brings an element of fairness between different investor groups and reduces the winner’s curse in the IPO market.