The Initial Public Offering (IPO) market exposes investors to a classic problem of asymmetric information: there's not much doubt that the insiders know far more about the true worth of their company than do potential purchasers. So, as outlined by George Akerlof in his classic treatise on the used car market, we would expect that the only companies on offer in this market should be the ones you really don't want to buy; companies with sticky accelerators and malfunctioning brakes. Traditionally there's a way around this impasse, the use of trusted intermediaries whose skill and judgement can be relied on by potential investors to overcome the urge of company owners to maximise their gains and who can distinguish the dross from the jewels. Bizarrely the result of this intervention supposedly sees companies floating at valuations below their real value but, unfortunately, this comes with the ever-present risk of abuse by trustees. Situation abnormal, as usual.

Detecting Lemons

George Akerlof's study of the effect of asymmetric information flows on markets is something we've looked at before. Briefly, what he showed was that, in some situations market mechanisms can breakdown leading to a market failure. In the case of used cars he pointed out that typically sellers know more about the car than buyers and that a seller of a good car will want a good price for it. Unfortunately buyers can't distinguish between good and bad vehicles so won't be prepared to pay top-dollar for if, sellers then won't sell and the net result is that the only vehicles available in the used car market are duds – so-called lemons.

This type of breakdown in markets is possible anywhere we find sellers and buyers with different levels of knowledge – information asymmetries. Quite clearly the sellers of companies during IPO's know a lot more than the buyers exposing both sides to these types of issue. The way around this is the classic one; to involve a trusted intermediary who can analyse the company properly and manage the creation of an orderly and fair market.

Such intermediaries generally have ways of signalling to investors that they're reliable. Mainly this is done by setting themselves up for business in such a way that everyone can see that they're in for the long-haul. This is why banks traditionally have such imposing premises: it's a statement that they're…

Unlock the rest of this article with a 14 day trial

Unlock with Email
Unlock with Google

Already have an account?
Login here