If potential investors pay attention not only to their own information about a new
issue, but also to whether other investors are purchasing or not and they attempt to judge the
interest of other investors, according to Welch (1992) (15), bandwagon effects or also known as
information cascades may develop:
Later investors can condition their bids on the bids of earlier investors, rationally disregarding
their own information. If an investor sees that no one else wants to buy, he may not buy even
when he possesses favourable information about the issue: Later investors abstain because
earlier investors abstain. In order to prevent this situation from happening, an issuer may have
to underprice the IPO to induce the first few potential buyers, and later induce a cascade in
which all subsequent investors want to buy irrespective of their own information. They will
imitate the first potential investors even if they have unfavourable and negative information
about the IPO. Since there are some investors interested in the IPO and bought, other
investors will be also interested in the offering and will request shares even if they think that
it is unattractive, their opinion will change and they will think that it is a hot offering.
So, if an issuer succeeds the first sales, he is sure that later investors are encouraged to invest
in his offering whatever their own information. Conversely, if an issuer fails the first sales to
the earlier investors, this will dissuades later investors from investing irrespective to their own
information.
In support for this informational cascade explanation, Amihud, Hauser and Kirsh (2001) find
that IPOs tend to be either undersubscribed or hugely oversubscribed, with very few offerings
moderately oversubscribed.
15 Welch’s cascades model remains one of the least explored explanations of IPO underpricing.