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.