Investor participation and underpricing in lottery-allocated Chinese IPOs

•Overall evidence consistent with the price bubbles•Excess demand positively related to initial return•Excess demand negatively related to long-term performance

We examine the association between IPO underpricing and investor participation using a unique sample of 411 Chinese IPOs where the offer price is not influenced by the issuers and underwriters, and allocation to subscribers is by a lottery mechanism. We find that investor participation does not increase with the profitability or liquidity of new issues contrary to the rational participation and liquidity hypotheses. However, consistent with the price bubbles hypothesis, we find robust evidence that initial returns and investor participation are positively related and that initial returns are inversely related with the three-year risk-adjusted abnormal return following IPOs. The implication is that excess demand inflated initial trading prices and exacerbated the Chinese “underpricing” phenomenon during our 1996–2000 sample period.