Efficient markets hypothesis and performance of IPO shares after lock-up period

Question

It's noted here that the Linked In shares dropped 7% after restrictions on insiders from share sales expired. The layman explanation is that a greater supply of shares, and a desire amongst at least some insiders to sell, pushed the share price down.

However, why wouldn't this well-publicized event (and a rich history of lock-up expiries) be telegraphed and priced into markets? Otherwise, one could generate a profitable strategy of buying puts or selling short IPOs ahead of the lock-up release dates. It seems that either there is an inefficiency, or there are constraints on executing this strategy.

Question -- why aren't releases of IPO shares anticipated by financial markets so that the price change post-lockup is random? Links to empirical research proving or disproving the opportunity is also welcome.

Answer 1

There are rules that prevent two of the reactive measures you suggest from occurring. First, on the date of and shortly following an IPO, there is no stock available to borrow for shorting. Second, there are no put options available for purchase. At least, none that are listed, of the sort you probably have in mind.

In fact, within a day or two of the LinkedIn IPO, most (all?) of the active equity traders I know were bemoaning the fact that they couldn't yet do exactly what you described i.e. buying puts, or finding shares to sell short. There was a great deal of conviction that LinkedIn shares were overpriced, but scant means available to translate that market assessment into an influence of market value.

This does not mean that the Efficient Markets Hypothesis is deficient. Equilibrium is reached quickly enough, once the market is able to clear as usual.

Answer 2

Who's to say it wasn't priced into the markets, at least to some degree? Without any information on the behaviour of holders pre-expiry, no one can know if they've been shorting the stock in advance of selling on expiry day.

And with the float being such a small proportion of the total issuance, there's always the risk of sudden fluctuations picking up big momentum - which could easily explain the 7% drop on expiry day.

Add into all this uncertainty, the usual risks of shorting (e.g. limited upside, unlimited downside), and the observed phenomena aren't by any means killer blows of the Efficient Market Hypothesis. That's not to say that such evidence doesn't necessarily exist - just that this isn't it.

Answer 3

That's the way the markets work in THEORY.

In actual fact, markets are subject to "real world" pressures. That is, there are so many things going on in the market that the end of the "Lined In" lock up is just one of many. To produce the result you describe, traders would have to hold cash in reserve for this so-called "contingency" to buy at the end of the lock-up. In most cases, they wouldn't want to because of everything else that is going on.

To use a real world analogy, would you want to wait until the last possible moment before going to the bathroom? Or would you go now while you had the chance? That's what the decision about "holding cash in reserve for a contingency" is like.