Dynamic Adverse Selection: Time-Varying Market Conditions and Endogenous Entry

Abstract

In this paper I analyze the effects of time-varying market conditions and endogenous entry on the equilibrium dynamics of markets plagued by adverse selection. I show that variation in gains from trade, stemming from market conditions, creates an option value and distorts liquidity when gains from trade are low. An improvement in market conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications: early stage financing, initial public offerings, and private equity buyouts. Disciplines Finance and Financial ManagementThis working paper is available at ScholarlyCommons: http://repository.upenn.edu/fnce_papers/24Electronic copy available at: http://ssrn.com/abstract=2653129 conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications:early stage financing, initial public offerings, and private equity buyouts. * I thank my advisors Andrzej Skrzypacz and Ilya Strebulaev for numerous lengthy discussions, valuable feedback, continuous support, and encouragement. I would also like to thank Peter DeMarzo, Steven Grenadier, and participants in the Stanford GSB Research Seminar for many constructive comments.†

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