Fluent Essays

one page summary for each article. Instruction summary should include;   1- What is the research question? Why is the research question important?    2- What are the main findings?   3- What are the limitations of the paper? Conflict of Interest and the Credibility of Underwriter Analyst Recommendations Roni Michaely Cornell University and Tel-Aviv University Kent L. Womack Dartmouth College Brokerage analysts frequently comment on and sometimes recommend compa- nies that their firms have recently taken public. We show that stocks that under- writer analysts recommend perform more poorly than “buy” recommendations by unaffiliated brokers prior to, at the time of, and subsequent to the recommen- dation date. We conclude that the recommendations by underwriter analysts show significant evidence of bias. We show also that the market does not recognize the full extent of this bias. The results suggest a potential conflict of interest inherent in the different functions that investment bankers perform. Investment banks traditionally have had three main sources of income: (1) corporate financing, the issuance of securities, and merger advisory services; (2) brokerage services; and (3) proprietary trading. These three income sources may create conflicts of interest within the bank and with its clients. A firm’s proprietary trading activities, for example, can con- flict with its fiduciary responsibility to obtain “best execution” for clients. A more frequent and more observable conflict occurs between a bank’s corporate finance arm and its brokerage operation. The corporate finance division of the bank is responsible primarily for completing transactions such as initial public offerings (IPOs), seasoned equity offerings, and merg- ers for new and current clients. The brokerage operation and its equity research department, on the other hand, are motivated to maximize com- The authors thank seminar participants at the University of Arizona, Boston College, New York Univer- sity, University of Utah, Yale University, the NBER Corporate Finance and Behavioral Finance Groups, and the WFA; Franklin Allen, Stephen Brown, John Elliott, Bob Gibbons, Les Gorman, Marty Gruber, Gustavo Grullon, William Gruver, Susan Helfrick, Jeff Hubbard, Paul Irvine, Charles Lee, Bob Libby, Avner Kalay, Abbott Keller, Dan Myers, Maureen O’Hara, Meir Statman, Jeremy Stein, David Stierman, Sheridan Titman, and Ingo Walter offered helpful comments. Special thanks to Jay Ritter for extensive comments and suggestions throughout this project. We also gratefully acknowledge data provided by First Call Corporation and the expert research assistance of Roger Lynch, Paul Davey, and Louis Crosier. Finally, we would like to thank Scott Appleby, Donal Casey, Amaury Rzad, and Robert Yasuda (all 1993 Johnson School MBA graduates) for helping us conduct a pilot study in 1993. We are solely responsible for any remaining errors. Address correspondence to Roni Michaely, Department of Finance, Johnson Graduate School of Management, Cornell University, 431 Sage Hall, Ithaca, NY 14853-6201, or e-mail: [email protected] The Review of Financial StudiesSpecial 1999 Vol. 12, No. 4, pp. 653–686 c© 1999 The Society for Financial Studies The Review of Financial Studies / v 12 n 41999 missions and spreads by providing timely, high-quality (and presumably unbiased) information for their clients. These two objectives may conflict. Many reports in the financial press also suggest that conflict of interest in the investment banking industry may be an important issue.1 One source of conflict lies in the compensation structure for equity research analysts. It is common for a significant portion of the research analyst’s compensation to be determined by the analyst’s “helpfulness” to the corporate finance professionals and their financing efforts (see, for example, theWall Street Journal, June 19, 1997, “All Star Analysts 1997 Survey”). At the same time, analysts’ external reputations depend at least partially on the quality of their recommendations. And this external reputation is the other significant factor in their compensation. When analysts issue opinions and recommendations about firms that have business dealings with their corporate finance divi- sions, this conflict may result in recommendations and opinions that are positively biased. A Morgan Stanley internal memo (Wall Street Journal, July 14, 1992), for example, indicates that the company takes a dim view of an analyst’s negative report on one of its clients: “Our objective. . . is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice.” Another possible out- come of this conflict of interest is pressure on analysts to follow specific companies. There is implicit pressure on analysts to issue and maintain pos- itive recommendations on a firm that is either an investment banking client or a potential client. Conflicts between the desire of corporate finance to complete transactions and the need of brokerage analysts to protect and enhance their reputations are likely to be particularly acute during the IPO process. First, this market is a lucrative one for the investment banking industry. Second, implicit in the underwriter-issuer relationship is the underwriter’s intention to follow the newly issued security in the aftermarket: that is, to provide (presumably positive) analyst coverage. This coverage is important to most new firms because they are not known in the marketplace and they believe that their value will be enhanced when investors, especially institutional investors, hear about them. For example, Galant (1992) and Krigman, Shaw, and Womack (1999) report surveys of CEOs and CFOs doing IPOs in the 1990s. About 75% of these decision makers indicated that the quality of the research department and the reputation of the underwriter’s security analyst in their 1 For example, Paine Webber allegedly forced one of its top analysts to start covering Ivax Corp., a stock that it had taken public and sold to its clients. According to theWall Street Journal(July 13, 1995), the “stock was reeling and needed to be covered.” On February 1, 1996, theWSJreported that the attitude of the investment bank analysts toward AT&T was a major factor in AT&T’s choice of the lead underwriter of the Lucent Technologies IPO. 654 Conflict of Interest and the Credibility of Underwriter Analyst Recommendations industry were key factors in choosing a lead underwriter. Hence a well- known analyst who follows a potential new client’s industry represents an important marketing tool for the underwriters. Finally, a positive recommendation after an IPO may enhance the like- lihood that the underwriter will be chosen to lead the firm’s next security offering. Consequently there may be substantial pressure on analysts to produce positive reports. These potential conflicts of interest may have been exacerbated in the last decade with changes in the marketing and underwriting strategies of investment banks. In the past the corporate finance arm of the investment bank was more likely to perform due diligence on an issuer using its own staff and not analysts in the equity research department. Only after an offering was completed would the underwriting firm assign an equity research analyst to cover the stock. The trend in the last two decades, however, has been to use equity research analysts directly in the marketing and due diligence processes [see McLaughlin (1994)]. While there are several good reasons that can explain this trend (less duplication of expertise, improved marketing efforts), it is likely that the “walls” between departments have become less clear. Consequently the analyst has become more dependent on the corporate finance group.2 The potential conflict of interest between a research analyst’s fiduciary responsibility to investing clients and the analyst’s responsibility to corpo- rate finance clients suggests several testable implications. First, underwriter analysts may issue recommendations that are overly optimistic (or positively biased) than recommendations made by their nonunderwriter competitors. Second, these analysts may be compelled to issue more positive recommen- dations (than nonunderwriter analysts) on firms that have traded poorly in the IPO aftermarket, since these are exactly the firms that need a “booster shot” (a positive recommendation when the stock is falling). The implication is that rational market participants should, at the time of a recommendation, discount underwriters’ recommendations compared to those of nonunder- writers. There is little empirical evidence relating the performance of investment bankers’ recommendations to their affiliation with issuing firms. There are some studies that examine the nature of the relation between the investment banker association with the issuing firm and how this relation affects the investment banker’s earnings forecasts and types of recommendations [see Dugar and Nathan (1995) and Lin and McNichols (1997)]. They find that around seasoned equity issues, underwriters’ earnings forecasts and rec- 2 See Dickey (1995). Several conversations with investment bankers confirm this conclusion. It should be noted that, while the transmission of information and the close links between the corporate finance division and the equity research division may result in biased recommendations, they do not constitute a violation of the “Chinese wall.” 655 The Review of Financial Studies / v 12 n 41999 ommendation ratings are more positive (but not in a statistically significant way) than those of nonunderwriters. Lin and McNichols (1997) report that recommendation classifications are more positive for underwriters’ recommendations. Dugar and Nathan (1995) find, despite the fact that affiliated analysts are more optimistic, that their earnings forecasts “are, on average, as accurate as those of non- investment banker analysts.” More recently, however, Dechow, Hutton, and Sloan (1997) conclude that the earnings estimates of underwriters’ analysts are significantly more optimistic than those of unaffiliated analysts, and that stocks are most overpriced when they are covered by affiliated underwriters. A credible alternative theory is that underwriters’ recommendations will be not only unbiased but also more accurate than those of nonaffiliated equity analysts. Several authors, including Allen and Faulhaber (1989), suggest that investment bankers will have superior information on firms they have underwritten. Underwriter analysts will have an informational advantage gained during the marketing and due diligence processes; they may thus be more knowledgeable than their competitors and produce more accurate forecasts. At the beginning of an IPO firm’s public life, information asymmetry is at its greatest, which could lead to differing forecasts. It is also plausible that the IPO firm will continue to provide the underwriter analyst more and better information to maintain a healthy agency relationship. If this superior information story is the dominant effect, the market should greet underwriters’ better information with a more pronounced immediate response. Ex post, if their information is superior, their recommendations should be more predictive of future prices and provide investors with su- perior investment results. (The superior information idea suggests no clear price behavior differences in the prerecommendation period.) We analyze three issues. Does an underwriting relationship bias analysts’ recommendations, or does it result in more accurate recommendations? Do underwriter analysts tend to be overly optimistic about stock prices of firms they underwrite? Does the market correctly discount the overly positive recommendations of affiliated underwriters? The regulatory environment provides a convenient testing ground for this question. Twenty-five calendar days after the IPO is an important date for a new company. It is only then that underwriters (and all syndicate mem- bers) can comment on the valuation and provide earnings estimates on the new company.3 And although nonunderwriters technically can express their 3 See Rule 174 of the Securities Act of 1933; Rule 15c2-8 of the Securities Exchange Act of 1934; and the 1988 revision to Rule 174 by the Securities and Exchange Commission. The revision to Rule 174 reduces the “quiet period” to 25 calendar days for any equity security that is listed on a national securities exchange. It does not apply to securities for which quotations are listed solely by the National Quotation Bureau in the “pink sheets.” SEC release #5180 (August 16, 1971) explicitly states that the issuers (i.e., the firm and its investment bankers) should avoid issuance of forecasts, projections, or predictions related to but not limited to revenues, income, or earnings per share,and refrain from publishing opinions concerning value, as long as the firm is in registration and in the posteffective period (i.e., the quiet period). 656 Conflict of Interest and the Credibility of Underwriter Analyst Recommendations opinions before that time, typically they do not. Thus the end of the Secu- rities and Exchange Commission (SEC) “quiet period” marks a transition. Before that time, investors must rely solely on the prospectus and audited financial information (disclosures regulated under security laws). After that time research analysts can interpret the factual information and disseminate estimates, predictions, and recommendations as to valuation of the new firm relative to its competitors. We examine the information — particularly the “buy” recommendations disseminated by brokerage analysts in the period after the end of the quiet period. Our findings indicate, first, that in the month after the quiet pe- riod lead underwriter analysts issue 50% more buy recommendations on the IPO than do analysts from other brokerage firms. Second, there is a significant difference in the prerecommendation price patterns of under- writer and nonunderwriter analysts’. Stock prices of firms recommended by lead underwriters fall, on average, in the 30 days before a recommen- dation is issued, while prices of those recommended by nonunderwriters rise. Third, the market responds differently to the announcement of buy rec- ommendations by underwriters and nonunderwriters. The size-adjusted ex- cess return at the event date is 2.7% for underwriter analyst recommen- dations (significantly different from zero) versus 4.4% for nonunderwriter recommendations. Finally, the long-run postrecommendation performance of firms that are recommended by their underwriters is significantly worse than the perfor- mance of firms recommended by other brokerage houses. The difference in mean and median size-adjusted buy-and-hold returns between the under- writer and nonunderwriter groups is more than 50% for a two-year holding period beginning on the IPO day. These results are consistent across the major brokers making buy rec- ommendations for both their underwriting clients and nonclients. The mean long-run return of buy recommendations made on nonclients is more posi- tive than those made on clients for 12 of 14 brokerage firms. In other words, it is not the difference in the investment banks’ ability to analyze firms that drive our results, but a bias directly related to whether the recommending broker is the underwriter of the IPO. 1. The Sell-Side Security Analyst 1.1 The Delivery of Financial Information and Recommendations to Customers Brokerage analysts (“sell-side” analysts) are responsible for distributing reports such as “buy” recommendations to investors. They provide exter- nal (“buy-side”) customers with information on and insight into particular companies they follow. Most analysts focus on a specific industry, although 657 The Review of Financial Studies / v 12 n 41999 some are generalists, covering multiple industries or stocks that do not easily fit into industry groupings.4 The analyst’s specific information dissemination tasks can be catego- rized as (1) gathering new information on the industry or individual stock from customers, suppliers, and firm managers; (2) analyzing these data and forming earnings estimates and recommendations; and (3) presenting rec- ommendations and financial models to buy-side customers in presentations and written reports. The analyst’s dissemination of information to investment customers oc- curs in three different time circumstances: urgent, timely, and routine. The result is the main “information merchandise” that is transmitted to cus- tomers on a given day. An urgent communication may be made following a surprising quarterly earnings announcement or some type of other cor- porate announcement while the market is open for trading. In this case the analyst immediately notifies the salespeople at the brokerage firm, who in turn call customers who they believe might care (and potentially transact) on the basis of the change. Once the sales force is notified, the analyst may directly call, fax, or send e-mail to the firm’s largest customers if the analyst knows of their interest in the particular stock. Less urgent but timely information is usually disseminated through a morning research conference call. Such conference calls are held at most brokerage firms about two hours before the stock market opens for trading in New York. Analysts and portfolio strategists speak about, interpret, and possibly change opinions on firms or sectors they follow. Both institutional and retail salespeople at the brokerage firm listen to this call, take notes, and ask questions. After the call, and usually before the market opens, the salespeople will call and update their larger or transaction-oriented customers (professional buy-side traders) with the important news and recommendation changes of the day. The news from the morning call is duplicated in written notes and released for distribution to internal and external sources such asFirst Call. Important institutional clients may receive facsimile transmissions of the highlights of the morning call. Thus the “daily news” from all brokerage firms is available to most buy- side customers, usually well before the opening of the market at 9:30A.M. The information is sometimes retransmitted via the Dow Jones News Ser- vice, Reuters, CNNfn, or other news sources when the price response in the market is significant. The importance and timeliness of the “daily news” varies widely. One type of announcement is a change of opinion by an analyst on a stock. 4 We thank managing directors and vice presidents in the equity research and M&A departments of BT Alex Brown, Goldman Sachs, Lehman Brothers, Morgan Stanley, and Salomon Brothers for extensive discussions on this topic. 658 Conflict of Interest and the Credibility of Underwriter Analyst Recommendations New “buy” recommendations are usually scrutinized by a research over- sight committee or the legal department of the brokerage firm before re- lease. Thus a new added-to-buy recommendation may have been in the planning stage for several days or weeks before an announcement. Sudden changes in recommendations (especially, removals of “buy” recommenda- tions) may occur in response to new and significant information about the company. Womack (1996) shows that new recommendation changes, par- ticularly “added to the buy list” and “removed from the buy list,” create significant price and volume changes in the market. For example, on the day that a new buy recommendation is issued, the target stock typically appreciates 3%, and its trading volume doubles. For routine news or reports, most of the items are compiled in written reports and mailed to customers. At some firms, a printed report is dated sev- eral days after the brokerage firm first disseminates the news. Thus smaller customers of the brokerage firm who are not called immediately may not learn of the earnings estimate or recommendation changes until they receive the mailed report. More extensive research reports, whether an industry or a company anal- ysis, are often written over several weeks or months. Given the length of time necessary to prepare an extensive report, the content is typically less urgent and transaction oriented. These analyst reports are primarily deliv- ered to customers by mail, and less often cause significant price and volume reactions. 1.2 Sell-side security analysts’ compensation An important aspect of our analysis is related to sell-side security analyst compensation, since a significant portion of it is based on their ability to gen- erate revenue through service to the corporate finance arm of the investment bank. At most brokerage firms, analyst compensation is based on two major factors. The first is the analyst’s perceived (external) reputation. The an- nual Institutional InvestorAll-American Research Teams poll is perhaps the most significant external influence driving analyst compensation [see Stickel (1992)]. All-American rankings are based on a questionnaire asking more than 750 money managers and institutions to rank analysts in several categories: stock picking, earnings estimates, written reports, and overall service. Note that only the first two criteria are directly related to accurate forecasts and recommendations. The top analysts in each industry are ranked as first, second, or third place winners or (sometimes several) runners-up. Directors of equity research at brokerage firms refer to these results when they set compensation levels for analysts. Polls indicate that analysts’ being “up to date” is of paramount importance. The timely production of earnings estimates, buy and sell opin- ions, and written reports on companies followed are also key factors. Polls 659 The Review of Financial Studies / v 12 n 41999 also indicate that initiation of timely calls on relevant information is a valu- able characteristic in a successful (and hence, well-compensated) analyst. An analyst’s ability to generate revenues and profits is the second signif- icant factor in compensation. An analyst’s most measurable profit contribu- tion comes from involvement in underwriting deals. Articles in the popular financial press describe the competition for deal-making analysts as intense. Analysts who help to attract underwriting for clients may receive a portion of the fees or, more likely, bonuses that are two to four times those of analysts without underwriting contributions. The distinction between vice president and managing director (or partner) for analysts at the largest in- vestment banks is highly correlated with contributions to underwriting fees [see Dorfman (1991), Galant (1992), and Raghavan (1997)]. Another potential source of revenues, commissions generated by trans- actions in the stock of the companies the analyst follows, may also be a factor in the analyst’s compensation. It is difficult, however, to define an analyst’s precise contribution to trading volume. There are many other factors, including the trading “presence” of the investment bank, that af- fect it. Moreover, customers regularly use the ideas of one firm’s analysts, but transact through another firm. For institutional customers, this is the rule rather than the exception. In the short run, institutional “buy-side” customers seek out the most attractive bids and offers independently of analysts’ research helpfulness. Over a quarter or a year, the allocation of commission dollars among brokerage firms is more closely tied to research value-added. 2. Data, Sample Selection, and Sample Description 2.1 Return Data for IPOs The data we examine come from two sources. First, we identify firms that conducted IPOs in 1990 and 1991 usingInvestment Dealers Digest (IDD). A total of 391 IPOs are included in the sample. We collected relevant in- formation on each offering, including the lead underwriter, offering price, size, and date. Stock returns are then collected from the Center for Research in Securities Prices (CRSP) NYSE/AMEX/Nasdaq data tape. Table 1 describes the IPO sample in terms of offering month, market capitalization, and industry distribution. We limit the sample to firm com- mitment offerings of equity only (no warrants or bonds attached) and an offering size of $5 million or more. The sample includes almost all un- derwritings by the major well-known underwriters in the United States. Most underwriters make their recommendation comments available on First Call. As in previous studies [e.g., Ibbotson, Sindelar, and Ritter (1994)], the number of IPOs is positively correlated with the lagged changes in the level of the market (panel A). Fifty-two percent of the firms in the IPO 660 Conflict of Interest and the Credibility of Underwriter Analyst Recommendations Table 1 Description of IPO sample Panel A: Distribution of firms conducting initial public offerings by month in 1990–1991 (with offering size (flotation) greater than or equal to $5 million) and the month-end Nasdaq price index Month and year Number of IPOs Nasdaq price index Jan 1990 8 415.81 Feb 6 425.83 Mar 14 435.54 Apr 16 420.07 May 13 458.97 Jun 19 462.29 Jul 17 438.23 Aug 10 381.21 Sep 5 344.51 Oct 1 329.84 Nov 1 359.06 Dec 2 373.84 Jan 1991 3 414.20 Feb 5 453.04 Mar 15 482.29 Apr 21 484.72 May 22 506.11 Jun 36 475.92 Jul 31 502.04 Aug 26 525.67 Sep 18 526.88 Oct 35 542.97 Nov 37 523.90 Dec 1991 30 586.34 Total 391 sample have market capitalizations between $50 million and $200 million (panel B). (Market capitalization is calculated as the number of shares out- standing, as reported on the CRSP tapes, multiplied by share price at the end of the SEC quiet period, 25 days after the IPO.) Twenty-six percent of the offerings have a capitalization of less than $50 million. The industry composition of the sample is well balanced; business services (including computer software), chemicals, health services, and high-tech equipment (including computer hardware) are the most frequent SIC code designations (panel C). Table 2 reports the number, size, first-day return, and two-year excess return of IPOs by underwriter. Seventy-two different underwriters acted as lead managers in our sample of 391 IPOs. Fourteen underwriters managed 246 or 63% of the IPOs. Because of an insufficient number of observations, we assign all the remaining underwriters to a single group. We find a general pattern of substantial underpricing at the offering date (10.8% mean excess return on the first day) and modest positive size- adjusted returns (relative to CRSP size-decile return) in the next five months. Thereafter the mean and median size-adjusted returns for the entire IPO sam- ple are mostly negative, averaging about−5% per year. These returns are 661 The Review of Financial Studies / v 12 n 41999 Table 1 (continued) Panel B: IPO firms differentiated by market capitalization in millions Market capitalization Percent of IPOs Number of IPOs Less than $50 26 100 $50–$99.9 27 105 $100–$199.9 25 98 $200–$400 15 58 Greater than $400 7 30 All IPO firms 100 391 Panel C: Distribution of IPO firms across industry groups (by two-digit SIC code) SIC code Percent of IPOs Number of IPOs Business services (73) 10.0 39 Chemicals and allied products (28) 9.5 37 Health services (80) 7.7 30 Electronic equipment (36) 6.9 27 Industrial equipment (35) 5.6 22 Instruments (38) 5.6 22 Insurance (63) 4.1 16 Banks and investment firms (67) 4.1 16 Oil and gas (13) 3.8 15 Durable goods (50) 3.1 12 Other industries (Various) 39.6 155 All IPO firms 100.0 391 All firms conducting IPOs in 1990 and 1991 with offering proceeds of $5 million or greater (with details available inInvestment Dealers Digest) are included in the sample. Panel A shows the time series of IPO dates across months in 1990–1991. Panel B shows the market capitalization of IPO firms, which is calculated as shares outstanding times market price as of the end of the 25-day SEC quiet period after the issue date. Panel C describes the sample by industry (two-digit SIC codes). consistent with Ritter’s (1991) and Michaely and Shaw’s (1994) findings of positive early term and negative longer-run performance of IPO firms. Because we eliminate smaller IPOs, which have the most negative long-run returns in Ritter’s study, our mean and median long-term returns are not as negative as his. The finding of a positive first-day excess return is not unique to a partic- ular underwriter, but holds for all the 14 major underwriters in the sample (it varies between 18.6% and 2.1%), as well as for the combined group of nonmajor underwriters. The two-year excess return is negative for 9 of the 15 underwriter categories, and it varies between−45.8% and+21.3%. 2.2 Analysts’ recommendation data Information on analysts’ recommendations of companies that completed IPOs was obtained fromFirst Call. First Call Corporation collects the daily commentary of portfolio strategists, economists, and security analysts at major U.S. and international brokerage firms and sells it to professional investors through an on-line PC-based system. As brokerage firms report electronically from their “morning calls,” First … ARTICLE IN PRESS 0304-405X/$ - s doi:10.1016/j.jfi $ We wish to Schwert (the e University, Un Virginia (Darde (2003) and esp Council for fin � Correspond E-mail addr Journal of Financial Economics 87 (2008) 610–635 www.elsevier.com/locate/jfec Second time lucky? Withdrawn IPOs that return to the market $ Craig G. Dunbar � , Stephen R. Foerster Richard Ivey School of Business, University of Western Ontario, London, Ontario, Canada, N6A 3K7 Received 3 March 2006; received in revised form 7 July 2006; accepted 11 August 2006 Available online 19 August 2007 Abstract We investigate issuers withdrawing an IPO (after security regulation filings) that return later for a successful offering. Venture capital backing and reputation of the lead underwriter are key factors in predicting successful return. The possibility of returning has a significant impact on the decision to withdraw and the pricing of offerings that succeed. Our sample of returning IPOs also provides a unique setting to investigate underwriter switching after a withdrawal but before a successful IPO. We find that switching occurs in response to poor bank performance and when switching firms ‘‘graduate’’ to banks that have high industry market shares. r 2007 Elsevier B.V. All rights reserved. JEL classification: G14; G24; G32 Keywords: IPOs; Withdrawals; Return performance; Investment bank reputation; Switching 1. Introduction The most significant event in the life of a corporation is arguably its transition from a private to public company through the initial public offering (IPO) process. The IPO provides a major source of capital and allows the existing owners to have a liquid market for their shares. Firms rely on the IPO for either their survival or their ability to take advantage of growth opportunities. Yet not all firms are successful in making the transition from a private to public company. In fact, after an IPO process has been initiated with the support of an investment bank, a surprisingly large number of proposed IPOs are withdrawn from the market before being completed. An emerging literature examines the prevalence of proposed IPOs that are registered but withdrawn before issue. For example, Dunbar (1998) and Busaba, Benveniste, and Guo (2001, BBG hereafter) show that between the mid-1980s and mid-1990s almost ee front matter r 2007 Elsevier B.V. All rights reserved. neco.2006.08.007 thank Mark Huson, Kathy Kahle, Kai Li, Michelle Lowry (the referee), Greg Nachtwey, Gordon Roberts, Tim Simin, Bill ditor), Lee Ann Woo, Chad Zutter, two anonymous referees, seminar participants at the Bank of Canada, Queens iversity of Arkansas, University of British Columbia, University of Hawaii, the University of Pittsburgh, University of n), York University, the Northern Finance Association Meetings (2002), the Financial Management Association Meetings ecially Colette Southam for excellent research assistance. We also thank the Social Sciences and Humanities Research ancial support. ing author. ess: [email protected] (C.G. Dunbar). www.elsevier.com/locate/jfec dx.doi.org/10.1016/j.jfineco.2006.08.007 mailto:[email protected] ARTICLE IN PRESS C.G. Dunbar, S.R. Foerster / Journal of Financial Economics 87 (2008) 610–635 611 one in five IPOs was withdrawn. Evidence from more recent periods, as uncovered in this paper, suggests that this fraction has increased to over one in two in some years. Several studies have attempted to explain the choice to withdraw an IPO. BBG argue that the decision to withdraw an IPO should depend on the issuer’s reservation value for the offering relative to possible investor valuations. Welch (1992) argues that negative information ‘‘cascades’’ can result in investor valuations falling below a level deemed reasonable by issuers, resulting in withdrawal. Dunbar (1998), however, finds that issuers withdrawing IPOs are unlikely to return for a successful public equity offering. In a related literature, Mikkelson and Partch (1988) and Clarke, Dunbar, and Kahle (2001) examine withdrawn seasoned equity offerings. If withdrawals are in response to temporary market misvaluations, it is surprising that so few firms return. The choice to withdraw, therefore, remains puzzling since it can significantly restrict a firm’s access to the liquid and relatively inexpensive public capital markets. To gain insights into the choice of withdrawal, we examine a sample of firms that withdraw an IPO but are able to return eventually to the public equity markets for a successful IPO. We first attempt to identify the factors that affect a withdrawn issuer’s likelihood of being able to return successfully for an IPO. We find that firms initially brought forward by more reputable investment banks, and those having venture capital backing, are more likely to return. Issues withdrawn in more active IPO markets, when interest rates are high and when market returns are low, are also more likely to be able to return. Since the likelihood of returning is predictable, we next examine whether this likelihood affects the firm’s choice to withdraw. We find that the probability of withdrawal is positively related to the likelihood of successful return. Issuers that face the choice to withdraw but do not expect a second chance are more likely to try to push forward and complete their IPO. The likelihood of withdrawal and the possibility of return should also impact the pricing of successful IPOs. In order to ensure success, firms expected to withdraw with a low chance of returning should be more likely to cut prices during the bookbuilding process. Controlling for commonly used variables in the literature, we find that price adjustments are more negative for these firms, leading to higher first-day returns. Overall, the evidence indicates that firms consider the costs of withdrawal when attempting to decide whether or not to proceed with an IPO. Our study makes a number of additional contributions to the literature on IPO withdrawals. First, we extend the analysis in Dunbar (1998), BBG, and Benveniste, Ljungqvist, Wilhelm, and Yu (2003) on the determinants of offering withdrawal. Dunbar examines 3,540 withdrawn and successful IPOs from 1984 to 1993 and relates the choice to withdraw to a short list of four observable variables. BBG consider a larger number of variables obtained directly from IPO prospectuses but only study 536 IPO filings from 1990 to 1992. Benveniste, Ljungqvist, Wilhelm, and Yu look at a longer time period (1985–2000) but focus on a number of market measures proxying for ‘‘information spillovers.’’ Like Benveniste Ljungqvist, Wilhelm, and Yu, we look at a longer time period but also examine a wider range of market and firm-specific variables, including prospectus-level information from the SEC’s Edgar system. Some new variables emerge as very important in explaining IPO withdrawals. The most significant variable in our probit model, economically and statistically, is the industry market share of the investment bank in the IPO. Issuers brought forward by banks having a significant presence in the industry of the issuer are more likely to be successful. Other significant new explanatory variables include corporate bond yield spreads and the industry average book-to-market ratio. As yield spreads increase and access to borrowing becomes more difficult, firms are less likely to withdraw. Firms with lower book-to-market ratios, or overvalued firms, are also more likely to withdraw. An interesting feature of the sample of returning IPOs is that in approximately 75% of the cases, the investment bank leading the successful IPO is different than the bank used in the initial unsuccessful attempt. Withdrawn IPOs that subsequently return to the market, therefore, provide a unique setting to explore underwriter switching compared with the existing literature examining switching after an IPO. Firms could switch because of dissatisfaction with the investment bank’s efforts in the original failed IPO process (the performance hypothesis) or because they can now obtain the services of a more reputable underwriter (the graduation hypothesis). Conversely, firms could choose not to switch after an unsuccessful IPO if they have confidence in the underwriter and view the previous failed IPO as related to other external and uncontrollable factors such as an unfriendly market environment. We find evidence supportive of both the graduation and performance explanations. ARTICLE IN PRESS C.G. Dunbar, S.R. Foerster / Journal of Financial Economics 87 (2008) 610–635612 The remainder of the paper is organized as follows. In Section 2 we describe the data used in our analysis. We develop hypotheses and present evidence on the factors affecting the choice to withdraw an IPO in Section 3. Evidence on factors affecting the successful return to the IPO market after withdrawal is presented in Section 4. We examine the underwriter switching choice for withdrawn IPOs that return to the market in Section 5. The effect of underwriter switching and the possibility of returning on the choice to withdraw is examined in Section 6. The effect of the possibility of withdrawal on the pricing of successful IPOs is examined in Section 7. Finally, we present conclusions in Section 8. 2. Data Our study examines all US firms that file documents to raise capital through a firm commitment initial public offering of equity between 1985 and 2000 (Ritter, 1987; Cho, 1992; Dunbar, 1998; also examine withdrawals but within the context of best�efforts offering methods). Our primary data source is Thomson Financial Securities Data’s (TFSD) New Issues Database. We begin our analysis in 1985, as TFSD’s coverage of withdrawn IPOs begins in 1984 but is complete only beginning in January 1985. We consider all IPOs filed over that period but, following the existing literature (e.g., BBG), we screen offerings on a number of criteria. Specifically, we exclude unit offerings (combinations of equity and warrants), REITs, ADRs, and closed-end mutual funds, although unlike BBG, we do not screen out firms in certain industries such as financials or service firms. For each offering, we gather data from TFSD on firm characteristics (e.g., data from past financial statements) and offering characteristics including offering size, price, and information to estimate investment bank reputation variables. Data on market returns around the proposed offerings are collected from the Center for Research in Security Prices (CRSP) database. Data on market interest rates around the proposed offerings are obtained from the Federal Reserve Bank of St. Louis web site (http:// research.stlouisfed.org/fred2/). For many withdrawn offerings, TFSD data are incomplete. Additional information on venture capital backing is obtained from VentureXpert. We also obtain initial prospectuses from the SEC’s Edgar system for all withdrawn IPOs starting in 1996 (electronic filing only began in the mid-1990s). Offering characteristics (proposed price and size) and past financial information are then obtained for these offerings. TFSD data allow us to identify all successful IPOs as well as all withdrawn IPOs. It is somewhat more challenging to identify which successful IPOs were previously withdrawn and then returned to the market. We use a number of approaches to identify these returners. The first step in identifying matches is to examine CUSIPs as well as unique company identifier numbers assigned to issuers by TFSD. Company identifier numbers and CUSIPs from TFSD’s withdrawn IPO dataset are matched to TFSD’s database of successful IPOs. To ensure the data are as complete as possible, we use a number of other approaches to identify returning IPOs. TFSD provides a contact name for each issuer in its database. We look for common names in the two databases. TFSD also provides information on business location, which we use as a check. In other cases we look for name matches (using parts of names). As a last step, where possible, we check our matches of withdrawn and successful offerings using actual filing documents from Edgar to ensure that the matches are correct. In spite of our best efforts, we recognize that it is likely that we have missed some returning issuers. In Table 1 we report the number of observations in our initial database, broken down by filing year and ultimate outcome (completed or withdrawn offering, and for withdrawn offerings we report the number of cases where the firm returns for a successful IPO). Overall we have 7,442 firms in our database, 1,473 of which were withdrawn (approximately 20%). Of those firms withdrawing an IPO, only 138 (or a little over 9%) ever return for a successful offering. The number of filings varies considerably over time from a low of 154 in 1989 to a high of 824 in 1996. The percentage of withdrawn IPOs ranges from 8.88% in 1991 to a staggering 55.29% in 2000. The percentage of successful returns also varies considerably over time from 0.34% in 2000 to 17.31% in 1992. Ignoring the more recent two years (since many of those firms have not had time to return), the lowest rate of successful returns is 2.70% in 1985. The correlation between the annual number of filings and the annual percent of withdrawals is 0.07. The correlation between the annual percentage of withdrawals and the percentage of those withdrawals that return is 0.08 (if the last two years are excluded, the correlations are �0.04 and 0.28, respectively). http://research.stlouisfed.org/fred2/ http://research.stlouisfed.org/fred2/ ARTICLE IN PRESS Table 1 IPO filings Number of IPO filings from 1985 to 2000. The sample is obtained from the Thomson Financial Securities Data (TFSD) database. Issues that are unit offerings, REITs, ADRs, or closed-end funds are excluded. Year of filing Number of IPOs filed in year Number filed in year that are withdrawn Number filed in year that are withdrawn then return for successful IPO Percentage of filings that are withdrawn Percentage of withdrawn offerings that return for a successful IPO 1985 298 37 1 12.42 2.70 1986 665 92 7 13.83 7.61 1987 448 95 14 21.21 14.74 1988 185 35 3 18.92 8.57 1989 154 15 1 9.74 6.67 1990 171 35 5 20.47 14.29 1991 394 35 4 8.88 11.43 1992 507 104 18 20.51 17.31 1993 623 83 14 13.32 16.87 1994 504 116 16 23.02 13.79 1995 564 54 8 9.57 14.81 1996 824 128 17 15.53 13.28 1997 569 113 6 19.86 5.31 1998 405 131 21 32.35 16.03 1999 592 102 2 17.23 1.96 2000 539 298 1 55.29 0.34 Total 7442 1473 138 19.79 9.37 C.G. Dunbar, S.R. Foerster / Journal of Financial Economics 87 (2008) 610–635 613 3. Determinants of the choice to withdraw an IPO While a number of studies have empirically investigated withdrawals, we provide a more thorough investigation by examining an extensive set of variables that we categorize into four areas: issuer and issue characteristics, investment bank characteristics, market conditions at the time of filing, and market conditions after the filing. Variables in the first two categories are used by Dunbar (1998, 2000) or BBG, while most of the variables in the last two categories are new. We describe predicted effects of each of these variables on withdrawals in some detail because we rely on similar arguments in later analyses that examine the likelihood that withdrawn firms will return. First, we consider variables related to deal riskiness. Benveniste and Spindt (1989) present a model where investment banks precommit to allocation and pricing schemes that induce investors to truthfully reveal information regarding the value of securities being issued prior to final pricing. When information revealed is sufficiently negative, offerings can be withdrawn. They argue that negative information is more likely to arise in offerings by firms whose value, ex ante, is more uncertain. This suggests that offerings by firms with greater ex ante valuation uncertainty, and hence risk, are more likely to be unsuccessful. Four issuer and issue characteristic variables related to deal riskiness are included in our empirical analyses. Filing size is the average filing price (the average of the low and high price indicated in the initial prospectus) multiplied by the number of shares (in millions) to be offered as indicated in the initial prospectus. In order to control for differences in filing dates, filing sizes are measured in January 2000 dollars using the CPI as a deflator. Firms with lower filing sizes (and lower prices) tend to be riskier (see Seguin and Smoller, 1997). The technology dummy is set equal to one when the issuer is from Fama and French (1997) industries 34 (business services) and 36 (chips). Withdrawal can cause bad publicity, and this is particularly true for technology firms where information asymmetries are likely to be most significant. Employees and suppliers are also likely to have job-specific skills making withdrawal very costly (see Titman and Wessels, 1988). Thus, we would expect the likelihood of withdrawal to be negatively related to our industry dummy. The venture capital backing dummy, a proxy for a firm’s access to capital, is set equal to one if the issuing firm has venture capital backing prior to the filing date. The debt retirement dummy, another measure of access to capital, is set equal to one if the primary use of ARTICLE IN PRESS C.G. Dunbar, S.R. Foerster / Journal of Financial Economics 87 (2008) 610–635614 proceeds in the IPO is to retire debt. Firms planning to retire debt and those with venture capital backing presumably have greater access to capital and, therefore, would be less dependent on an IPO. This would suggest that the likelihood of withdrawal should be positively related to the debt retirement dummy and the venture capital dummy. Alternatively, issues with venture capital backing could be argued to have greater certification. In this case, the probability of withdrawal should be lower. Given this ambiguity, we leave it to the data to determine which effect dominates. Second, we consider variables investment bank reputation variables. Potential IPO investors face the classic lemons problem (Akerlof, 1970): since insiders have better information regarding the true value of their firm, they have an incentive to offer securities when they are overvalued by investors. Booth and Smith (1986) argue that this problem can be ameliorated if insiders credibly certify that they are not selling overpriced securities by hiring an investment bank, which relies on its reputation to win future business, to manage the offering. Other certification mechanisms, such as insider retention and venture capital backing, are examined by Grinblatt and Hwang (1989) and Lerner (1994). Three investment bank reputation and certification variables are included in our empirical analyses. Carter-Manaster rank is obtained from Carter and Manaster (1990) as updated by Carter, Dark, and Singh (1998) and more recently by Loughran and Ritter (2004). These rankings are on a 0 to 9 scale, with 9 being the most reputable underwriter. Bank market share is measured for the bank taking the firm public. For each IPO we examine all IPOs in the year leading up to the offer (including the IPO). We compute the sum of gross proceeds (on global shares excluding overallotments) for which the underwriter is also the book manager. To account for mergers in the investment banking industry, we gather data from TFSD on all combinations during the period. If the book manager recently merged, the gross proceeds of all offerings by any precedent bank are added together. In cases with multiple book managers, equal credit is given to each bank. Market share is then defined as the sum of gross proceeds for the bank, divided by the sum of gross proceeds for all IPOs over the sample period. Bank industry market share is measured as the sum of gross proceeds for the bank over the year prior to the IPO of all offerings in the same Fama-French industry as the issuer (where the book manager is the same as the one in the current deal) divided by the sum of gross proceeds on all industry IPOs over the same period. Offerings brought forward by banks with higher Carter-Manaster ranks, overall market shares, and industry market shares have greater certification. We would, therefore, expect that the likelihood of withdrawal is lower for those issuers. Welch’s (1992) cascades model results in a similar prediction for investment bank ranking. Bates and Dunbar (2002) note that market share could also be capturing a bank’s market power. If banks use this power to ensure that deals are completed, the relation between market share and withdrawal should still be negative. Third, we consider five variables reflecting market conditions at the time of the filing. As a measure of the intensity of the IPO market, we include the number of IPO filings over the two months prior to the IPO’s filing date, number of filings in prior two months (Dunbar, 1998; BBG; Booth and Chua, 1996; and Benveniste, Ljungqvist, Wilhelm, and Yu, 2003). Market intensity can have two effects on withdrawals. In markets with more filings, information spillovers become more significant, resulting in enhanced precision of valuation, suggesting that withdrawals are less likely 1 . Alternatively, the pool of available capital could be limited, suggesting that withdrawals are more likely. A second measure of market intensity is the number of filings over the two months prior to an IPO in the same Fama-French industry as the issuer (number of industry filings in prior two months). If information spillovers are more effective in reducing valuation uncertainty at the industry level, this variable would do a better job of picking up this effect. Access to capital could remain important at the industry level, however, so we again leave it to the data to determine which relation dominates. We include two interest rate variables to provide information about market conditions at the time of the filing. BAA-AAA yield spread at filing is defined as the difference between average rates on BAA-rated corporate bonds (by Moody’s) and AAA-rated bonds. This yield spread is often used as an indicator of default probabilities in the economy. In periods when the spread is large, default probabilities are expected to be higher. If negative firm information is more likely to arise in this market environment, we would expect withdrawals to be more 1 Booth and Chua (1996) present a model of the IPO market where information-gathering costs are reduced when offerings are clustered. This process results in a greater precision of IPO valuation by investment banks, increasing the probability of offering success. Number of filings could also be positively associated with the probability of success if filings are proxying for general economic conditions (i.e., more business starts during expansionary periods) or market irrationality (more firms file when valuations are positively biased). ARTICLE IN PRESS C.G. Dunbar, S.R. Foerster / Journal of Financial Economics 87 (2008) 610–635 615 likely when spreads are higher. As an alternative view, access to capital is often limited when spreads are large. Firms attempting to raise capital in high-spread environments could have few alternatives and are, therefore, less likely to cancel an IPO. The relation between yield spreads and the probability of withdrawal is ultimately, therefore, an empirical question. The second interest rate variable is the yield on ten-year Treasury bonds (ten-year Treasury yield). In periods when interest rates are high, alternative sources of capital should be either scarce or expensive. An alternative view is that long-term rates tend to increase during expansionary periods. Again, the relation with the probability becomes an empirical question. As a measure of relative valuation we include the industry average book-to-market ratio, measured one year prior to the filing 2 . If book-to-market captures growth opportunities, then the relation should be positive (firms with more growth having lower book-to-market ratios are less likely to withdraw; the argument leading to this prediction is similar to that made for the technology dummy variable). On the other hand, if book-to-market captures market misvaluation, firms with low book-to-market ratios (overvalued firms) should be more likely to withdraw (it is more likely that firms will be detected as overvalued during the bookbuilding process). All of the empirical measures in the three categories discussed thus far are observable at the time of the initial IPO filing. A probit model estimated just with these variables, therefore, provides insights into the ex ante likelihood of offering success. Information received after the filing date should also affect a firm’s decision to withdrawal, however. We therefore examine a fourth category that includes six variables to proxy for market conditions after filing. Number of filings two months after filing and number of industry filing two months after filing capture the IPO market intensity during bookbuilding. Changes to the interest rate environment are captured by the change in BAA-AAA yield spread two months after filing and the change in ten-year Treasury yield two months after filing. Changes to the stock market environment are captured by the return on the Nasdaq composite index over two months after filing and the change in industry BM (book-to-market) over year of filing. Predictions regarding the relation between these variables and withdrawals are similar to those for similar variables before withdrawals. Where there are ambiguous arguments regarding the effect of variables, it is possible to have different relations before and after filing (one argument could dominate before and the other after). As a preliminary univariate investigation, we report descriptive statistics for the data items, broken down according to the ultimate success of the offering in Table 2. Note that sample sizes change depending on the variable examined, reflecting the fact that TFSD coverage of data items is extremely limited in some cases (especially for withdrawn issues). Most of the differences between successful and withdrawn IPOs are significant and as expected. Withdrawn offerings have significantly lower average initial filing size compared to completed offerings. A greater percentage of technology firms are successful than withdrawn. Firms with venture capital backing are more likely to succeed. This is consistent with venture capital backing acting as a certification for the offering (but not with the capital constraints conjecture). Also, Gompers (1996) notes that venture capitalists have an incentive to bring firms early to the IPO market to capitalize their claims. This argument would suggest that venture capitalists would lobby hard for IPO completion. Withdrawn offerings are also more likely to have been targeting for debt retirement. Successful offerings are more likely to be taken public by banks with greater reputations, proxied by Carter-Manaster rankings, market share, and industry market share. Withdrawn IPOs are filed after periods with a greater average number of filings over the prior two months than completed offers, suggesting that companies are more likely to withdraw when more companies are competing for limited capital. In addition, withdrawn IPOs are filed after periods with greater numbers of industry filings, suggesting a limited pool of capital. BAA-AAA yield spreads are higher for successful offerings, suggesting that yield spreads are more likely to be capturing access to capital than default probabilities. Withdrawn offerings are more likely to be from industries with lower book-to-market ratios, consistent with predictions from the misvaluation theory (firms in lower book-to-market industries are more likely to be detected as overvalued). The effect of changes in yield spreads is opposite to that detected pre-filing (the change is more positive for withdrawn offerings). The Nasdaq composite return post-filing is more positive for successful offerings, suggesting a better investment climate. Finally, the changes to the industry book-to-market ratio are less 2 Obtained from Ken French’s web site (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ARTICLE IN PRESS Table 2 Descriptive statistics—successful and withdrawn IPOs This table reports sample means and number of observations for different variables broken down by whether the IPO filing is successful or withdrawn. Issuer and issue characteristic variables are defined as follows. Average filing price is the average of the high and low price indicated in the initial filing. Filing size equals the average filing price multiplied by the number of shares to be sold as indicated in the initial filing (reported in January 2000 dollars using the CPI as a deflator). Technology dummy takes the value one if the issuer is in Fama-French industries 34 (business services) or 36 (chips) and zero otherwise (see Fama and French, 1997). Venture capital backing dummy takes the value one if the issuing firm has received venture capital investments prior to filing and zero otherwise. Debt retirement dummy takes the value one if the primary stated use of proceeds is retirement of debt. Investment bank characteristic variables are defined as follows. Carter-Manaster rank is the Carter-Manaster (1990) ranking on a 0–9 scale for the book … THE JOURNAL OF FINANCE * VOL. XLVI, NO. 3 * JULY 1991 Venture Capitalist Certification in Initial Public Offerings WILLIAM L. MEGGINSON and KATHLEEN A. WEISS* ABSTRACT This paper provides support for the certification role of venture capitalists in initial public offerings. Consistent with the certification hypothesis, a comparison of venture capital backed IPOs with a control sample of nonventure capital backed IPOs from 1983 through 1987 matched as closely as possible by industry and offering size indicates that venture capital backing results in significantly lower initial returns and gross spreads. In effect, the presence of venture capitalists in the issuing firms serves to lower the total costs of going public and to maximize the net proceeds to the offering firm. In addition, we document that venture capitalists retain a significant portion of their holdings in the firm after the IPO. THE ABILITY OF THIRD-PARTY specialists to certify the value of securities issued by relatively unknown firms in capital markets that are characterized by asymmetric information between corporate insiders and public investors has attracted much academic interest in recent years. Several authors, including James (1990), Blackwell, Marr, and Spivey (1990), and Barry, Muscarella, Peavy, and Vetsuypens (1991) have developed and tested models based at least in part on the formal certification hypothesis presented in Booth and Smith (1986). A related body of work, represented by DeAngelo (1981), Beatty and Ritter (1986), Titman and Trueman (1986), Johnson and Miller (1988), Carter (1990), Simon (1990), and Carter and Manaster (1990) has examined how investment bankers and auditors help resolve the asymmetric information inherent in the initial public offering (IPO) process. In this paper we examine whether the presence of venture capitalists, as investors in a firm going public, can certify that the offering price of the issue reflects all available and relevant inside information. We hypothesize that venture capitalists can perform this function; that it will be an economically *The University of Georgia, Department of Banking and Finance, School of Business Adminis- tration, Athens; and The University of Michigan, School of Business Administration, Ann Arbor; respectively. We are grateful to Mike Barclay, David Blackwell, Michael Bradley, Susan Chaplinsky, Harry DeAngelo, Cliff Holderness (discussant), E. Han Kim, Laura Kodres, Ron Masulis, Jeff Netter, Annette Poulsen, Bill Sahlman, H. Nejat Seyhun, Dennis Sheehan, and seminar participants at Harvard University, the University of Oregon, and Purdue University for their comments and recommendations. We also acknowledge the data collection assistance provided by Rick Mull, Eric Van Houwelingen, and So Han Lee. Financial support for this project was provided by the Center for Entrepreneurial Studies at New York University, the University of Michigan Summer Research Program, and the University of Georgia Research Foundation. 879 880 The Journal of Finance valuable function; and that the certification provided by venture capitalists will be both a partial subsititute for and a complement to the certification provided by prestigious auditors and investment bankers. We employ a matched pairs methodology where a sample of venture capital (VC) backed IPOs is matched by industry and offering size with a qualitatively equivalent set of non-VC backed IPOs, to focus as clearly as possible on the question of whether venture capital certification occurs and is valuable. Our results strongly indicate that the presence of venture capitalists in offering firms maximizes the fraction of the proceeds of the IPO, net of underpricing and direct costs, which accrues to the issuing firm. Specifically, we document that VC backing reduces the mean and median degree of IPO underpricing and that such backing significantly reduces the underwriting spread charged by the investment banker handling the issue. Further support for the venture capitalist certification hypothesis is provided by our finding that VC backed issuers are able to attract more prestigious auditors and underwriters than non-VC backed issuers. In addition, VC backed issuers also elicit greater interest from institutional investors during the IPO and are able to go public at a younger age than other firms. Finally, the credibility of venture capitalists' information is enhanced by the fact that they are major shareholders prior to the IPO and retain significant portions of their holdings after the offer. This study is organized as follows. In Section I, a general model of venture capital certification is provided. The sample selection criteria and descriptive statistics are presented in Section II. In Section III, the comparison of underwriter and auditor quality and the level of institutional shareholdings between VC and non-VC backed firms is examined. Empirical tests of the certification hypothesis are presented in Section IV. The pre- and post-IPO ownership structure of venture capitalists in the issuing firm is documented in Section V. Section VI concludes the study. I. Certification by Venture Capitalists Third party certification has value whenever securities are being issued in capital markets where insiders of the issuing firm and outside investors have different information sets concerning the value of the offering firm. Corpo- rate insiders have an incentive to conceal (or at least delay the revelation of) adverse information because doing so will allow them to sell securities at a higher price. Rational outside investors understand these incentives and will only offer a low average price for the securities offered unless they can be credibly assured that the offering price already reflects all relevant private information. This informationally induced standoff can lead to market failure of the type described by Akerlof (1970) unless the information asymmetry can be reduced. Although Allen and Faulhaber (1989), Grinblatt and Huang (1989), and Welch (1989), have presented signalling models which predict that corporate insiders can unilaterally convey their private information, there are several Venture Capitalist Certification in Initial Public Offerings 881 factors which make first-party statements and actions suspect. For one thing, Gale and Stiglitz (1989) show that IPO signalling models break down when insiders are allowed to sell equity more than once. More fundamentally, insiders have everything to gain and very little to lose from signalling falsely at the time of an IPO. They sell securities only infrequently and thus would only be "punished" far in the future if at all. Their gain, however, would be immediate and possibly quite large. While disclosure regulation will surely discourage flagrant lying and material omissions [see Tinic (1988)], it is unlikely to be completely effective in forcing disclosure of all relevant infor- mation. Therefore, in the absence of effective signalling mechanisms in IPOs, outside investors are likely to be convinced that accurate information disclo- sure has occurred only if a third party, with reputational capital at stake, has asserted such and will be adversely and materially affected if that assertion proves false. Specifically, for third-party certification to be believable for outside in- vestors, three tests must be met. First, the certifying agent must have reputational capital at stake which would be forfeited by certifying as fairly priced an issue which was actually over-valued. Second, the value of the agent's reputational capital must be greater than the largest possible one-time wealth transfer or side payment which could be obtained by certifying falsely. Third, it must be costly for the issuing firm to purchase the services of (lease the reputational capital of) the certifying agent, and this cost must be an increasing function of the scope and potential importance of the information asymmetry regarding intrinsic firm value. There are strong a priori reasons to believe that all three of these tests are met by venture capitalists and that the certification they can provide will have value in an IPO. First, as the Venture Capital Journal (VCJ) (1988) makes clear, many of the more established venture capitalists bring compa- nies in their portfolio to market on an ongoing basis as well as participating, over time, in a stream of direct equity investments in entrepreneurial firms. In our sample, 53 venture capitalists bring more than five firms public from 1983 to 1987. Venture capitalists, therefore, have a very strong incentive to establish a trustworthy reputation in order to retain access to the IPO market on favorable terms. Furthermore, the greater a venture capital fund's perceived access to the IPO market the more attractive it will be to en- trepreneurs, thus assuring a continuing deal flow. Finally, a reputation for competence and honesty will allow venture capitalists to establish enduring relationships with pension fund managers and other institutional investors who are vitally important as investors in venture capital funds and as purchasers of shares in IPOs. Support for the second criterion, that the value of venture capitalists' reputational capital must exceed the maximum possible benefit from certify- ing falsely, is provided by Sahlman (1990). He documents that (1) successful venture capitalists are able to achieve very high returns on relatively modest capital outlays; (2) these returns are directly related to the age and historical performance of the VC fund, as well as to the size of its investment portfolio; 882 The Journal of Finance (3) successful VC fund managers are able to establish profitable "follow-on" funds and are also able to achieve an enhanced deal flow from entrepreneurs; and (4) the VC fund manager market is a relatively small, tight-knit, and efficient labor market where individual performance is constantly monitored and valued. Therefore, the investment in reputational capital by venture capitalists allows them to remain competitive in the venture capital industry as well as the capital markets. In addition to venture capitalists' investment in reputational capital, they also are large shareholders in the issuing firm. One way in which they might profit from false certification and take advantage of the high price is to sell shares in the IPO. Retention by venture capitalists of their holdings after the offer, therefore, can act as a bonding mechanism for credible certification. The final criterion for third-parity certification to be successful or economi- cally valuable is that the services of the certifying agent must be costly for the issuing firm to obtain and the cost structure must be such that a separating equilibrium is achieved between high and low information quality firms. Venture capitalists certainly appear to meet this test since the bundle of services they provide-including financial capital, managerial and techni- cal expertise, enhanced access to other financial specialists as well as certifi- cation when the firm ultimately goes public-is both very costly and very difficult to obtain. For example, Morris (1987), Gartner (1988), and Sahlman (1990) all demonstrate that venture capitalists expect to earn a compound annual return of from 25 to over 50 percent (depending upon the stage of the investment) on their investments in private companies. Therefore, en- trepreneurs typically hand over large holdings of equity in exchange for relatively small cash infusions. Nor is this the only cost of VC investment for entrepreneurs. In addition to very high required rates of return, venture capitalists invariably structure their investments in such a way that most of the business and financial risk is shifted to the entrepreneur. As described in Golder (1987), Testa (1987), and Sahlman (1988, 1990), venture capitalists employ rather draconian features in their capital investments, including (1) the use of staged invest- ment under which the venture capitalist retains the right to cancel (cease funding) an entrepreneur's venture; (2) the use of convertible preferred stock as an investment vehicle, which gives the venture capitalist both a claim senior to that of the entrepreneur and an enforceable nexus of security covenants;1 and (3) the retention by the venture capitalist of the option to replace the entrepreneur as manager unless key investment objectives are met. The cost and stringency of VC investment, as well as the sheer difficulty in obtaining it (venture capitalists typically fund less than one percent of all the proposals they receive), implies that only those firms which would benefit most from the services venture capitalists provide will be willing and able to accept such participation. While the role of venture capitalists in the firm is 1Megginson and Mull (1991) find that 41.9% of the VC backed firms have convertible preferred stock in their capital structure compared to 12.6% of non-VC backed firms. Venture Capitalist Certification in Initial Public Offerings 883 obviously not limited to their activity at the IPO, one of the services that entrepreneurial firms purchase with VC funding is easier access to capital markets and the ability of venture capitalists to reduce asymmetrical infor- mation in the offering process. Logic suggests that growth options which are characterized by both greater information asymmetry and uncertainty are more likely to be associated with new entrepreneurial firms than with older, more established companies. Therefore, the certification function of venture capitalists should be most attractive to relatively young, rapidly growing, research and development-intensive companies. This being the case, we expect such firms to make greater use of VC than do other firms.2 The model of VC certification in IPOs developed above yields three testable hypotheses. First, since the ongoing nature of venture capitalists involved with firms going public builds relationships with all participants in the offering process, VC backed IPOs should have higher quality underwriters and auditors as well as a larger institutional following than comparable non-VC backed firms. Second, the ability of venture capitalists to reduce the information asymmetry associated with a firm involved in the offering pro- cess should result in a reduction of both the underpricing associated with the issue as well as the costs of underwriter, legal, auditor, and other miscella- neous expenses. If venture capitalists are able to convey credible information about the firm, the compensation to investors, underwriters, and auditors will be reduced since their cost of acquiring information about the company (personally certifying the issue) will be lowered. Finally, an additional bonding mechanism that ensures that venture capitalists' certification is credible is the level of their capital investment in the firm both before and after the offer. Venture capitalists who retain significant holdings in the firm give up the opportunity to profit from false certification. Therefore, we hypothesize that venture capitalists will not be selling a large portion of their shares in the IPO. II. Sample Selection Criteria In order to test the certification role of venture capitalists in the IPO market, we match a sample of 320 VC backed firms with 320 non-VC backed firms in the same industry as closely as possible by offering size. The universe of 2,644 firm commitment IPOs issued from January 1983 through September 1987 from which the matched sample is constructed is obtained from Investment Dealer's Digest Corporate Database (IDD). After eliminating financial institutions, S&Ls, reverse LBOs, and firms whose first day trading price is unavailable from Standard and Poor's Daily Stock Price Record: Over-the-Counter, the remaining sample consists of 1,833 offers.3 2Mull (1990) documents that venture capitalists do in fact concentrate their investments in rapidly growing industries and VC backed firms are able to grow faster, use less debt, and invest significantly more in R&D than do non-VC backed firms. 3This sample excludes, by definition, closed-end funds since they trade either on the NYSE or the AMEX. 884 The Journal of Finance Initially, 390 VC backed offers issued from January 1983 through Septem- ber 1987 were identified in the Venture Capital Journal which reports IPOs of VC backed firms with offering amounts of $3 million or more and offer prices of at least $5. In order to be included in our sample, the VC backed firm must be contained in the screened IDD sample and must also have an offering prospectus available from Bechtel Information Service. Furthermore, any VC backed firm that is either misclassified as having venture capital participation from the prospectus or has other confounding events at the time of the IPO, such as an acquisition, is also eliminated.4 Given that venture capital activity and the level of returns on the first trading day (see Ritter (1984)) tends to be clustered by industry, we match the sample of VC backed firms as closely as possible by offering amount to non-VC backed firms in the same three-digit SIC classification.5 The final sample consists of 320 VC backed and 320 non-VC backed firms.6 Table I documents the concentration of VC backed IPOs in certain industries. The majority of the sample falls within 11 separate industries with a large concentration in the high technology area. In addition, as shown in Table II, there are no apparent differences in the number of offerings in each year between VC backed and non-VC backed firms. Table III reports the differences in offering and firm characteristics for VC versus non-VC backed IPOs using a standard t-test as well as a van der Waerden nonparametric test. Even though firms within the same industry are matched as closely as possible on the offering amount, VC backed IPOs, on average, have higher offering amounts ($19.7 million versus $13.2 mil- lion) and offer prices ($11.18 versus $10.16) than non-VC backed IPOs. In fact, the majority of IPOs with the largest offering amounts in specific industries tend to be VC backed firms. A comparison of the preceding year's revenue of the VC sample and the control sample indicates that the sample is well matched in terms of operat- ing revenues. VC backed IPOs have $37.1 million in revenue reported for the previous year while non-VC backed offers have a slightly higher revenue of 4We define an inside shareholder (listed in the prospectus) as a venture capitalist if (1) the prospectus notes define him as such or (2) the shareholder is clearly a company and has the word "venture," "capital" or "investment company" in its title. 5In our matching criteria, we attempted to follow the same offering characteristics as the Venture Capital Journal (price 2 $5 and amount offered 2 $3 million). Due to the large concentration of VC backed firms in the Office, Computing & Accounting Machines industry as well as the Electronic Components & Accessories industry, we included 18 non-VC backed IPOs that had either prices less than $5 or offering amounts less than $3 million. If we exclude these smaller firms from the control sample our results do not change. 6As a sensitivity test to the choice of control sample selection, we compared the results using the matched sample to the results utilizing all of the 496 non-VC backed firms that are in the same industries as the VC backed sample and met the Venture Capital Journal criteria. Our results using the sample of all non-VC backed firms in the same industries do not materially differ. This screen, however, tends to overrepresent some industries which have a low percentage of VC backed firms but a large number of IPOs and underrepresents the industries mentioned in the previous footnote. Venture Capitalist Certification in Initial Public Offerings 885 Table I SIC Classification For Venture Capital and Non-Venture Capital Backed IPOs SIC classification and percentage of the total sample in each industry for the matched sample of 320 VC backed and 320 non-VC backed IPOs issued from January 1983 through September 1987 as identified from Investment Dealer's Digest Corporate Database and the Venture Capital Journal. SIC Number Percentage Code Classification of IPOs of IPOs 283 Drugs 30 4.7% 357 Office, Computing & Accounting 154 24.1% Machines 366 Communication Equipment 30 4.7% 367 Electronic Components & Accessories 48 7.5% 382 Measuring & Controlling Instruments 12 1.9% 384 Surgical, Medical & Dental Instruments 26 4.0% & Supplies 581 Eating and Drinking Places 14 2.2% 599 Retail Stores Not Elsewhere Classified 10 1.6% 737 Computer and Data Processing Services 70 10.9% 739 Miscellaneous Business Services 52 8.1% (Biotech and Pharmaceutical Engineering) 808 Outpatient Care Facilities 10 1.6% Other 184 28.7% TOTAL 640 100.0% Table II Number of VC Backed and Non-VC Backed IPOs By Year Venture Non-Venture Capital Capital Year Backed Backed 1983 104 137 (32.5%) (42.8%) 1984 47 42 (14.7%) (13.1%) 1985 36 44 (11.2%) (13.8%) 1986 78 58 (24.4%) (18.1%) 1987 55 39 (17.2%) (12.2%) TOTAL 320 320 886 The Journal of Finance Table III Tests of Differences in Sample Descriptive Statistics for VC Backed and Non-VC Backed IPOsa Tests of differences in offering characteristics using a difference in means test and a van der Waerden normal scores test for the sample of 320 VC backed and 320 non-VC backed IPOs matched as closely as possible by industry and offering size. Source: Investment Dealer's Digest Corporate Database and the offering prospectus. Venture Non-Venture Difference van der Capital Capital in Means Waerden Variable Backed Backed t-stat Z score Amount offered $19.7m $13.2m 5.20* 6.38* [15.0m] [9.2m] Offering price $11.18 $10.16 2.83* 3.41* [10.50] [10.00] Preceding year's revenue $37.lm $39.4m - 0.33 1.49 [16.2m] [13.0m] Book value of assets $23.9m $27.2m - 0.76 3.90* [12.9m] [7.6m] Growth in EPS per year 76.8% 65.5% 1.28 0.98 [61.1%] 42.1%] Total debt as a percentage 31.3% 31.9% -0.11 - 2.61* of the book value of assets [16.0%] [21.5%] Book value of common equity 41.7% 28.1% 3.02* 3.70* as a percentage of the book [44.8%] [34.2%] value of assets Years from incorporation 8.6 yrs 12.2 yrs - 3.70* - 2.30** date to offer date [5.3] [8.1] aMedians in brackets. *Significant at the 0.01 level. **Significant at the 0.05 level. $39.4 million. This difference is insignificant using either a t-test or the van der Waerden test. The average book value of assets is insignificantly differ- ent between VC backed firms ($23.9 million) and non-VC backed IPOs ($27.2 million). The median, however, is larger for VC backed issues. The mean and median yearly growth in earnings per share does not significantly differ between the two samples, with VC backed firms having a somewhat higher average growth rate in earnings per share (EPS) of 76.8% than non-VC backed offers with an average of 65.5%. In addition, the average proportion of the book value of debt as a percentage of the book value of equity is not significantly different (31.3% for VC backed firms versus 31.9% for non-VC backed firms). The median level of debt, however, is significantly higher for non-VC firms. Furthermore, VC backed firms have a significantly higher ratio of the book value of common equity to the book value of assets than non-VC firms (41.7% versus 28.1%) under both tests. Muscarella and Vetsuypens (1989) document a statistically significant negative relationship between the age of the firm and the corresponding Venture Capitalist Certification in Initial Public Offerings 887 initial return. They attribute their findings to the higher amount of publicly available information associated with older firms. In our sample, VC backed firms are younger in age than their non-VC backed counterparts. The aver- age number of years from the incorporation date to the offer date is 8.6 years for VC backed IPOs and 12.2 years for non-VC IPOs, and these differences are significant under both tests. The difference in ages between the two samples supports the role of venture capitalists in reducing information asymmetry. Venture capital participation and the associated certification allow the firm to go to the public market sooner than non-VC backed 7 companies. III. Underwriters, Auditors, and Institutional Holdings As the firm approaches the public offering for the first time, it has the task of hiring underwriters and auditors to manage the issue as well as to certify the information in the prospectus. After the preliminary prospectus is filed with the SEC, the management of the firm travels with the underwriter on a "road show" to provide information as well as to generate interest with institutional investors for the IPO. In general, searching for underwriters and auditors is both costly and time-consuming for firms wishing to go public. For the VC backed firms, however, it is likely that the venture capitalist has been involved with other IPOs in the past and will have built relationships with underwriters, auditors, and institutional shareholders. Furthermore, each of these participants can infer information concerning the IPO from their prior experience with the venture capitalist. Because venture capitalists have reputational capital at stake in both their ability to maintain access to the public capital markets and to attract entrepreneurial firms for investment in the future, they have an incentive to reveal information truthfully about the new issue. This being the case, VC backed firms should attract higher quality underwriters and auditors since it both lowers these participants' cost of due diligence and protects their own reputational capital. The venture capitalists' association with high quality underwriters, in turn, will increase their ability to place the issue with institutional managers. A. Frequency of Underwriter Use By Venture Capitalists An assumption of the certification role of venture capitalists is that they build valuable relationships with underwriters that would be forfeited if they certified falsely. Table IV shows that many of the venture capitalists in the sample are frequent participants in the IPO market. As mentioned previ- ously, 53 of the venture capitalists in our sample bring five or more issues to 7Admittedly, the differences in the financial and operating characteristics at the time of the IPO between the two samples cannot be solely attributed to the presence of venture capitalists. From the information publicly available about the control firms, we are unable to determine if the non-VC backed companies attempted to obtain venture capital financing and were turned down or simply did not need that type of capital. 888 The Journal of Finance Table IV Frequency of Board Participation, Percentage of Issues That the Venture Capitalist is the Lead and Underwriter Selection for Venture Capitalists Who Brought 8 or More Issues to Market Number of issues brought to market from 1983 to 1987 for the venture capitalist, percentage of those issues for which the venture capitalist was the lead and the most frequent underwriters used by the venture capitalist. Percentage of Percentage of Number of Issues issues the VC is on issues the VC is Most Frequent Venture Capitalist Brought to Market the Board of Directors the leada Underwritersb Kleiner, Perkins, Caufield & Byers 22 50% 27% Robertson, Colman (9) Morgan Stanley (7) Hambrecht & Quist Venture Partners 21 67% 38% Hambrecht & Quist (14) Citicorp Venture Capital 15 40% 40% Alex. Brown (4) Mayfield Funds 15 80% 33% Robertson, Colman (9) TR Berkeley Funds 14 0% 7% Robertson, Colman (6) Alex. Brown (5) Venrock Associates 14 86% 21% Robertson, Colman (5) Morgan Stanley (6) Greylock Partners 13 77% 23% Hambrecht & Quist (8) Morgan Stanley (5) Merrill, Pickard, Anderson & Eyre 13 39% 0% Morgan Stanley (6) Robertson, Colman (5) Oak Investment Partners 13 69% 23% Alex. Brown (7) Advent Funds 11 82% 73% L. F. Rothschild (3) TA Associates 11 55% 45% L. F. Rothschild (3) Bessemer Venture Partners 10 70% 40% Robertson, Coleman (3) L. F. Rothschild (3) Venture Capitalist Certification in Initial Public Offerings 889 Table IV-Continued Percentage of Percentage of Number of Issues issues the VC is on issues the VC is Most Frequent Venture Capitalist Brought to Market the Board of Directors the leada Underwritersb JH Whitney & Co. 10 80% 30% Alex. Brown (5) Morgan Stanley (5) New Enterprise Associates 10 90% 20% Alex. Brown (5) Robertson, Colman (5) Continental Illinois Venture Corp 9 22% 22% Alex. Brown (3) Charles River Partnership 9 44% 44% Hambrecht … Journal of Financial Economics 34 (1993) 231-250. North-Holland he underpricing of initial public offerin and the partial adjustment phe enon* Kathleen Weiss Hanley Univeuity oj' Michigan, Ann Arbor. MI 48109, USA Received May 1991, final version received January 1993 This paper documents that the relation of the final o&r price to the range of anticipated offer prices disclosed in the preliminary prospectus is a g,ood predictor of initial returns. Issues that have final offer prices which exceed the limits of the offer range have greater underpricing than all other initial public oRerings, and are also more likely to increase the number of shares issued. These results are consistent with the pricing and allocation schedule proposed by Benveniste and Spindt (1989), in which shares in an offering are rationed and prices only partially adjust to new information. KeJy words: IPOs; Partial adjustment; Underpricing 1. Introduction Tht empirical anomalv of positive average initial returns on invesmenth in w initial public offerings (IPOs) has been well documented.’ While many studies have researched the underpricing phenomenon, few have examined the process whereby the offer price is set. This study investigates how information-gathering activities by underwriters during the pre-issac period affect the final ofZer price, the size of the issue, and the subsequent level of initial returns. Microsoft’s initial public offering in March 1986 is an example of how information gathered prior to the IPO date affects the setting of the final ofkr Correspondence to: Kathleen Weiss Hanley, Schoo! of Business Administration, University of Michigan, Ann Arbor, MI 48109-i 234, USA. *This paper is based on my Ph.D. dissertation at the University of l%riCa. i lm grateful to Roger Huang (chairman), Roy Crum, and Roe+.,. m-7 Blair of my dissertation committee for ::.. ir guidance and encouragement. Helpful comments from Susan Chaplinsky, Larry Benvenistc, Hbvry DeAngelo, Craig Dunbar, Jayant Kale, Naveen Khanna, Laura Kodres, Jonathan Paul, Jay Rit;,r: Cliff Smith (the editor), Bill Wilhelm, Gary Zeune, participants at the University of Michigan woI kshops, and an anonymous referee are appreciated. This paper was presented under the title ‘The Rel, tionship of OfEPer Price to the Preliminary File R 3n~e 2nd the IJse of the Owrallntm-+ nn+;- A Offerings’ at the 1990 Western Financi Association meetings. ____.., . . .._... vp,IvII 1~~ Iiii id Pubiic ‘See Smith ( 1986) and Hanley and Ritter (1992) for a review of the IPO literature. 0304-405X/93/$06.00 Q 1993- Elsevier Science Publishers B.V. All rights reserved 232 K. W. Hanley, IPO underpricing and partial price adjusfmenf price and, hence, the amount of underpricing. Initially, the firm and its under- writers filed a preliminary prospectus with the Securities and Exchange Com- mission (SEC) that indicated a range of minimum and maximum anticipated of&r prices of $16 to $19. During the ‘road show’ for the Microsoft issue, Goldman Sachs’ marketing group considered the offering ‘very hot’ and that ‘big institutional customers indicated they would take as much stock as they could get’ [Uttal(1986, p. 2811. Furthermore, ‘the $16 to $19 price range would have to be raiced . . . and so would the number of shares to be sold.’ Conse- quently, the final offer price was raised to $21. The number of shares was also raised in the offering, as two shareholders were persuaded to sell an additional 295,000 shares (or 14.8% of the original issue amount). When Microsoft went public, the closing price on the first trading day was $27.75, with a correspond- ing initial return of 32%. Consistent with the case of Microsoft, the results in this paper indicate that information gathered during the pre-issue period afltects the pricing and alluca- tion of initial public offerings. Issues that have positive revisions in the offer price, and are thus hypothesized to have favorable information revealed during the pre-issue period, show not only increases in the number of shares issued but also greater underpricing than other IPOs. Further, the relation of the final offer price to the range of anticipated offer prices disclosed in the preliminary prospect;., IS a good predictor of the amount of underpricing on the first trading day. For a sample of IPOs issued from 1983 to 1987, the mean initial return for firms going public at a price above the anticipated range is 20.7%. Offerings that decrease the offer price to below the lowest anticipated price quoted in ;he preliminary prospectus have an average initial return of 0.6%, which is not significantly different from zero. The remaining issues, representing offerings within the anticipated range, have an average initial return of 10.0%. The differences in initial returns among each of the three categories are significant ZG the 1% level. In addition, investors who purchase issues whose final offer price exceeds the anticipated range almost uniformly receive positive initial returns. The high level of initial returns associated with issues with positive revisions in their final offer prices has been termed the ‘partial adjustment’ phenomenon by Ibbotson, Sindelar, and Ritter (1988). Instead of raising the final offer price to the market value of equity on the initial trading day, the underwriter (and the issuin,g firm) only partially adjust the price upwards. Why, then, does the surplus go to investors rather t&an to the issuing $rm? - Benveniste and Spindt (1989) explain why prices only partially adjust to demand. They note that changes in the offer price between the filing of the preliminary piospectus and the offer date are a product of information gathered by underwriters from investors during the pre-issue period. When good informa- tion is revealed through high demand for the issue, the final offer price will exceed the expected offer price. Alternatively, bad information is revealed by low demand and results in a decrease in the offer price to below the expected v&P. K. W. Hanley, IPO underpricing and pcmki price adjustment 233 In their model, investors are motivated to truthfullv reveal the level of demand through a pricing and allocation schedule that maximizes the investors’ total expected profit. Investors who truthfully reveal good information must expect greater profits than if they reveal bad information. Profits, in this case, are generated by a tradeoff between increased allocation and underpricing. [Sternberg (1989) independently documents this process and models the adjust- ment of offer prices to new information during the waiting period by a sym- metric Nash bargaining solution between the underwriter and the issuer.] The finding:* of this study are consistent with a pricing and allocation schedule in which dematld exceeds the available allocation. The results indicate that underwriters preCer to compensate investors for truthfully revealing information by allocating a smaller number of highly-underpriced shares rather than a larger amount of slightly. underpriced shares. Interestingly, alth augh short-run returns are related to the relationship of the fital offer price to thi* anticipated range of offer prices disclosed in the prelimi- nary prospectus, the .‘ong-run performance of IPOs cannot be explained by either revisions in the ,jffer price or the level of initial returns. “’ Ine rdmainder of the paper is organized as follows. In section 2, the institu- tional aspects of the offering process and the model developed by Benveniste and Spindt are described. Section 3 presents the data, descriptive statistics, and the determinants of the final offer price, initial return, and number of shares offered. The long-run performance of the sample is examined in section 4. The paper concludes with a brief summary in section 5. 2, The offering pcess After a company has decided to go public and has engaged an underwriter, it files a preliminary prospectus with the SEC that contains, among other things, the terms of the offering. In a firm commitment offering the anticipated offer price is stated in the form of an offer range, in which a minimum and maximum price are given; the expected offer price is the midpoint of this range. The setting .a of the offer range is prescribed by the SEC’s Regulation S-K only in that it must be a ‘bona fide estimate’ of the final offer price.2 The time from the filing of the preliminary prospectus to the final offer date is called the ‘waiting period’, during *which the underwriter squires information about the demand for the issue from regular investors through nonbinding indications of interest. Regular investors are those that are actively involved on an ongoing basis in purchasing shares of firms going public. If demand for the issue is greater than expected, the final offer price will be set higher than the 2Regulation S-K, Item 501(c)(6), T’IC.F.IL 22%501, Fzd. Sec. L. Rep. (GCH) 671,05? (Octokt 21, 1987). 234 K. W. Hanky, IPO underpricing and partial price adjustment cxpccted offer price disclosed in the preliminary prospectus. Alternatively, if demand is low, the final offer price will be below the expected ~fki* price In * practice, than,+,, mpc in the offer price are accompanied by revisions in the num’ber of shares being issuedr Benveniste and Spindt (1989) develop a model of the pricing and allocation rules that are used by underwriters of initial public offerings to induce regular invlsstors to truthfully reveal information. In order for investors with good informatlon to be motivated to reveal that information in the pre-issue period, these investors must expect to profit more by being truthful than by revealing false information. This expected profit consists of a tradeoff between the alloca- tion of shares and the level of initial returns. For example, when demand is high, the underwriter adjusts the offer pric e upward which, in turn, reduces the expected level of urfderpricing. Truth-telling is induced, therefore, by giving the investor who acknowledges his or her gosd information a larger portion of a smaller return. As long as the allocations increase at a rate greater than the rate at which returns decrease, the truth-tellers will be better off than the liars.” An investor is deterred from revealing false information because doing so would jeopardize his or her expected allocation. In the model, underwriters give preference in allocating shares to investors who reveal good information. There- fore, when shares in the issue are rationed, an investor who falsely indicates bad informatio,l risks an economically injurious reduction in his or-her alloc;Jtion. If shares of the issue are rationed, then underpricing musl also be dd to compensate investors for truthfully revealing good information. Benveniste and Sgindt state (in their theorem 1) that, holding the level of pre-sales constant, underpricing will occur in states in which demand by investors indicating good inforrr,ation exceeds f$, IAul- vv. 0 ~~~~h~~ of shares to be pre-sold. In this case, ‘underpric- ing is directly r&M IO the level of interest in the pre-market’. An empirical prediction put forth bl~ Bcmveniste and Spindt is that ‘issues priced in the upper part of the offer range are likely to be more underpriced’ (p. 353) than other IPOS. What this tLe,orem suggests is that if the potential underpricing at the expected ofYea price 1s very large, a firm can increase its final offer price, thus reducing iis own underpricing, yet still have higher underpricing than other firms with r.nore accurate offer ranges. 3. Data and empirical results 3.1. Data and descriptive statistics Data on the 1,430 firm commitment IPBs from January 1983 through September 1987 used in this study are compiled from Investment Dealers’ Digest jI thank the referee for pointing this cut. K. W. Hanley. IPO wderpririnq and partial price u&h,;ert 235 Corporate Dtztabase (IDD). IDD reports company, offering, and underwriting characteristics including the high and low anticipated offer prices quoted in the preliminary prospectu s. Issues ihat !!rrve missing values for either the high or LOGY offer prices are excluded. The sample does not iAide unit offerings and bank stocks. In additior, the stock price AX an IPO on the first trading day mclst be available from Star;dard and Poor’s Daily Stock Price Record: Over-the- Counter for use ini calculztin? initial returns, defined as the unadjusted percent change in stock value from the fin4 other pri<e TV the first trading day price: Rl = Pl - PO), PO 9 where PO is the final offer price and PI is the first recorded closing or bid price. In order to examine thl: descriptive statistics associated with revisions in the offer price, the sample is broken into three groups, reflecting the hypothesized type of information revealed in the pre-issue maket: 1) offerings with final offer prices that exceed the highest price quoted in the preliminary prospectus, i.e., those which have good information revealed, 2) offerings within the oEer range of the preliminary prospectus, i.e., those which have little or no information disclosed, and 3) offerings with offer prices below the lowest pricn quoted in the preliminary prospectus, i.e., those which have bad informatiofl revealed. On average, 10% of all IPOs increase the final offer price above the limit of the offer range, 63% go public within the offer range, and 27% decrease the final oKer price below the offer range; these percentages are fairly constant over the sample time period. Table 1 presents descriptive statist;cs tin the ofiering and firm characteristics for all IPOs according to thie relation of the final offer price to the preliminary offer range. There appears to be little variation among categories in either the average dollar width or the alerage percent width of the offer range. The dollar width of the offer range is calculated as the difference between the highest and lowest anticipated offer prices quoted in the preliminary prospectus. The percent width is the dollar width divided by the lowest anticipated offer price. If the preliminary prospectus contains only a single price, the percent width of the offer range is zero. While the means differ slightly among categories, the median dollar and percent width for each category of IPOs are identical at $2.00 and 16.794, respectively, indicating that the ‘offer range is set to a preexisting ‘industry’ standard. Table 1 also documents average values of the preceding year’s revenue for the issuing firm, the expected offer price, the actual offer price, and the total proceeds of thz &ering (excluding the exercise of the overallotment option). Issues that revise the offer price outside (either above or below) the offer range have significantly larger revenues in the year preceding the IPO and higher expec:d &ix prices than issues that are ultimatJy priced within the offer range. As noted earlier, changes in [email protected] prices are often accompanied by changes in the 236 K. W. Hanley, IPO underpricing and partial price adjustment Table 1 .L _ Mean descriptive statistics on offer ranges, revenues, offer prices, and to?al proceeds by relation of the final offer price to the offer range quoted in the preliminary prospectus.8 The data for the sample of 1,430 IPOs issued from January 1983 to September 1987 are from Investment Dealers’ Digest Corporate Database. Medians are in brackets. _ - Final offer Final offer Final offer price less price price greater All than the within the than the IPOS offer range offer range offer range Number of issues 1,430 386 895 149 PeTcent of sample 27.0% 62.6% 10.496 Ddiar width of offer rangeb $ 1.54 $ 1.71 % 1.41 $ 1.89 P-W P*W [2.00] C2*00] Percent width of offer rangeb 15.1% 1 S.S% 14.7% 15.9% [16.7?G-J [ 16.7%) [16.7%-J [ 16.7%) Preceding year’s revenue $59.4 m $71.9 m $49.1 m $85.4 m [18.8m] C26.2 m] [lS.S m] C22.1 m] Expected offer price in the $10.45 $11.96 $ 9.35 $13.10 preliminary prospectusc [WY Actual offer price $ 9.95a ~K?.OO] C9.W c13.503 $ 9.24 $ 9.30 $15.70 C9.75) C9JW i8.751 [ 16.00] Total proceedsd $16.04 m 514.34m %14.15m $31.83 m C9.75 m] [13.4Om] C7.50 m] [22.1Om] -- “The offer range is defined as the lowest, PL, and highest, PH, anticipated values of the offer price as quoted in the preliminary prospectus. Final offer prices that are less than the offer range have values that are lower than PL. In contrast, final offer prices that are greater than the offer range have values that are higher than PH. Final offer prices within the offer range lie between PL and PH. bThe dollar width of the offer range is defined as PH - PL. The percent width f the offer range is (PH - hNpL. ‘The expected o&r price is defined as (PH + P,)/2. dTotal proceeds exclude the exercise of the overal!otment option. number of shares offered. Thus, issues whose final offer price exceeds the offer range have significantly greater actual offer prices and total proceeds. Table 2 presents changes in the offer price, number of shares offered, and total proceeds from the time of the filing of the preliminary prospectus to the offer date. In order to examine the relative change in offer price for all categories of IPOs, the percent difference between the expected offer price and the actual offer price is calculated as: Change in offer price = (PO - PE)/PE , where BE is the expected offer price and is defined as (PH + P&‘2, PH is the highest price in the offer range, PL is the lowest price in the offer range, and PO is the final offer price. K. IV. Han/e]*, iP0 underpricing and partial price adjustntent 237 Table 2 Mean percent change in the offer price and the number of shares offered, and changes in the total proceeds from the filing of the preliminary prospectus to the offer date, by relation of the final offer price to the offer ‘range quoted in the preliminary prospectus? b The data for the sample of 1,430 IPOs issued from January 1983 to September 1987 are from Investment Dealers’ Digest Corporate Database. Medians are in brackets. --- -..--- Final offer Final offer Final offer price less price price greater All ttian the within the than the IPOS offer range offer range offer range - - -- Mean percent difference from the expeckd offer price to the final offer price’ -4.3% [O.O%] Mean percent difference in high or low anticipated price and the .final offer priced Mean percent change in the -0.8% number of shares offered’ [O.O%] Percent of IPOs ;hpt have a positive chang;c in sir l?es 19.7% Average doliar value difkrence :k-twe’? act:ac’ and exp cti< proceeds quoted AJ the preliminary prospectus’ -599m CO.0 m] Average ratio of actual proceeds to the expected proceeds quoted in the preliminary prospectus 0.96 [LIFO] Average ratio of actual proceeds to the minimum proceeds quoted in the preliminary prospectus 1.03 Cl-W Average ratio of actual proceeds to the maximum proceeds quoted in the preliminary prospectus 0.90 CO.921 - 22.4% [ - 21.2%] - 16.5% [ - 1 LO%] - 10.0% [O.O%] 7.8% -$65m [ -4.4m] 0.70 CO.721 0.75 [0.78-J 0.66 CO.671 - a.696 [O.O%] 1 .L+ 3/o [O.O%] 19.0% $0.01 m CO.0 m] 1.01 C1.W 1.08 [l.OS] 0.95 [O.SS] 20.9% [19.6%-J 12.7% [ lO.O%] 10.0% [5.30/b] 54.4% $8.0 m I- 5.0 In] 1.33 Cl.283 ,::G] 1.24 C1.20) “All of the numbers presented exclude the exercise of the overailotment option. bThe offer range is defined as the lowest, PL, and highest, PH, anticipated values of the offer price as quoted in the preliminary prospectus. Final offer prices that sre 1~ than the offer range have values that are lower PL. In contrast, final offer prices that are greater than the offer ra;,ge have values that are higher than PH. Final offer prices within the offer range he between PL and PH. ‘The percent difference from the expected offer price to the tinal offer price is calculakd as (PO - PE)/PE, where PO is the final offer price and PE = (PH + P,)/2 is the expected offer price. dThe percent difference in the high or low anticipated offer price to the final offer p__ce is defined as (1) (PO- PL)/PL for issues with actual offer prices less than the expected offer price and (2) (PO - P,+)/Pi, for issues with actual offer prices greater than the expected offer price. ‘The percent change in shares offered is defined as (No - &)/I$, where No is the actual nurr.ber of shares offered and N, is the number of shares quo:cd in ihe preliminary prospectus. ‘Actual proceeds are calculated as (No*Po) and the average proceeds quoted in the preliminary prospectus are defined as (NF*PE,. itiinimum preliminary proceeds are (NF*PL) and maximum preliminary proceeds are (Nr*P,,). 238 K. W. Hanky, IPO underpricing at:d partial price adjr~stnwnt The results of table 2 indicate a substantial revision in the terms of the offering for issues whose final offer price is above or below the oiler range, while the median revision in oflter price for the sample as a whole is zero. Offerings that go public below the of&r range have final offer prices that are, on average, 22.4% less than expected, while offerings above the offer range have final offer prices that are, on average, 20.9% above the expected offer price. For issues below the offer range, the diflerence between the final offer price and the lowest price in the rEer range [([email protected] - PL)/Pk] is - 16.5%. Similarly, if the offer price is above the offer range, the percent difference from the actual offer price to the highest offer price i3 the offer range [a$o - Pu)/Pn] is 12.7%. Changes in the offer price from the filing of the preliminarv prospectus to the m offer date are often accompanied by changes in the number of shares offered. Since IDD does not separately report the number of shares filed in the prelimi- nary prospectus that are sales by insiders, the changes in proceeds are to both the issuing firm and any selling inside shareholders. In additidn, the number of shares filed and subsequently offered does not include the amount of the overallotment option. On average, the number of shares issued is increased (decreased) by 10% if the final offer price is above (below) the olZr range. Furthermore, issues above the older range are approximately three (seven) times more likely to increase the number of shares than issues that are within (below) the offer range. The median percent change in the number of shares issued is zero for all categories except issues whose offer price exceeds the offer range. Although an exact test of changes in ailscation to investors revealing good information is impossible due to the lack of data on indications of interest in IPOs, an increase in the number of shares offered for issues with good informa- tion is consistent with a model in which truth-telling is partially compensated with greater share allocation. Since changes in the offer price are often accompanied by changes in the number of shares o&red, the total proceeds of the issue also change. In table 2, the change in proceeds is examined by comparing t.he actual proceeds on the offer date to the expected proceeds listed in the preliminary prospectus, exclud- ing the exercise of the overallotment option. The expected proceeds are cal- culated as the number of shares registered multiplied by t,. : expected offer price quoted in the preliminary prospectus. in general, there is no difference between the median actual and expected proceeds for the full sample of IPOs. When the sample is broken down by revisions in the offer price, issues above the offer range increase the amount issued by $8.0 million, for a ratio of actual-t o-expected pro c::ds of 1.33. In addition, issues above the oiler range receive [email protected]% of the maximum proceeds (the preliminary number of shares multiplied by the highest price in the offer range) disclosed in the preliminary prospectus. By conzast, issues below the offer range raise $6.5 million less than expected, for a ratio c,f actual-to-expected proceeds of 0.70. In addition, these issues receive only 75% of the minimum proceeds (the preliminary number of K. W. Hanley, IPO unrierpricitlg arui partial price a~xstmerrt 239 shares multiplied by the lowest price in the of%~ rcllnng~j 4e;~ttfd in the preliminary prospectus. One consequence for a firm whose offer prize falls below the offer range is that the SEC can require the firm to file an amendment to the registration statement stating the reason for and effect of lowering the o&r price. The Commission can also require the firm to recirculate a revised preliminary prospectus to the selling gi’oup and/or investors who have made indications of interest in the waiting period. It is not surprising, therefore, that issues that lower G-Y o#et price spend more time in registration than do all other IPOs. The avegz;e length of time from the filing of the preliminary prospectus to the offer date is 64 days ior !POs below the offer range, compared to 48 days for IPOs above the offer range. Offerings within the offer range spend, on average, 56 days in registration. These results indicate that changes in the offer price are often accompanied by changes in the number of shares offered, affecting the total proceeds to the issuing firm. Further, a decline in the expected proceeds can require a fi~*rr. to comply with additional regulatory demands that potentially affect the ability of the underwriter to time the issue advantageously. 3.2. Detevmhairts of revisions in offer prices Benveniste and Spindt argue that revisions in the offer price are the result of information collected by underwriters during the waiting period. In order to examine the influence of pre-selling activities and other aspects of the IPO process on changes in the offer price, a cross-sectional ordinary least squares (OLS) regression analysis of the absolute revision in offer price, measured as IP - PE 1 /I$, is undertaken using several independent variables: the width of theooffer rang& the expected proceeds of the offering (prior to the issue), the absolute change in the market during the waiting period, the $ze of the overallotment option, the market share of the underwriter, and the percent of the issue held by institutions one quarter after the offeriarg. Benveniste and Spindt hypothesize that firms that have greater uncertainty surrounding the true value of the shares are more likely to have revisions in their of5er price, The ex ante risk of an issue is measured as both the percent width of the offer range and the expected size of the offering. Underwriters who are unsure of the price of an issue are likely to set wider offer ranges to provide greater flexibility in setting the final offer price. The wider the offer range, therefore, the greater the uncertainty about the true value of the issue. In addition, the size of the offering is hypothesized to be inversely related to changes in the offer price. Ritter (1987) documents that the aftermarket standard deviation of returns is neg atfvely correlated with issue size. The absolute percent change from the file date to the offer date in the equally-weighted bL4SE&~ kdex of the Center for Research in Security Prices is expected to be * %ositivelj related to changes in the offer price. If information 240 K. I-t’. Haniey, IPO underpricing and partial price adjustment gathered during the waiting period indicates that the market will decline (increase) around the time of the offering, investment bankers will revise their expectation of the value of the firm’s stock downward (upward) to reflect both the prevailing market conditions and to stimulate (meet) emand in a falling (rising) market. An empirical extension of the model, noted by Benveniste and Spindt, is that the overallotment option reduces the incentive for the underwriter to pre-sell the issue and thereby gather information from regular investors dur:ng the waiting period. Therefore, the greater is the available overallotment option: the lower will be the change in the of%er price. The number of shares available for use in the overallotment option is contained in the ; D database and is expressed here as 3 percent of the number of shares of!‘ered. The experience of the underwriter is included as an independent variable to capture two potential explanations for changes in offer prices. The first explana- tion is ithat smaller, inexperienced underwriters may be less likely to have the expertise necessary to evaluate the firm a!.d are therefore more likely to misprice the issue. If this is the case, the market share of the lead underwriter will be negatively related to changes in the oiler price. The second explanation is that larger, experienced underwriters are able to sell to a greater pool of informed investors who provide valuable information during the waiting period. There- fore, changes in the offer price will be positively related to the experience or reputation of the lead underwriter. The market share of the …