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li (2003) vc investment by ipo underwriters, miami xi li.pdf

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1、 Venture capital investments by IPO underwriters: Certification or conflict of interest? Xi Li School of Business University of Miami Coral Gables, FL 33146 Phone: 305-284-6891 Fax: 305-284-4800 x.limiami.edu and Ronald W. Masulis Owen Graduate School of Management Vanderbilt University Nashville, T

2、N 37203 Phone: 615-322-3687 Fax: 615-343-7177 ronald.masulisowen.vanderbilt.edu Current Version: August 5, 2003 We would like to thank Shane Corwin, Mara Faccio, Gordon Hanka, Jay Ritter and participants at the WFA 2003 Annual Meetings and at workshops at Notre Dame University, Tulane University, Va

3、nderbilt Law School and the University of New Orleans for helpful comments. We also want to thank Alexander Ljungqvist for supplying us with information on SDC New Issues file errors. 1 Venture capital investments by IPO underwriters: Certification or conflict of interest? Abstract We study IPO pric

4、ing when underwriters are venture capital investors in issuers and evaluate whether this creates a serious conflict of interest with IPO investors or reduces the conflict of interest with IPO issuers. Theoretically, prior underwriter venture investment has several effects. First, it can improve unde

5、rwriter access to IPO issuer information, thereby enhancing the credibility of due diligence investigations, which raises investor demand and IPO offer prices. Second, it can increase an underwriters conflict of interest with IPO investors, which decreases the credibility of its due diligence invest

6、igatio n, lowering investor demand and IPO offer prices when prices are set competitively. Third, it improves the alignment of interest of underwriters and IPO issuers, which results in higher IPO offer prices, if underwriters have some pricing power and capture rents from allocating underpriced iss

7、ues. Empirically, venture capital investments by lead underwriters significantly reduce IPO underpricing, while venture investments by other syndicate underwriters have no effect. This lead underwriter certification effect is stronger when investors have greater uncertainty about IPO valuation. The

8、certification effect weakens as lead underwriter shareholdings rise to 10% or above, which is consistent with a more serious moral hazard problem for IPO investors under these circumstances. Controlling for endogeneity effects does not change our conclusions. Lead underwriter venture investment in I

9、PO issuers also reduces underwriting fees. This evidence is consistent with a certification effect and greater alignment of interests between lead underwriters and IPO issuers, which lead to higher offer prices and lower underwriter spreads. 1 1. Introduction The last several years have witnessed a

10、wide array of financial controversies concerning conflicts of interest between financial institutions offering related services to their customers. This policy debate continues in the light of well publicized legal actions taken to resolve the conflicts of interest when investment banks offer broker

11、age and stock analyst functions under one roof.1 Since the early 1990s many investment banks and large commercial banks have made large equity investments in the venture capital market, while many of these same commercial banks started underwriting equity offerings through section 20 subsidiaries.2

12、3 One effect of this trend is many IPO underwriters are prior equity investors in issuers. We examine the effects of underwriter venture investments in issuers on IPO offer prices and underwriting fees. Integrating the venture capital and underwriting functions can have positive or negative effects

13、on IPO prices and underwriting fees, depending on the relative strength of the resulting moral hazard problems with IPO investors and the credibility of the due diligence process as well as the competitiveness of the market for underwriting services as explained below. When banks are both underwrite

14、rs and prior venture investors (of debt or equity) in issuers, underwriters are affected in several disparate ways. First, banks can cheaply acquire proprietary firm specific information from their lending and venture capital relationships and thus, lower their information costs relative to competin

15、g banks. At the same time, underwriters superior access to issuer information sends credible signals to the capital market that these issuers are financially healthy Leland and Pyle (1977), Puri (1999), which we term the certification hypothesis. Second, having pre-existing investments in issuers ca

16、n create a moral hazard problem between underwriters and outside investors. For example, Puri emphasizes that banks with outstanding loans to weak issuers have incentives to underwrite these lower quality security offerings, which they would otherwise decline to underwrite. Banks have 1 For evidence

17、 on this issues, see studies by Lin and McNichols (1998) and Michaely and Womack (1999) 2 Since the 1990s U.S. commercial banks can invest in equity securities through venture capital subsidiaries. 3 Beginning in 1990, the Federal Reserve slowly permitted limited underwriting by commercial banks on

18、a case by case basis. Then in 1999, the Gramm-Leach-Bliley Financial Modernization Act repealed the Glass-Steagall Act ending nearly a 70-year prohibition on securities underwriting by U.S. commercial banks. See Chaplinsky and Erwin (2001) for additional details on commercial bank underwriting activ

19、ity. 2 incentives to underwrite because it strengthens an issuers financial condition, thereby decreasing the likelihood banks will sustain losses from issuer loan defaults, which we term the conflict of interest hypothesis. At the same time, if an underwriter has a prior equity investment (venture

20、capital) in an issuer, then its incentives with respect to the issuer change. While the underwriter still benefits from allocating underpriced shares to favored customers, the underwriter now benefits from selling overvalued stock because it reduces the dilution of its equity position in the issuer

21、raising new equity capital.4 So the underwriter relationship to an issuer improves and its incentive to set higher IPO offer prices rises, which we term the issuer alignment hypothesis. In studying the impact of underwriter venture capital investments in the IPO issuers on the underwriting process,

22、we distinguish between lead underwriters and other syndicate members since lead underwriter have greater syndicate decision making power. To preview our results, we find IPO underpricing is significantly reduced and underwriter fees are lower when lead underwriters have prior equity investments in i

23、ssuers than when they do not. Following the introduction, the study reviews the prior research and empirical evidence on IPO underpricing and underwriting fees in section 2 and then discusses data sources and descriptive statistics in section 3. Section 4 explores the impact on underpricing of prior

24、 venture capital investments by underwriters. In section 5, we examine underwriter spreads and whether they are systematically affected by prior venture investments. The conclusions of this study follow. 2. Related Literature There are a number of theories of IPO underpricing, underwriter certificat

25、ion and moral hazard problems. Several models of IPO underpricing assume that underwriters set market clearing prices in a perfectly competitive market where rational IPO investors demand offer price discounts to compensate 4 An example of how this conflict of interest could manifest itself follows.

26、 On April 2, 1991 Merrill Lynch led an IPO underwriting of Regeneron Pharmaceuticals, a young biotech firm. At the time, Merrill was also the firms largest equity investor. After receiving indications of strong investor interest, Merrill decided the night before the 3 for expected adverse selection

27、effects caused by: (1) issuer timing of offers to avoid periods of underpricing (Myers and Majluf (1984), (2) informed traders competing for underpriced issues (Rock (1986), Beatty and Ritter (1986)5 and (3) preferential underwriter allocation of oversubscribed issues (Benveniste and Spindt (1989) a

28、nd Sherman and Titman (2002).6 Benveniste and Spindt (1989), Cornelli and Goldreich (2002), Sherman and Titman (2002) and Baron (1982) all emphasize underwriter information production in the bookbuilding process to ascertain investor demand for an IPO at alternative offer prices. Yet, underwriters a

29、lso perform a due-diligence function by producing information about an issuers fundamental economic worth, which is the focus of several other theories. Titman and Trueman (1986) develops a model of reputable underwriter certification of issuer quality. Puri (1996, 1999) develops a model of bank cer

30、tification of issuer quality when banks have prior debt or equity investment in issuers. These two theories predict that rational investors demand less underpricing when more informed underwriters are involved. However, Puri also recognizes that as an underwriters venture investment rises, conflicts

31、 of interest with IPO investors rises, which can create an offsetting effect on IPO pricing. In contrast to these rational investor models of underpricing in a competitive market setting, several theories presume that underwriters operating in a less competitive market determine IPO pricing for thei

32、r own benefit. Baron (1982) argues that underwriters have information advantages over issuers in setting IPO prices and can benefit financially from allocating underpriced IPOs to favored customers, which is detrimental to issuer interests. Tinic (1988) and Hughes and Thakor (1992) posit that underw

33、riters intentionally underprice IPOs to minimize their litigation risk from IPO investors questioning the care and accuracy of an underwriters due diligence process, if the stock price drops significantly in the after market. Recent studies by Cliff and Denis (2003), Ljungqvist and Wilhelm (2003) an

34、d Loughran and Ritter (2003) report evidence that underwriters set IPO offer prices substantially public offering to raise its offer price by 22% and number of shares issued by 50%. The market reception was poor, with the stock price falling 20% over the first two days of trading and by 30% within t

35、wo weeks. 5 Beatty and Ritter show that underpricing should be positively related to issue price uncertainty. 4 below the market clearing price in the Bubble” period of 1999-2000. This evidence suggests the IPO market is not always perfectly competitive and that IPO investors can be infra-marginal.

36、Muscarella and Vetsuypens (1989) study investment banks self underwritten IPOs, which are IPOs where underpricing incentives are lessened as a result of a reduced asymmetric information effect and better alignment of interests with issuers. They find that these IPOs are underpriced to a lesser exten

37、t than other IPOs, which is consistent with a certification hypothesis or an issuer alignment of interest hypothesis. Existing empirical evidence on bond underwriting focuses on bond offer pricing and quality when a prior lending relationship exists. U.S. evidence indicates a dominant certification

38、role for underwriters having prior banking relationships with issuers. For example, Ang and Richardson (1994), Kroszner and Rajan (1994), and Puri (1994) show that prior to the Glass-Steagall Act default rates on bank underwritten bond issues were lower than those on non-bank investment houses. Gand

39、e, Puri, Saunders, and Walter (1997) and Puri (1996) find that bank-underwritten bond issues fetch higher price (have lower yields) in both the post- and pre-Glass-Steagall period. Yasuda (2003) documents that the entry of commercial bank underwriters into the US corporate bond market is greatest fo

40、r the financially weaker issuers where the banks certification ability as a prior lender is most valuable. She also finds that they can charge lower fees when they have a prior lending relationship, which is consistent with their having lower underwriting costs due to their superior access to issuer

41、 information. However, it is only the lead lending syndicate member that has significant certification ability. Overall, this body of evidence is consistent with bank underwriters attracting or sele cting higher quality issues. Several researchers investigate the empirical evidence on whether bank u

42、nderwriters that own issuer debt have greater conflicts of interest than do other underwriters. Hamao and Hoshi (1998) find that Japanese bond issues brought to market by commercial banks have lower offer prices than other issues in the post-1994 era, suggesting greater concern about underwriter con

43、flicts of interest with investors. Ber, Yafeh, and Yosha (2001) show that Israeli IPOs underwritten by banks with prior lending 6 They develop models of underwriter information production where underwriters induce investors to reveal their potential IPO demand with allocations in underpriced IPOs. 5

44、 relationships are significantly overpriced. However, this effect appears confined to underwriter-lenders who manage investment portfolios that also invest in these IPOs. They interpret this pattern as primarily evidence of a conflict of interest between bank underwriters and investors in their mana

45、ged funds. However, there is also evidence of a lesser underwriter conflict of interest with other IPO investors; a conflict that appears to go unrecognized by the IPO investors. In contrast to the prior international evidence, Schenone (2003) finds lower IPO underpricing when a US commercial bank i

46、s both the underwriter and a prior lender or underwriter of an issuers bond offering, which is consistent with the certification hypothesis. Several studies have examined the impact of prior equity ownership on the equity underwriting process by studying venture capital (VC) backed IPOs where underw

47、riters and VC investors are affiliated. Hamao, Parker, and Ritter (2000) show that Japanese IPOs ba cked by lead underwriter with VC subsidiaries have similar long-run performance, but greater IPO underpricing compared to other VC-backed IPOs. They interpret their findings as evidence supporting a c

48、onflict of interest between these underwriters and IPO investors, with IPO prices discounted for the perceived moral hazard risk. Klein and Zoeller (2001) find lead underwriters with venture investments in German IPOs exhibit higher underpricing, which is also supportive of a dominant conflict of in

49、terest effect. Ljungqvist and Wilhelm (2003) examine the causes of U.S. IPO underpricing in the Dot-com period and include prior equity investments by venture capital funds and investment banks as separate regressors.7 They find that both types of investments are associated with reduced underpricing, though equity shareholdings by investment banks yield an insignificant parameter estimate. This latter result is weakly inconsistent with 7 They measure equity ownership by investment banks rather than by underwriters, though in one regression they include an interaction te

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