Who profits from IPO underpricing?

A firm going public relies on the capital raised in its initial public offering to grow and thrive, but studies have found that IPOs in the United States are underpriced an average of 15 percent. Conventional wisdom has held that the gap is inevitable given the risks in taking public a young company that often has little or no track record. But W. P. Carey management professor Robert E. Hoskisson and researchers from three other U.S. universities challenge this assumption in an exhaustive analysis of 300 IPOs from the 1990s. The researchers applied agency theory — a concept used to sort out the interests of owners and managers — and concluded that underpricing of IPOs occurs because it is in the interests of some of the key players.

An Initial Public Offering (IPO) is a critical moment for a company. A firm going public relies on the capital raised in its IPO to grow and thrive. The stakes also are high for other parties. Investors can reap huge profits or sustain big losses. For the firm's owners and managers, as well as the venture capitalists with a stake in the firm and the investment bankers who underwrite the sale, careers and fortunes can be made.

Studies have found that IPOs in the United States are underpriced an average of 15 percent. Thus, at the end of the first day of trading, the stock price of a company is typically 15 percent higher than the initial price set by the underwriter. Conventional wisdom has held that the gap is inevitable given the risks in taking public a young company that often has little or no track record.

But W. P. Carey management professor Robert E. Hoskisson and researchers from three other U.S. universities challenge this assumption in an exhaustive analysis of 300 IPOs from the 1990s. The researchers applied agency theory — a concept used to sort out the interests of owners and managers — and concluded that underpricing of IPOs occurs because it is in the interests of some of the key players.

"In the IPO setting, the investment bank agents and the venture capital agents become short-term oriented," says Hoskisson. "When you have powerful investment banks and more ties between the investment banks and the institutional investors and the venture capitalists, underpricing goes up, and the venture has less capital."

Cashing out at the firm's expense

It is in the interest of investment banks to underprice an IPO because it nurtures ties to institutional investors, who are often repeat customers of the banks and who benefit directly from the underpricing, according to the study. Venture capitalists are looking to cash out as quickly as possible, and to do so need to maintain good relations with the underwriters.

For this reason, venture capitalists, who are on the boards of many of the IPO firms, also are motivated to support underpricing, according to the authors. This dynamic can be harmful to companies, according to Hoskisson. "Fifteen percent of all these ventures is a lot of money on the table. It's all going to institutional investors who usually flip the shares in the first couple of days," he says.

In a recently published paper, Hoskisson and his co-authors, Jonathan D. Arthurs of Washington State University, Lowell W. Busenitz of the University of Oklahoma, and Richard A. Johnson of the University of Missouri, use agency theory to craft a series of hypotheses about the behavior of the players in an IPO.

The hypotheses focus on the boards of directors of companies, which are made up of insiders and outsiders, many of whom have different motivations, according to the authors. The researchers challenged the widely held notion that having outsiders on a board is good for a company that is going public. Since the Enron debacle and similar scandals, regulators and legislators have put in place measures requiring more outsiders on boards.

Outsider staffing or outsider majorities now are required on auditing committees and other key committees of publicly traded firms. But in an IPO, outsiders actually are the ones looking for short-term gains, and the insiders, or managers of a firm, are the players with the long-term vision a young and growing company needs, the researchers believe.

The institutional investors usually will cash out in a matter of days, and the venture capitalists typically have exited the company within six months on average. On the other hand, the managers will be with the company long after the IPO, and they have an interest in seeing the venture succeed in the long run, according to the authors. "In this paper, managers are the good guys in regards to agency theory. Usually they're the bad guys," says Hoskisson.

How insiders help

The researchers sifted through the details of IPOs that occurred between 1990 and 1994, a period before the late 1990s dot-com bubble, which the researchers regarded as atypical. They logged the extent of underpricing for each sale, then recorded the characteristics of the members of each company's board of directors, gleaned from the prospectus for each IPO. Using this data, the researchers looked for correlations between IPO underpricing and director traits.

The primary hypothesis, that there is an inverse relationship between underpricing and the presence of insiders on the board, was supported by the data. "Thus, it would appear that higher levels of insiders on the board would allow for greater vigilance in avoiding underpricing by the underwriter," the authors conclude. Similarly, a hypothesis that there would be a negative correlation between underpricing and the presence of directors who have more experience generally also was supported.

The authors contend that more experienced board members have access to information that allows them to counter the efforts of the underwriters and venture capitalists to set IPO prices too low. "What we found was when you have a majority of insiders on the board who have an interest in making sure the venture is a going concern into the future, and the more experience they have in previous IPOs, the lower the underpricing," Hoskisson says.

The role of experience

The experienced insider directors are able to make their case against underpricing in board deliberations and in the so-called "road show," at which the parties to an IPO present the proposed sale to potential investors, according to Hoskisson. Also supported by the data was the hypothesis that older manager-directors tend to reduce underpricing. The authors argue that the older directors have fewer employment options and would take stronger measures to make sure the venture would have the capital needed to succeed.

"Our findings suggest that insiders monitor others in order to protect their own interests; they are motivated to protect their employment status by ensuring higher levels of capital for the new venture," the researchers state in the paper. One hypothesis of the researchers that the data did not support was that managers with more tenure on the job at the firm going public would be stronger monitors on a board and would tend to prevent underpricing.

There was no significant correlation between tenure at the firm and underpricing. The authors suggest as an explanation that managers in IPO firms tend to have shorter tenures than managers at mature companies and thus do not have the firm-specific skills needed to perform the monitoring role on the board.

Bottom line

• Research has found that IPOs are underpriced an average of 15 percent. A common explanation for this gap between the initial and close-of-the-first-day prices is that firms going public are risky ventures and investment banks are prudent to set initial prices low.
• An alternative explanation for underpricing is that it is in the interests of some of the parties to the sale — mainly the institutional investors, venture capitalists, and underwriting investment banks — to have a low initial price.
• Socials scientists use agency theory to explain the actions and motivations of individuals. In economics, agency theory reveals the conflicts between interests of managers and owners of firms.
• Agency theory predicts that managers will be motivated to prevent IPO underpricing because they typically stay with the firm after the IPO and want it to have the capital needed to succeed.
• Managers who serve on boards of directors can deter underpricing by monitoring the efforts of other players and making the case for higher prices when the IPO is being presented.