Monitoring as a Motivation for IPO Underpricing

Abstract

Brennan and Franks (1997) and Stoughton and Zechner (1998) provide contrasting arguments for why monitoring considerations create incentives for managers to underprice their firms' IPOs (initial public offerings). Like Smart and Zutter (2003), we examine these arguments using a sample of U.S. IPOs. However, we find evidence that the determinants of initial returns, institutional shareholdings, and post-IPO likelihood of acquisition are not consistent with these arguments. Thus, we conclude that monitoring considerations are not important determinants of IPO underpricing.EVIDENCE THAT THE PRICES OF UNSEASONED NEW ISSUES of common stock (IPOs) in early secondary market trading are substantially higher, on average, than their offer prices has evoked an extensive literature trying to explain such underpricing. While prior literature has tended to focus on uncertainty/asymmetric information stories for such underpricing (e.g., Rock (1986) and Benveniste and Spindt (1989)), recent literature has suggested that post-IPO ownership considerations are also important. More specifically, this literature has suggested that monitoring considerations create incentives for managers to underprice their firm's stock in its first public offering. Brennan and Franks (1997), for example, argue that insiders have an incentive to underprice the IPO of their firm's stock in order to ensure its wide distribution, thereby reducing the likelihood of being monitored or removed by new shareholders, particularly institutional shareholders. Brennan and Franks call their hypothesis the reduced monitoring hypothesis. Consistent with their hypothesis, for a sample of 69 U.K. IPOs during 1986 to 1989, they find that:(1) Smaller applicants are allocated a larger share of oversubscribed/underpriced issues, and (2) the size and amount of subsequent outside large shareholdings are inversely related to the firm's degree of IPO underpricing. 1 * Onur Aruǧaslan is from Western Michigan University, Douglas O. Cook is from the University of Alabama and Robert Kieschnick is from the University of Texas at Dallas. The authors wish to thank an anonymous referee, Rick Green (the editor), Ted Day, Larry Merville, Suresh Radhakrishnan, Scott Smart, Harry Turtle (FMA discussant), and Yexiao Xu for their suggestions for improving this paper. Cook acknowledges the partial support of a summer grant from the Robert M. Hearin Support Foundation.1 They examine the fraction of outside (nonaffiliated) holdings held by the largest outside shareholder and the fraction of outside holdings held by all large shareholders, where "large" shareholders are shareholders with more than 3% of the firm's stock. 2403

Economic freedom and IPO underpricing

“…For the IPO-specific control variables, IPO size (Proceeds)is often used as a proxy for large firms that are generally believed to have less severe information asymmetry problems and thus less underpricing problems (Ritter, 1984;Arugaslan et al, 2004;Boulton et al, 2011. Consistent with these studies, the coefficients of Proceedsare negative and significant at the 1% level in both regressions.…”

“…Specifically, we include four firm-specific IPO control variables: the IPO's offering size (Proceeds), the demand for IPO (Oversold), an underwriter reputation dummy variable (Uwrt), and the prior-IPO firm performance proxied by the return of equity (ROE) 1 year before the IPO date. In previous single country IPO studies, these variables are the most popular control variables and are considered to be related with ex ante uncertainty in the information asymmetry literature (Ritter, 1984;Michaely and Shaw, 1994;Arugaslan et al, 2004;Loughran and Ritter, 2004;Ljungqvist, 2007).…”

Cross-country IPOs: What explains differences in underpricing?

“…We try to control for such bias by looking at sub samples with no perceived consequences associated with unfavorable response. 26 Arugaslan et al (2004), and Habib and Ljungqvist (1998) point out some limitations of using this variable as a proxy for information uncertainty.…”

On the decision to go public with dual class stock

“…However, Arugaslan et al (2004) demonstrate that Smart and Zutter's results are due to an omitted variables problem introduced by the fact that the characteristics of firms that choose to go public with dual class stock are also correlated with the determinants of their initial returns. 3 Furthermore, both Field and Sheehan (2004) and Arugaslan et al (2004) find evidence that is inconsistent with the link between IPO underpricing and subsequently share ownership that is the core of Brennan and Franks' (1997) argument.…”

“…3 Furthermore, both Field and Sheehan (2004) and Arugaslan et al (2004) find evidence that is inconsistent with the link between IPO underpricing and subsequently share ownership that is the core of Brennan and Franks' (1997) argument.…”