Ebook Venture capital investments by IPO underwriters: Certification or conflict of interest?
The last several years have witnessed a 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 brokerage and stock analyst functions under one roof. Since the early 1990’s 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.
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 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 underwriters and prior venture investors (of debt or equity) in issuers, underwriters are affected in several disparate ways. First, some banks can cheaply acquire proprietary firm specific information from their lending and venture capital relationships and thus, lower their information costs relative to competing 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 can 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 incentives to underwrite because it strengthens an issuer’s 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 in an issuer, then its incentives change. The underwriter continues to benefit from allocating underpriced shares to favored customers, but it now benefits from reducing underpricing because the dilution of its equity position in the issuer is reduced. So the underwriter's incentives are better aligned with the issues and its incentive to set higher IPO offer prices rises, which we term the issuer alignment hypothesis.
In studying the impact on the underwriting process of underwriter venture capital investments in the IPO issuers, we distinguish between venture investments by 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 when underwriters have prior equity investments in issuers and underwriter fees are also lower when lead underwriters have prior share ownership positions in issuers. 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 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.
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