Monitoring as a motivation for IPO underpricing (original) (raw)

2004, The Journal of Finance

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