Venture capital investments by IPO underwriters: Certification or conflict of interest?

Xi LiSchool of Business

University of MiamiCoral Gables, FL 33146Phone: 305-284-6891

Fax: 305-284-4800x.li@miami.edu

Ronald W. MasulisOwen Graduate School of Management

Vanderbilt UniversityNashville, TN 37203Phone: 615-322-3687

Fax: 615-343-7177ronald.masulis@owen.vanderbilt.edu

Current Version: November 3, 2002

Venture capital investments by IPO underwriters: Certification or conflict of interest?

Abstract

We study the impact on IPO pricing when underwriters have venture capital investments in

issuers and evaluate whether these investments create a serious conflict of interest between

underwriters and IPO investors. Theoretically, prior underwriter investment has two effects.

First, it can improve underwriter access to IPO issuer information, thus enhancing the credibility

of its due diligence investigations, thereby raising investor demand and IPO offer prices. Second,

it decreases alignment of underwriter interests with IPO investors, which can decrease the

credibility of underwriter due diligence investigations. However, underwriters can increase their

credibility through several contracting mechanisms. They can voluntarily accept a lockup

clause, which requires them to be long term shareholders, thereby increasing their alignment

with outside investors. Alternatively, they can seek an independent outside opinion of the

appropriate IPO offer price. Empirically, it is not prior equity investments by any underwriter

that significantly reduces IPO underpricing, but rather an equity investment by a lead

underwriter. Controlling for endogeneity effects does not change the conclusions. We also

observe a stronger certification effect for IPOs with higher investor uncertainty about issue

valuation. However, the issuer benefit from reduced underpricing is partially offset by larger

underwriter fees. In sum, we find support for a dominant certification benefit from underwriter

venture investments in IPO issuers. The evidence also suggests that additional contracting

mechanisms employed by underwriters have substantially reduced the moral hazard problem

faced by IPO investors.

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1. Introduction

The costs and benefits of permitting commercial bank underwriting are at the heart of the

debate over banking system reform in many countries. In the United States, the 1999 Gramm-

Leach-Bliley Financial Modernization Act repealed the 1933 Glass-Steagall Act ending nearly a

70-year prohibition on securities underwriting by commercial banks. In the last decade,

commercial banks are again able to invest in equity securities, through the creation of venture

capital subsidies and holding company structures.1 Given these recent and contemplated

regulatory changes, there is heightened interest in potential conflicts of interest created by

universal banking. These policy issues continue to be debated in the U.S., while banking

regulation continue to limit direct equity investments by banks and to restrict underwriting

activity to separate subsidiaries. Our focus is on one major element of this debate, the effects of

permitting commercial banks as well as other investment banks to be prior investors in the

issuers of securities that they underwrite

Since banks can have both lending and investment banking relationships with an issuer,

several conflicts of interest can result. First, banks can acquire proprietary firm specific

information from their lending and venture capital relationships and thus, lower their information

costs relative to competing investment banks. Having prior investments in issuers can give

underwriters superior information, which sends credible signals to the capital market that these

issuers are likely to be financially healthy [Leland and Pyle (1977), Puri (1999)]. 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 issuers’ securities, which they might otherwise

1 Prior to enactment of the Gramm-Leach-Bliley Act, the Federal Reserve had slowly permitted limited underwriting by commercial banks on a case by case basis.

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decline. Banks have such an incentive because it strengthens an issuer’s financial condition,

thereby decreasing likelihood banks will sustain losses from issuer defaults. Alternatively, if an

underwriter has a prior venture capital investment in an issuer, it can benefit from having the

issuer sell overvalued stock to the public.2

In this study, we focus on the IPO underwriting process and the impact of underwriter

venture capital investments in IPO issuers and how that affects the IPO pricing decision and

underwriter percentage spreads and relate this to the potential conflicts of interest between IPO

investors and underwriters. To preview our results, we find that underwriters with prior equity

investments tend to set higher offer prices than those with no prior equity investments.

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.

2. Related Literature

Existing evidence focuses on the conflicts of interest in bond underwriting when there is

a prior lending relationship. U.S. evidence indicates a certification role for underwriters with

prior issuer banking relationships. For example, Ang and Richardson (1994), Kroszner and Rajan

(1994), and Puri (1994) show that pre-Glass-Steagall the default rates of bank underwritten bond

issues are lower than those of non-bank investment houses. Gande, Puri, Saunders, and Walter

(1997) and Puri (1996) find that bank-underwritten bond issues fetch higher price (lower yields)

2 Since underwriters’ pre-IPO investment is subject to longer lock-up period than issuer management, this lock-up clause may reduce underwriters’ incentive to overprice a deal. See NASD Rule 2710 for detailed regulation on the lock-up period of underwriter pre-IPO ownership.

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in both the post- and pre-Glass-Steagall period. This is consistent with bank underwriters

attracting or selecting higher quality issuers.

Evidence from other countries provides mixed evidence on whether bank underwriters,

who can also be issuer investors, have greater conflicts of interest than other underwriters.

Hamao and Hoshi (1998) find that Japanese bond issues brought to market by commercial banks

have lower offer prices (higher yields) than other issues in the post-1994 era, suggesting greater

market skepticism about issue quality. Ber, Yishay, and Yosha (2001) show that Israeli IPOs

underwritten by banks with prior lending relationships are significantly overpriced and exhibit

significantly lower after-market performance, which they interpret as evidence of a conflict of

interest between bank underwriters and IPO investors, which goes unrecognized by investors at

the time.

Several studies have examined the impact of prior equity ownership on the equity

underwriting process by studying venture capital (VC) backed IPOs where underwriters and VC

investors are affiliated. Hamao, Parker, and Ritter (2000) show that Japanese IPO firms backed

by the lead underwriters’ VC subsidiaries have similar long-run performance but higher IPO

underpricing compared to other VC-backed IPOs. Klein and Zoeller (2001) find similar results

for lead underwriter investments in German IPO issuers. Both interpret their finding as evidence

supporting the conflicts of interest between underwriters and IPO investors, who may discount

these IPO prices for perceived moral hazard risk. Ljungqvist and Wilhelm (2003) examine the

effects of prior venture capital and investment bank equity holdings of issuers on underpricing of

U.S. IPOs and find that both indicator variables are associated with less underpricing. However,

interacting the investment banking indicator with the underwriting indicator to generate an

underwriter equity holding indicator yields an insignificant parameter estimate. This suggests

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that the positive an negative effects of a venture capital investment by the underwriter are largely

offsetting with respect to the IPO pricing decision.

Our paper is the most closely related to that of Gompers and Lerner (1999). They find

that U.S. IPOs have significantly positive five-year excess returns only when all underwriters are

also venture investors in the issuer. Gompers and Lerner report that prior underwriter ownership

has no effect on the issuer’s bankruptcy and liquidation probability over the subsequent five

years. They also find no significant relationship between IPO underpricing and underwriter

ownership, although they argue that the sign of the coefficient estimates suggest a conflicts of

interest effect because underwriter ownership generally increases underpricing, though

insignificantly.

Our study differs from the previous literature with respect to the hypotheses we test. First,

the previous literature compares mean IPO underpricing based on whether underwriters have

prior equity ownership or not. We extend this analysis by examining the relation between the

size of underwriter ownership and IPO underpricing. Puri (1999) predicts that underwriter

ownership of issuer debt or equity strengthens the certification effect. However, a larger

shareholding in an issuer exacerbates the conflict of interest with outside investors, thereby

undermining an underwriter’s credibility in the capital market. Thus, issues underwritten under

such circumstances could fetch lower, rather than higher prices. We can directly test this

hypothesis, given our detailed underwriter shareholding information,. We also control for

selection bias in our sensitivity tests. Finally, our study benefits from access to more recent IPO

data. Consistent with Puri’s certification prediction, we find underwriter ownership significantly

reduces IPO underpricing. We also find the explanatory power of our model substantially

exceeds that reported in most of the earlier literature, which may reflect our larger sample.

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Second, the previous literature does not examine the effects of regulations which are

created to mitigate the conflicts of interest between IPO investors and underwriters. In 1971

NASD issued Rule 2720 which specifically regulates the pricing of IPOs when a lead

underwriter has significant debt or equity ownership in an issuer. Changes in this rule could

significantly reduce the conflicts of interest with IPO investors and NASD has substantially

revised the rule in the intervening period.3 Fortunately, over our sample period this rule has

essentially unchanged.

Thirdly, our study focuses on stock prices immediately following IPOs. We develop a

new approach to differentiating the moral hazard and certification hypotheses which does not

require data on long-run abnormal stock price performance. This is advantageous since

measures of long run abnormal performance are very sensitive to the benchmarks used. Fourth,

we focus on a hot IPO period, when underwriters can face stronger conflicts of interest with both

issuers and IPO investors. As a result, our evidence should be more informative on the

importance of moral hazard effects in the underwriting relationship.

Fifth, we also investigate the relation between underwriting fees and their ability to

certify the quality of their offerings. Puri (1999) predicts that more credible underwriters can

charge higher underwriting fees due to their superior certification ability. Gande et. al. (1999)

examines the difference in underwriting fees between Section 20 bank subsidiaries and

investment houses, but do not find any significant difference. Instead of inferring the existence of

3 NASD initially required two qualified independent underwriters (QIU) who each own less than 10% of either of the issuer’s debt or equity to set the maximum IPO prices, whenever the lead underwriter has a position of more than 10% ownership in the firm that it underwrites. NASD reduced the number of QIUs from 2 to 1 in 1983. In 1988, NASD changed the ownership requirement for a QIU so that they can own no more than 5% of the debt or equity of an IPO firm. Currently, Rule 2720 presumes conflicts of interest if the lead underwriters own more than 10% or more of the outstanding voting securities, common equity, subordinated debt, or preferred equity of a company. The rule requires the opinion about offering price from a qualified independent underwriter (QIU). The offering price should not exceed the price recommended by the QIU. QIU should meet several requirements and own less than 5% of the outstanding voting securities, common equity, subordinated debt, or preferred equity of a company. We find that in all cases during our sample, the QIU actually introduced does not have any ownership in the IPO firms.

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underwriter ownership positions in issuers’ debt from the fact that commercial banks are active

debt investors, we analyze the relationship between underwriting fees and underwriters’ actual

equity ownership positions. Our study is also related to research examining the reputation effects

of underwriters and VCs on issue underpricing and long-run performance.

3. Data Sources and Descriptive Statistics

We focus on the 1996-2000 period because there are a large number of investment banks

with venture capital investments in this period and NASD rules regarding conflicts of interest in

securities underwriting remain relatively stable over the period. Prospectuses are taken from

online databases such as Lexis-Nexis and Edgar Online. To obtain our sample, we first identify

976 venture-backed IPOs from Securities Data Corporation’s (SDC) Corporate New Issue

Database, after excluding unit offers, closed-end funds (including REITs), ADRs, limited

partnership, and foreign issues. We then search for prospectuses on Lexis-Nexis, and if

unavailable, go to Edgar Online. We verify that the IPOs in our sample are venture capital

backed by reading the “Principal Shareholder” section of each prospectus.

Of the 976 offerings, 772 have prospectuses available and are backed by venture capital

funds. Requiring issuers to have at least 125 stock returns during the post-IPO period, defined as

event days +6 to +255 relative to the IPO event day 0, yields a final sample of 674 IPOs. We

have four issues with offer prices lower than $5. Since the offer prices are all at least $4, we

decided to include them in our sample, though our results are invariant to excluding them.

Detailed underwriter ownership information is obtained from the prospectuses. Usually

underwriters disclose their pre-IPO equity ownership in the “Underwriting” section of the

prospectus, though we also searched in the “Principal Shareholder” section. Underwriter

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ownership includes both direct ownership by all underwriters in the syndicate and indirect

ownership by employees or their subsidiaries such as a captive venture capital funds. The vast

majority of these underwriter share investment positions involve venture capital.

Detailed underwriter ownership information is hand collected from IPO prospectuses.

Underwriter pre-IPO equity ownership is typically disclosed in the “Underwriting” section of

prospectuses and less frequently in the “Principal Shareholder” section. Table 2 presents

descriptive information for the final sample. The sample has the fewest observation in 1998 and

the most in 1999. The annual percentage of venture-backed IPOs ranges from 25 to 38%, with a

clear upward trend. The lead underwriters tend to make roughly half those investments.

However, all underwriters’ prior shareholding percentage of issuers’ outstanding shares falls

from 14% to 4% over the five year sample period. Among venture-backed IPOs, we find lead

underwriter involvement in 128 issues and lead or non-lead underwriter involvement in 232

issues. In issues that involve pricing by QIUs, lead underwriters are prior shareholders in 18

cases, while non-lead underwriters are shareholders in 28 cases. Only three IPOs required a QIU

because underwriters owned more than 10% of the debt of the IPO firms.

We obtain information on underwriters’ warrant ownership from IPO prospectuses.

Because there are very few non-lead underwriters who own warrants in IPO firms, we focus on

the 14 IPO firms where lead underwriters own warrants. The information source for issuer size,

stock closing prices, bid, and ask on event days 1, 5, and 10, stock returns and trading volume

over event days +6 through +250, and market returns over event days –255 through -6 and +6

through +255 is the University of Chicago’s Center for Research in Securities Prices (CRSP).

IPO issuer industry classification codes are also taken from CRSP. Information on IPO filing

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price range, lock-up clauses and simultaneous global offering designations is taken from

Thomson Financial’s SDC New Issues database.

Turning to Panel B of Table 2, we can compare the mean level of underpricing, measured

by the first two-day return for IPOs with and without prior underwriter venture investments. The

table examines IPO statistics classified by share ownership of all underwriters, lead underwriters

and non-lead underwriters. For all underwriters, we find little evidence that underpricing is

significantly different across IPOs with and without underwriter venture investments. However,

when we isolate lead underwriter venture investment, IPO underpricing appears to be reduced

when they have prior shareholdings. At the same time, just the reverse pattern is observed for

non-lead underwriters. This indicates that we need to distinguish between these two groups of

underwriters when studying the impacts of shareholdings on the IPO process. However, we

should use caution in drawing conclusions about underpricing, since we do not control for

various issuer differences across the two samples.

4. Empirical Results on Underpricing

We begin our analysis by examining whether there is evidence that underwriters with

venture investments have superior information about IPO issuers. We approach this question by

first examining revisions (measured in absolute values) of IPO offer prices from their indicative

price range midpoints, as reported in their registration statements. The left panel of Table 3

presents evidence on the effect of prior venture investment by lead and non-lead underwriters on

IPO percentage price revisions between registration and offering dates, measured by the

difference between offer price and pricing range midpoint divided by pricing range midpoint.

Because other differences across IPOs could affect the degree of price revision, we also control

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for a variety of issuer characteristics in our OLS regressions. The basic result is that there is a

significant reduction in price revision size when the lead underwriter has a prior venture

investment in the IPO issuer. This evidence is consistent with underwriters having lower IPO

pricing uncertainty when they have prior equity investments in issuers.

One measure of underwriter IPO pricing uncertainty is the filing range of high and low

indicative prices taken from the IPO issuer’s registration statement. An underwriter with

superior access to the issuer’s financial condition would be expected to set a lower indicative

range, everything else the same. So if underwriters with prior shareholdings in the firm have

superior information access, then we would expect them to have greater confidence in pricing the

IPO, which they could signal with a lower filing price range. The right hand panel of Table 3

presents estimates for regressions similar to the left hand panel, except that the dependent

variable is the IPO filing price range. Similar to the evidence on the left panel of Table 3, we

again find lead underwriter venture capital investments are associated with lower filing ranges.

We also find that this is primarily related to lead underwriter with large equity investments

requiring the use of a QIU. This may reflect the impact of having a QIU involved in the pricing

IPO decision, or it may proxy for lead underwriters owning issuer equity exceeding 10% of

outstanding shares. One explanation for this reduced price uncertainty is that lead underwriters

with venture investments have greater access to issuer specific information. As a major equity

investor in a privately held firm, an underwriter can have possible board membership or board

observation rights as well as frequent access to senior management.

Turning to our primary concern, we examine whether conflicts of interests with IPO

investors become worse when underwriters have prior issuer shareholdings. Table 4 reports

estimates from regressions of IPO two-day initial returns on underwriter share ownership

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measures such as prior percentage and dollar shareholdings and indicators of lead and non-lead

underwriter share holdings. The key result is that only prior percentage shareholdings of

underwriters significantly reduce underpricing. The sum of the percentage equity stakes held by

lead and non-lead underwriters exhibits a significant impact on underpricing. However, when

lead and non-lead ownership are separated, only lead underwriter ownership matters. The

adjusted R-squares indicate that these ownership measures by themselves have modest

explanatory power.

Puri (1999) predicts that the underwriter certification effect is reduced with larger

underwriter stock ownership. She argues that underwriters will have greater incentives to

underwrite bad firms when they have larger financial investments in these issuers. The

reasoning is that underwriters incur smaller losses when their prior percentage ownership in bad

firms is reduced by the success of these IPOs. However, our results do not support this

prediction. Parameter estimates on the venture capital indicator show no significant impact of

prior underwriter equity investment on underpricing, which is similar to the conclusions of

Gompers and Lerner (1999). Analyzing underwriter percentage shareholdings suggests a

positive certification effect, which dominates any moral hazard concerns.

Puri (1999) observes that the length of the holding period in an issuer’s stock is crucial to

a credible underwriter certification effect. Her prediction of a negative relationship between the

underwriter certification effect and prior stockholdings assumes that an underwriter cannot be

contractually bound to retain issuer stock for an extended period of time, as required by a lock-

up clause, and is apt to sell quickly following the IPO. The fact that our evidence does not

support this prediction suggests that a lock-up clause can be an effective mechanism for

protecting outside shareholders from an underwriter moral hazard problem. In addition,

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subsequent sales by underwriters can be severely limited by SEC disclosure regulations and

NASD rule 2710, which tightly restricts subsequent sales of stock by underwriters and venture

capital investors.

Given the significance of underwriter venture investment for IPO underpricing, we next

examine how underwriter shareholdings affect initial post-IPO two day stock returns. Table 5

reports the marginal effects of underwriter venture investment on these initial returns, after

inclusion of a wide set of control variables which primarily capture issuer characteristics.4

Almost all the regression estimates on the control variables are significant. The adjusted R2 levels

indicate that 45% of the cross sectional variability in IPO returns is explained. In the first model,

we examine the impact of the prior equity ownership stakes of all underwriters (lead and non-

lead) together. We find that the sign of the parameter estimate on percentage ownership is

negative as expected, though insignificant. When we distinguish between lead and non-lead

underwriter ownership in the second regression, we find that only lead underwriter ownership

significantly reduces underpricing. This suggests that the previous finding of an insignificant

effect from the sum of underwriter ownership stakes is mainly due to non-lead underwriter

shareholdings having little impact on IPO initial returns.

In the third regression, we further segment our underwriters into cases that do and do not

use a qualified independent underwriter (QIU) to set the offer prices. As explained earlier, the

1971 rule requires a QIU when the lead underwriter has a relatively large equity investment in an

issuer, which is typically the result of venture capital activity. We find that lead underwriter

ownership significantly reduces underpricing when a QIU is not involved. When a lead

underwriter is a shareholder and a QIU is involved there appears to be a marginally significant

reduction in underpricing, but it is only a quarter of the size observed when a QIU is not

4 Previous studies have found issuer characteristics useful in predicting stock issue flotation costs.

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involved. Since a QIU is usually employed when underwriter share ownership exceeds 10%, it

appears that lead underwriter shareholdings reduce underpricing more as the size of these

investments rises. Separating non-lead underwriter ownership into cases with and without a QIU,

indicates that non-lead underwriter ownership is not important in either case and has negligible

impact on the strength of the lead underwriter ownership - IPO underpricing relationship.

An interesting result that we uncover is that although lead underwriter share ownership

has a negative effect on underpricing, the effect is much smaller when a QIU is involved. Since

the purpose of a QIU is to prevent overpricing, the smaller underpricing effect associated with

using a QIU suggests that this mechanism is effective in reducing the perceived underwriter

conflict of interest with IPO investors, which on average enables a higher offer price to be set on

average. An alternative interpretation is that the QIU reduces the information asymmetry

between the issuer and IPO investors, which enables a higher offer price to be set. We will

further investigate this issue latter in this study.

In examining the results for the control variables, we see that underwriting spread, offer

size, IPO share volume and the prior market return over event days -5 to -1 all have positive

effects on underpricing. This evidence indicates that underpricing rises with offer size which is

consistent with there being a larger adverse selection effect as offer size rises. Underpricing also

rises with the initial share trading level, which may also be a proxy for adverse selection since

sophisticated institutional investors with IPO allocations are more likely to sell their shares

quickly if they view them as overvalued. The evidence also indicates that underpricing and

underwriter spread are positively related, presumably because they are both related to certain

issuer qualities such as the prior sales and earnings history. Finally, a rise in the market return

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over the week prior to the IPO appears to result in a smaller adjustment in the IPO offer price,

which is consistent with prior IPO studies.

We explore the robustness of our initial findings in several ways. We first examine

whether the results in Table 5 on underpricing are insensitive to replacing two-day IPO returns

with five-day returns as the dependent variable. We also examine initial ten and twenty day IPO

returns, but do not present these results since they are qualitatively similar to the two day returns.

We also re-estimate the earlier regressions when two-day IPO returns are based on the midpoints

of closing bid and ask quotes, instead of closing prices. This procedure extracts any bid-ask

bounce effect from initial IPO returns, an effect which Lease-Masulis-Page (1991) find has a

significant impact on public offering date returns of seasoned equity offers. We find the earlier

results are insensitive to this stock return adjustment. Moreover, we find that the bid-ask bounce

effect has little effect on initial IPO returns.

The above evidence indicates the positive certification effect of underwriter stock

ownership dominates the agency cost effect arising from the conflict of interest between

underwriter and IPO investors. To pursue this question further, we take the following approach.

Since IPOs are regarded as overpriced if their initial returns are zero or negative, we study the

relationship between underwriter share ownership and whether an IPO is overpriced. So in the

current approach we ignore size of the underpricing, focusing instead on whether the IPO is

overpricing or not. Using a probit model, it is possible to find a significant negative impact of

underwriter venture investments, even though a few IPOs with prior venture investment by

underwriters are seriously overpriced. This approach is also quite similar to the approach taken

by several prior researchers.

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Explaining a pattern of overpriced IPOs requires something more than an enhanced

certification effect due to under writer venture investment, but must also appeal to an underwriter

moral hazard problem. Thus, a simple negative relationship between underpricing and prior

underwriter ownership implies that initial IPO returns could become negative (overpriced) as

prior underwriter ownership increases substantially. Once the offer price reaches the stock’s true

value, represented by the initial after market closing price, an underwriter is exploiting its

certification reputation to reap financial benefits at the expense of IPO investors. If investors

reduce their assessment of underwriter credibility as its venture capital investment rises, then the

functional relation of underwriter venture investment and underpricing should attenuate as the

size of the venture investment gets large. A probit model has several attractive properties. It

allows us to focus on only certain qualitative aspects of the dependent variable (e.g. its sign) and

its estimates are not strongly influenced by a few outliers.

We define the dependent variable in our probit model to equal one if an IPO has a non-

positive initial two-day return and is zero otherwise. Looking at the probit estimates on Table 6,

we find that none of the prior underwriter ownership measures has a significant impact on the

probability of an IPO being overpriced, which suggests the conflict of interest arising from prior

underwriter share ownership is not a serious factor in IPO pricing for this sample period. We also

estimate the probit model with IPO initial returns defined over the first 5, 10, and 20 trading days

and come to similar conclusions.

If underwriter ownership serves as a certification device in IPOs, then the certification

benefit should be stronger for IPO issuers with greater investor uncertainty. We use aftermarket

stock return variance measured over trading days +6 to +255 as a proxy for investor uncertainty

about IPO valuation. Investors in IPOs with high stock return variance are likely to face more

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information asymmetry and thus the certification effect of underwriter ownership should be more

pronounced in these cases. We test this prediction by including as added regressors two indicator

variables for high and low stock return variance IPO issuers, measured over trading days +6 to

+255, where we divide the sample at the median return variance. We create interactive variables

by multiplying these variance indicators by indicators of syndicate status (lead or non-lead) and

QIU presence.

In Table 7, we replicate some earlier results after effectively splitting the IPO sample by

stock return variance, which we use as proxy for information asymmetry. In the first regression,

we find no difference between issuers with high and low return variance when underwriter

venture capital investment is measured as the sum of lead and non-lead underwriter equity

stakes. In the second regression, we decompose underwriter investment into leads and non-leads

and find that only lead underwriter venture investment reduces underpricing. Moreover, the

economic significance of the parameter estimate for high return variance issuers is more than

four times larger than that for low variance issuers. In the third regression, we further separate

lead and non-lead underwriter ownership by QIU status. The underwriter certification effect of

lead underwriter ownership is economically and statistically more significant for high return

variance issuers when there is no QIU. This is consistent with the QIU reducing the information

asymmetry borne by IPO investors. For IPOs employing a QIU, the certification effect of the

lead underwriters of high variance issuers is more than twice as large as the low return variance

issuers, though surprisingly, it is only statistically significant for low variance issuers. The

adjusted R-squares show that the regressions explain about 58% of the underpricing. Non-lead

underwriter ownership does not matter in any of these cases, which is similar to the findings in

Table 5.

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Up to this point, the analysis treats underwriter shareholdings in an issuer as an

exogenous variable. However, it could be endogenously determined, causing selection bias in the

prior model estimates. The key economic issue is whether the factors that cause a banker to

underwrite a particular IPO also caused the banker to make a prior venture investment in the

issuer. That is to say, the various issuer characteristics that influenced underwriter decisions to

make venture capital investments could also be relevant in determining underwriter positions on

IPO pricing. Looking back at Panel B of Table 2, there seem to be a number of notable

differences in issuer characteristics across the two samples. Specifically, issuers with prior

underwriter venture investments are larger in equity capitalization, increase outstanding shares

by a larger percentage, are more apt to be internet stocks, are less frequently global offers, are

marginally smaller offers and subsequently tend to trade less frequently.

Selection bias creates inconsistent parameter estimates in regressions. As noted above,

selection bias may adversely affect our prior estimates if underpricing is strongly influenced by

some of the same characteristics that attract underwriters to make prior venture investments. This

would result in the venture investment variable capturing some of effects of these underlying

issuer characteristics on the IPO pricing decision. To address this concern, we use a variation on

the Heckman (1979) correction to control for self-selection bias induced by the prior venture

investment decision [Greene (1997)]. It is easy to see that the prior underwriter equity

investment (UPCT) is a Tobit variable:

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Where UPCT* is the latent variable, observed only when underwriters make a minimum size

venture investment. Of course, the model also yields information on what attracts underwriters to

make venture investments in these privately held firms.

Specifically, we estimate the prior equation as a tobit regression and then in the second-

step linear regression replace underwriter venture investment with the residual from the first step

tobit model:

First Step:

Second Step:

In Table 8, we report IPO underpricing results based on initial two-day stock returns,

after controlling for a selection bias or endogeneity problem in the underwriter shareholdings

variable. We find that lead underwriter venture investment is significantly affected by several

explanatory variables used to explain IPO underpricing. Specifically, the initial two-day market

return and its prior five day return, post issue return squared and an utility industry indicator are

all significant. It should not be surprising that the results in the second-step OLS regression are

qualitatively similar to those in Table 5, given the limited explanatory power of the first stage

regressions. Specifically, it is only the lead underwriter shareholdings that reduce IPO

underpricing.

5. Evidence on Underwriter Spreads

The remainder of the paper examines another major component of IPO flotation costs,

gross underwriting spread and the impact of prior underwriter ownership on it. Puri (1999)

predicts that issuers benefiting from higher offer prices will find this partially offset by

underwriter rent seeking in the form of higher underwriting fees. However, Gande et al. (1999)

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find that debt offering underwriting fees charged by Section 20 bank subsidiaries are lower than

those charged by other investment houses, though not significantly so. Thus, even though

Section 20 bank underwriters have more credibility in certifying debt offerings due to their

superior monitoring ability as lenders, they don’t appear to charge higher fees.

Before examining the effect of prior venture investment on underwriting fees, we need to

first be better acquainted with the basic properties of underwriter percentage gross spreads in our

IPO sample. Figure 1 shows that there could be some economies of scale in the issuance

process since percentage gross spreads are much lower when issue size is larger. Figure 2

suggests that the predominant percentage spread charged by underwriters in our IPO sample is

7% and that it exhibits little cross-sectional variation, which is consistent with the previous

literature.

Table 9 investigates the impact of underwriter share ownership on gross spreads in a

multivariate framework. The left panel is based on OLS estimation. We find that gross spread

exhibits scale economies, indicated by a negative coefficient on gross proceeds, which

diminishes with offer size, as indicated by a significantly positive coefficient on gross proceeds

squared. Simultaneous global offerings are found to entail significantly lower underwriter fees.

One potential explanation for this finding is that global IPOs create greater underwriter

competition. This evidence complements a recent study by Chaplinsky and Ramchand (2000),

who report weak evidence that global offerings of seasoned common stock reduce underpricing,

but not underwriting fees. Underwriter reputation also significantly reduces spreads, which is

counterintuitive if one believes that higher quality underwriters charge higher fees. However,

since these underwriters can select from a large group of potential issuers, they are likely to be

underwriting the financially stronger issuers. They are also likely to capture a larger fraction of

19

rapidly growing firms likely to need more investment banking services and underwriters may be

willing to offer these issuers more attractive rates.

Focusing on prior underwriter shareholdings, we find the sum of lead and non-lead

underwriter stakes significantly reduces gross spread, in addition to our earlier finding that this

venture investment reduces underpricing. Separating underwriter ownership into lead and non-

lead holdings shows that only non-lead underwriter ownership affects underwriting fees. Further

analysis shows that this is primarily associated with prior venture investments by non-lead

underwriters in the presence of QIUs. One possible explanation for this result is that non-lead

underwriters may advise an issuer how to effectively negotiate for lower fees when they are an

issuer shareholder. Further, since the QIU has part of the pricing responsibility and receives a

separate fee for this work, the issuer has a strong argument in favor of lowering the underwriting

fee. The adjusted R-squares of these regression models averaged about 40%, indicating strong

explanatory power.

The sign of the underwriter ownership coefficient is consistent with Gande et al. (1999),

although they do not find the reduction in gross spread to be significant when Section 20 bank

subsidiaries underwrite debt offerings. Our evidence points to a more complex relationship with

underwriters than that predicted by Puri (1999) who argues that underwriters will charge higher

underwriting fees when they have better certification ability, without exploring the impact that

their position in the syndicate might have on this prediction.

It is interesting that only prior non-lead underwriter shareholdings matter in determining

the gross spread charged by an underwriting syndicate, while only lead-underwriter ownership

matters for IPO underpricing. One explanation is that lead underwriters and issuer management

usually negotiate the final IPO offer price, leaving a negligible role for non-lead underwriters in

20

IPO pricing decisions. In contrast, other syndicate members can play an important role in

determining underwriter gross spreads for several possible reasons. First, their participation may

be important to the success of the underwriting, especially in global offers. Second, they may

aid the issuer in negotiating a lower fee. Yet, this leaves unexplained why lead and non-lead

underwriters with similar venture investments in the issuer will have different incentives

regarding the setting of underwriter spreads. To see why these incentives could be different, we

have to take account that underwriters with prior venture investments have two different

incentives. As an issuer shareholder, they are better off if flotation costs are reduced, but as

underwriters, they are worse off. For the lead underwriter who captures a large portion of the

fee, it is almost surely the case that they are better off by setting a higher fee. For non-lead

underwriters with a venture investment, their shareholder incentive can dominate if their

percentage shareholding exceeds the portion of the underwriting fee they receive, which is quite

likely based on the Lee-Lochhead-Ritter-Zhao (1996) which finds that the non-lead underwriter

on average receives a small faction of the total underwriting fee due to its small issue allocation.

Since cross-sectional variation in gross spread is rather limited, we also use an ordered

probit model to examine the impact of prior venture investments by underwriters on gross

spread. We define the dependent variable as an indicator variable, GS, which is equal to zero if

the IPO’s percentage gross spread is less than 7%, one if the gross spread is equal to 7% and two

if gross spread exceeds 7%. The results are presented in the right panel of Table 9. Underwriter

ownership significantly reduces the probability that gross spread equals 7%. Most of the

reduction is due to venture investments by non-lead underwriter when a QIU is used to price the

IPO. This result is quite similar to that obtained when we use ordinary least squares regressions

with raw gross spread as the dependent variable.

21

One explanation for the more important role of non-lead underwriter ownership on gross

spread is related to how underwriter fees are allocated within the syndicate. If a top tier bank can

successfully demand to be lead underwriter, even though an underwriter-shareholder would

normally serve this role, then the incentives of this influential shareholder and the lead

underwriter are significantly changed. When a large shareholder serves as IPO lead underwriter,

it captures much of the underwriting fee, while its shareholdings are reduced in value only by its

share ownership percentage multiplied by the fee (assuming that issuer equity value is reduced

dollar for dollar with underwriting fee). In contrast, if the equity owner is a non-lead

underwriter, then a higher underwriter spread can mean a wealth transfer from itself to a

competing investment banker serving as the lead underwriter.

6. Conclusion

We study the impact of IPO underwriters having venture investments in these issuing

firms on IPO pricing and underwriting fees. Since banks are allowed to invest in IPOs through

venture capital subsidiaries, banks acting in the dual capacity of IPO underwriters and equity

investors provide a unique opportunity for evaluating the joint effects of share ownership and

underwriter due diligence. We provide some indirect evidence on IPO issuer’s costs and benefits

from allowing universal banks to underwrite equity offers, which is at the heart of the banking

reform debate in many countries. We find lead underwriters’ prior shareholdings significantly

reduce IPO underpricing. This result is primarily associated with venture investments by the lead

underwriters. However, this issuer pricing benefit is partly offset by larger gross spreads charged

by these underwriters. We also examine whether the differences in underpricing across these

underwriter groups is attributable to an underwriter conflict of interest or a certification effect.

22

We find that the probability of IPO aftermarket prices falling below their offer prices within a 20

trading days is unrelated to prior underwriter shareholdings, which does not support a serious

moral hazard problem between the underwriters and IPO investors. The certification effect is

also more pronounced for IPOs with higher information asymmetry as measured by aftermarket

stock return variances. This body of evidence is consistent with underwriter ownership in issuer

shares generally serving as a credible certification mechanism, rather than the source of a serious

moral hazard problem for IPO investors over our sample period.

23

Reference:

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Ber, Hedva, Yishay Yafeh, and Oved Yosha, 2001, Conflict of interest in universal banking: Bank lending, stock underwriting, and fund management, Journal of Monetary Economics 47, 189-218.

Chaplinsky, Susan and L Ramchand, 2000, The Impact of Global Equity Offerings, Journal of Finance, December 2000, 2767-2789.

Gande, Amar, Manju Puri, Anthony Saunders, and Ingo Walter, 1997, Banking underwriting of debt securities, modern evidence, Review of Financial Studies 10, 1175-1202.

Gande, Amar, Manju Puri, and Anthony Saunders, 1999, Bank entry, competition, and the market for corporate securities underwriting, Journal of Financial Economics 54, 165-185.

Gompers, Paul and Joshua Lerner, 1999, Conflict of interest in the issuance of public securities: Evidence from venture capital, Journal of Law and Economics 42, 1-28.

Greene, William H., Econometric Analysis, 3rd edition, (Prentice Hall: Upper Saddle River NJ) 1997.

Hamao, Yasushi, and Hoshi, T., 1999, Bank underwriting of corporate bonds: Evidence from post-1994-Japan, Unpublished working paper, University of Southern California.

Hamao, Yasushi, Frank Packer, and Jay Ritter, 2000, Institutional affiliation and the role of venture capital: Evidence from initial public offerings in Japan, Pacific-Basin Finance Journal 8(5), 529-558.

Heckman, James, 1979, Sample selection bias as a specification error, Econometrica 47, 313-318.

Klein, Peter G. and Kathrin Zoeller, 2001, Universal-bank underwriting and conflicts of interest: Evidence from German initial public offerings, Unpublished working paper, University of Georgia.

Kroszner, Randall S. and Raghuram G. Rajan, 1994, Is the Glass-Steagall Act justified? A study of the U.S. experience with universal banking before 1933, American Economic Review 84, 810-832.

Lease, Ronald, Ronald W. Masulis and John Page, 1991, An investigation of the earnings information content in issuer tender offers, Journal of Finance, 46.

24

Lee, I., S. Lochhead, J. Ritter, and Q. Zhao, 1996, The Costs of Raising Capital, Journal of Financial Research 19 (3), 59-74

Leland, H. and D. Pyle, 1977, Informational Asymmetries, Financial Structure and Financial Intermediation, Journal of Finance 32, 371-387.

Ljungqvist, A. and W. Wilhelm, 2003, IPO Pricing in the Dot-com Bubble, Journal of Finance forthcoming.

Michaely, Roni, and Kent L. Womack, 1999, Conflict of interest and the credibility of underwriter analyst recommendations, Review of Financial Studies 12, 653-686.

Puri, Manju, 1994, The long term default performance of bank underwritten security issues, Journal of Banking and Finance 18, 397-418.

Puri, Manju, 1996, Commercial banks in investment banking: Conflict of interest or certification role? Journal of Financial Economics 40, 373-401.

Puri, Manju, 1999, Commercial banks as underwriters: Implications for the going public process, Journal of Financial Economics 54, 133-163.

25

Table 1Definitions of variables used in the analysis

Underwriter Reputation Investment Bank Rankings from Ritter and Loughran (2002)First Two-Day Return (Closing Price) (Closing Price on Day +1 - Offer Price) / Offer Price (%)First Two-Day Return (Bid-Ask Midpoint) (Midpoint of Closing Bid and Ask on Day +1 - Offer Price) / Offer Price (%)Offer Price Revision Revision in Offer Price from the Midpoint of the Filing Range (%) Abs (Offer Price Revision) Absolute Value of Offer Price RevisionIPO Filing Range IPO High-Low Filing Price Range Divided by the Midpoint of the Filing Range (%)Global Offering Equals 1 if IPO Is a Simultaneous Global Offering, and Is 0 Otherwise Underwriter Spread Underwriter’s Percentage Gross Spread Dollar Amount Offered Log (Dollar Gross Proceeds) Square of Dollar Amount Offered Log (Dollar Gross Proceeds) SquaredPercentage of Shares Offered Number of Shares Offered in IPO / Post-IPO Shares Outstanding Dollar Share Volume (+6, +255) Average Daily Dollar Volume of IPO from Event Day +6 to +255Dollar Share Volume Square Square of Average Daily Dollar Volume from Event Day +6 to +255Stock Return Variance (+6, +255) Stock Daily Return Variance of IPO from Event Days +6 to +255Market Return (-5, -1) Average Daily Return on the Nasdaq or NYSE Index from Event Days -5 to -1Market Return on Day 0 Average Daily Return on the Nasdaq or NYSE Index on Event Day 0“Bubble” Period Equals 1 if IPOs are Issued in 1999 or 2000Internet IPO Issuers Are Internet Companies Based on Ritter’s ClassificationUtilities IPO Issuers Are Utilities Based on SIC CodeFinancials IPO Issuers Are Financials Based on SIC CodeAll Underwriter Shareholders Pre-IPO Stockholdings in Issuer of All UnderwritersLead Shareholders Pre-IPO Stockholdings in Issuer Prior Stockholdings in Issuer of Lead Underwriter (%)Non-Lead Shareholders Pre-IPO Stockholdings in Issuer of Non-lead Underwriters (%)Lead Shareholders with QIU Pre-IPO Stockholdings in Issuer of Lead Underwriter when a QIU (%) Is UsedLead Shareholders without QIU Pre-IPO Stockholdings in Issuer of Lead Underwriter when a QIU (%) Is Not UsedNon-Lead Shareholders with QIU Pre-IPO Stockholdings in Issuer of Non-lead Underwriter when a QIU (%) Is Used Non-Lead Shareholders without QIU Pre-IPO Stockholdings in Issuer of Non-lead Underwriter when a QIU (%) Is Not UsedUnderwriter Shareholders (High Variance Stk) Interactive Variables of Underwriter Stockholdings and a Dummy Variable Equaling 1 if IPO

Stock Return Variance from Event Days +6 to +255 Is above the Median across all IPOs and 0 otherwise

Underwriter Shareholders (Low Variance Stk) Interactive Variables of Underwriter Stockholdings and a Dummy Variable Equaling 1 if IPO Stock Return Variance from Event Days +6 to +255 Is below the Median across all IPOs and 0 otherwise

Warrant Ownership Warrant Ownership of Lead Underwriter (%)

26

Table 2Summary statistics on prior underwriter share ownership

Panel A. Pre-IPO Underwriter Ownership by Year Proportion of IPOs with Prior Underwriter Ownership (%)

Percentage Underwriter Ownership

Year 1996 1997 1998 1999 2000 1996 1997 1998 1999 2000

Number of IPOs 118 121 76 244 115

Stock Ownership of All Underwriters 28 25 32 32 38 14 8 6 3 4

Stock Ownership of Lead Underwriters 14 12 18 17 25 13 4 4 2 4

Stock Ownership of Non-lead Underwriters 16 15 18 20 23 13 10 5 3 3

Stock Ownership of Lead With QIU 6 1 4 1 4 27 6 11 6 10

Stock Ownership of Lead, Without QIU 8 12 14 16 21 2 4 2 1 2

Stock Ownership of Non-lead With QIU 6 4 7 2 5 26 29 9 11 6

Stock Ownership of Non-lead, Without QIU 10 11 12 18 17 5 3 3 3 2

Warrant Ownership of Lead Underwriters 2 5 5 1 0 16 30 10 10 0

Panel B. Mean Statistics of Key Variables by Pre-IPO Underwriter OwnershipAll

IPOs All Underwriters Lead UnderwritersNon-lead

UnderwritersNo Stock Stock No Stock Stock No Stock Stock

Initial Two-Day Return (Closing Price) 0.608 0.620 0.552 0.594 0.641 0.580 0.729Initial Two-Day Return (Bid-Ask Midpoint) 0.622 0.635 0.562 0.605 0.662 0.591 0.759Offer Price Revision 0.131 0.129 0.143 0.125 0.146 0.127 0.151Abs (IPO Price Revision) 0.263 0.264 0.258 0.261 0.268 0.260 0.274IPO Filing Range 0.166 0.166 0.165 0.166 0.165 0.166 0.166Log (Firm Size) 19.227 19.207 19.322 19.160 19.377 19.178 19.437Offer Price 13.885 13.685 14.849 13.497 14.755 13.773 14.370Underwriter Reputation 8.162 8.123 8.350 8.030 8.458 8.072 8.553Offer Price Revision from Midpoint of IPO Filing Range (%) 0.131 0.129 0.143 0.125 0.146 0.127 0.151Global Offering 0.634 0.642 0.595 0.661 0.572 0.656 0.535“Bubble” Period 0.533 0.518 0.603 0.511 0.582 0.517 0.598Underwriter Spread (%) 0.070 0.070 0.070 0.071 0.070 0.071 0.069Log (Gross Proceeds) ($) 17.844 17.816 17.978 17.784 17.979 17.806 18.007Percentage of Shares Offered 0.345 0.298 0.574 0.304 0.438 0.314 0.479Average Daily $ Share Volume (Event Days +6 to +255) 15.908 16.152 14.730 16.021 15.653 15.591 17.273Average Daily Return (Event Days +6 to +255) 0.035 0.047 -0.025 0.046 0.009 0.033 0.041Average Return on Nasdaq Index (Event Days -5 to -1) 0.153 0.151 0.163 0.152 0.155 0.153 0.154Average Return on Nasdaq Index (Event Day 0) 0.003 0.002 0.006 0.002 0.005 0.002 0.004Internet 0.377 0.373 0.397 0.345 0.447 0.346 0.512Utilities 0.095 0.090 0.121 0.097 0.091 0.101 0.071Financials 0.015 0.018 0.000 0.013 0.019 0.011 0.031QIU Use in IPO Pricing 0.099 0.061 0.284 0.021 0.274 0.064 0.252NYSE Listed IPOs 0.030 0.029 0.034 0.026 0.038 0.026 0.047

27

Table 3Effect of underwriter prior share ownership on IPO price revision and filing price range

Table 3 presents regression estimates of the following model:

The dependent variable Price Revision is the unsigned difference between IPO offer price and midpoint of the filing range divided by the same filing range midpoint. Filing Price Range is the high filing price minus low filing price divided by the midpoint of the range. UPCT represents alternative measures of percentage underwriter ownership. Control Variable definitions are given on Table 1. Coefficients are estimated using ordinary least squares and the t-statistics are based on White’s (1980) heteroscedasticity-consistent standard errors. The data are drawn from daily trading days in the January 1996 through December 2000 period.

Abs (IPO Price Revision) IPO Filing Price Range1 2 3 4 5 6

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-statIntercept 0.094 1.91 0.092 1.86 0.094 1.91 0.171 8.59 0.171 8.57 0.169 8.51All Underwriter Shareholders -0.043 -0.41 -0.021 -0.82Lead Shareholders -0.241 -2.34 -0.071 -1.75Non-Lead Shareholders 0.057 0.45 0.004 0.17Lead Shareholders with QIU -0.183 -1.65 -0.095 -2.08Lead Shareholders without QIU -0.634 -1.57 0.085 0.99Non-Lead Shareholders with QIU 0.109 0.74 0.005 0.20Non-Lead Shareholders without QIU -0.123 -0.67 0.008 0.11Warrant Ownership -0.002 -0.02 0.009 0.10 0.004 0.04 0.024 0.44 0.027 0.49 0.029 0.54Underwriter Reputation 0.008 1.32 0.008 1.37 0.008 1.35 -0.001 -0.46 -0.001 -0.43 -0.001 -0.40“Bubble” Period 0.057 2.74 0.056 2.72 0.057 2.77 -0.007 -1.21 -0.007 -1.23 -0.007 -1.28Dollar Share Volume (+6, +255) 0.004 4.63 0.004 4.62 0.004 4.62 0.000 1.33 0.000 1.30 0.000 1.27Dollar Volume Square -0.067 -4.10 -0.067 -4.09 -0.068 -4.09 -0.004 -2.34 -0.004 -2.31 -0.004 -2.29Stock Return Variance (+6, +255) 0.041 1.18 0.042 1.21 0.041 1.18 0.009 0.80 0.009 0.83 0.009 0.85Internet 0.048 1.68 0.047 1.65 0.048 1.65 0.008 1.79 0.007 1.73 0.007 1.74Utilities -0.026 -0.88 -0.025 -0.84 -0.026 -0.88 -0.004 -0.57 -0.004 -0.52 -0.003 -0.45Financials -0.021 -0.21 -0.023 -0.24 -0.026 -0.27 -0.004 -0.37 -0.005 -0.43 -0.004 -0.39

Adjusted R2 0.16 0.16 0.16 0.01 0.01 0.01

28

Table 4 Effects of prior underwriter share ownership on IPO underpricing

Table 4 presents estimates of the following model:

The dependent variable Underpricing is the IPO initial two-day return based on the closing price at the end of day +1. Underwriter Ownership represents alternative measures of underwriter share ownership: underwriter percentage shareholdings, a dummy variable representing underwriter shareholdings, and dollar amounts of underwriter shareholdings where underwriters are distinguished by syndicate status. Control Variable definitions are given on Table 1. Coefficients are estimated using ordinary least squares and the t-statistics are based on White’s (1980) heteroscedasticity-consistent standard errors. The data are drawn from daily trading days in the January 1996 through December 2000 period.

1 2 3 4 5 6Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat

Intercept 0.625 16.83 0.627 16.82 0.594 14.23 0.594 14.53 0.592 14.18 0.591 14.47All Underwriter % Shareholdings -0.889 -2.84Lead % Shareholdings -1.741 -4.25Non-Lead % Shareholdings -0.501 -1.13Underwriter Shareholding Dummy 0.047 0.57Lead Shareholding Dummy -0.089 -1.02Non-Lead Shareholding Dummy 0.160 1.47Log (Underwriter $ Ownership) 0.004 0.64Log (Lead $ Ownership) -0.006 -0.95Log (Non-Lead $ Ownership) 0.011 1.50

Adjusted R2 0.003 0.003 0.004 -0.001 0.002 0.001Number of Observations 674 674 674 674 674 674

29

Table 5Effect of underwriter shareholdings in an issuer on IPO underpricing based on initial two-day returns

Table 5 presents regression estimates of the following model:

The dependent variable Underpricing is the IPO initial two-day return based on the closing prices at the end of day +1. UPCT represents alternative measures of percentage underwriter ownership. Control Variable definitions are given on Table 1. The coefficients are estimated using ordinary least squares. Heteroscedasticity-consistent t-statistics [White (1980)] are used to measure significance of the coefficient estimates. The data are daily from January 1996 through December 2000.

1 2 3Coeff. t-stat Coeff. t-stat Coeff. t-stat

Intercept -3.707 -3.31 -3.799 -3.38 -3.711 -3.31All Underwriter Shareholders -0.218 -0.83Lead Shareholders -0.981 -2.13Non-Lead Shareholders 0.170 0.58Lead Shareholders with QIU -0.702 -1.63Lead Shareholders without QIU -2.818 -2.23Non-Lead Shareholders with QIU 0.121 0.37Non-Lead Shareholders without QIU 0.270 0.37Warrant Ownership 0.195 1.27 0.239 1.53 0.205 1.29Underwriter Reputation 0.031 1.56 0.033 1.63 0.032 1.57Global Offering -0.101 -1.37 -0.099 -1.35 -0.099 -1.35Underwriter Spread 18.420 3.32 18.786 3.40 18.378 3.31Dollar Amount Offered 0.115 2.15 0.118 2.20 0.115 2.16Dollar Share Volume (+6, +255) 0.021 7.89 0.021 7.89 0.021 7.87Dollar Share Volume Square -0.374 -6.09 -0.373 -6.09 -0.374 -6.07Stock Return Variance (+6, +255) -0.099 -1.07 -0.096 -1.04 -0.099 -1.07Market Return (-5, -1) 3.978 5.73 3.994 5.75 4.001 5.76“Bubble” Period -0.057 -0.68 -0.061 -0.73 -0.058 -0.69Internet 0.100 1.16 0.096 1.12 0.095 1.10Utilities -0.062 -0.66 -0.057 -0.62 -0.061 -0.66Financials -0.369 -1.61 -0.380 -1.67 -0.382 -1.67

Adjusted R2 0.45 0.45 0.45

30

Table 6The impact of underwriter shareholdings on

the probability of IPO overpricing

Table 6 reports probit estimates of the relationship between underwriter percentage shareholdings and the probability that IPO’s closing price on event day two is below its offer price. The following model is estimated:

The dependent variable is 1 if the first two-day returns of IPOs based on the closing prices at the end of day +1.is non-positive and is 0 otherwise. UPCT represents alternative measures of prior underwriter shareholdings. P-values for the coefficient estimates are reported in the adjacent columns. The data are daily from January 1996 through December 2000.

1 2 3 4 5 6Coeff. p-val Coeff. p-val Coeff. p-val Coeff. p-val Coeff. p-val Coeff. p-val

Intercept -0.847 0.00 -0.848 0.00 -0.828 0.00 -0.824 0.00 -0.821 0.00 -0.818 0.00All Underwriter Shareholders 0.616 0.40Lead Shareholders 0.907 0.49Non-Lead Shareholders 0.482 0.59All Shareholders Dummy -0.024 0.84Lead Shareholder Dummy -0.008 0.96Non-Lead Shareholder Dummy -0.056 0.70Log (Syndicate $ Ownership) -0.003 0.70Log (Lead $ Ownership) -0.001 0.89Log (Non-Lead $ Ownership) -0.005 0.60

Log Likelihood -338.59 -338.55 -338.91 -338.85 -338.85 -338.77Number of Observations 674 674 674 674 674 674

31

Table 7Effect of underwriter venture investment on IPO underpricing

with varying levels of issuer information asymmetry

Table 7 shows estimates of the following model:

The dependent variable Underpricing is the first two-day returns of IPOs based on the closing prices at the end of day +1. UPCT represents various measures of percentage underwriter ownership. Information asymmetry is measured as stock return variance over the period from event day +6 through +255. Control Variable definitions are given on Table 1. The coefficients are estimated using ordinary least squares. Heteroscedasticity-consistent t-statistics [White (1980)] are used to measure significance of the coefficient estimates. The data are daily from January 1996 through February 2000.

1 2 3Coeff. t-stat Coeff. t-stat Coeff. t-stat

Intercept -3.663 -3.298 -3.877 -3.490 -3.834 -3.408All Underwriter Shareholders (High Variance) 0.827 0.505All Underwriter Shareholders (Low Variance) -0.323 -1.310Lead Shareholders (High Variance) -3.523 -1.659Lead Shareholders (Low Variance) -0.739 -1.761Non-Lead Shareholders (High Variance) 2.589 1.201Non-Lead Shareholders (Low Variance) -0.113 -0.463Lead Shareholders with QIU (High Variance) -1.078 -0.568Lead Shareholders with QIU (Low Variance) -0.677 -1.536Lead Shareholders without QIU (High Variance) -11.115 -3.304Lead Shareholders without QIU (Low Variance) -1.288 -1.265Non-Lead Shareholders with QIU (High Variance) 1.745 0.671Non-Lead Shareholders with QIU (Low Variance) -0.050 -0.188Non-Lead Shareholders without QIU (High Variance) 4.473 1.217Non-Lead Shareholders without QIU (Low Variance) -0.358 -0.856Warrant Ownership 0.145 0.860 0.343 1.828 0.230 1.346Underwriter Reputation 0.030 1.469 0.028 1.381 0.029 1.415Global Offering -0.102 -1.378 -0.108 -1.454 -0.102 -1.375Underwriter Spread 18.333 3.295 18.364 3.402 18.222 3.308Dollar Amount Offered 0.113 2.131 0.126 2.357 0.124 2.305Dollar Share Volume (+6, +255) 0.021 7.912 0.021 7.901 0.021 7.877Dollar Share Volume Square -0.373 -6.100 -0.370 -6.100 -0.374 -6.067Stock Return Variance (+6, +255) -0.118 -1.184 -0.085 -0.832 -0.096 -0.931Market Return (-5, -1) 3.994 5.718 3.916 5.628 3.957 5.668“Bubble” Period -0.053 -0.632 -0.056 -0.668 -0.047 -0.566Internet Companies 0.101 1.168 0.085 0.975 0.088 1.007Utilities -0.062 -0.662 -0.044 -0.477 -0.051 -0.550Financials -0.361 -1.576 -0.378 -1.677 -0.390 -1.737

Adjusted R2 0.45 0.45 0.45

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Table 8Effect of prior underwriter share ownership on IPO underpricing controlling for selection bias

Table 8 reports on the relationship between IPO underpricing and underwriter share ownership controlling for selection bias. It presents estimates of the following two-step estimation procedure:First Step:

Second Step: In the Tobit regression, the dependent variables, UPCT, represents alternative measures of prior underwriter share ownership. The definitions of the control variables are in Table 1. The second step estimation uses ordinary least squares (OLS), where the dependent variable, Underpricing, is the IPO’s initial two-day return based on the closing price at the end of day +1. The residuals from the Tobit regressions are used to replace the corresponding UPCT. Heteroscedasticity-consistent t-statistics [White (1980)] are used to measure significance of the coefficient estimates. Daily data are taken from the sample period January 1996 through December 2000.

First Step: Tobit Model Estimation Second Step: OLS EstimationAll IPOs Lead Non-Lead All Lead Non-Lead

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-statIntercept -0.126 -10.12 -0.092 -6.83 -0.163 -8.99 -3.826 -3.43 -3.727 -3.34 -3.728 -3.33Lead Underwriter Shareholders -1.064 -2.17 -0.224 -0.83 0.012 0.04Warrant Ownership 0.236 1.53 0.195 1.27 0.191 1.24Underwriter Reputation 0.033 1.65 0.031 1.56 0.032 1.56Global Offering -0.100 -1.35 -0.101 -1.37 -0.101 -1.37Underwriter Spread 18.564 3.39 18.414 3.32 18.669 3.34Gross Proceeds 0.115 2.16 0.114 2.14 0.115 2.14Market Return (-5, -1) 3.998 5.77 3.978 5.73 3.975 5.71“Bubble” Period -0.062 -0.74 -0.057 -0.68 -0.054 -0.65Dollar Share Volume (+6, +255) 0.000 -0.07 0.000 0.70 0.001 1.69 0.021 7.90 0.021 7.88 0.021 7.88Dollar Share Volume Square -0.001 -0.10 -0.013 -1.05 -0.058 -1.56 -0.372 -6.07 -0.373 -6.06 -0.374 -6.06Stock Return Variance (+6, +255) 0.011 0.53 -0.017 -0.74 -0.043 -1.36 -0.103 -1.12 -0.097 -1.05 -0.098 -1.05Internet -0.013 -0.85 0.007 0.40 0.039 1.72 0.102 1.19 0.100 1.16 0.101 1.18Utilities 0.041 2.03 0.042 1.83 0.006 0.20 -0.074 -0.82 -0.066 -0.72 -0.068 -0.74Financials -0.729 0.00 0.037 0.68 0.093 1.49 -0.282 -1.22 -0.372 -1.62 -0.371 -1.62Percentage of Shares Offered 0.007 1.65 0.008 1.50 0.007 1.27Market Return on Offer Date 0.840 2.10 0.341 0.81 -0.039 -0.07

Log Likelihood / Adjusted R2 -84.549 -103.315 -125.359 0.45 0.45 0.45

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Table 9Effect of prior underwriter share ownership on IPO gross spreads

Table 9 presents regression estimates of ordinary least square models and ordered probit models. The dependent variable for columns (1) through (3) is the underwriter gross spread measured as a percentage of IPO issue size. The dependent variable for columns (4) through (6) is an indicator variable, GS, which is equal to zero if the IPO’s percentage gross spread is less than 7%, one if it is equal to 7% and two if it exceeds 7%. The independent variables include various measures of percentage underwriter share ownership distinguished by syndicate status and some control variables. The definitions of the control variables are in Table 1. Heteroscedasticity-consistent t-statistics [White (1980)] are used to measure significance of the coefficient estimates in columns (1) through (3). Daily data are taken from the sample period January 1996 through December 2000.

Ordinary Least Square Regression Ordered Probit Model

1 2 3 4 5 6

Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat Coeff. t-stat

Intercept 0.504 4.01 0.504 4.02 0.502 4.01 -72.079 -2.80 -72.204 -2.81 -72.323 -2.81

All Underwriter Shareholders -0.004 -2.07 -2.210 -2.49

Lead Shareholders -0.003 -0.76 -1.228 -0.70

Non-Lead Shareholders -0.005 -2.22 -2.581 -2.51

Lead Shareholders with QIU -0.002 -0.52 -1.159 -0.63

Lead Shareholders without QIU -0.008 -1.77 -1.920 -0.33

Non-Lead Shareholders with QIU -0.005 -2.18 -2.660 -2.33

Non-Lead Shareholders without QIU -0.005 -0.86 -2.312 -1.08

Warrant Ownership -0.001 -0.11 -0.001 -0.12 -0.001 -0.13 0.565 0.42 0.497 0.37 0.485 0.36

Underwriter Reputation -0.001 -5.25 -0.001 -5.25 -0.001 -5.24 -0.294 -4.45 -0.295 -4.46 -0.296 -4.47

Global Offering -0.002 -6.07 -0.002 -6.08 -0.002 -6.07 -0.408 -2.13 -0.415 -2.16 -0.417 -2.17

Dollar Amount Offered -0.046 -3.26 -0.046 -3.26 -0.045 -3.25 9.527 3.27 9.550 3.28 9.565 3.28

Dollar Amount Offered Square 0.001 3.16 0.001 3.16 0.001 3.15 -0.292 -3.59 -0.293 -3.61 -0.293 -3.61

Log Likelihood / Adjusted R2 0.48 0.48 0.48 -167.55 -167.31 -167.29

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Figure 1. Scatter diagram relating actual proceeds and gross spread. The sample consists of 674 firm-commitment venture-backed IPOs from 1996 to 2000.

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Figure 2. Gross spread distribution for IPOs The sample consists of 674 firm-commitment venture-backed IPOs from 1996 to 2000. Category 1, 2, and 3 includes IPOs whose gross spread is less than, equal to, and higher than 7% of gross proceeds, respectively.

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