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IPOs are rife with ethical conflicts of interest, but board insiders play it straight, study finds

May 1, 2008

For more information, contact: Benjamin Haimowitz,

"It was rape and pillage." So did an employee of a major investment bank describe his experience of initial public offerings in comments to a leading US newspaper seven years ago.
Today some measure of normalcy seems to have been restored to the field: witness the recent news that Frank Quattrone, the investment banker most associated with IPO-related abuses during the dot-com bubble, has been welcomed back to the securities business following his exoneration in a court of law.
Yet, aberrant though the bubble years were, the seeds of the flagrant IPO abuses that flourished then were planted in prior years and are probably present today, a new study suggests.
The research, in the current issue of the Academy of Management Journal, finds that, even before the dot-com era, IPOs were rife with ethical conflicts of interest that led to wholesale underpricing of shares -- that is, sale of IPO companies' stock by their investment banks at below-market prices. As a result, many millions of dollars were diverted from nascent public companies to preferred customers of the banks, often institutional investors, who paid a bargain price for the shares and quickly resold them on the market at a handsome profit.


"Research indicates that many institutional investors are interested in short-term gains associated with underpricing in IPO investments," write the study's authors, Jonathan D. Arthurs of Washington State University, Robert E. Hoskisson of Arizona State University, Lowell W. Busenitz of the University of Oklahoma, and Richard A. Johnson of the University of Missouri. "Ties between investment banks and institutional investors may be more salient for investment banks than the shorter-term agency relationship with the focal firm to market the IPO and thus may lead to increased underpricing."
Conflict of interest also afflicts many venture capitalists invested in IPO firms. In about one fourth of the more than 300 offerings investigated in the study, the underwriter banks responsible for underpricing had cozy relationships with firms' venture capitalists. Since venture capitalists "often seek to bring their funded ventures to IPO faster, maintaining ties with certain underwriters is important for their own success," the professors explain. To that end, VC investors become amenable to underpricing, the study concludes, even though it may diminish the future prospects of the firms in which they have invested.
But, if neither regulation nor ethical standards failed to squelch such conflicts of interest, something else did -- the presence of company executives on the board of directors. 
"It would appear that higher levels of insiders on the board would allow for greater vigilance in avoiding underpricing by the underwriter," the study concludes. Also helpful toward that end, it finds, is if outsider directors are substantially invested in the company and if board members are older individuals who have served on other boards, since additional directorships foster understanding of the nuances of going public and greater age endows appreciation of "a regular income in a stable organization." 
Comments Prof. Hoskisson: "The conventional wisdom about corporate governance nowadays is that insiders are the bad guys on boards of directors. But that appears not to be the case for companies going public. More than the other players in IPOs, it is the insiders who are most committed to the firm's performance over the long haul. They are out to protect their employment status by garnering as much capital for the young venture as they can, and so they make the case against underpricing in board deliberations and in so-called 'road shows,' at which parties to IPOs make their pitch to potential investors."
Asked  how conflicts of interest play out in particular IPOs, Prof. Arthurs cites the case of Micrografx, a Dallas-based graphics software developer whose lead underwriter, Alex Brown & Sons, had done six previous deals with a venture-capital firm, TA Associates, that had an 11% stake in the company. In an evident instance of flagrant underpricing, the stock was offered at $16 per share but closed on the day the firm went public at $23, a jump of more than 40% in that single day, compared to a mean of 10% for all the firms in the study.
In contrast, the lead underwriter in the IPO of Arrow International, Morgan Stanley, had no previous ties with the company's  venture-capital group, Resources Liquidity Tank. In addition, two thirds of the board of directors were insiders, well above the average insider representation of about 40%. The offer price was $18, and the stock closed the first day at $18.125, a rise of less than one percent.
Comments Arthurs: "When we launched the study, we thought that venture capitalists would turn out to be a force for underpricing. After all, it would not affect their own equity stakes, so it made sense to believe that they would adopt a short-term perspective at the IPO stage, given the pressure to generate returns for their funds' investors.
"But venture capitalists by themselves, we discovered, do not have a significant impact on underpricing without the additional factor of previous ties to the investment bank. It is the benefit that a bank gains from underpricing combined with the benefit a VC gains through a cozy relationship with a bank that provides impetus for below-market offering prices."
The study's findings derive from an analysis of data on 307 firms in 10 different industries that went public during the five years 1990-94. The time frame, spanning multiple years while avoiding the extremes of the dot-com bubble of the late 1990s, was a period not very different, the professors believe, from the present. The conflicts of interest in the IPOs they studied are relevant, they write, to "other settings where multiple agents are involved, such as in private equity deals... Situations of multiple agency are growing as more agents are watching agents in increasingly complex monitoring settings involving acquisitions, divestitures, IPOs, and private equity deals, as well as joint ventures and strategic alliances where minority equity positions are taken."
The new study, entitled "Managerial Agents Watching Other Agents: Multiple Agency Conflicts Regarding Underpricing in IPO Firms," is in the April/May 2008 issue of the Academy of Management Journal.  This peer-reviewed publication is published every other month by the academy, which, with close to 18,000 members in 102 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Review, Academy of Management Perspectives, and Academy of Management Learning and Education
Media Coverage:
Dow Jones Newswires. Study Links Underpricing to Venture Capital - Bank Ties. (Monday, July 14, 2008).

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