Abstract

According to the information asymmetry theory of underpricing (Rock, 1986), firms and underwriters underprice IPOs to induce investors without full information to participate in the market. One way to reduce underpricing is through signals that indicate the value of a venture (e.g., Stuart, Hoang, & Hybels, 1999). One such signal is retained equity (e.g., Leyland & Pyle, 1977). At each IPO, the pre-IPO owners decide how much of a firm’s equity they will continue to hold after the IPO. Much prior work suggests that such ownership serves as a quality signal that reduces underpricing, but some studies have yielded mixed or even positive results (e.g., Beatty, 1989; Daily et al, 2004; Van Der Goot, 1997). More recent work indicates that the relationship may in fact be curvilinear (e.g., Bruton et al, 2009).

Our study considers the role of the competitive environment in shaping this relationship in order to reconcile conflicting past findings. Consistent with Bruton et al, (2009) we hypothesize that that there is a U shaped relationship between the amount of retained equity and IPO underpricing because moderate levels of retained equity can signal that previous owners have confidence in the future of the firm. Large blockholder may, however, feel little pressure to initiate changes in firm strategies and this entrenchment can reduce a firm’s ability to effectively react to adaptive demands of the competitive environment (Bruton et al, 2009). Thus, in the case of large blockholdings, IPO investors may need more information to understand the intentions of these blockholders and how they may affect firm value.

We also propose that this U shape relationship will be moderated by the competitive context of the IPO firm. In changing technical and market environments, retained ownership may be a less reliable signal about the quality of the firm since pre-IPO owners are less able to predict the future value of the firm. We also investigate how entrenchment by large blockholders may affect this relationship. In summary, we predict that the U shape relationship between underpricing and retained equity will be less pronounced in changing environments.

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