Heterogeneous Beliefs, Short Sale Constraints, and the Economic Role of the Underwriter in IPOs

Financial Management, 41: 769-811, 2012

EFA 2008 Athens Meetings Paper

64 Pages Posted: 17 Mar 2008 Last revised: 16 Dec 2017

See all articles by Thomas J. Chemmanur

Thomas J. Chemmanur

Boston College - Carroll School of Management

Karthik Krishnan

Northeastern University

Date Written: November 1, 2009

Abstract

Several theoretical papers have argued that the valuation of equity will reflect the beliefs of the most optimistic investors and be at a premium over intrinsic value when rational investors subject to short sale constraints have heterogeneous priors. We test the above theories by analyzing the effect of IPO underwriter reputation on the heterogeneity in investor beliefs and the tightness of short sale constraints and consequently on equity valuation in IPOs. We propose a “market power” hypothesis, postulating that higher reputation underwriters are able to attract a greater number of higher quality market participants (such as institutional investors, analysts, and co-managing underwriters) to the IPOs backed by them, thereby yielding higher IPO valuations by increasing the heterogeneity in investor beliefs and the tightness of short sale constraints. We empirically distinguish between the above hypothesis and the “certification hypothesis,” which implies that higher reputation underwriters are associated with IPOs priced closer to intrinsic value. We find that equity in higher reputation underwriter backed IPOs are priced higher and further away from intrinsic value compared to lower reputation underwriter backed IPOs. We show that the above relationship between underwriter reputation and IPO valuation is driven by the greater heterogeneity in investor beliefs, tighter short sale constraints, and greater participation by institutional investors, analysts, and higher reputation co-managing underwriters that characterize higher reputation underwriter backed IPOs. Overall, our results support the market power hypothesis and reject the certification hypothesis.

Keywords: Investment banks, Underwriter reputation, IPOs

JEL Classification: G24

Suggested Citation

Chemmanur, Thomas J. and Krishnan, Karthik, Heterogeneous Beliefs, Short Sale Constraints, and the Economic Role of the Underwriter in IPOs (November 1, 2009). Financial Management, 41: 769-811, 2012; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=890859 or http://dx.doi.org/10.2139/ssrn.890859

Thomas J. Chemmanur (Contact Author)

Boston College - Carroll School of Management ( email )

Finance Department, 436 Fulton Hall
Carroll School of Management, Boston College
Chestnut Hill, MA 02467-3808
United States
617-552-3980 (Phone)
617-552-0431 (Fax)

HOME PAGE: http://https://www2.bc.edu/thomas-chemmanur/

Karthik Krishnan

Northeastern University ( email )

360 Huntington Avenue
414C Hayden Hall
Boston, MA 02115
United States
617-373-4707 (Phone)

HOME PAGE: http://www.northeastern.edu/kkrishnan

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