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

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.