Managerial Rationality and Agency Problem in the IPO Market

When firms raise equity capital through initial public offerings (IPOs), do the managers act rationally? Recently Loughran and Ritter (2002) argued that some IPO issuers become "complacent" on receiving "good news", and that such issuers do not negotiate optimally. In this paper, I show that, upon observing good news, managers strategically select certain option quantities to their advantage. These options have a positive payoff only if the underlying IPO shares are underpriced. The evidence does not corroborate that managers become complacent upon observing good news. For the underpriced IPOs, potential payoff or recovery from the option is approximately 4 million dollars on average. Competition among underwriters reduces friction and improves the recovery rate while top ranked IPO underwriters with primarily institutional clients have the opposite impact. Finally, negotiated outcome for the option term is superior when interests of the directors and managers are aligned and less favorable when the directors have incentive but the managers do not. This may be construed as a weak evidence of effort based agency problem.