Guru Analysts' Conflicts of Interest and IPOs Underpricing via Overvaluation

Abstract

In the context of hot IPOs markets, the large participation of unsophisticated retail investors offers to sell-side guru analysts a substantial influence on initial market valuation of firms going public due to divergence of opinions under short-sell constraints. As a result, gurus are directly or indirectly subjected to pressures from head-to-ahead competing clients endowed with conflicting interests as regards initial stock prices and performance-measurement horizon. Indeed, Firm's insiders and privileged investors favor an initial stock price overvaluation that induces underpricing: the resulting information momentum generates additional demand and supports short/mid-term performance until the expiration of the lock-up period. At the contrary, long-term investors favor initial fair valuation that supports long-term performance of IPOs. Thanks to a delegated common agency game under moral hazard and incomplete contracting, we endogenize the influence of environment variables on conflicts outcome as regards market initial valuation. We demonstrate first that the risk of underpricing through overvaluation depends crucially on the extent of the relative pricing preferences of opposite financial interests at stake in the IPO process. Thus, the more the potential profit from underwriting activities exceeds potential brokerage commissions, the more the bank favors issuers over investors, and the more likely initial market overvaluation is. Consequently, to protect unsophisticated retail investors unable to de-biais guru's recommendations, we introduce in a second time a regulator in the framework of a simultaneous intrinsic relationship, which suffers from overvaluation on the one hand, and is allowed to take costly judicial proceedings to penalize banks on the other hand. We then show that coercive regulation greatly mitigates damaging conflicts outcomes as regards IPOs' long-term underperformance when short-term focus is strong, even if it induces free-riding behaviors among fair-valuation partisans.