Ch. 7: IPO Underpricing 409
make optimal operating and investment decisions. In particular, where the separation of
ownership and control is incomplete, an agency problem between non-managing and
managing shareholders can arise (Jensen and Meckling, 1976): rather than maximizing
expected shareholder value, managers may maximize the expected private utility of their
control benefits (say, perquisite consumption) at the expense of outside shareholders.
Two principal models have sought to rationalize the underpricing phenomenon within
the context of an agency cost approach. Their predictions are diametrically opposed:
whileBrennan and Franks (1997)view underpricing as a means to entrench managerial
control and the attendant agency costs byavoidingmonitoring by a large outside share-
holder,Stoughton and Zechner’s (1998)analysis instead suggests that underpricing may
be used to minimize agency costs byencouragingmonitoring.
5.1. Underpricing as a means to retain control
Brennan and Franks (1997)argue underpricing gives managers the opportunity to pro-
tect their private benefits by allocating shares strategically when taking their company
public. Managers seek to avoid allocating large stakes to investors for fear that their non-
value-maximizing behavior would receive unwelcome scrutiny. Small outside stakes
reduce external monitoring, owing to two free-rider problems. First, because it is a pub-
lic good, shareholders will invest in a sub-optimally low level of monitoring (Shleifer
and Vishny, 1986). Second, greater ownership dispersion implies that the incumbent
managers benefit from a reduced threat of being ousted in a hostile takeover (Grossman
and Hart, 1980). The role of underpricing in this view is to generate excess demand. Ex-
cess demand enables managers to ration investors so that they end up holding smaller
stakes in the business.
5.1.1. Testable implications and evidence
The principal testable implication of the Brennan–Franks model is that underpricing
results in excess demand and thus greater ownership dispersion. Using detailed data
on individual bids and allocations in 69 U.K. IPOs completed between 1986 and 1989,
Brennan and Franks confirm that large bids are discriminated against in favor of small
ones, an effect that is stronger the more underpriced and oversubscribed the IPO. How-
ever, the protection of private benefits of control may not be the only reason why
managers favor greater dispersion.Booth and Chua (1996)argue that owners value a
more dispersed ownership structure because it likely results in a more liquid secondary
market for their shares. InZingales (1995), a more diffuse ownership structure helps
managers negotiate a higher price when selling their controlling shareholding some
time after the IPO. Thus, a link between underpricing and ownership dispersion is not
sufficient evidence in favor of Brennan and Franks’ model.
Zingales (1995)assumes that an IPO is frequently only the first stage in a multi-
period sell-out strategy which will culminate in the complete transfer of ownership and
control from the original founders to new owners. Brennan and Franks, on the other