Analysts' Strategic Distortion during IPO Waves

• Author: Jianguo Xu,Ya Tang,Jing Chen,Yan Yu
• DOI: http://doi.org/10.1111/irfi.12149
• Date: 01 September 2018
• Published date: 01 September 2018

Analysts’Strategic Distortion

during IPO Waves*

YAN YU

†

,JING CHEN

‡

,YATANG

‡

AND JIANGUO XU

§

†

Business School, Beijing Technology and Business University, Beijing, China,

‡

Guanghua School of Management, Peking University, Beijing, China and

§

National School of Development, Peking University, Beijing, China

ABSTRACT

We study analysts’strategic distortion during different stages of initial public

offering (IPO) waves. We find analysts affiliated with leading underwriters

time the market and “speak in two tongues”in recommendations and

forecasts when they balance between conflicting interests of corporate finance

clients and brokerage clients. They are more optimistic than nonaffiliated

analysts in recommendations, but not in earnings forecasts in the early stages

of IPO waves. More positive recommendations help them win a larger share of

the booming IPO business. This distortion is absent in the late stages of IPO

waves. We also find that the market discounts strong-buy recommendations

from affiliated analysts in the early stages of IPO waves.

JEL Codes: D82; G10; G14; G24

Accepted: 12 July 2017

I. INTRODUCTION

The conflict of interest problem is widely recognized in the analyst behavior

literature.

1

Brokerage clients want high quality and “unbiased”research while

corporate finance clients expect optimistic reports. Sell-side analysts, therefore,

may choose to sacrifice objectivity and give upwardly biased recommendations

in response to pressure from investment banking divisions (Francis et al. 1997;

Michaely and Womack 1999; Chen and Matsumoto 2006). Malmendier and

* The authors thank Liyan Yang, Bing Han, Daixi Chen, and seminar participants at Peking Univer-

sity for helpful comments and suggestions. The authors are responsible for all remaining errors and in-

accuracies. Ya Tang gratefully acknowledges the financial support from the National Natural Science

Foundation of China (no. 71472006). Yan Yu gratefully acknowledges the financial support from

the National Natural Science Foundation of China (no. 71502007) and CICSOAA of Beijing Technol-

ogy and Business University (no. GZ20130801 and no. GZ20131002).

1 Many reports in the financial press also suggest that the conflict of interest in investment

banking may be an important issue. One source of the conflict lies in the compensation struc-

ture for equity research analysts. It is common for a significant portion of the research ana-

lyst’s compensation to be determined by the analyst’s“helpfulness”to the corporate

finance professionals and their financing efforts (Michaely and Womack 1999).

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12149

International Review of Finance, 18:3, 2018: pp. 331–357

DOI:10.1111/irfi.12149

© 2017 International Review of Finance Ltd. 2017

Shanthikumar (2014) find underwriter analysts that may speak in two tongues,

issuing overly optimistic recommendations to please the management while

being conservative in their earnings forecasts to protect their career reputations.

The conflict between the desire to generate corporate business and the need to

maintain analyst reputation is likely to be more severe during the early stages of

initial public offering (IPO) waves (Michaely and Womack 1999). Given the

severe information asymmetry during the early stages of IPO waves (Alti 2005),

affiliated analysts have the strongest desire to help expand investment banking

business. In reach for higher expected profitability, brokerage houses are likely

to underwrite better firms and issue more optimistic recommendations to

promote the firm and stimulate investors’optimism (Lin and McNichols 1998;

Pástor and Veronesi 2005). On the other hand, affiliated analysts have incentive

to provide quality researches and offer accurate forecasts in serving institutional

investors when information asymmetry is high. Particularly, when less informa-

tion is available during early stages of IPO waves, institutional investors expect

more accurate forecasts from affiliated analysts given their information advan-

tage through working relationships with the IPO firm. As a result, the conflict

of interest in serving their investment banking and brokerage clients is most

severe in the earlier stage of IPO waves. Consequently,affiliated analysts are more

likely to speak in two tongues when they make recommendations and earnings

forecasts in earlier stages of IPO waves (Malmendier and Shanthikumar 2014).

In this paper, we use an ideal scenario, that is, IPO waves, to study how

affiliated analysts behave differently as the relative importance to serve two

competing purposes changes. We first illustrate that the level of information

asymmetry gradually declines as an IPO wave proceeds. We then explore the

possibility that affiliated analysts strategically distort their recommendations:

They issue positively biased recommendations while providing less optimistic

forecasts in the early stages of an IPO wave, precisely when information asymme-

try is at the highest. Consistent with previous studies (Michaely and Womack

1999; Malmendier and Shanthikumar 2014), we also find that the market

optimally offsets the early stage bias of affiliated analysts. That is, the market is

not deceived by overly optimistic recommendations from affiliated analysts in

the early stages of IPO waves.

Our empirical study is conducted in three steps. First, using different methods

to identify spurts in IPO volume and several different proxies for valuation

uncertainty, we show that valuation uncertainty is higher in the early stages of

an IPO wave than in the late stages. We provide evidence that the information

environment is opaque at the beginning of an IPO wave and that the level of

information asymmetry gradually decreases as the IPO wave proceeds.

Second, we show that in the early stages of an IPO wave, when valuation is

high but information quality is poor, analysts affiliated with underwriters

provide disproportionately more positive recommendations but conservative

earnings forecasts. Later in the wave, when valuation and information asymme-

try are much lower, affiliated and unaffiliated analysts show no difference in

recommendations and earnings forecasts. It seems that, in the early stages of

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