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INSTITUTIONAL AFFILIATION AND THE ROLE OF VENTURE
CAPITAL: EVIDENCE FROM INITIAL PUBLIC OFFERINGS IN JAPAN
Yasushi Hamao, Frank Packer and Jay Ritter

Federal Reserve Bank of New York
Research Paper No. 9807
April 1998

This paper is being circulated for purposes of discussion and comment.
The views expressed are those of the author and do not necessarily reflect those
of the Federal Reserve Bank of New York oftlie Federal Reserve System.
Single copies are available on request to:
Public Information Department
Federal Reserve Bank of New York
New York, NY 10045

Institutional Affiliation and the Role of Venture Capital:
Evidence from Initial Public Offerings in Japan

First draft: November 1997
This version: April 3, 1998

Yasushi Hamao
Graduate School of Business
520 Uris Hall
Columbia University
New York, NY 10027
Phone/Fax 212-854-5631/212-678-6958
E-Mail: yasushi.hamao@columbia.edu
Frank Packer
Capital Markets Department
Federal Reserve Bank of New York
33 Liberty Street, New York, NY 10045
Phone/Fax 212-720-6320/212-720-1773
E-Mail: frank.packer@ny.frb.org
Jay R Ritter
Warrington College of Business Administration
University of Florida
Gainesville, FL 32611-7168
Phone/Fax 352-846-2837/352-392-0301
E-Mail: jritter@dale.cba.ufl.edu
http://www.cba.ufl.edu/fire/faculty/ritter.htm

We thank Daiwa Securities and Nippon Investment & Finance for providing part of the data and
Mingzhu Wang for research assistance. The views expressed in this paper are those of the
authors' and not necessarily those of the Federal Reserve Bank of New York or the Federal
Reserve System.

Institutional Affiliation and the Role of Venture Capital:
Evidence from Initial Public Offerings in Japan

Abstract
The presence of venture capital in the ownership structure of U.S. firms going public has
been
associated with both improved long-term performance and lower underpricing at the time
of the
IPOs. In Japan, we find the long-run performance of venture capital-backed IPOs to be no
better
than that of other IPOs. Many of the major venture capital firms in Japan are subsidiaries
of
securities firms that may face a conflict of interest when underwriting the venture capital-b
acked
issue. When venture capital holdings are broken down by their institutional affiliation, we
find
that firms with venture backing from securities company subsidiaries perform significantly
worse
over a three-year time horizon than other IPOs. We also find that IPOs in which the lead
venture
capitalist is also the lead underwriter have higher initial returns than other venture capital-b
acked
IPOs, and sell at higher PIE ratios than comparable listed stocks. These results suggest that
conflicts of interest influence the pricing and long-run performance of initial public offering
s in
Japan.

Institutional Affiliation and the Role of Venture Capital:
Evidence from Initial Public Offerings in Japan

I. Introduction
Venture capitalists are increasingly recognized as financial intermediaries that overcome
problems of moral hazard and asymmetric information in financial markets (Gompers (I 995),
Lerner (1995)). Empirical work focusing on the underpricing of initial public offerings (IPOs)
suggests that venture capitalists in the United States, who take concentrated equity positions in
the issuing firm and retain significant portions of their holdings subsequent to the IPO, are
associated with a reduction in the underpricing of new issues (Megginson and Weiss (1991)).
Lower initial returns have been viewed as due to venture capital's role in the certification of
IPOs, and the reduction of information asymmetry between inside and outside investors.
An alternative to the certification framework does not assume equilibrium, but instead
permits the possibility that issuing firms and their financial advisors have some marketing power,
with which they can influence either the offer price, the (short-run) market price, or both. This
framework assumes that not all investors are sufficiently skeptical about firm quality, with the
result that "hyping" a stock can be successful. (See Forsythe, Lundholm, and Rietz ( 1997) for
experimental evidence that hyping a stock can be successful, and Lang and Lundholm (1997) for
empirical evidence in the context of seasoned equity offerings.)
Brav and Gompers (1997) report that venture capital-backed IPOs, unlike other IPOs, do
not significantly underperform over the long term, suggesting that reputational concerns may
constrain their actions. Reputational concerns may also be responsible for the fact that potential
conflicts of interest on the part of venture capitalists appear to play little role in the pricing and
performance ofU.S. IPOs (Gompers and Lerner (1997)). A number of U.S. venture capital firms
are subsidiaries of investment banks. If chosen as the lead underwriter, these investment banks
have increased incentives to overstate the value of the IPO to investors. Gompers and Lerner,
however, find no evidence that the offerings underwritten by affiliated investment banks perform
1

significantly worse over the long-term than other venture capital-backed issues.
In this paper, we present tests of the "certification" and "conflict of interest" hypotheses.
The evidence is from Japan, a country where venture capitalists frequently take stakes in firms
prior to their IPO on the over-the-counter (OTC) market. We use a sample of IPOs that took
place on Japan's OTC market between 1989 and 1995. We concentrate on the OTC market for
three reasons: (I) Tokyo Stock Exchange-listed IPOs tend to be large offerings of mature firms,
and in some cases represent the privatization of state-owned enterprises, for which venture
capitalists do not play any role, (2) pure IPOs on stock exchanges (i.e., excluding transfers from
the OTC to exchanges) occur much less frequently, and (3) just as Nasdaq is the primary venue
for IPOs in the U.S., during the last decade the OTC market has become the primary venue in
Japan.
In a related study, Packer (1996) has examined the association of venture capital with the
initial returns of 158 Japanese IPOs on the OTC between 1989 and 1991. Our study expands his
sample considerably, including nearly 300 additional IPOs that took place between April 1991
and December 1995. In addition, this study also explores the relation between venture capital
investment and long-term IPO performance. While our main focus is on the role of venture
capitalists in the IPO market, this is the first study of the long-run performance of Japanese firms
going public in the OTC market. We use a combination of pricing and returns information that
was previously unavailable to nonpractitioners.
Of the 456 IPOs in our sample, nearly one-half had at least one venture capitalist as one
of the firm's top 10 shareholders prior to the IPO. Unlike the U.S., venture capitalists are only
rarely independent. Instead, they are usually affiliated with major financial institutions such as
securities companies or banks.
Venture capitalists that are owned by securities companies have the potential to present a
conflict of interest of the sort discussed above. In all of the cases of our sample of Japanese IPOs
in which the lead venture investor has a securities company parent, the related securities firm was
part of the underwriting syndicate. In three-quarters of the cases, it was the lead underwriter. As
an owner of the issuing company, the lead underwriter has an incentive to market an issue more
aggressively and set a higher offer price· than it would if it was acting solely as a financial

2

intermediary. If this conflict of interest were important but not fully recognized by investors, we
would expect the IPOs where the lead underwriter was also the lead venture capitalist to exhibit
exceptionally poor long-run performance.
Equilibrium models based upon certification and screening predict that both the offer
price and the market price should be at higher levels for "certified" issues, and the difference
between the offer price and the market price should be less. Equilibrium models, by definition,
predict no abnormal returns beyond the initial return period. If there are concerns about conflicts
of interest, this should show up in increased underpricing and reduced price-earnings (PIE) ratios.
Since information asymmetries deal with unobservable information, a stock which is discounted
by the market would have a lower PIE ratio, holding other observable variables constant. In this
paper, we examine both the PIE ratios of IPOs relative to comparable firms, and the long-term
performance of IPOs relative to comparable firms. We also examine the short-run underpricing
patterns. In Figures 1-3, we summarize the predictions of the conflict of interest and certification
frameworks for PIE ratios (Figure I), long-run performance (Figure 2), and short-run
underpricing (Figure 3).
Bank-affiliated venture capital does not present the same conflict of interest that
securities firm-affiliated venture capital does, since commercial banks do not directly underwrite
equity offerings in Japan. Because of a lending relationship with the issuer, it is possible that a
bank-related venture capitalist will have better information than other venture capitalists. In the
U.S., there is less underpricing when the firm has bank loans outstanding (James and Wier
(1990)). Corporate bond issues in the U.S. underwritten by the Section 20 subsidiaries tend to
have lower yield spreads at issue for risky firms when the related bank has a loan stake in the
firm (Gande; Puri, Saunders, and Walter (1997)). This evidence is important because yield
spreads are a measure of valuation.
Bank-related venture capital is more long-term than that of other venture capitalists in
terms of continuing to hold shares after the IPO. In the U.S., Field (1996) has found that IPOs
with substantial institutional holdings post-IPO tend to outperform other IPOs. It is also possible
that IPOs with backing from a bank-related venture capitalist may exhibit better long-term
performance than other IPOs. In the U.S. bond market before Glass Steagall, both Puri (1996)

3

and Kroszner and Rajan (1994) find that bank underwritten issues were likely to result in fewer
defaults than other bond issues. 1
Another form of shareholding which we examine along with that of venture capital is
direct bank shareholding. Unlike the U.S., banks can own significant equity shares (up to 5
percent of any single company) in Japanese firms. We also investigate the special role of
keiretsu banks. A number of empirical studies have documented that the impact of a bank
relationship in Japan can differ if it is a relationship with a keiretsu bank. Hoshi, Kashyap, and
Scharfstein ( 1990) have found that firms in financial distress with a keiretsu bank affiliation are
more likely to maintain investment levels, while Prowse ( 1990) presents evidence that keiretsu
banks with substantial debt and equity stakes mitigate the agency costs of debt. It is possible that
the role of banks in influencing the pricing and/or long-term performance of IPOs is greater for
keiretsu banks than it is for other banks, because of the potential access to even greater inside
information about firm quality than a non-keiretsu bank. Dewenter, Novaes, and Pettway (1997)
find that, for a sample of Tokyo Stock Exchange (TSE)-listed IPOs, keiretsu-linked IPOs have
higher initial returns and Somewhat worse long-run performance than other IPOs.
Our principal empirical findings are as follows. First, we document average initial
returns of 15.7% on 456 OTC IPOs from April 1989-December 1995. Pettway and Kaneko
(1997, Table 2) report an average initial return of 12.7% for 69 TSE IPOs over the identical time
period. We document average three-year buy-and-hold returns of -46.1 % for 355 IPOs from
April 1989 to December 1994, with nonissuing firms matched on size and industry having
average three-year buy-and-hold returns of -27.2%. This results in a wealth relative of0.74
(=0.539/0.728). In other words, investing an equal amount in each of the IPOs would have left
an investor with 74 percent as much wealth 3 years later than if the money had been invested in
nonissuing firms. This three-year wealth relative is identical to that reported by Cai and Wei
(1997, Table 2) for 180 TSE-listed IPOs from 1971-1992 using an assets- and industry-matched
benchmark.
Second, in contrast to the U.S., venture capital-backed firms on the whole perform neither
better nor worse than non-venture backed firms. However, when we distinguish venture
capitalists by parental affiliation, the results differ greatly. Firms whose lead venture capitalist is

4

affiliated with a securities company perform noticeably worse long-term than other IPOs. The
worse performance of these IPOs is consistent with a conflict of interest that is not fully
discounted by the market.
Third, consistent with Packer (1996), initial returns for venture capital-backed IPOs also
differ depending on institutional affiliation. While all of the other forms of venture capital appear
to lead to lower initial returns-- consistent with venture capital alleviating informational
uncertainty about the IPO at the time of issue-- IPOs backed by venture capitalists whose parent
is the lead underwriter do not have lower initial returns. This is consistent with several
interpretations: investors demand more underpricing to compensate for the potential conflict of
interest, or the market price is (temporarily) too high as a result of a very successful job of
marketing the stock. In our examination of PIE ratios of IPOs relative to comparable listed
stocks, we find weak evidence for the latter hypothesis: the average PIE (computed using the
offer price) for IPOs backed by venture capitalists affiliated with the lead underwriters is 34.3,
relative to 29.7 for comparable firms.
Fourth, venture capital investment through bank subsidiaries appears to have an impact
on underpricing distinct from that of direct bank investment. Bank-related venture capital
investment is related to decreased underpricing, but this is not apparent in the case of direct bank
investment. Neither form of bank investment affects long-term performance relative to that of
non venture capital-backed firms.
Finally, whether the bank is a keiretsu bank does not appear to influence the impact that
bank-related venture capital or direct bank investment has on either underpricing or long-term
performance.
Our findings suggest that, while reputation effects constrain the behavior of financial
intermediaries faced with a conflict of interest in underwriting securities where they have an
ownership stake, reputation effects may not completely overcome the conflicts of interest. Thus,
unlike the conclusions from much of the academic literature using U.S. data, regulatory
constraints may offer protection to investors who otherwise may be too gullible. Whether this is
specific to Japan or not is an open question. Kang and Stulz (1996) conclude, for instance, that
Japanese managers decide to issue shares based on different considerations than American
5

managers.

In the next section, we outline the relative importance of the OTC market in Japan, our
principal data source for this paper, and changes in the regulatory regime governing IPOs. In
section 3, we examine and quantify the types of holdings in privately held companies by venture
capital prior to the initial public offering. We highlight differences in investor behavior after the
IPO by investor class. In section 4, the sample and data sources are introduced in detail, as well
as the methodology. Section 5 presents statistical evidence concerning the influence of the
different types of shareholding stakes on new issue underpricing, the long-term performance of
IPOs, and PIE ratios relative to comparable firms. We end with a brief summation of our results
and suggestions for future research in section 6.

II. The OTC Market and Changes in the IPO Regulatory Regime: 1989-1995
2.1 The OTC Market

The recent history of initial public offerings in Japan has been characterized by the
increasing importance of the over-the-counter market. In 1983, the Ministry of Finance relaxed
regulations to allow companies to raise equity capital through the over-the-counter market. Firm
age and per share dividend requirements were abolished, and a per-share profit requirement was
relaxed from 10 yen per share after-tax to 10 yen per share before-tax. Requirements for the
number of shares in the public float, shareholders, years with audited financial statements, years
with dividend payments, and the amount of profits were already much lower than those of the
Tokyo Stock Exchange (TSE).
By the late 1980s, the OTC had become the central market for initial public offerings in
Japan. Between April 1989 and December 1995, while Pettway and Kaneko (1997) report that
69 firms publicly issued equity concurrent with a listing on the TSE, our sample of OTC IPOs
totals more than 456 firms (Table 1). The OTC offerings in our sample tend to be fairly large,
with mean gross proceeds of 4.8 billion yen, although of modest size relative to mean gross
proceeds of 18.2 billion yen for Pettway and Kaneko's sample of TSE IPOs. (The yen/dollar
exchange rate averaged about 120 yen per dollar during our sample period.)
Firms that go public in Japan, including firms on the OTC, are much older on average

6

than those that go public in the U.S. The average age of firms going public in our sample is 35
years; by contrast, the average age of the 640 firm sample of U.S. IPOs from the mid-1980s
studied in Megginson and Weiss ( 1991) was just over IO years. The relatively high age numbers
may be due in part to the requirement in Japan that firms show profits prior to going public.
Though less demanding for OTC IPOs than the TSE, each firm in our sample was required to
show minimum pre-tax profits of 10 yen per share (and at least 1 million shares were to be
outstanding prior to the IPO). There also was a paid-in capital minimum of 200 million yen
(about $1.7 million).2
2.2 Changes in Regulations
The underpricing of initial public offerings in Japan has been well documented and until
the 1990s had been much larger than that of the United States. In the 1980s, initial returns
averaged 30-50 percent (Hebner and Hiraki (1993)). Underpricing was particularly large between
1986 and 1988. During this period, the first market prices of issues were around 55 percent
higher than the offering prices, with average initial returns of nearly 75 percent characterizing the
1988 market (Jenkinson (1990)). These large initial returns became the target of public criticism
during the Recruit scandal in which certain politicians, who were the recipients of preferentially
allocated shares, made large capital gains. The scandal served as a stimulus to reform and led to
a new system governing IPOs being implemented in April 1989. 3
Prior to reforms, the offering price for an IPO had been determined around 20 days prior
to the offering date by comparing its financial ratios with those of a comparable listed company.
The comparable company was chosen by the lead underwriter. The ratio of the offer price of the
IPO to the share price of a comparable company was the simple average of the ratios of
dividends, earnings, and book value per share to those of the comparable company. However,
the underpricing that resulted suggests that the competitive pressures on securities companies to
choose appropriate comparable companies were limited.

In the 1989 reform, the Ministry of Finance decided to continue using a method based on
the share price and financial ratios of a comparable company (though dropping dividends per
share from the formula). However, the value that resulted was only to serve as a floor on the
subsequent offer price. 30-40 percent of the shares being sold would be auctioned off in a

7

discriminatory auction fully open to the public where a maximum limit price of 30 percent above
the floor price was also established. The balance was to be sold at an offer price equal to the
weighted average of successful bid prices. 4 The first-stage auction occurred two weeks before
the public offering of the balance and data such as the total amounts bid and the settlement price
were released to the public on the day of the auction.
Auctions began in April 1989, and the evidence from TSE- and regional exchange-listed
IPOs, presented by Hebner and Hiraki (1993), is that average initial returns decreased from 34
percent to 21 percent. For our sample of 206 IPOs made on the OTC between April 1989 and
March 1992, Table 1 reports an average initial return of 19.8 percent. Between April 1989 and
March 1991, more than 50 percent of the first-stage auctions resulted in rationing at the upper
limit price, suggesting that even after allowing for a value 30 percent greater than the price
reached by a comparable company method, the offer price determined by the first-stage auction
procedure did not reflect initial demand (Packer (1996) ).
In mid-December 1991, after a sharp market downturn, and a month-long period in which
the first trading price was lower than the public offering price for more than half of around 30
IPOs, regulators temporarily closed down the IPO market. The next new listing on the OTC
market occurred in late May 1992.
As the narrow band for the first-stage auction was particularly costly to underwriters in a
down market, and there was a lack of a strong rationale for maintaining the band, the rules
regarding the setting of the offer price were revised twice within a year. First, starting in April
1992, the minimum bid price for auctions of newly listed stock was dropped from 100 percent to
85 percent of the "theoretical price" based on related companies, and the ceiling on the bids in
the auction was removed. Second, starting in January 1993, the lead underwriter was allowed to
discount the issue from the initial offer price determined at the auction. Initial returns on IPOs
subsequent to this combination of revisions, through the end of our sample period in 1995,
averaged 12.3 percent (Table 1), a significantly lower level than in 1989-1991.
Table 1 also reports the mean 3-year holding period return for the IPOs, and the mean 3year return in excess of that realized by an industry- and size-matched non-IPO portfolio (the
matching procedure is described more fully in section 4 ). The holding period returns are

8

calculated from the first market price of the IPO. The table also reports the 3-year wealth
relative--determined by dividing the average gross 3-year holding period IPO return by the
average gross return of industry- and size-matched firms.
Inspection of Table 1 reveals that in none of the cohort years of our sample were IPOs on
the OTC in Japan a good long-term investment. For IPOs issued during April 1989-March 1992,
the 3-year holding period return averaged -51.1 %, nearly 17% less than the industry and sizematched firms, giving a wealth relative of0.743. For IPOs issued during April 1992-December
1994, while the mean 3-year return improved somewhat, the wealth relative is 0.737. These 3year wealth relatives are even less than those of 0.86 documented for IPOs from 1989 to 1992 on
the Tokyo Stock Exchange (Cai and Wei (1997)), and 0.80 documented for IPOs in the U.S.
between 1970 and 1990 in Loughran and Ritter (1995). Thus, the long-term underperformance
of initial public offerings is apparent in our sample, as it has been in the majority of studies
around the world (see Loughran, Ritter, and Rydqvist (1994)).

III. Types of Venture Capital in Japan and Bank Shareholding
3.1 Venture Capital in Japan
There are significant differences between venture capital in Japan and the United States.
For one, the industry is more concentrated than in the United States. Of the aggregate investment
portfolio of 877 billion yen reported by the respondents to a 1997 survey of major venture capital
firms, the top 4 firms accounted for 46.1 percent, while the top 10 accounted for 66.5 percent
(Nikkei Kinyu Shimbun (1997)). Secondly, venture capital companies which invest in unlisted
companies tend to be relatively young. The first private venture capital firms in Japan were
established in the early 1970s. The median year of establishment for the ten largest private
venture capital firms listed in the above-mentioned survey is 1983.
One striking characteristic of Japanese venture capital is that none of the leading venture
capital firms are independent. Among the top twenty-five venture capital firms listed in the
Nikkei survey, 11 were the affiliates of banks, and 8 were the affiliates of securities firms; the
rest were either semi-governmental institutions (3), the affiliates of non-bank financial
institutions (2), or the affiliate of a software company (1). 5

9

Unlike the United States, where many venture capitalists specialize in taking an active
role in the financing and advising of young companies, venture capital investing in Japan is not
associated with an active monitoring role. In fact, until 1995, the anti-monopoly law prohibited
employees of a venture capitalist firm from being on the board of directors of a firm that it
invested in. Venture capital's relatively inactive role in the governance of the firm is paralleled
by a pattern of providing financing relatively late in the life cycle of portfolio companies. The
Ministry of International Trade and Industry's (MITI) estimate of the percent of new Japanese
venture capital funding during fiscal year 1995 that went to startup firms is 3 percent, much
lower than the 30 percent reported for U.S. venture capital. At the other extreme, 38 percent
went to firms over 20 years of age (Venture Enterprise Center ( 1997) and !soda ( 1997)).
Consistent with the tendency to invest in relatively mature companies, there is no strong hightech bias in venture capital investments in Japan, unlike the U.S.
While Japanese venture capitalists may fund more established firms and provide less
managerial advice, they still generally invest with the objective of holding on to the shares until
the company goes public. According to an estimate of !soda ( 1997), 58 percent of the venture
capital investment in Japan, on an investment-cost weighted base, results in an IPO. The
comparative numbers for U.S. and European venture capital are 47 percent and 31 percent. The
Japanese percentage is relatively high due to the aversion to investments in startups, which are
more likely to result in disposition via bankruptcy or acquisition at a fire-sale price.
3.2 Characteristics of Venture Capital-backed IPOs

The presence of venture capital in Japanese IPOs is clearly evident in Table 2 when we
examine the ownership of our sample of 456 firms which went public in Japan between 1989 and
1995 on the OTC market. 210 firms, or 46 percent, have a venture capitalist among the top 10
shareholders prior to listing.
Table 2 also compares the characteristics of these venture capital-backed IPOs with the
rest of the IPO sample. The size of the IPO, as measured by gross proceeds, averages 4.2 billion
yen (about $35 million U.S.) for venture capital-backed IPOs; the median is 2.6 billion yen. Both
the mean and median are significantly smaller than those of the non-venture IPOs. Similar to the
U.S., venture-capital backed IPOs tend to be younger than other IPOs.
10

Underpricing of venture capital-backed IPOs tends to be greater than that of other IPOs in
Japan. The mean of 19 .2 percent and median of 8 percent are both significantly higher than those
of other IPOs. While this pattern was not found in the U.S. (See Megginson and Weiss (1991,
Table VI) and Barry, Muscarella, Peavy, and Vetsuypens (1990, Table 4)) for IPOs from the
1980s, we show below that in the 1990s, the U.S. pattern is similar to that of Japan. Increased
underpricing on average might suggest that venture capital does not alleviate informational
problems by certifying the quality of the IPO firm. In our regressions to be reported later, we
will control for other firm-specific variables such as size and age, which may affect underpricing
independently of venture capital participation.
The book-to-market measures are not significantly different between venture capitalbacked and other IPOs, and the means and medians of the 3-year returns, excess returns, and
wealth relatives are also not statistically different. During our sample period, IPOs in Japan have
been a relatively poor investment regardless of whether they had venture capital-backing or not.
Table 3 reports that the average stake of the lead venture capitalist is 5.92 percent, less
than one-half of the participation documented in similar studies of the United States. On
average, the post-IPO equity share held by the lead venture capitalist declines by around 40
percent of the pre-IPO share.

Since the increase in the number of shares outstanding from a

public offering is limited to 30 percent, this implies that some cashing out by the venture capital
investors occurs either during the offering or its immediate aftermath.
3.3 Small Business Investment Companies.
There appear to be distinct patterns in the behavior of venture capital depending on
institutional affiliation. The oldest venture capital firms in Japan are the semi-governmental
institutions. In 1963, Small Business Investment Companies (SBIC) were set up in Tokyo,
Nagoya, and Osaka by the enactment of the Small Business Investment Law under MITI's
initiative. Capital was contributed into these SBICs by both local government institutions and
local financial institutions and companies. Regulations limited their investment to small, yet
profitable, dividend paying companies, and further required that the investment be at least 15
percent of the total equity (Clark (1988)).
Because of their early start, the investments outstanding of the three SBICs are relatively
11

large, and the Tokyo and Osaka SBICs were ranked 7th and 9th in the 1997 Nikkei survey of
venture capital firms, based on outstanding investments. The fruits of past SBIC investment
decisions are evident in our sample of IPOs. Table 3 indicates that they were the leading venture
capitalist in 24 out of the 210 cases in which pre-IPO venture capital funding occurred. A
distinctive feature of SBIC cases is that they are the leading venture capital shareholder in almost
every case in which their investment appears. This phenomenon reflects the minimum
shareholding requirement at the time of the investment. By the time of the IPO, however, they
usually hold less than 15 percent, since other private equity investments occurred between their
investment and the time of the IPO.

3.4 Securities Company-Affiliated Venture Capital.
Another class of players in the Japanese venture capital industry are those companies
which are affiliates of a Japanese securities company. Five out of the top ten, and eight out of the
top twenty-five, firms in 1997 were affiliated with securities companies. A striking parallel with
the securities industry is the dominance of one firm (Table 4). Nomura Securities' affiliated
subsidiary, Japan Affiliated Finance Company (JAFCO) accounted for 21.7 percent of the
reported stock of investment by private venture capital in Japan in 1997. In addition to its market
share dominance, JAFCO is also the only venture capital firm which has publicly traded shares.
Securities firm-affiliated venture capitalists are the most numerous in the pre-IPO
investment ledger of our sample (Table 3). 99 of the 210 firms with venture capital funding had
as their lead venture capitalist one that was affiliated with a securities firm. Another 32 had one
as a secondary provider of venture funds. Thus, more than 28 percent of the entire IPO sample,
and 60 percent of the venture capital-backed sample, had a securities firm-affiliated venture
capitalist among their top ten shareholders.
Venture capitalists affiliated with securities companies may intend to obtain the lead
underwriter position for the parent if the company goes public. It is customary for the managing
underwriter to underwrite around 40-60 percent of the issue itself compared to 25-35 in the U.S.
(Sutton and Benedetto (1990)). Thus, it obtains most of the underwriting fee, which is
customarily set at about 3.5% of the offer price. In Table 4, the relationship between venture
capital participation and the position ofthe lead underwriter is documented for our sample. A
12

company with a securities company-affiliated venture capitalist among its top ten shareho
lders
chooses that company as its lead underwriter more than 75 percent of the time.
In the analysis to follow, we will be examining whether the impact of securities firmaffiliated venture capital investment differs if the venture capitalist is also affiliated with
the lead
underwriter. There is reason to believe that a managing underwriter may have better informa
tion

about the quality of the firm. 6 At the same time, the lead underwriter faces a greater conflict
of
interest when it also holds a stake in the firm through a venture capital subsidiary. The
managin

g

underwriter may have an increased incentive to market the issue and generate overly optimist
ic
forecasts of the firm's prospects. The greater tendency of securities firm-affiliated venture
capital to cash out at the IPO merely exacerbates this conflict of interest.
Of course, there is also the possibility that concerns over reputation may constrain the
securities company and/or related venture capitalist from overpricing an IPO. Gompers
and
Lerner ( 1997) have found no evidence that the conflicts of interests between underwriter
and
their captive venture capital subsidiaries affects either after-market performance of IPOs
or the
magnitude of underpricing at issue. In the context of underpricing alone, Beatty and Ritter
(1986) have found evidence that the market "punishes those underwriters who cheat."
Carter and
Manaster ( 1990) and others have found empirical evidence of significantly negative relation
s
between underwriter prestige and the magnitude of underpricing.

3.5 Bank-Affiliated Venture Capital.
The third major class of players in the Japanese venture capital industry are companies
which are affiliates of Japanese banks. Two out of the top ten, and eleven out of the top
twentyfive firms in the industry, are affiliated with commercial banks. In our 456 firm IPO sample,
the
presence of bank venture capital subsidiaries among the top ten shareholders is almost as
frequent as that of the securities firm subsidiaries (Table 3). More than one-third of the
210
venture capital-backed IPOs have a bank subsidiary as their lead venture capitalist prior
to the
IPO.
Bank-affiliated venture capital involvement appears to be somewhat more long-term
oriented than its securities company-affiliated counterpart. The percentage of equity held
by the
lead venture capitalist increases from 4.3% pre-IPO to 4.5% afterwards (Table 3). Bank13

affiliated venture capital shareholding is often associated with a lending relationship. In more
than one-half of the cases of bank-affiliated venture capital investment, the related bank is listed
as the top transaction bank. Holding shares in the firm is sometimes viewed as a mechanism
through which Japanese banks reduce the agency costs associated with debt (Prowse (1990),
Aoki (1988)). Bank shareholding through venture capital subsidiaries may also be of relevance
to the costs of information asymmetries in going public as well.

3.5 Foreign and Independent Venture Capital
The final class of venture capital firms are either foreign or independent. IPO firms with
foreign or independent venture capital involvement comprised less than IO% of all IPOs (Table
3). Cases in which the lead venture capitalist fell into this category were distinct in two respects.
First, the foreign/independent venture capitalist tended to own a larger share of the firm prior to
the IPO -- 8.4% on average -- than either bank- or securities firm-affiliated venture capitalists.
Second, the foreign/independent venture capitalist, when it was the lead, tended to be a part of a
larger syndicate. The mean number of venture capitalists as major shareholders, 2.7, and the
mean percentage of equity held by all venture capitalists, 11.5%, are larger than any of the other
classes of venture capital (Table 3).

3.6 Direct Bank Shareholding.
Unlike U.S. banks, which cannot hold stocks of nonfinancial corporations, Japanese
banks are allowed to take equity positions in Japanese companies. 7 Thus, banks may invest in
the firm prior to the IPO directly and not just through venture capital subsidiaries. As with that
of their venture capital subsidiaries, bank shareholding is usually associated with a lending
relationship. In our sample, the lead bank shareholder subsequent to the IPO is listed as the top
transaction bank by the firm more than 80 percent of the time.
The recruitment of banks as major shareholders generally occurs well in advance of going
public, and is usually given high priority in "how to go public" manuals in Japan (Kakitsuka
(1989)). The emphasis is usually on the creation of stable shareholders and by extension the
minimization of "floating" shareholdings which can fall into unfriendly hands. As stable
shareholders, banks are not only expected to hold on to their pre-IPO shares, but also to buy up
shares in the offering or after-market to preserve or increase the proportion of their holdings.

14

In Table 5, we see that the presence of banks as major shareholders for companies going

public is more common than that of venture capitalists. 363 firms, or 78% of our sample, have at
least one bank as one of their top ten shareholders prior to going public. The average percent
holding for the lead bank is somewhat lower than that documented for venture capitalists -around 2.9% (remember that any one bank cannot hold more than 5% of the equity). Keiretsu
banks, which are the lead banks around two-thirds of the time, tend to own a little less equity
(2.6%) and tend to be accompanied by fewer banks when they hold shares.
An important difference between direct bank shareholding and the behavior of most of
the more formal forms of venture capital shareholding can be seen in the columns that document
post-IPO holdings. Not only do more banks on average enter the ranks of the top ten
shareholders with a larger aggregate share, but the share of the lead bank shareholder increases
subsequent to the IPO to 3.3% on average. Banks increase their shareholding either during or
subsequent to the IPO. Because of this, it is possible that direct bank shareholding may have
more credibility as a mechanism of certification than that of the formal venture capital
institutions in Japan.

IV. Data and Methodology for Tests Using Returns
4.1 Sample Selection and Data.

Because we only have records of long-term (three-year) performance through December
31, 1996, we restrict our sample for the analysis that follows to those IPOs between April 1989
(the introduction of the auction system) and December 31, 1994. The 101 OTC-listed IPOs from
1995 are not used for our long-term performance analysis.
For each IPO firm, matching listed firms were searched for. First, firms in the same fourdigit industry classification were first chosen from all firms that have been traded (on either the
OTC market or the Tokyo Stock Exchange) for more than three years. These firms are then
divided into deciles according to the market value of equity. We choose firms in the same size
decile as the IPO firm to be industry and size-matched firms. If there is more than one qualifying
matching firm, we form a portfolio of matching firms. In this matching, we lost 56 firms from

a

our observations because of the lack of comparable firm, resulting in 355 IPO firms between
15

April 1989 and December 1994. The 3-year excess return which serves as the dependent variable
in the regressions reported in Table 7 is calculated as the three year buy-and-hold return for the
IPO (from the end of first trading day price) minus the average three-year buy-and-hold return
over the same period for the matched non-lPO firms. IPO firms that are delisted are included
until the date of delisting. Reflecting the relative infrequency of delistings, in no case did a
portfolio of matching firms cease to have at least one component firm.
Data on individual daily stock prices and OTC index values are taken from the Nikkei
NEEDS electronic database. Shareholding data, firm size and age, as well as identification of the
transaction bank and lead underwriter, are taken from various editions of the Japanese language
version of the Kaisha Shiki Ho (Japan Company Handbook). Price and quantity information
about the auction and initial public offerings were provided by Daiwa Securities, including the
number of shares put up for sale, the allowable bid interval, the number of bids submitted, and
weighted average of bids (offering price) from the auction.

4.2 Methodology and Variables Used
To test our hypotheses, we estimate two sets of regressions using returns. First, we
regress the 3-year excess return (over matched firms) on control variables and dummies
accounting for different types of IPO shareholding. Second, we estimate the impact of different
types of pre-lPO shareholding on the difference between the offering price and the first trading
price. We have designed the estimation procedures to control f,pr important institutional features
of the IPO process in Japan as well as other factors commonly used in empirical tests of the
determinants of the long-term performance and initial return of IPOs.

Size, Book-to-Market, and Age. The first set of equations, estimating the determinants of
long-term performance, includes three control variables. We include the natural logarithm of
offer proceeds. Smaller firms tend to perform worse in studies of long-term performance in the
United States (Ritter (1991), Brav and Gompers (1997)). We also include the natural logarithm
of the firm's book-to-market equity ratio, based on the first market price of the share subsequent
to the IPO and the post-issue book value. We also include the natural logarithm of the age of the
firm.
The second set of equations, estimating the determinants of underpricing, includes each

16

of the three control variables discussed above, with the modification
that the market value of the
book-to-market ratio is estimated using the lower limit of the auctio
n bid range. Issues with
greater ex ante uncertainty should be most subject to the winne r's curse
and thus equilibrium
underpricing. Both age and offering proceeds are commonly used proxie
s for ex ante
uncertainty. Beatty and Ritter ( 1986) and others have shown that large
offerings are less
underpriced.
The second set of regressions also includes the following additional
variables to account
for the IPO regulatory regimes.

Auction Results. As explained above, the offering price is determined
in an auction of
part of the issue, which occurs two weeks before the trading of the issue.
During the April 1989 March 1991 period, the offering price was constrained to be within a
price range determined by
the comparable company method. These results are revealed to all potent
ial subsequent
subscribers to the issue. In addition to the offering price (the weighted
average of successful
bids), the most informative single number is the ratio of the numbe r
of total bids submitted at the
auction to the numbe r of shares auctioned. This number is particularly
important should the
issue have been sold out at the upper limit price during the first IPO
pricing regime of I 9891991, as it proxies for the numbe r of bidders rationed out of the issue
on a non-price basis. We
include the ratio of this numbe r to the total numbe r of shares issued
as a variable ("Subscription
Ratio") which we expect to be positively related to expectations after
the auction concerning the
actual value of the issue. Since the effect of the subscription ratio should
differ depending on

the
allowable bids, we allow the coefficient on the subscription ratio to
differ depending on each of
the regimes by including three variables, each of which is the subscr
iption ratio during one
regime, 0 otherwise.
A proble m with using the subscription ratio as an explanatory variab
le is that it is
endogenous: the popularity of the auction may also reflect variables
such as ex ante uncertainty
as well as the venture capital dummies, and it is likely to be correlated
with the disturbance term
of the equation. Since the OLS estima tor is biased, even asymptotical
ly, in this case, the method
of instrumental variables will be used. The instrument will be that sugges
ted by the 2SLS
procedure. Namely, the subscription ratio will be regressed against
the three exogenous variables
17

described above, an additional variable which measures market movement over the period
between setting of the auction price parameters and the actual auction itself, and the venture
capital dummies described below. The estimated values for the subscription ratio which result
will then be used as the instrumental variable for the subscription ratio.
Institutional Lag. In general there is a time lag between the auction and the formation of
an initial trading price of usually two weeks. To the extent that the value of the issue is related to
that of the market, market movements in the interim period may affect the spread of the initial
trading price over the offer price. Thus, a variable is included which is the return of the Nikkei
OTC index during the time period between the company's auction and formation of an initial
trading price. We expect the coefficient on this variable to be positive and significant.
Regime Dummies. As discussed above, there were three distinct IPO regulatory regimes
during the period of our sample (1989-1991, 1992, and 1993-1995). The second and third
regime are distinguished by fewer constraints on the first stage bidding, and the third regime is
distinguished by increased discretion awarded the underwriter to discount the issue from the
price reached at the auction if market conditions warranted. We are already controlling for how
these regimes may change the influence of the subscription ratio as a predictor of underpricing.
We include two straight regime dummies as well to control for any additional impact regime
changes had on the absolute level of underpricing.
Venture Indicators. For both the long-term performance and underpricing regressions,
we include six different specifications which differ in their combination of variables indicating
venture capital participation. In specification (I), we include an indicator variable that equals
one if any venture capitalist is on the list of top ten shareholders. Specification (2) is identical to
specification ( 1) except that we include an additional indicator variable which equals one if the
IPO also has a direct bank investor among its list of 10 largest shareholders prior to the IPO that
is greater than any of the venture capital investors. In specification (3), we include four mutually
exclusive indicator variables that equal one if the lead venture capitalist of the IPO was affiliated
with a securities firm, a bank, an SBIC, or was foreign/independent, respectively. Specifications
(4) and (5) include dummy variables measuring whether a securities firm-affiliated venture
capitalist was or was not the lead underwriter. In specification (5), we include a dummy variable
18

for whether the IPO also has a direct bank investor among its largest pre-issue shareholders.
In specification (6), we also include seven exclusive indicator variables, but this time

divide up the indicator variable for bank-related venture capital backing into one that equals one
if the related bank was a keiretsu bank, another equaling one if the related bank was not a
keiretsu bank. Two additional indicator variables are added: the first of which equals one if there
is a direct keiretsu bank investor among the top ten shareholders that holds more shares than the
venture capital investors, the second that equals one if the direct bank investment is from a nonkeiretsu bank.

V. Empirical Evidence
5.1 Sample Summary Statistics.
In Table 6, characteristics of the firms going public on the OTC in the years 1989-1994

are presented according to the existence and type of venture backing, and the presence of direct
bank investment. Since full three-year performance histories are not available for IPOs after
1994, we do not include them in the regression analysis to follow. Striking differences are
evident in the summary statistics when we divide up the sample by different types of venture
capital.
As shown in Table 6, the firms in which SBICs invest are much older than average (45.2
years as opposed to the average of 32.9 years) at the time of the IPO and have a much smaller
issue size. Furthermore, the book-to-market ratio is much higher. While the initial return on
SBIC-backed issues is generally much lower, the subsequent 3-year excess return and wealth
relative tend to be larger (though still negative and less than one, respectively).
Venture capital-backed issues in which a securities company affiliate was the lead venture
capitalist tend to be slightly younger and somewhat larger. The initial returns are somewhat
larger and the long-term returns somewhat worse than the entire venture capital-backed sample.
This suggests that conflict-of-interest may be accounting for worse long-term performance and
increased underpricing at the time of issue. Firms in which the venture capital backing comes
from a firm related to the lead underwriter tend to be much larger than the others.
New stock issues in which a bank-affiliated venture capital firm is the lead venture

19

capitalist also tend to be slightly younger and somewhat larger than other venture capital-backed
IPOs. The initial returns and long-term excess returns are fairly similar to that of the entire
sample. Larger distinctions are apparent from the sample of keiretsu bank-affiliated venture
capital-backed IPOs. These tend to be smaller issues than other IPOs, and exhibit dramatically
less underpricing at the time of issue (10% versus an average of22.6%). At the same time, the 3year excess return is 4 percent worse than the venture capital-backed IPO average of -22.0%.
The final two rows give summary statistics for those cases of direct bank investment in
which their holdings exceeded those of the venture capitalists. These IPOs tend to be much
larger than the venture capital-backed IPOs, on average by more than one-third. They tend to be
older, have lower initial returns, and more positive long-term returns than venture capital-backed
IPOs. When we examine IPOs with direct keiretsu bank investment in isolation, they tend to be
even larger and older, have even lower initial returns and more positive long-term returns than
other IPOs with direct bank investment. These numbers suggest that the type of firm that banks
(both keiretsu and non-keiretsu) invest in directly prior to the IPO differ from the type that they
invest in through their venture capital subsidiary. Dewenter, Novaes, and Pettway (1997), in an
examination of TSE-listed IPOs, find that IPOs affiliated with a keiretsu bank have higher initial
returns, a finding that contrasts with our results.
5.2 Determinants of Long-Term Performance.
Table 7 reports the results of the six specifications of the long-term performance
regressions discussed in section 4.2 above. In an attempt to partly control for omitted factors, we
include cohort year dummy variables (whose coefficients are not reported) to account for yearly
fixed effects. Since many of the return intervals overlap, they are subject to common (omitted)
factors, and thus the heteroskedasticity-corrected !-statistics may still overstate the significance
levels.
In all specifications, the coefficients on age and book-to-market are insignificantly

different from zero. Surprisingly, the coefficient on gross proceeds is always significantly
negative. In contrast to the United States, larger issues tend to exhibit systematically worse longterm performance relative to matched firms. The first and simplest specification suggests that
venture-capital issues, taken as a whole and controlling for other factors, may exhibit even worse

20

long-term performance than other IPOs. The coefficient estimate indicates 4.8% worse
performance relative to other IPOs over three years. However, the coefficient estimate is not
statistically significant (t-statistic of -1. 10).

In regression (3) with the four venture-capital dummies separated by institutional
affiliation, we find a significantly negative coefficient on one of the four variables. Venturecapital-backed firms where the parent of the lead venture capitalist is a securities company
exhibit significantly worse performance relative to a matched sample than do other IPOs: 11
percent worse over three years. These results are consistent with increased marketin g of the issue
and overly optimistic projections when securities company-affiliated venture capitalists have
invested. Other forms of venture backing, however, do not appear to relate to significant
differences in long-term performance relative to other IPOs.
The coefficients from regressions (4) and (5) indicate that the negative performance of
IPOs in which the securities company has invested through its venture capital affiliate cannot be
attributed in particular to the role it may take as a managing underwriter. F-tests indicate that the
negative coefficients for the indicator variables for the two types of securities firm-affiliated
venture capital are not significantly different from each other.
The results from the remaining regressions are also negative. Regression (6) indicates
that the insignificance of bank venture backing to long-term performance is independent of the
keiretsu affiliation of the bank. Regressions (2) and (5) indicate that direct bank investme nt is
not associated with changes in long-term performance, and regression 6 indicates that the
insignificance of bank direct investment is independent of whether the bank is a keiretsu bank.

5.3 Determinants of Underpricing
As mentioned in the introduction, evidence from the U.S. using IPOs from the 1980s is
that venture capital-backed IPOs are underpriced to a lesser extent than non venture capitalbacked IPOs. Two of the major studies are summarized in Table 8. While the study of Barry,
Muscarella, Peavy, and Vestuypens (1990) found no significant difference, based on at-test of
differences of means, Megginson and Weiss (1991) found in multiple regression analysis that
venture capital-backed IPOs had significantly less underpricing than a matched sample of non
venture capital-backed IPOs. This has been interpreted as consistent with venture capitalists
21

certifying IPOs, and a reduction in information asymmetry between inside and outside investors.
In the third panel of Table 8, we report the results from U.S. IPOs over the same time
period -- 1989-1995 -- as our sample of Japanese IPOs. In sharp contrast to the U.S. evidence
from the 1980s, venture capital-backed IPOs have been more underpriced than non venture
capital-backed IPOs. The average initial return on venture capital-backed IPOs is 14.7%,
compared to an average of 11.3% for other IPOs. The association of venture capital backing with
greater initial returns stands up in unreported regressions that control for some of the other crosssectional determinants of short-run underpricing, including six industry dummy variables. Thus,
the relation of U.S. venture-capital backing to IPO initial returns appears to have shifted over
time.
We report_the detailed results for our sample of Japanese IPOs from April 1989December 1995 in Table 9. The table reports six specifications of the underpricing regressions.
The resulting adjusted-R2 statistics round to 0.13 to 0.15 for the six specifications, at the upper
end of the range of adjusted-R2 statistics of 0.07 to 0.15 for most of the studies purporting to
explain cross-sectional variation in the underpricing of IPOs in the United States. In all
specifications, the instrument for the subscription ratio, age, book-to-market, and gross proceeds
are significantly positive. The latter three results are surprising since there is reason to expect
that ex-ante uncertainty would be less for older firms and larger issues, and for firms with higher
book-to-market ratios. Nonetheless, underpricing is systematically greater for these firms. As
expected, the institutional lag variable comes in positive, though it is not statistically significant
in any of the specifications. Regression ( 1) of Table 9 indicates that venture capital-backed
issues exhibit a significant reduction in underpricing relative to other IPOs. On average, the
reduction in underpricing is nearly 11 percent (t-statistic -2.39). In regression (3) wiih the four
venture-capital dummies separated by institutional affiliation, we find a negative coefficient on
all four of the variables.

In regression (4) it is apparent that all of the reduced underpricing associated with
securities firm-related venture backing occurs when the securities firm is not the managing
underwriter of the issue. The coefficient on the indicator variable for the managing underwriter
is insignificantly different from zero, while the coefficient on the other securities firm-related
22

venture capital variable is -0.35 and highly significant. It appears that the market at least partially
anticipates the long-term underperformance of securities firm-related IPOs, but only when the
managing underwriter of the issue faces a clear conflict of interest.
Just as in the long-term performance regressions, the coefficient estimates of regression
(6) suggests that there is no significant difference between the certification effect of bank-related
venture capital (or direct bank) investment depending on whether the bank is a keiretsu bank or
not. In addition, the estimates of regressions (2), (3), (4) and (5) indicate that the reduction in
underpricing that might be expected from bank certification of the quality of the IPO is only
associated with investment through the bank venture capital subsidiary, and not with direct bank
investment. At least for this sample, bank certification through pre-IPO investment appears to be
limited to their venture capital subsidiaries and does not differ by keiretsu affiliation.

5.4 /PO Valuation.
Finally, we investigate how institutional affiliation affects the level of the pricing of
initial public offerings in Japan relative to comparable firms. As discussed in the introduction,
concerns over conflict of interest should show up in the levels of price-earnings (PIE) ratios at
the time of issue. If investors are not sufficiently skeptical, and issuing firms and their financial
advisors have marketing power, "hyping" the stock may result in a PIE ratio at the time of the
offering and in the early after-market that is considerably above those of comparables.
In the first panel of Table I 0, we report the mean PIE ratios for IPOs and comparable

firms, as well as at-test for pairwise differences. Of note is that venture capital-backed IPOs
where the lead underwriter is also a securities firm that has a venture stake have a mean PIE ratio
of 34, which is higher than the mean PIE of 29 .6 for their comparables. This is consistent with
the hypothesis that these IPOs are priced more aggressively when they are brought to market.
Recall that this was the only class of venture capital for which venture capital backing did not
result in a significant reduction of initial issue returns. Further, IPOs backed by this class of
venture capital tended to perform worse than others long-term. The results for PIE ratios
provide weak (t=l.48), but confirming, evidence that the conflicts of interest may show up in a
higher offering price, to the detriment of new investors.
In the second panel of Table I 0, ·we report the percentage of earnings forecasts for the

23

period subsequent to the IPO that were above realized earnings. While 61 percent of the
forecasted earnings of IPOs backed by securities firm-affiliated venture capital that was not the
affiliate of the lead underwriter exceeded realized earnings, in the more frequently observed
cases when the securities venture capital-backed firm had the parent as a lead underwriter, only
49 percent of the time did forecasted earnings exceeded realized earnings. Thus, if the lead
underwriter was more likely to hype the IPO in which it has a venture capital stake, it does not
appear to do so by generating overly optimistic forecasts for the current accounting period.

VI. Conclusion
The presence of venture capital in the ownership structure of U.S. firms going public has
been associated with improved long-term performance. In Japan, most of the major venture
capital firms are subsidiaries of securities firms and banks. Using a sample of firms going public
on the OTC during April 1989-December 1995, we document short-run underpricing and longrun negative abnormal returns that are similar to those documented in other studies using Tokyo
Stock Exchange-listed IPOs. Specifically, we report average initial returns of 15.7 percent, and a
three-year wealth relative of 0.74, calculated as the ratio of the average gross return on IPOs
(from the first closing market price) relative to the average gross return on a size/industry
matched sample of nonissuing firms.
We find that venture capital-backed IPOs in Japan do not perform better in the long run
than other IPOs relative to size/industry matched firms. When venture capital holdings are
broken down by their institutional affiliation, in multiple regressions we find that firms with
venture backing from securities company subsidiaries have excess returns 11 percent lower over
a three-year time horizon than other IPOs. This suggests that conflicts of interest influence the
pricing and performance of initial public offerings in Japan. While there is more short-term
underpricing for venture capital-backed IPOs, once other determinants of underpricing are
controlled for, venture capital-backed IPOs are actually underpriced less. This is consistent with
venture capital playing a certification role in alleviating informational uncertainty about the IPO
at the time of issue. Issues for which the lead underwriter is also the parent of the lead venture
capitalist, however, do not show reduced initial returns. To the degree that the higher initial

24

returns are due to more aggressive marketing of the IPO, the lower Jong-run returns that we
document would be predicted. Consistent with this conflict of interest story, we also find PIE
ratios to be higher at the first trading price of IPO firms , when the parent of the lead venture
capitalist is also the lead underwriter, relative to comparable listed firms. Surprisingly, while the
distinction between bank-related venture capital and direct bank ownership appears important in
the pricing of IPOs, whether the related bank is a keiretsu bank or not does not.
Our results suggest that regulations aimed at limiting conflicts of interest among financial
intermediaries are not necessarily redundant. While there are undoubtedly reputation effects at
work, whether or not concerns about reputation outweigh opportunistic considerations is an
empirical question. Our results suggest that caution may be appropriate when relaxing these
regulations.

25

VII. Endnotes

1. Within the bank underwritten issues of the pre-Glass-Steagall era, there was considerable
heterogeneity as well. Kroszner and Rajan ( 1997) have found that securities underwritten by the
bank that did not set up an organization structure that separated lending and underwriting, and
thus had more perceived potential for conflicts of interest, were discounted relative to
comparable securities underwritten by another organization.
2. In July 1995, a new special section on the OTC was created in which profit requirements were
abolished and paid-in capital requirements were reduced; however, the new section has failed to
attract more than a handful of listings. Another indication of the relative maturity of IPO firms
in Japan is the relative paucity of technology firms listed on the OTC. For example, the market
share of computer and communications firms (of total market cap of OTC firms) in September
1997 is 2.4 percent, only one-tenth the corresponding percentage for Nasdaq in December 1996
(!soda (1997)).
3. See Shihon Shijo Kenkyukai (Committee on Capital Markets, and advisory committee for the
Ministry of Finance) (1989), or Pettway and Kaneko (1996).
4. If the issue was overbid at the maximum limit price, then rationing of the bids at the first stage
would occur according to strict lottery.
5. There were 88 respondents to the Nikkei survey. A more comprehensive list from late 1997 of
167 venture capital companies and their affiliation is contained in !soda (1997). This list
indicates that 80 of the companies were bank affiliated, 22 securities company-affiliated, 25
trading, leasing, or manufacturing company affiliated, 12 insurance company affiliated, 5
government affiliated, 4 foreign, and 19 independent.
6. The responsibilities of the lead underwriter are substantial. The lead underwriter has the
responsibility for preparing the application documents for listing. In the case of an OTC
company, it is also given the responsibility for the official investigation ofthe financial condition
of the company.
7. U.S. banks can still act as agents of "certification" through the provision of loans ("inside
debt"). In fact, U.S. studies show that IPOs of firms with credit relationships with private lenders
are less severely underpriced on average (James and Weir ( 1990)). In the Japanese context, the
loan/no loan dichotomy is not quite as interesting, since only extremely rarely does a firm go
public without having bank loans on its books.

26

VIII. References

Aoki, M., 1988, Information, Incentives, and Bargaining in the Japanese Economy, Cambridge:
Cambridge University Press.
Barry, C., C. Muscarella, J. Peavy, and M. R. Vetsuypens, 1990, The Role of Venture Capital in
the Creation of Public Companies: Evidence from the Going-Public Process, Journal of
Financial Economics 27: 447-471.
Beatty, R.P. and J. R. Ritter, 1986, Investment Banking, Reputation, and the Underpricing of
Initial Public Offerings, Journal of Financial Economics 15: 213-232.
Brav, A., and P. Gompers, 1997, Myth or Reality? The Long-Run Underperformance of Initial
Public Offerings: Evidence from Venture and Nonventure Capital-backed Companies, Journal of
Finance 52: 1791-1821.
Cai, J. and K. C. J. Wei, 1997, The Investment and Operating Performance of Japanese Initial
Public Offerings, Pacific-Basin Finance Journal 5: 389-417.
Carter, R., and S. Manaster, 1990, Initial Public Offerings and Underwriter Reputation, Journal
of Finance 45: 1045-1067.
Clark, R., 1988, Venture Capital in Britain, America, and Japan, London: Croom Helm.
Dewenter, K., W. Novaes, and R. Pettway, 1997, Market timing as a motive for IPOs: Evidence
from IPOs of Japanese keiretsu firms, Unpublished University of Washington working paper.
Field, L.C., 1996, Is Institutional Investment in Initial Public Offerings Related to the Long-Term
Performance of These Firms? Working Paper, UCLA and Penn State.
Forsythe, R., R. Lundholm, and T. Reitz, 1997, Cheap Talk, Fraud, and Adverse Selection in
Financial Markets: Some Experimental Findings, Unpublished University of Iowa working paper.
Gande, A., M. Puri, A. Saunders, and I. Walter, 1997, Bank Underwriting of Debt Securities:
Modern Evidence, Review of Financial Studies 10: 1175-1202.
Gompers, P., 1995, Optimal Investment, Monitoring, and the Staging of Venture Capital, Journal
of Finance 50: 1461-1490.
Gompers, P., and J. Lerner, 1997, Reputation and Conflict of Interest in the Issuance of Public
Securities: Evidence from Venture Capital, Working Paper, Harvard Business School.

27

Hebner, K. J., and T. Hiraki, 1993, Japanese fuitial Public Offerings, in I. Walter and T. Hiraki eds.,
Restructuring Japan's Financial Markets, Homewood, IL: Business One/Irwin.
Hoshi, T., A. Kashyap, and D. Scharfstein, 1990, Bank Monitoring and fuvestment: Evidence from
the Changing Structure of Japanese Corporate Banking Relationships, in R. G. Hubbard ed.,
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Unpublished mimeo, Nippon fuvestment Finance.
James, C. and P. Wier, 1990, Borrowing Relationships, futermediation, and the Costs of Issuing
Public Securities, Journal of Financial Economics 28: 149-171.
Jenkinson, T. 1990, fuitial Public Offerings in the United Kingdom, the United States, and Japan,
Journal of the Japanese and International Economies 4: 428-449.
Kakitsuka, M., 1991, Oonaa Kaisha no Kabushiki Kokai 50 no Hiketsu, Tokyo: Gyosei.
Toyo Keizai Shimpo Sha, Quarterly, 1988-96, Kaisha Shikiho, Tokyo.
Kang, J., and R. Stulz, 1996, How Different Is Japanese Corporate Finance? An fuvestigation of the
fuformation Content of New Securities Issues, Review of Financial Studies 9: 109-139.
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Commercial Bank Securities Activities Before the Glass-Steagall Act, Journal of Monetary
Economics 39: 475-516.
Lang, M., and R. Lundholm, 1997, Voluntary Disclosure During Equity Offerings: Reducing
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35: 293-316.
Lerner, J., 1995, Venture Capitalists and the Oversight of Private Firms, Journal of Finance 50: 301317.
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28

Loughran, T. J. R. Ritter, and K. Rydqvist, 1994, Initial Public Offerings: International Insights,
Pacific-Basin Finance Journal 2: 165-199.
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ed., Empirical Issues in Raising Equity Capital, Amsterdam: North-Holland.
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Japanese IPOs versus the U.S. Discretionary Allocation System, unpublished U of Missouri working
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Prowse, S., 1990, Institutional Investment Patterns and Corporate Financial Behavior in the United
States and Japan, Journal of Financial Economics, 27: 43-66.
Puri, M., 1996, Commercial Banks in Investment Banking: Conflict of Interest or Certification
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Ritter, J. R., 1991, The Long-Run Performance of Initial Public Offerings, Journal of Finance 46:
3-27.
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Toshi Jokyo Chosa Yoshi (Summary of the March 1996 Survey of the Condition of Japanese Venture
·
Capital), Tokyo.

29

TABLE 1
Average Initial Return and Long-term Performance of Initial Public Offerings on the OTC: April 1989 - December 1995.

Year

Sample
Size

Gross
Proceeds
(mm yen}
(Mean}

Initial
Return
(Mean}

3-Year
Holding
Period
Return
(Mean)

-47.0%
(36.2%)

1989

43

6151.4
(8739.6)

7.7%
(10.5%)

1990

82

5449.6
(5283.1)

17.6%
(31.6%)

1991

81

5573.1
(9538.4)

1992

9

1993

3-Year
Comparables
HPR
(Mean)

3-Year

3-Year
Wealth
Return
Relative
(Mean) (Ratio of Means)

Excess

-45.0%
(14.5%)

-2.0%
(37.7%)

0.963

-56.7%
(26.5%)

-30.5%
(22.0%)

-26.2%
(30.8%)

0.623

28.5%
(52.1%)

-47.5%
(47.4%)

-32.0%
(19.4%)

-15.5%
(47.3%)

0.772

3255.5
(2049.4)

15.8%
(23.5%)

-56.0%
(27.7%)

-18.6%
(29.1 %)

-37.5%
(50.6%)

0.540

44

6159.2
(10622.3)

12.8%
(14.3%)

-38.0%
(34.9%)

-13.2%
(31.5%)

-24.7%
(45.4%)

0.715

1994

96

4802.9
(5613.7)

11.1%
(13.1%)

-38.4%
(30.7%)

-19.6%
(19.8%)

-18.8%
(36.8%)

0.766

1995

101

2795.7
(3221.1)

12.8%
(16.0%)

NA

8904-9203

206

5644.7
(7890.0)

19.8%
(39.2%)

-51.1%
(38.0%)

9204-9412

149

5110.0
(7337.3)

11.9%
(14.2%)

-39.3%
(31.9%)

9204-9512

250

4175.0
(6120.5)

12.3%
(14.9%)

NA

NA

NA

NA

Total from
1989-95

456

4838.9
(7006.0)

15.7%
(28.8%)

NA

NA

NA

NA

Total from
1989-94

355

5420.2
(7656.9)

16.5%
(31.5%)

-46.1%
(36.0%)

NA

NA

NA

-34.2%
(20.3%)

-16.9%
(40.3%)

0.743

-17.7%
(24.3%)

-21.7%
(40.4%)

0.737

-27.2%
(23.5%)

-18.9%
(40.3%)

0.740

Note: The sample includes only those IPO firms for which a matching sample of at least one non-I PO firm in the same industry and
size decile could be obtained. Gross proceeds are the value of shares sold in the pre-issue auction and the IPO at the offer price.
The initial return is the percentage difference between the first market price and the offer price at the time of the IPO. The excess
three year return is the three year buy-and-hold return minus the three-year buy-and-hold return over the same period for a portfolio
(composed of at least one firm) of comparable non-lPO firms matched by size and industry. The wealth relatives are defined as one
plus the average three-year buy-and-hold return divided by one plus the average three-year return for the comparable non-I PO firms.
For example, the 1989 wealth relative of 0.963 is calculated as 0.53/0.55. For 1994 IPOs, holding period return, excess return and
wealth relatives calculated through 12/31/96 only. The average yen-dollar exchange rate was about 120 during this period, so the
mean proceeds is about $40 million. Firms that went public and subsequently delisted are included until the date of delisting. The
numbers in parentheses are standard deviations.

30

TABLE 2
Characteristics of Venture-Backed versus Other IPOs: April 1989 - December 1995

Venture-Backed IPOs
(210 Firms)

Other IPOs
(246 Firms)

Mean

Median

Mean

Median

Gross Proceeds
(mm yen)

4192.4.
(5735.6)

2632.0...

5390.8
(7901.3)

3350.3

Book-to-Market

0.41
(0.64)

0.28

0.36
(0.54)

0.27

Age (Years)

33.2***
(13.0)

32.0**"'

36.78
(13.3)

36.0

Initial Return

19.2%"'**
(32.9%)

8.0%

12.7%
(24.5%)

5.8%

3-Year Holding
Period Return
(IPO)

-47.3%
(34.2%)

-45.2%
(37.5%)

-53.1%

-53.2%

3-Year Holding Period
Return
(Comparables)

-26.4%
(24.1%)

-27.9%
(23.0%)

-28.9%

-28.9%

3-Year Excess
Return

-21.0%
(38.5%)

-17.2%
(41.8%)

-21.4%

Wealth Relative

0.716

-25.8%

0.760

Venture Backed IPOs are defined as those that had a venture capitalist as a top ten shareholder immediately prior to the IPO. The
Book-to-market ratio is calculated using post-offering book value of equity and offer price. Age is time between the establishment
of the company and its IPO. Gross Proceeds, underpricing, excess returns, and wealth relatives calculated as in Table 1. Mean and
median 3-year holding period return, excess return, and wealth relatives are calculated only for IPOs that took place prior to 12/31/94.
A •, ••, ••• indicates that mean (or median) for the venture-backed sample is significantly different than that for the
non-venture-backed sample at the 10%, 5% and 1% level. {I-tests for differences in means, assuming independence, Wilcoxon
rank-sum tests for differences in medians). Numbers in parentheses are standard deviations.

31

TABLE3
Venture Capital Investment in Firms Going Public on the OTC, April 1989-December 1995

No. of
Firms

Firms with Venture
Capitalist as Major
Shareholder
Prior to IPO

Number of
Firms for
Which this
Type is a
Secondary
Ven. Capitalist

210

Mean Number
Of Venture Capitalists
as Major §h§tl!bold~r~
Pre-I PO
Post-I PO

Mean % of Equity
Held by Lead
Venture Q§l2i!alist
Pre-lPO Post-I PO

Mean % of Equity
Held by Venture
Capitalists Which
Are M!!iQr §hs1rnbolder~
Pre-lPO Post-lPO

1.51

1.39

5.92%

4.07%

7.50%

4.92%

Categorized by Affiliation of Lead Venture Capitalist:
Securities
firm subsidiary

99

32

1.53

1.40

5.46%

3.34%

7.00%

4.28%

Bank subsidiary

71

47

1.45

1.31

4.28%

4.54%

5.66%

5.49%

SBIC

24

1.33

1.22

11.06%

7.18%

12.32%

7.82%

Foreign or
independent

16

1.94

1.52

8.38%

2.93%

11.50%

3.71%

27

Post-lPO equity holdings are from Toyo Keizai Shimpo Sha, Kaisha Shikiho, measured at the end of the first accounting cycle that
is at least six months after the offer date. Major shareholders are defined as being one of the top ten shareholders. A venture
capitalist is counted as the lead if it is among the top ten shareholders prior to the IPO and it has more shares than any other venture
capitalist. All other venture capitalists among the firm's top ten shareholders are classified as secondary venture capitalists. SBIC
stands for small business investment corporations, semi-governmental institutions set up in Nagoya, Osaka, and Tokyo with capital
contributed by local governments and local financial institutions.

32

TABLE4
The Relationship Between Venture Capital Participation and the Position of Lead Underwriter:
IPOs on the OTC,
April 1989- December 1995

Securities
Firm

Number of IPOs
in Which Venture
Capital Subsidiary
was the Lead
Venture
Capitalist (A)

Number of (A)
in Which the
Securities Firm
was the Lead
Underwriter

Nomura

59

49

83.1%

Daiwa

9

8

88.9%

Nikko

8

8

100.0%

Yamaichi

7

7

100.0%

Sanyo

5

0

0.0%

Maruman

3

0

0.0%

Waka

2

1

50.0%

Marusan

2

Okasan

2

(8)/(A)
(Percent)

50.0%
0

0.0%

Kankaku

100.0%

Shinnippon

100.0%

TOTAL

99

76

Note: Lead venture capitalist is defined as in Table 3.

33

76.8%

TABLE 5
Direct Bank Investment in Firms Going Public

No. of
Firms

Mean No. of Banks
as Major Shareholder
Pre-lPO Post-lPO

Mean % of Equity
Held by Lead
Bank Shareholder
Pre-lPO Post-lPO

Firms with Bank as
Major Shareholder
Prior to IPO

363

2.16

2.77

2.89

(of which group
bank is lead bank
shareholder)

249

1.59

1.83

2.62

Sources: Kaisha Shikiho, quarterly issues, 1989-1996.

34

3.29

2.78

Mean % of Equity Held
by Banks Which Are
Major Shareholders
Pre-lPO Post-lPO

5.22

7.10

3.74

4.44

TABLE 6.
Mean Sample Characteristics According to Institutional Affiliation of Lead Venture Capitalist or Identity of Direct Bank Investor

No. of
Firms

Venture-Backed IPOs

Gross
Proceeds
(mm yen)

Age

Book-to
Market

Initial
Return

Mean of Mean of
3-Year
3-year
3-year
Excess
HPR
HPR
Return
(IPO) (Comparables)

3-Year
Wealth
Relative

113

4445
(6425)

32.9
(11.9)

0.32
(0.49)

22.6%
(41.5%)

·51.1%
(33.7%)

·29.0%
(24.5%)

·22.0%

0.689

(Securities Firm
Affiliated)

56

4808
(7790)

31.5
(10.9)

0.30
(0.39)

23.3%
(43.4%)

-52.9%
(33.7%)

-25.7%
(26.0%)

-27.1%

0.635

(Lead Underwriter)

40

5687
(9055)

32.2
(10.6)

0.33
(0.46)

22.0%
(38.4%)

-54.7%
(31.6%)

-28.0%
(23.9%)

·26.8%

0.628

(Bank Affiliated)

35

4785
(5892)

30.1
(11.3)

0.29
(0.20)

20.7%
(40.8%)

-51.6%
(37.1%)

-29.7%
(25.2%)

-21.9%

0.689

(Keiretsu Bank)

10

3764
(2484)

31.4
(12.3)

0.31
(0.30)

10.2%
(14.7%)

·56.5%
(28.5%)

-30.4%
(28.9%)

-26.1%

0.624

(SBIC)

14

3235
(1677)

45.2
(11.0)

0.57
(1.11)

17.2%
(25.8%)

·48.2%
(22.7%)

·34.6%
(20.3%)

·13.6%

0.792

8

2532
(1033)

33.9
(11.5)

0.22
(0.12)

36.6%
(55.5%)

-41.5%
(38.6%)

·39.7%
(13.3%)

~1.8%

0.970

134

5981
(7635)

34.6
(12.8)

0.29
(0.46)

16.9%
(34.7%)

-47.8%
(42.0%)

·30.8%
(23.4%)

-17.0%

0.755

71

6856
(8838)

35.3
(12.5)

0.26
(0.35)

11.7%
(23.3%)

-47.2%)
(46.5%)

-31.0%
(24.8%)

·16.2%

0.765

(Foreign or other)

Direct Bank Investment

(Keiretsu Bank)

Note: Variables ·defined as in Tables 1·3. IPOs that occurred in 1994-95 are not used in the calculation of this table. Numbers in parentheses
are standard deviations.

35

TABLE 7.
Long-term Performance Regression with Cohort Year Fixed Effects

Model 1

Model 2

Model 3

Model 4

Model 5

Model 6

intercept

-0.059
(-0.25)

-0.053
(-0.22)

-0.066
(-0.27)

-0.066
(-0.27)

-0.068
(-0.27)

-0.040
(-0.17)

ln(age)

0.038
(0.65)

0.037
(0.65)

0.038
(0.65)

0.038
(0.65)

0.038
(0.64)

0.037
(0.62)

ln(proceeds)

-0.075
(-2.71)

-0.075
(-2.68)

-0.075
(-2.68)

-0.075
(-2.66)

-0.075
(-2.62)

-0.081
(-2.73)

ln(b/m)

-0.023
(-0.91)

-0.022
(-0.91)

0.021
(-0.86)

-0.021
(-0.85)

-0.021
(-0.86)

-0.021
(-0.84)

VG-Backed

-0.048
(-1.10)

-0.051
(-1.17)

BankDirect

0.009
(-0.21)

0.002
(0.04)

SecV

-0.110
(-2.16)

BankV

-0.006
(-0.09)

-0.006
(-0.09)

-0.004
(-0.06)

SBIC

-0.026
(-0.42)

-0.026
(-0.42)

-0.026
(-0.42)

-0.036
(-0.56)

OtherV

0.122
(0.88)

0.122
(0.85)

0.123
(0.84)

0.129
(0.90)

SecVleadU

-0.110
(-2.01)

-0.110
(-1.96)

SecVnonleadU

-0.109
(-1.27)

-0.109
(-1.27)

-0.116
(-2.23)

BankVKeiretsu

-0.005
(0.04)

BankVnonK

-0.011
(-0.16)

BankDirectK

0.400
(0.65)

BankDirectnonK

-0.038
(-0.72)

Adjusted R2

0.0365

0.0338

0.0418

0.0391

0.0362

0.0383

Prob>F

0.0092

0.0155

0.0083

0.0135

0.021

0.0189

355

355

355

355

355

355

No. of Firms

36

Note: The table reports regression coefficients of 3-year excess return (over matched firms) of IPOs on various
independent variables. Ln(age) is defined as the log of age of the IPO firm plus 1. Ln(proceeds) is defined as the
log
of gross proceeds of the IPO. Ln(b/m) is defined as the log of book equity to market value equity on the first trading date.
VG-Backed is a dummy that takes on the value one when venture capitalist is among the top 1O shareholders in the
IPO.
SecV is a dummy that takes on the value one when a securities venture capital is the lead investor. SecVleadU
is a
dummy that takes on the value one when SecV =1 and the securities firms that is the parent of the lead venture capital
company is also the lead underwriter, otherwise SecVnonleadU =1 (SecVleadU + SecVnonleadU = SecV). BankV
is a
dummy that takes on the value one when a bank affiliated venture investor is the lead investor. BankVKeiretsu
is a
dummy that takes on the value one when a parent of affiliated venture capitalist is one of keiretsu banks, otherwise
BankVnonK=1 (BankVKeiretsu + BankVnonK = BankV). SBIC is a dummy that takes on the value one when a SBIC
is
a lead shareholder. OtherV is a dummy that takes on the value one when foreign investor or independent venture
capitalist is a lead shareholder. BankDirect is a dummy that takes on the value one if a bank directly invests in the
IPO
firm and leads other venture capitalists and direct financial institution holdings, but excluding cases when BankV
= 1.
BankDirectK is a dummy that takes on the value one when IPO's lead shareholder belongs to keiretsu bank group,
otherwise BankDirectnonK = 1 (BankDirectK + BankDirectnonK = BankDirect). The sample period is 1989-1994,
with
returns measured through December 31, 1996. Cohort year dummy variables (not reported) are used for 1989-1993.
Heteroskedasticity-consistent I-statistics are reported in parentheses.

37

TABLE 8
Comparing the Findings Relating the Existence of Venture Capital Backing
to Initial Returns of IPOs in the U.S.

N

Mean
(median)
Initial Return,

%

Mean
(Median)
Proceeds,
million

Empirical Finding

Panel A: Barry, Muscarella, Peavy, and Vetsuypens (1990, Table 4, Panels C/D) Sample period: 1983-1987
Non VC-backed IPOs

VC-backed IPOs

991

220

7.7%
(1.5%)

$28.3
($10.4)

6.9%
(2.0%)

$22.9
($16.8)

Venture capital-backed IPOs
do not have significantly
different initial returns.

Panel B: Megginson and Weiss (1991, Table 6, Panel B) Sample period: 1983-1987
Non VC-backed IPOs

VC-backed IPOs

320

320

7.6%
(1.6%)

$13.2
($9.2)

7.1%
(2.5%)

$19.7
($13.2)

Venture capital-backed IPOs
have lower initial returns.

Panel C: Securities Data Co. (this paper) Sample period: April 1989-Dec. 1995
Non VC-backed IPOs
VC-backed IPOs

1228
937

11.3%
(5.6%)

$66.1
($28.5)

14.7%
(7.1%)

$41.2
($28.6)

Venture capital-backed IPOs
have higher initial returns.

The empirical finding of Barry et al (Panel A) was based on a I-test of difference in means; the empirical findings of last
two panels were based on multiple regressions in which the initial return is the dependent variable and the existence of
venture capital backing is one of the independent variables. The sample of Megginson and Weiss (Panel B) involved a
procedure that matched venture capital-backed firms with non venture capital-backed firms based on size and industry.
Data for Panel C are from Securities Data Co. That panel's sample Is composed of firm commitment IPOs with an offer
price of at least $5.00 and proceeds of at least $5 million. Closed-end funds, ADRs, and unit offerings are excluded. Initial
returns are the percentage price change from the offer price to the first closing market price. Proceeds are calculated on
a global basis assuming no overallotment options are exercised.

38

TABLE 9
Initial Return Regressions
Model 1

Model 2

Model3

Model4

Models

Model 6

Intercept

-1.269
(-2.88)

-1 .281
(-2.87)

-1.277
(-2.96)

-1 .126
(-2.71)

-1.141
(-2.69)

-1.301
(-2.96)

ln(age)

0.210
(2.49)

0.210
(2.48)

0.207
(2.49)

0.186
(2.31)

0.186
(2.31)

0.208
(2.50)

ln(proceeds)

0.092
(3.17)

0.091
(3.17)

0.092
(3.24)

0.073
(2.68)

0.072
(2.68)

0.089
(3.24)

marketreturn

0.414
(1.96)

0.413
(1.95)

0.415
(1.91)

0.428
(1.99)

0.427
(1.98)

0.411
(1.91)

ln(b/m)

0.225
(3.72)

0.224
(3.72)

0.223
(3.83)

0.201
(3.65)

0.199
(3.66)

0.224
(3.82)

Subscription 1

0.084
(4.27)

0.083
(4.27)

0.085
(4.42)

0.081
(4.35)

0.080
(4.37)

0.087
(4.48)

Subscription2

0.111
(4.92)

0.111
(4.85)

0.119
(5.17)

0.103
(5.09)

0.106
(5.22)

0.125
(4.24)

Subscriptlon3

0.063
(3.70)

0.063
(3.69)

0.062
(3.73)

0.058
(3.57)

0.057
(3.58)

0.061
(3.68)

dummY9204·9212

-0.276
(-2.12)

-0.282
(-2.09)

-0.295
(-2.51)

-0.200
(-1.74)

-0.226
(-2.10)

-0.324
(-1.64)

dummY9301-9412

0.078
(1.09)

0.079
(1.11)

0.102
(1.42)

0.097
(1.34)

0.096
(1.33)

0.125
(1.79)

VC-Backed

-0.106
(-2.39)

-0.096
(-2.19)

BankDirect

0.025
(0.78)

-0.028
(0.77)

SecV

-0.114
(-2.14)

BankV

-0.094
(-1.93)

-0.085
(-1.75)

-0.064
(-1.24)

SBIC

-0.058
(-0.90)

-0.052
(-0.81)

-0.053
(-0.82)

-0.062
(-0.96)

OlherV

-0.207
(-1.50)

-0.190
(-1.38)

-0.179
(-1.33)

-0.192
(-1.41)

SecVleadU

-0.029
(-0.58)

-0.019
(-0.41)

SecVnonleadU

-0.353
(-3.24)

-0.341
(-3.14)

-0.106
(-2.05)

BankVK

-0.048
(-0.93)

BankVnonK

-0.087
(-1.33)

BankDirectK

0.050
(1.32)

BankDlrectnonK

0.011
(0.22)

Adjusted R2

0.1452

0.1428

0.1438

0.1397

0.1263

0.1475

Prob>F

0.0001

0.0001

0.0001

0.0001

0.0001

0.0001

355

355

355

355

355

355

Number of Firms

39

Note: The table reports regression coefficients of initial returns on various independent variables. ln(age) is defined
as the log of age of the
IPO firm plus 1. ln(proceeds) is defined as the log of gross proceeds of the IPO. Marketreturn is the return of the
OTC index from the date
of the auction until the first day of trading. ln(B/M) is defined as the log of book equity to market value equity based
on the lower limit of bids.
Subscription1, 2, and 3 are fitted values from auction subscription ratios from the first stage regression of subscription
ratios on the relevant
variables listed above, for 8904-9202, 9204-9212, and 9301-9412, respectively. Subscription ratios are the ratio of
shares bid for divided by
the number of shares being auctioned. Dummy9201-9212 and Dummy9301-9412 are time period dummy variables.
VG-Backed is a dummy
that takes on the value one when venture capitalist is among the top 10 shareholders in the IPO. SecV is a dummy
that takes on the value·
one when a securities venture capital is the lead investor. SecVleadU is a dummy that takes on the value one
when SecV =1 and the
securities firms that is the parent of the lead venture capital company is also the lead underwriter, otherwise SecVnonlead
U =1 (SecVleadU
+ SecVnonlead U = SecV). BankV is a dummy that takes on the value one when a bank affiliated venture investor is
the lead investor.,
BankVK is a dummy that takes on the value one when a parent of affiliated venture capitalist is one of keiretsu banks,
otherwise BankVnonK
= 1 (BankVK + BankVnonK = BankV). SBIC is a dummy that takes on the value one when a SBIC is a lead shareholder.
OtherV is a dummy
that takes on the value one when foreign investor or independent venture is a lead shareholder. BankDirect is a dummy
that takes on the value
one if a bank directly invests in the IPO firm and leads other venture capitalists and direct financial institution holdings,
but excluding cases
when Ban kV = 1. BankDirectK is a dummy thattakes on the value one when IPO's lead shareholder belongs to keiretsu
bank group, otherwise
BankDirectnonK = 1 (BankDirectK + BankDirectnonK = BankDirect). Heteroskedasticity-consistent !-statistics are
reported in parentheses.

40

TABLE 10
P/E Ratios of IPOs versus Comparables, and Forecasted Earnings Relative
to Actual Earnings

Mean P/E of IPO
firms

Mean P/E of
comparable firms

t-test for pairwise
difference

N

Non VG-backed

30.58

32.55

-1.06

246

Securities VG-backed but parent
is not lead underwriter

25.83

35.11

-1.71

23

Securities VG-backed and parent
is lead underwriter

34.31

29.69

1.48

76

Bank VG-backed

27.86

30.21

-0.85

71

Percentage of forecasted
earnings > actual earnings

N

Non VG-backed

46.75

246

Securities VG-backed but parent is not lead
underwriter

60.87

23

Securities VG-backed and parent is lead underwriter

48.68

76

Bank VG-backed

53.52

71

P/E of IPO is measured using the offer price and trailing fiscal year earnings
. Comparable firms are chosen on the
basis of industry and size deciles from among firms that have been publiclytraded for at least three years. Mean P/E
ratios are calculated as the reciprocal of the mean E/P ratio, to reduce
the effect of outliers.

41

dominating effects

anticipated by
investors

certification

conflict of
interest

higher
reputation
associated
with higher

more severe
conflicts
result in
lower PIE

PIE
unanticipated by
investors

no relation

more severe
conflicts
result in
higher PIE

Figure I -- Predictions regarding price/earnings (PIE) ratios valued
at the offering price. The
left column lists the predictions if reputation effects dominate among
underwriters, whereas the
right column lists the predictions if conflicts of interest are of param
ount importance. The top
row lists the predictions assuming that investors fully anticipate the incent
ives of underwriters, and
set market prices accordingly. Thus, if conflicts of interest are import
ant, but are anticipated by
investors, issues where underwriters have an incentive to set a higher
offering price will show
lower PIE ratios because investors rationally demand a "lemo ns" discou
nt. The bottom row lists
the predictions assuming that investors are not sufficiently skeptical.
This gives an incentive for
underwriters to set an extremely high offering price when they have
a strong conflict of interest,
so there will be a higher PIE, the greater is the conflict of interest.

42

dominating effects
certification

conflict of
interest

anticipated by
investors

no
abnormal
returns

no
abnormal
returns

unanticipated by
investors

higher
reputation
leads to
higher
returns

more severe
conflicts
result in
lower returns

Figure 2 -- Predictions regarding long-run abnormal returns, measured from the first clsoing
market price. The left column lists the predictions if reputation effects dominate among
underwriters, whereas the right column lists the predictions if conflicts of interest are of paramount
importance. The top row lists the predictions assuming that investors fully anticipate the
incentives of underwriters. As with any model assuming investor rationality, there are no
predictable long-run abnormal returns. The bottom row lists the predictions assuming that
investors are not sufficiently skeptical. This gives an incentive for underwriters to set an extremely
high offering price when they have a strong conflict of interest. Since investors are insufficiently
skeptical, investors receive a low long-run return when their expectations are systematically
disappointed if conflicts of interest dominate.

43

dominating effects
certification

conflict of
interest

anticipated by
investors

higher
reputation
results in
lower initial
return

more severe
conflicts
result in
lower initial
return

unanticipated by
investors

no
prediction

more severe
conflicts
result in
lower initial
return

Figure 3 -- Predictions regarding short-run underpricing. The left column lists
the predictions
if reputation effects dominate among underwriters, whereas the right column lists
the predictions
if conflicts of interest are of paramount importance. The top row lists the predict
ions assuming that
investors fully anticipate the incentives of underwriters. Thus, if conflicts of interest
are important,
but are anticipated by investors, issues where underwriters have an incenti
ve to set a higher
offering price will show a lower initial return because investors are willing to pay
a market price
no higher than if the offering price had been set lower. The bottom row lists
the predictions
assuming that investors are not sufficiently skeptical. This gives an incentive for
underwriters to
set an extremely high offering price when they have a strong conflict of interest
. Since investors
are insufficiently skeptical, investors still bid up the market price, albeit by not
as much as if the
issue had been priced less aggressively.

44

FEDERAL RESERVE BANK OF NEW YORK
RESEARCH PAPERS

1998
The following papers were written by economists at the Federal Reserve Bank of
New York either alone or in collaboration with outside economists. Single copies of up
to six papers are available upon request from the Public Information Department,
Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045-0001
(212) 720-6134.

9801. Higgins, Matthew, and Carol Osler. "Asset Market Hangovers and Economic Growth:
U.S. Housing Markets." January 1998.
9802. Lopez, Jose. "Methods for Evaluating Value-at-Risk Estimates." March 1998.
9803. Malz, Allan. "Interbank Interest Rates as Term Structure Indicators." March 1998.
9804. Peristiani, Stavros. "Modelling the Instability of Mortgage-Backed Prepayments."
March 1998.
9805. Morgan, Donald. "Judging the Risk of Banks: What Makes Banks Opaque?"
March 1998.
9806. Estrella, Arturo, and Frederic Mishkin. "Rethinking the Role ofNAIRU in Monetary
Policy: Implications of Model Formulation and Uncertainty." April 1998.

To obtain more information about the Bank's Research Papers series and other publications
and papers, visit our site on the World Wide Web (http://www.ny.frb.org/rmagbome). From the
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