The risks of losing underwriters in direct listings

Traditional ways of going public rely on investment banks to determine a company’s value and equity price. A new study shows its significance is actually greater than that

By Ellis Ng

Going public is a big step for companies intending to raise significant capital, reduce debt, and expand operations. Before taking that path, financial institutions called underwriters are needed to help assess the risk and appropriate price of equities. These institutions normally are investment banks that employ specialists in initial public offerings (IPOs).

However, a 2020 move by the US Securities and Exchange Commission (SEC) to approve rule changes by the New York Stock Exchange and Nasdaq allowed firms to conduct direct listing without underwriters. In a direct listing, a company’s existing shareholders can sell their shares directly to the public without issuing new shares or raising new capital.

This move was propelled by digital music streamer Spotify, which was the first to list directly on the bourse in 2018, followed by the messaging app Slack and the data analytics company Palantir Technologies. After the SEC officially changed the rules, a few have joined the club, including eyewear maker Warby Parker, online game platform Roblox, and crypto exchange Coinbase.

“The new SEC regulations beg for a thorough investigation of the effects of equity underwriting relationships on clients,” says Zhao Meiling, Assistant Professor of Accounting at the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School.

While direct listings are typically faster and less expensive, the benefits for the market and public may be less obvious, particularly regarding what the underwriters can bring to the table. In a paper titled The role of equity underwriters in shaping corporate disclosure, Professor Zhao, along with Cheng Mei of the University of Arizona and Zhang Yuan of the University of Texas at Dallas, suggests that underwriters provide the edges that extend after the IPO process.

“Our study suggests the important informational role of underwriters beyond the IPO period and could potentially better inform regulation,” says Professor Zhao.

Reflection from the crisis

The 2008 financial crisis served as a natural experiment to test the informational effects of losing an underwriter on corporate information disclosures. The collapse of Lehman Brothers, which had been involved in underwriting since 1899, had immediate and profound effects on companies having underwriting relationships with the fallen firm.

After analysing the various data from Securities Data Corporation from 1998 to 2008 to compare Lehman clients to clients of other similar investment banks, the researchers found that since the collapse, Lehman clients significantly increased the frequency of their earnings forecasts by 13.31 per cent and voluntary SEC filings to update shareholders by 10.19 per cent. Such behaviour was more pronounced for Lehman clients with stronger underwriting relationships or those experiencing negative returns at the time of the collapse.

“Our study suggests the important informational role of underwriters beyond the IPO period and could potentially better inform regulation.”

Professor Zhao Meiling

“Earnings forecasts and voluntary SEC filings are used to measure the companies’ level of voluntary disclosure activities,” says Professor Zhao. “These disclosures are critical to provide insights into a company’s future performance and operational expectations, which are essential for investors making informed decisions.”

The study also found that Lehman clients that did not increase or only made small increases in their voluntary disclosures faced more challenges in trading their stocks after the collapse compared to non-Lehman clients. However, this predicament is significantly attenuated for Lehman clients with substantial increases in their voluntary disclosures, indicating that greater corporate transparency can partially offset the loss of an established relationship.

Coping with the loss of underwriters

Underwriters invest considerable effort in gathering detailed information about their clients to validate and endorse equity issuances. Although their main role is managing securities distribution and promotion, underwriters also build strong relationships with their clients. These connections enable them to gather and share non-public information with current and prospective investors, extending their influence beyond the transactions.

This informational effect is likely to continue beyond IPOs, the researchers argue, and underwriters continue to shape firms’ information environments as information intermediaries. Information environments refer to the context and conditions under which information is created, disseminated, and utilised. So, when an underwriter collapses, as Lehman did, the companies begin to fill the information gap themselves.

The study also shows that companies seem to balance their own voluntary disclosures against the information provided by their underwriters after an IPO. When underwriters offer strong informational benefits, companies tend to reduce their own voluntary disclosures, suggesting that firms consider the value of information from underwriters to be greater than the potential advantages of making additional voluntary disclosures themselves. “Thus, upon losing underwriting relations, firms actively manage their information environments by increasing public disclosures to offset the increase in illiquidity,” Professor Zhao adds.

Is bypassing equity underwriting a good call?

Equity underwriters play important and unique roles during IPO. Not only to reduce information gaps in the market and improve clients’ information environments, but also to provide business insights. “To secure potential future engagement for financing or other brokerage services, equity underwriters continuously meet with top managers of their clients post-IPO to discuss financing needs, business conditions, as well as potential merger and acquisition opportunities,” says Professor Zhao.

The underwriter’s reputation was also found to negatively correlate to the number of voluntary disclosures the client makes. Reputable underwriters help their clients shape their information environments, and companies feel less of a need to disclose information voluntarily if they are partnered with a more reputable underwriter.

Reputable underwriters provide a certification effect for the companies they represent, Professor Zhao argues, enhancing investor confidence and potentially lowering the cost of capital for issuing firms. Given these benefits and the large network of institutional investors the underwriters have, clients may suffer significant value and information loss when the relationship ends.

“The research indicates that the loss of an underwriter is associated with increased information uncertainty and consequently an increase in firms’ voluntary disclosure,” she adds. “Investors can use these findings to better anticipate the changes in firms’ information environment and makeup of where information comes from and thus make more informed decisions.”