Functional Evolution—An Analysis with Particular Interest to the Function of an Underwriter's Goodwill

How the Function of Goodwill Is Shaped

The functionality of a market is closely related to its information dissemination mechanism. A great deal of information asymmetry exists between the issuer and investors in the securities-issuing market, particularly in the IPO market. Booth and Smith (1986) discussed the subject and presented a "certification hypothesis." They believe that the issuer owns real information about financial and business performance, and therefore has a more accurate expectation of future growth prospects and cash flows. However, investors do not have access to such information. As a result, if the issuer announces an issue price on its own, the information asymmetry between investors and the issuer leads to "adverse selection." To reduce information asymmetry, the issuer needs a trustworthy third party to disseminate information to investors and make them see that the price set by the third party reflects the true value of the issuer's securities. As the third party, an underwriter is an information producer who fulfills due diligence, completes corporate valuation, and passes such information to investors. The underwriter has some information superiority over investors and helps reduce information asymmetry between the issuer and investors.

However, a credibility problem with the underwriter as a third party may still exist. A goodwill mechanism plays an important role here to help reduce moral hazard and improve the credibility of the underwriter, who is responsible for participating in the IPO/issuance, valuing the company, and determining an appropriate issue price. Under such a mechanism, a reputable underwriter would feel more favorably disposed toward reaching a price that better reflects the true value of the company. Overvaluation could lead to failure in subsequent underwriting activities and damage to goodwill for investors, who would learn from their mistakes and only buy low in the future.

If the function of goodwill is sound, the management of an IPO company that anticipates good business performance in the foreseeable future will likely hire a reputable underwriter at a relatively higher price for better information accuracy. Management would feel that such an underwriter would send a positive signal to investors. An underwriter of good reputation, for the good of its own goodwill, would also choose high performance companies as clients. On the other hand, an IPO company with low anticipation of business performance in the foreseeable future would be reluctant to hire a reputable underwriter, worrying that the information revealed by the underwriter could tell an unpleasant truth. The reputable underwriter would also be less motivated to take the offer for his or her own reasons. In the end, a high performance IPO company would hire a reputable underwriter, knowing that investors would be able to judge a company's investment value by the goodwill of the underwriter the company hires.

< Prev   CONTENTS   Next >