Conflict of interest in the issuance of public securities: Evidence from venture capital

In this paper we investigate potential conflicts of interest in the issuanc e of public securities in a setting analogous to a universal bank, that is, the underwriting of initial public offerings by investment banks that hold equity in a firm through a venture capital subsidiary. We contrast two hyp otheses. Under "rational discounting," all market participants fully antici pate the conflict. The "naive investor" hypothesis suggests that investment banks are able to utilize superior information when they underwrite securi ties. The evidence supports the rational discounting hypothesis. Initial pu blic offerings that are underwritten by affiliated investment banks perform as well or better than issues of firms in which none of the investment ban ks held a prior equity position. Investors do, however, require a greater d iscount at the offering to compensate for potential adverse selection. We a lso provide evidence that investment bank-affiliated venture firms address the potential conflict by investing in and subsequently underwriting less i nformation-sensitive issues. Our evidence provides no support for the prohi bitions on universal banking instituted by the Glass-Steagall Act of 1933.