We examine the effect of a pre-IPO audit committee on IPO pricing from the perspectives of information asymmetry and agency problems. We propose a bargaining power hypothesis to disentangle the information asymmetry explanation (financial reporting quality) from the agency problems explanation (underwriter bargaining power) on IPO pricing. IPO underpricing can be reduced by increasing the financial reporting quality under information asymmetry and/or by decreasing the underwriter bargaining power under agency problems. An audit committee can raise the quality of financial reporting and reduce the bargaining power of underwriters. With a pre-IPO market, the IPO markets in Taiwan have little information asymmetry, thus leading to the weak importance of reducing information asymmetry. We show that the establishment of a pre-IPO audit committee improves IPO pricing efficiency by reducing underwriter bargaining power rather than by raising the quality of financial reporting in Taiwan.

Introduction

An initial public offering (IPO) is the process of offering shares of a firm that is transitioning from private to public status by selling stocks to a large number of diversified investors. Although information is disclosed in the IPO prospectus, it is still difficult to value an IPO because no price history is available for firms before going public. Because of the value uncertainty of IPO firms, investors cannot fully identify high-value IPOs from low-value IPOs. Leland and Pyle (1977) argue that investors benefit from knowing the true information of the issuers. However, moral hazard hampers the truthful release of information from issuers to investors. Issuers gain substantial rewards by exaggerating positive information. To overcome the existence of substantial information asymmetry between them and investors, issuers must reveal information and credible signals to the market. The best-known anomaly of IPOs is the underpricing of IPO shares that are listed for the first time. Lowry et al. (2017) indicate that most of the fundamental models of IPO underpricing focus on information asymmetry. Because of the heterogeneity of skills among investors, some investors obtain more information on the issuing firms than do other investors (Rock (1986); Amihud et al. (2003)).