Analyst coverage and IPO management forecasts

Highlights

• IPO firms that provide a forecast in their prospectus are more likely to receive analyst coverage.

• IPO forecasts are more important to coverage decision of lower quality analysts.

• Reputation concerns are important to analysts' coverage decision.

• Affiliated analysts align their forecast with IPO forecast more than unaffiliated ones.

Abstract

Given the all-importance of analyst coverage for IPO firms, we examine the interaction between the initiation of analyst coverage and management forecast disclosure in IPO prospectuses. We find that IPO firms that provide a prospectus forecast are more likely to receive coverage (and earlier), particularly from lower quality analysts. The depth of coverage, measured by the number of analysts issuing a recommendation on the firm, is also greater for forecasters. These results hold after controlling for potential endogeneity due to simultaneity in management decision to provide a forecast and analysts' decision to cover the firm. Further analyses show that reputation concerns matter to analyst coverage decisions — conditional on firms providing a prospectus forecast, the likelihood of receiving coverage decreases with the magnitude of the absolute management forecast error. There is evidence of quid pro quo where the analyst working for the underwriter of the IPO aligns her forecast with the management forecast more than unaffiliated analysts. Insofar as management forecasts are important to coverage decision and analyst coverage is valuable, our research has important implications for strengthening the safe harbour provision for prospectus forecasts in litigious environments such as that in the U.S.

Introduction

We investigate the role of management forecasts in the initiation of financial analyst coverage of IPO firms. The importance of analyst coverage to firms that are going public has been highlighted by several studies. For instance, analyst coverage has been found to add firm value through enhancing investor attention and recognition of the issuer (Cliff and Denis, 2004), generating more customers (Hakenes and Nevries, 2003), and creating liquidity (Irvine, 2003). With these benefits, it is not surprising that IPO firms “lust” for analyst coverage and often spend considerable resources to obtain it (Cliff and Denis, 2004, Loughran and Ritter, 2004, Rajan and Servaes, 1997).¹

Our analysis begins by asking whether by voluntarily providing a management forecast in the prospectus, IPO firms are able to attract analyst coverage. In more than half of the 763 Australian IPO firms in our sample, the information set available to the analysts includes a management forecast. The Australian IPO disclosure regime thus contrasts that in the U.S., where forecast disclosure in the offer document is virtually non-existent due primarily to the highly litigious environment (Baginski et al., 2002). Previous studies of seasoned firms find that management forecasts are an important determinant of analyst following and their properties (Baginski and Hassell, 1990, Cotter et al., 2006, Lang and Lundholm, 1996, Waymire, 1986). However, it is not known whether analysts are as responsive to management forecasts released by IPO firms, which typically are young and lack a track record of operating performance. Since the provision of management forecasts widens the pool of value-relevant information about the IPO firm and reduces the uncertainty in analysts' valuation, we predict that, all else equal, analysts are more likely to initiate coverage on IPO firms which provide a management forecast.

We next ask whether prospectus forecasts have varying importance to coverage initiations by analysts of different qualities. We argue that low quality analysts have more limited information channels and resources, a lower level of technical ability and (industry) experience (Jacob et al., 1999), and possibly expend less effort in performing their services. Therefore, we expect lower quality analysts to rely more on firm-specific information disclosure such as management forecasts, suggesting that low quality analysts are more likely to initiate coverage (and earlier) on IPO firms with a management forecast.

In addition to the act of providing a forecast, we also ask whether the (ex post) forecasting ability of IPO management matters to analysts' decision to initiate coverage. The literature suggests that there are reputational costs to mimicking if management forecasts prove to be highly inaccurate (Agrawal and Chen, 2008, Ljungqvist et al., 2007). The reputation hypothesis predicts that, conditional on firms self-reporting a forecast, analysts are less likely to initiate coverage on firms which issue highly inaccurate management forecasts (ex post).

Our final question examines the quid pro quo rent seeking activities between underwriters and issuers where analysts working for the underwriter of the IPO give more favourable stock recommendations than non-affiliated analysts. Numerous studies show that analysts' recommendations are indeed tainted by conflicts of interest (He et al., 2016, Chan et al., 2007, Bradley et al., 2006, Michaely and Womack, 1999). We argue that analysts with incentives to please the managers of their covered firms are more likely to align their own forecast with that of management (Lim, 2001). Since IPO management forecasts tend to be optimistic (Lee et al., 1993), it also pays to replicate the management forecasts as doing so enables the underwriter-analyst to more easily offload any unsold IPO shares under the Australian standby agreement contract.² The quid pro quo hypothesis therefore predicts that affiliated analysts issue an earnings forecast that is more aligned with the forecast provided by IPO management relative to the forecast issued by non-affiliated analysts.

Using the Cox's proportional hazard model, we find issuers with self-reported forecasts are more likely to receive coverage than non-forecasters. Forecasters are also associated with deeper coverage, measured by the number of analysts following the firm, consistent with the financial intermediary role of analysts (Lang and Lundholm, 1996). Lower quality analysts, where quality is measured by the analyst's experience and clientele base, are more responsive to management forecast disclosure, as expected. These results are robust to a correction for potential endogeneity in management forecast disclosure and analyst coverage decisions. Overall, our results support the proposition that analysts' attraction to more transparent firms outweighs their role as agents who actively reduce information asymmetry (Bhushan, 1989), and that this association is stronger for lower quality analysts.

Tests using management forecast accuracy (ex post) show that reputation concerns are important to analyst coverage initiations. Conditional upon IPO firms providing a management forecast, the likelihood of analyst coverage decreases with the size of the absolute management forecast error. We also find evidence of quid pro quo where analysts working for the investment bank that underwrites the IPO align their own forecast with the forecast provided by the IPO management more than unaffiliated analysts. Our finding thus echoes the concerns of the Australian Securities and Investments Commission (ASIC) that there is some risk that research analysts (and their employers) do not adequately avoid and manage conflicts of interest when they arise (Report 24: Research Analyst Independence, 2003). Additionally, we report evidence which suggests that investment banks in Australia were not immune to the conflict of interest arising from the dual nature of the sell-side research analysts' role in the pre-Global Research Analyst Settlement period.

This paper makes several contributions. First, we contribute to the literature on the value-added of analyst coverage by showing that the provision of management forecasts in the offer document increases the likelihood and expedites the timing of analyst coverage. The earlier the analyst coverage is initiated, the earlier the firm and its shareholders are able to extract the benefits of the coverage. Second, we contribute to the understanding of how reputation concerns and incentives to please management affect analysts'behaviour by showing that management forecast accuracy is an important input in affiliated analysts' forecasts. Whilst the literature has examined aspects of the association between management forecasts and analyst forecasts in seasoned firms (Lang and Lundholm, 1996), it is silent on the implications of this association for unseasoned issuers. Our third contribution lies in showing that, in a market where information asymmetry is highly pervasive, the act of management disclosing an earnings forecast plays a more important role than management forecast accuracy in the initiation of analyst coverage.

The rest of this paper is organized as follows. In the next section, we discuss the Australian prospectus disclosure regime. Our theoretical arguments are outlined in Section 3. Section 4 describes the data and Section 5 the research methods. Results are discussed in Section 6, and Section 7 provides a summary and conclusion.