When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket

This paper examines aftermarket trading of underwriters and unaffiliated market makers in the three-month period after an IPO. We find that the lead underwriter is always the dominant market maker; he takes substantial inventory positions in the aftermarket trading, and co-managers play a negligible role in aftermarket trading. The lead underwriter engages in stabilization activity for less successful IPOs, and uses the overallotment option to reduce his inventory risk. Compensation to the underwriter arises primarily from fees, but aftermarket trading does generate positive profits, which are positively related to the degree of underpricing.     

UNDERWRITER REPUTATION AND AFTERMARKET PERFORMANCE OF CLOSED‐END FUNDS

I find a positive relation between underwriter reputation and the initial and long‐run aftermarket performance of closed‐end funds. This relation persists even after controlling for fund characteristics, types, and investment strategies. The positive relation between underwriter reputation and initial returns supports the notion that prestigious investment bankers tend to promote a price run‐up in the immediate aftermarket to enhance their reputation with the issuers and the investors. The better long‐run performance for funds underwritten by prestigious underwriters suggests that prestigious underwriters protect their reputation by underwriting only high‐quality issues that will perform well in the long run.     

Laddering in initial public offerings

Laddering is a practice whereby the allocating underwriter requires the ladderer to buy additional shares of the issuer in the aftermarket as a condition for receiving shares at the offer price. This paper identifies factors that create incentives to engage in this type of manipulation and models the effect of laddering on initial public offering (IPO) pricing. I show that laddering has a bigger effect on the market price of IPOs with greater expected underpricing (without laddering) and greater expected momentum in the aftermarket; laddering increases the IPO offer price, the aftermarket price, and the money left on the table but does not necessarily increase the percentage underpricing; laddering contributes to long-run underperformance and creates a negative correlation between short-run and long-run returns; and profit-sharing increases the extent of laddering and the percentage underpricing.     

Strength of analyst coverage following IPOs

Firms with poor aftermarket performance are given higher target prices and are more likely to receive strong buy recommendations, especially by analysts affiliated with the lead underwriter. This favorable coverage is relatively short lived, typically lasting less than six months. Controlling for the quantity of coverage received, stock prices of newly public firms increase more when the target price ratio is high and recommendation is a strong buy. These results suggest that when a firm goes public, underwriter-affiliated analysts provide protection in the form of “booster shots” of stronger coverage if the firm experiences poor aftermarket stock performance.     

Deliberate premarket underpricing and aftermarket mispricing: New insights on IPO pricing

We decompose initial returns into deliberate premarket underpricing and aftermarket mispricing using stochastic frontier analysis. We model deliberate underpricing as a function of proxies of information asymmetry surrounding IPO value between market participants. Equity retained is an unlikely signalling mechanism to convey IPO value to outside investors through deliberate premarket underpricing. The presence of lock-in agreements, underwriter fees, number of uses of proceeds, and venture capital or private equity backing have positive impacts on deliberate premarket underpricing. Demand for firms' capital also explains deliberate premarket underpricing, whereas new issues market conditions have no impact. All these factors are found to explain a significant fraction of the variations in our deliberate underpricing estimates. Deliberate underpricing is the more dominant component that makes up initial return when compared to the fraction of aftermarket mispricing. We attribute aftermarket mispricing to trading volume in IPO shares on the first day, price adjustment between the filing price range and the offer price, and offer size. Equity retained explains the aftermarket mispricing rather than the deliberate premarket underpricing in contradiction to the signalling argument. More reputable underwriters are likely to provide price support in the early aftermarket, whereas we observe no impact on deliberate premarket underpricing.     

Presidential Address: Issuers, Underwriter Syndicates, and Aftermarket Transparency

I model strategic interaction among issuers, underwriters, retail investors, and institutional investors when the secondary market has limited price transparency. Search costs for retail investors lead to price dispersion in the secondary market, while the price for institutional investors is infinitely elastic. Because retail distribution capacity is assumed to be limited for each underwriter‐dealer, Bertrand competition breaks down in the primary market and new issues are underpriced in equilibrium. Syndicates emerge in which underwriters bid symmetrically, with quantities allocated internally to efficiently utilize retail distribution capacity.     

合资承销商影响新股破发率的实证研究

新股破发是目前中国股市目前面临的一个重要现象。本文基于2004年至2010年上市的A股IPO,研究合资承销商对新股破发率的影响。研究发现,合资承销商所承销的新股破发率显著低于本土承销商。合资承销商的低破发率主要归功于更加有效且符合市场预期的一级市场发行定价能力,其表现为合资承销商发行的股票的短期市场价格相对发行价的偏离程度显著低于本土承销商发行的股票。另外,我们还发现合资承销商采取了一定的托市行为,该行为也减小了短期内新股跌破发行价的概率。本文的发现从新股发行的角度提供了开放金融市场对我国资本市场影响的新现象。     

Heterogeneous Beliefs,IPO Valuation,and the Economic Role of the Underwriter in IPOs

We empirically analyze the economic role of the underwriter in initial public offerings (IPOs), distinguishing between the “certification” and “market power” hypotheses. We find that equity in high‐reputation underwriter backed IPOs is priced higher and further away from intrinsic value than that in low‐reputation underwriter backed IPOs. Our results are robust to controlling for the endogenous selection of firms to take public by underwriters. Overall, our results support the market power hypothesis and reject the certification hypothesis, indicating that the role of underwriters is to obtain the highest possible valuation for the IPOs that they back rather than to price the equity close to intrinsic value.     

IPO Placement Risk and the Number of Co‐Managers

Previous studies show that co‐managers mainly affect initial public offering (IPO) aftermarket activities. We investigate the role of co‐managers in IPO pre‐market activities. We argue that co‐managers help reduce IPO placement risk and hypothesize that IPO issuers hire more co‐managers when placement risk is higher. We find the number of co‐managers is positively associated with three proxies for placement risk. IPOs with more price uncertainty and high‐tech IPOs hire more co‐managers, while IPOs in regulated industries hire fewer co‐managers. We also find larger IPOs, recent IPOs, and IPOs with more reputable lead underwriters hire more co‐managers.     

Underpricing and long-run performance of Chinese IPOs: the role of underwriter reputation

This study examines the impact of underwriter reputation on IPO underpricing and long-run performance in the China stock market over the period 2001 to 2006. This sample period is notable for the implementation of a verification and approval system that occurred during it, which provided underwriters more freedom to price IPOs. We develop two alternative proxies to measure underwriter reputation based on either the ratio of the total gross proceeds raised or the number of IPOs managed by each underwriter. We find that underwriter reputation does not affect the level of underpricing, but that the level of long-run underperformance is significantly mitigated when IPOs are managed by more prestigious underwriters.     

Underwriter Quality and Long‐Run IPO Performance

We analyze the relationship between the quality of underwriters and the long‐run performance of initial public offerings (IPOs) in light of underwriter marketing, certification and screening, and information production. We find that higher underwriter quality (measured by the number of managing underwriters, underwriter reputation, and absolute price adjustment) predicts better long‐run performance, even when returns are value weighted. We compare underwriter quality measures and find that the effects of the number of managing underwriters and underwriter reputation are mutually complementary and are especially strong among IPOs with high uncertainty, while absolute price adjustment, which is more likely to be associated with information production than marketing or certification/screening, loses significance. Our findings are consistent with the marketing and certification and screening roles of investment banks but lend little support for the information production role of underwriters.     

Foreign Entry into Underwriting Services: Evidence from Japan's “Big Bang” Deregulation

We examined the effect of foreign entry into bond market underwriting activity using issue‐level data from the Japanese “Samurai” and euro–yen bond markets. We found that the fees charged by Japanese underwriters were higher on average than those of foreign underwriters, but the difference could be explained by conditioning on issue characteristics. Our results also suggest that bond issuers sorted properly across underwriters, as switching across underwriter nationalities would be expected to result in higher fees. However, the savings enjoyed by firms issuing with foreign underwriters were modest and statistically insignificant, while those of firms issuing with Japanese underwriters were substantial and statistically significant. This result suggests that Japanese underwriters priced their services aggressively over the sample period, perhaps in an effort to retain or gain market share. This conjecture is supported by a matching exercise that examined the liberalization of foreign underwriter access to the Samurai bond market, using euro–yen bond issues as a control. Foreign entry led to a statistically and economically significant decrease of 16 basis points on average in underwriting fees in the Samurai bond market. Overall, our results suggest that the international market for Japanese bond underwriting services was partially segmented by nationality as issuers appear to have preferred habitats, but that liberalization increased overall market competition.     

Two‐Sided Matching: How Corporate Issuers and Their Underwriters Choose Each Other

In this article, the authors update and confirm the findings of a 2005 article that was the first to view corporate underwriter choices as the outcome of a two‐sided matching process in which issuers look to the abilities of the underwriters offering their services and underwriters focus on the quality of the issuers that wish to use their services. This view offers a contrast with both the conventional representation of issuer‐underwriter associations as one‐sided decisions (by either issuers or underwriters) and the classical economist's representation of a competitive market in which prices serve as the primary market‐clearing mechanism. In their examination of both initial public offerings (IPOs) and seasoned equity offerings (SEOs) during the period 1980–2010, the authors continue to find strong evidence that higher‐quality issuers associate with more reputable underwriters and lower‐quality issuers match with lower reputation underwriters. Moreover, when examining cases of underwriter switching between an IPO and SEOs by the same issuer, they find that cases involving the largest divergence in the relative rankings of issuer and underwriter were the most likely to produce a change of underwriter—and that issuers that experienced larger post‐ IPO increases in quality were more likely to find more reputable underwriters for their SEOs (than for their IPOs). The authors also find that the larger the number of offerings brought to market in a given year, the smaller the market share of the top‐tier underwriters, likely reflecting the willingness of the most reputable underwriters to turn down business to maintain quality and reputation. Finally, the most reputable underwriters appear to benefit from the fact that the issuers whose IPOs they underwrite end up raising larger amounts of capital, both at the time of the IPO and in the larger and more frequent seasoned offerings by such issuers that come after the IPO. This evidence in support of two‐sided matching suggests that, especially for high‐quality issuers, the reputation of the underwriters they contract with for security offerings is likely to be more important than the underwriting fees they incur. What's more, the authors' finding that the most reputable underwriters are less likely to lose high‐quality clients and have more stable market share—and that the higher‐quality issuers they attract end up raising larger amounts of capital over their lives as public companies—suggests that underwriters' investments in building and preserving their reputations have a large expected payoff.     

League table: a study of the competition to underwrite floating rate debt

We find evidence of price and non-price competitions in the competition for market shares among underwriters. The market pricing for underwriter’s service is rationally determined. Gross spread is a function of cost of production and distribution, underwriter’s organizational assets, and the extent of competition. Strategic discount pricing affects market share in the short run. There exists evidence of client loyalty to an underwriter, albeit much weaker than expected. The number of effective competitors for any particular issuer is quite small, ranging from three to five. Commercial banks are more aggressive in pricing to first-time issuers and have gained limited success in attracting clients of investment banks. They expand the market by bringing in new issuers, while causing gross spread to fall.     

MARKET STRUCTURE,CHANGING INCENTIVES,AND UNDERWRITER CERTIFICATION

Early studies find that higher quality underwriters are associated with lower underpricing; however, more recent evidence suggests the opposite relation. By controlling for influences associated with the changing market structure of the underwriter industry, I provide a potential explanation for this conflict, that is, that higher quality underwriters do certify initial public offerings, resulting in lower underpricing. However, effects associated with increasing market shares tend to offset certification benefits, particularly for issues underwritten by the largest investment banks.     

Debt Issue Costs and Issue Characteristics in the Market for U.S. Dollar Denominated International Bonds

This paper analyzes the issue costs and initial pricing of bonds in the international market. In particular, we investigate the determinants of three components of issue costs: underwriter fee, underwriter spread (the difference between the offering price and the guaranteed price to the issuer), and underpricing (the difference between the market price and the offering price). Total underwriter compensation increases with the bonds' credit risk and maturity, but it is insignificantly related to issue size. Interestingly, underwriters appear to price some issue characteristics directly (by adjusting the fee) and other characteristics indirectly (by setting the guaranteed price). The two compensation components (fee and spread) are negatively related to each other. We provide evidence that this trade-off is consistent with income tax considerations, as well as with two-tier pricing by underwriters. We find no evidence of underpricing.     

RELATIONSHIPS AND UNDERWRITER SPREADS IN THE EUROBOND FLOATING RATE NOTE MARKET

We examine the role of issuer‐underwriter relationships in determining underwriter spreads for Eurobond floating rate notes from 1992 to 2002. Financial and nonfinancial firms with long‐term relationships pay a higher underwriter spread. Financial issuers that switch underwriters receive a discounted spread that is invariant to the underwriter's reputation and quality of the issue. However, the discount is not evident for nonfinancial firms. For both financial and nonfinancial firms, spreads are higher for noninvestment grade issues and, within investment grade, increase as quality declines. We also find higher spreads when underwriting is syndicated, and a strong negative time trend consistent with increasing competitive pressures.     

Valuing and pricing IPOs

This paper investigates how underwriters set the IPO firm’s fair value, an ex-ante estimate of the market value, using a unique dataset of 228 reports from French underwriters. These reports are issued before the IPO shares start trading on the stock market and detail how underwriters determined fair value. We document that underwriters often employ multiples valuation, dividend discount models and discounted cash flow (DCF) analysis to determine fair value but that all of these valuation methods suffer from a positive bias with respect to equilibrium market value. We also analyze how this fair value estimate is subsequently used as a basis for IPO pricing. We report that underwriters deliberately discount the fair value estimate when setting the preliminary offer price. Part of the intentional price discount can be recovered by higher price updates. We find that, controlling for other factors such as investor demand, part of underpricing stems from this intentional price discount.     

An analysis of the liquidity benefits provided by secondary markets

Listing shares in liquid secondary markets either to facilitate acquisitions or to diversify owner’s personal wealth are among the most important reasons for firms to go public [Brau, J.C., Fawcett, S.E., 2006. Initial public offerings: An analysis of theory and practice. Journal of Finance 61, 399–436]. We contend that the expected benefits derived from the liquidity provided by secondary markets are relevant for understanding important decisions made in preparation for an IPO. We hypothesize that the potential losses caused by an IPO failure induce firms that benefit more from going public to hire more reputable underwriters and to adopt more conservative pricing policies. We use several proxies for the benefits firms derive from post-IPO liquidity. The results indicate that firms that benefited more from liquidity were taken public by more prestigious underwriters and exhibited substantially larger levels of price revisions and underpricing. Post-IPO liquidity is also important for understanding the decision to retain the lead underwriter in subsequent SEOs.     

Stabilization Activities by Underwriters after Initial Public Offerings

Prior research has assumed that underwriters post a stabilizing bid in the aftermarket. We find instead that aftermarket activities are less transparent and include stimulating demand through short covering and restricting supply by penalizing the flipping of shares. In more than half of IPOs, a short position of an average 10.75 percent of shares offered is covered in 22 transactions over 16.6 days in the aftermarket, resulting in a loss of 3.61 percent of underwriting fees. Underwriters manage price support activities by using a combination of aftermarket short covering, penalty bids, and the selective use of the overallotment option.