The Underwriting Spread in IPOs

What are the costs of IPOs for IB? Risk of firm commitment underwriting: not selling all shares at a designated price and suffering a loss. Costs of analyzing and administrating the issue. Analyst coverage: often included in the underwriting contract.

4. High effort to maintain reputation. Compensation paid to syndicate members. Price support: Aftermarket support of the stock to ensure a minimum of liquidity and to prevent a price slump due to some investors selling their shares.

Underwriting spread and costs Chen and Ritter (2000) Facts: Spreads in the US are much larger than in the rest of the world At first sight, the fee structure does not reflect the existence of fixed costs Investment bankers concede that there is no price competition

In 90% of cases, the spread of IPOs raising $20m-$80m is 7% (despite fixed costs). Spread is higher for IPOs below $20m (existence of fixed costs). (http://bear.cba.ufl.edu/ritter/sprd99.pdf) Japan: average spread of 3-3.5% Australia: average spread of 3.4% Suggests that spreads are competitive for deals below $20m-$30m, but increasingly profitable on larger deals This does not necessarily imply that fees are too high. There are indeed other dimensions in competition (effort, analysts coverage, price support etc).

Competition and the spread Hansen (2001) Potential explanations for the 7% underwriting spread: Explicit collusion hypothesis: Joint agreement to fix the spread at 7%. Implicit collusion hypothesis: Long-term competition between IB. Price cut may trigger price war and induce lower profits in the long-run. Competition in other dimensions: underpricing, reputation, placement efforts, analysts coverage etc. Hansen argues that the 7% spread is consistent with efficient contracting. By fixing one dimension of the contract, the competition is in the other dimensions. This also saves time.

Evidence on the state of competition Concentration in the IB industry: The same as before the 7% era. Argues against collusion Entry: New banks enter the market. Moreover there is volatility in IPO market shares. Argues against collusion Effect of Department of Justice probe: No effect on spread. Argues against collusion Profit: No evidence of abnormal profit when the spread is 7%. Argues against collusion

Evidence of efficient contracts: 7% spread IPOs are more frequent for firms with high earnings volatility, high debt, i.e. firms that are risky and difficulty to value. The risk factors associated with the IPO placement difficulty could explain the 7% contract use.

Ljungqvist and Wilhelm (1999) The 7% spread in the US is competitive, otherwise US firms would flock to non-US investment banks. Many issuing firms are willing to pay a premium to have a US bank in the syndicate The presence of a US bank in a syndicate may decrease by 17% the IPO underpricing