Syndicates in IPOs

Syndicate = A group of investment banks that work together to sell new security offerings to investors. The underwriting syndicate is led by the lead underwriter. The issuing firm may decide that several underwriters are needed to underwrite the equity The size of the syndicate varies (5 underwriters for ICBC, 28 for Google) The primary underwriter is designated the “lead” underwriter The lead underwriter allocates portions of the offering to syndicate members Syndicate members may be lead underwriters on other offerings, so the relationships are frequently based on equal stature in terms of mutual respect

Compensation Underwriting spread = difference between price to the public and the price received by the issuer The spread is determined by negotiation The spread reflects the effort and the risk taken by the underwriter (firm commitment) Compensation includes mainly: Manager’s fee (20%) Syndicate allowance (20%) Selling concession (60%, buying stock at a discount and then reselling it to the public at a higher price)

Potential functions of underwriting syndicates Risk of underwriting large offers There is a risk that the offering price is too high, and underwriters not being able to sell the shares For firm commitment contract: A single underwriter risks losing money if the price is difficult to determine. More underwriters means lower risk for each underwriter However, large size IB can bear risk, so why having syndicates?

Information production - Underwriters have to price a stock with no trading history - Syndicates help estimate the demand for the IPO thanks to different clientele or geographic origin (e.g. ICBC had 2 Chinese, 2 European and 1 US underwriters) Channels of information: Underwriters may inform directly the lead underwriter about market interest. This is however not in their best interest because they compete with the other underwriters. Underwriters prefer disclosing information directly to the issuer. This improves their reputation. The issuer uses this information in the negotiation process with the lead underwriter. He may also directly reveal this information to the lead underwriter.

Certification and underwriter reputation The issuer’s quality may be unknown. Certifiability hypothesis: Reputable underwriters signal that the offered price is fair. This reduces uncertainty and the underpricing problem. Coverage by analysts Syndicate members can provide analyst coverage once trading starts. This is crucial to maintain investors’ interest in the issuing company. An underwriter with analyst coverage in the aftermarket may increase the demand for the stock. Krigman et al.(2001): analysts coverage is an important determinant when selecting underwriters.

Empirical findings (Corwin and Schultz 2005) What is the added value of syndicates? Syndicate participation evidence An IB with top-ranked analyst in the issuer’s industry increases the likelihood of being included in the syndicate Geography matters: Being in the same state as the lead underwriter decreases the likelihood of being included in the syndicate Strong relationship with lead underwriter increases the probability of entering the syndicate. Suggests that ongoing relationships may mitigate the agency problems within the syndicate

Syndicate structure and offer price revision An efficient syndicate should uncover information on what the offer price should be. In that case, the price revision from the expected offer price to actual offer price should be substantial. Evidence shows that larger syndicates increase the likelihood of an offer price revision. This suggests that syndicates produce valuable information.

Syndicate structure and certification effect The syndicate’s composition has no effect on the “fairness” of the offer price. Hence, there is no evidence of the certification effect. Syndicates and analysts’ services The number of analysts covering the firm depends on the number of syndicate members co-managing the equity issue.

Syndicates and effort (Pichler and Wilhelm 2001) Companies choose the lead underwriter. The lead underwriter chooses the syndicate members. Why do issuers want to have several underwriters? Moral hazard problem: Companies cannot measure perfectly how well IB work for their course, i.e. how much effort they put to attract the highest price investors. Syndicates may induce more effort.

How do syndicates induce effort? Stability of composition of syndicates, but changing lead underwriter. The lead underwriter receives by far the highest fee. Hence, there is competition between IB to become lead underwriter. This induces them to exert high effort. Moreover, the lead underwriter selects the syndicate members. He has an incentive to monitor them in order to be selected as lead underwriter for future deals.

How does a company choose a lead underwriter? (Hansen and Khanna 1994) General theories: the best way to choose a lead underwriter is to organize an auction. Indeed, letting underwriters compete may reduce the fees. In reality negotiation takes place with a single lead underwriter. Why? The bidding process gives lowest fee but not the highest price for the issue.

The lead manager has to exert effort: evaluate demand, contact investors etc. More effort increases the offer price. Effort is costly. Assuming that the profit of syndicates is constant, low fees are associated with low effort. Hence, issuers do not necessarily prefer lower fees. An IB approached has first to exert costly effort to determine the approximate offer price. In a bidding process, there is uncertainty on whether it will be selected as lead underwriter. This induces low effort. In negotiation, instead, the effort is unlikely to be useless. This induces higher effort.