Initial Public Offerings and Underwriter Reputation

Abstract

This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of "informed" activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns. AN INITIAL PUBLIC OFFERING (IPO) is the first effort by private firms to raise capital in a public equity market. Previous research shows that, on average, the difference between the IPO subscription price and the first secondary market price is greater than a "reasonable" risk premium would require. Thus, it appears that issuing firms and underwriters are deliberately underpricing their IPOs.Several We would like to acknowledge the useful comments of our colleagues Sanjai Bhagat, Jeff Coles, Dick Jefferis, Uri Lowenstein, and Jay Ritter. Our interactions with Dick Jefferis in particular helped to identify and clarify several critical issues. We would also like to thank Jay Ritter for the provision of data. Support from the University of Utah Graduate School of Business, the Garn Institute of Finance, and Iowa State University is gratefully acknowledged. Substantial technical assistance was provided by Denise Woodbury. We would also like to thank the staff at the Chicago Library of Arthur Andersen and Company for their assistance. We alone are responsible for any errors or omissions.1 For a review of empirical research as well as an overview of the IPO process, see Though our model has been influenced by all of this antecedent literature, it is most similar to the model of Rock (1986) and its extension by Beatty and Ritter (1986) (see especially the appendix to their paper). Rock (1986) argues that IPO underpricing compensates uninformed investors for the risk of trading against superior information. In our model, consistent with Rock, the greater the proportion of informed investor capital participating in an IPO, the greater is the equilibrium underpricing. If investors have scarce resources to invest in information acquisition, they specialize in acquiring information for the most uncertain investments. Since informed investor capital migrates to the highly uncertain IPOs, the underpricing and subsequent price run-up for these firms are greater.Underpricing is costly to the issuing firm. Therefore, low risk firms attempt to reveal their low risk characteristic to the market. One way they can do this is by selecting underwriters with high prestige. In this paper, we provide empirical evidence that supports our theoretical result that underwriter prestige is associated with the marketing of low risk IPOs. The empirical analysis is facilitated by our dev...

M&A Due Diligence, Post‐Acquisition Performance, and Financial Reporting for Business Combinations

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Put Your Money Where Your Mouth Is: A Model of Certification with Informed Finance

“…The idea that banks or auditors certify the quality of borrowing or issuing firms has been theoretically examined by Booth and Smith (), Titman and Trueman (), Carter and Manaster (), Chemmanur and Fulghieri (), Tirole (, pp. 249–251), among others.…”

“…Specifically, in the papers by Titman and Trueman () and Chemmanur and Fulghieri (), certification is done with the certifier reporting its finding of the firm's quality truthfully by assumption . In the papers by Booth and Smith () and Carter and Manaster (), firms’ quality is signaled by the reputation of the matched certifier—namely the underwriter—and this reputation is observed by the uninformed investors. Lastly, Tirole () assumes that a borrower can buy at a certain cost a signal (namely, certification) “that perfectly reveals the borrower's type”.…”

Do the underwriters efficiently set first-trade prices in IPOs?

“…We use this criterion to separate high-ranked investment bankers from the low-ranked ones. The traditional view is that prestigious underwriters use their reputation capital to certify the value of the firm and reduce investor's uncertainty about the value of the issue, and that consequently lowers the level of underpricing in IPOs (see Smith (1986), Booth and Smith (1986), Beatty and Ritter (1986), Carter and Manaster (1990), and Chemmanur and Fulghieri (1994), among others).…”

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