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E-MailEvgeny Lyandres is Associate Professor of Finance at Boston University’s Questrom School of Business. This post is based on an article by Professor Lyandres; Fangjian Fu, Associate Professor of Finance at the Lee Kong Chian School of Business at Singapore Management University; and Erica X. N. Li, Assistant Professor of Finance at the Cheung Kong Graduate School of Business.
The U.S. IPO underwriting market is highly profitable. IPO gross spreads, most of which cluster at 7% of the proceeds, are high in both absolute terms and relative to those in other countries. In addition, returns on IPO stocks on the first day of trading (i.e. IPO underpricing) are even higher than the gross spreads, leaving much money on the table. Investors who are allocated underpriced IPO shares are beneficiaries of the money left on the table. Since the allocation of IPO shares is at the discretion of the underwriters, interested investors have incentives to reward underwriters for their favorable allocations. This indirect compensation of the underwriters typically takes the form of “soft” dollars, such as abnormally high trading commissions, spinning, and laddering. There is an ongoing debate as to whether the high profitability of the U.S. IPO underwriting market is suggestive of oligopolistic competition among underwriters—i.e. a situation in which each underwriter sets the price for its services with the objective of maximizing its own expected profit—or, alternatively, of implicit collusion in price setting among underwriters—i.e. a situation in which underwriters cooperate in price setting, i.e. they choose underwriting fees and set IPO offer prices with the goal of maximizing their joint expected profit.
The existing evidence regarding the competitive structure of the U.S. IPO market is mixed. Evidence supporting implicit collusion includes: (i) clustering of IPO underwriting spreads at 7%; (ii) high gross spreads in the U.S. that cannot be justified by non-collusive reasons, such as legal expenses, retail distribution costs, litigation risk, cost of research analysts, and the possibility that higher fees may be offset by lower underpricing. On the other hand, there is also evidence supporting the oligopolistic competition hypothesis: (i) the U.S. IPO underwriting market is characterized by low concentration and high degree of entry; (ii) IPO spreads did not decline following the SEC announcements of allegations of collusion, and (iii) the underwriting spreads of IPOs that do not belong to the 7% cluster are typically higher than 7%.
In our article, we contribute to this debate by rigorously testing the hypotheses of oligopolistic competition versus implicit collusion among underwriters setting IPO prices and fees. Our strategy consists of two steps. First, we construct a model of the IPO underwriting market and solve it under two distinct assumptions regarding the competitive structure of the market: oligopolistic competition or implicit collusion. Both solutions of the model predict equilibrium relations between the proportional and absolute (dollar) compensation of higher-quality and lower-quality underwriters on one hand and firms’ demand for public incorporation on the other hand. The comparative statics obtained in the two settings are, in many cases, different from each other, and thus allow to distinguish between the two possibilities empirically. Our second step is to employ U.S. IPO data during the period 1975–2013 to test the predictions from the two versions of the model and examine whether oligopolistic competition or implicit collusion fits the data better.
Our model features investment banks of heterogeneous quality that provide underwriting services to heterogeneous firms: Higher-quality underwriters provide higher value-added to their underwriting firms. Providing underwriting services entails costs, which depend both on the volume of underwritten IPOs and on the demand for public incorporation. Firms choose whether to go public or stay private and, in case they decide to go public, which underwriter to employ for their IPO, with the objective of maximizing the benefits of being public net of IPO costs. The resulting equilibrium outcome is an assortative matching of firms and underwriters: Higher-quality underwriters charge higher fees; firms with relatively high valuations employ higher-quality underwriters; medium valued firms are taken public by lower-quality underwriters; and low-valued firms stay private, since for them the costs of going public outweigh the benefits of public incorporation.
The model’s main comparative statics are as follows. First, in the oligopolistic competition scenario, the mean equilibrium proportional underwriter compensation (i.e. compensation relative to IPO proceeds) is predicted to be increasing in the demand for public incorporation for both higher-quality and lower-quality underwriters. In the collusive setting, this relation is positive for higher-quality banks, however, is U-shaped for lower quality underwriters. Second, in the oligopolistic competition scenario, the ratio of mean equilibrium dollar compensation received by higher-quality underwriters to that received by lower-quality underwriters is predicted to be decreasing in the demand for public incorporation. In the collusive scenario, this relation is hump-shaped.
Our empirical results are generally in line with the implicit collusion model and less supportive of the oligopolistic competition model. This conclusion is robust to various definitions of higher-quality and lower-quality underwriters. It holds when we focus exclusively on the direct component of underwriter compensation, i.e. underwriting gross spread, and also holds when we account for its indirect component, that is, various portions of the IPO underpricing. The conclusion also holds when we restrict the sample to underwriters with the highest reputation. This is consistent with implicit collusion being more likely among large banks, which are less interested in coordinating prices with their fringe rivals. Finally, our results suggest that implicit collusion, if present, is not likely to take the form of perfect price discrimination. The reason is that comparative statics following from a model of perfect price discrimination are very different from the model of implicit collusion analyzed in this paper, in which underwriters pseudo-compete on price by setting IPO fees and pricing to achieve optimal allocation of IPOs.
To summarize, our results, which are more consistent with the hypothesis of implicit collusion among underwriters in IPO price setting, are in line with recent evidence suggesting that by providing analyst coverage and/or aftermarket price support, underwriters compete less fiercely on the IPO pricing dimension.
The full article is available for download here.
