Strategic Underwriting in Initial Public Offers

Research by Gerard Hoberg

UNDERPRICING IS COMMON IN INITIAL PUBLIC OFFERINGS—TO A CERTAIN EXTENT, IT MAY BE DIFFICULT TO AVOID. BUT SOME FIRMS CONSISTENTLY SELL NEW STOCK ISSUES AT A MUCH GREATER DISCOUNT THAN OTHERS. IS THIS PHENOMENON DRIVEN BY PURELY COMPETITIVE FORCES, OR BY A SYSTEM THAT DOES NOT ADEQUATELY PROTECT IPO ISSUERS FROM PREDATORY UNDERWRITING PRACTICES?

Gerard Hoberg, assistant professor of finance, is one of many academians exploring the lines between ethical and unethical conduct in the wake of the spectacular corporate scandals of recent times. In his paper, “Strategic Underwriting in Initial Public Offers,” Hoberg examines IPO underpricing, partial adjustment phenomenon and underwriter persistence. His is believed to be the first study to document that some underwriters persistently experience initial returns that are higher than others—significantly higher, in fact. Hoberg found that underwriters who were in the highest quartile based on their past initial returns brought to market future IPOs with 32.1% initial returns, compared to just 17.4% for those in the lowest quartile.

His research indicates that some underwriters may use underpricing as a profitmaximizing strategy, to the detriment of the issuers, average investors and the engine that drives business development. Hoberg created a new measure of underwriter reputation based on each underwriter’s initial past returns to quantify his results. Unlike existing measures, it is among the most significant predictors of future initial returns.

Though Hoberg started with seven logical hypotheses to explain why certain underwriters persistently discount stock prices to a far greater extent than their fellows, he quickly eliminated five of them. Underwriter prestige, industry specialization, or short-term hot IPO markets clearly could not explain persistent under-pricing. Nor did it seem to be a way to compensate underwriters for providing better services to issuers, or a simple matter of habitual, behavioral underpricing by some underwriters.

Rather, Hoberg’s evidence supports two hypotheses. The first is that underwriters who discount more tend to serve institutional, rather than retail, investors. When the price of a new issue is too low, the issue is often oversubscribed. Investors aren’t able to purchase all of the shares they want, and underwriters can allocate shares among subscribers. Hoberg believes institutional underwriters like Goldman Sachs and Morgan Stanley benefit from consistent underpricing because they work with large industries, with whom they are able to organize profitable quid pro quo arrangements in exchange for preferment. Retail underwriters like Paine Webber or AG Edwards & Sons, on the other hand, work mainly with small investors and so don’t have the same opportunity for quid pro quo benefits, according to Hoberg.

“Institutional underwriters persistently underprice because it is profitable for them,” says Hoberg bluntly. “They would say that they choose the investors whose hands are the strongest, to build a stable investment base for the issuer. But these same institutional investors often sell their shares within days of the IPO, while the average investor holds on to stocks for a long time.”

Hoberg acknowledges that his second hypothesis is controversial. He suggests that underwriters who persistently discount stock prices are better at identifying companies which are undervalued by the public and are able to take advantage of their own access to information not available to the public.

Existing academic work suggests that underwriters know how much an IPO firm is really worth at the time they set the IPO price. Hoberg’s work suggests that underwriters treat good news and bad news regarding the firm’s value differently. Underwriters reveal bad news because it gives them a reason to lower the IPO price, but they may deliberately conceal good news in order to avoid raising the IPO price. This allows them to extract the surplus value associated with this good news in the form of quid pro quos from the institutional investors to whom they allocate these deeply discounted shares. For underwriters, then, knowledge is definitely power—or at least profit.

The practice of persistently discounting stock prices in IPOs has a distinct downside. “There are two effective losers—the issuers and society,” says Hoberg. “The issuers lose because they realize less capital on their IPO when their stock is underpriced. But society loses too, because of the wealth loss involved when that issuing company isn’t able to grow as fast and create as many new jobs. It results in deadweight loss in the economy.” Average investors also lose out when stocks are highly discounted, simply because they are unable to get shares in an oversubscribed offering.

Random allocation, Hoberg believes, would make it much less profitable for underwriters to persistently underprice. “If you take away an underwriter’s ability to profit from allocation, then they would be relying simply on commission for profit. And competition will drive commissions to the right level.”

Hoberg is working on a second paper to discuss the theoretical and policy implications of this study. Hoberg may be reached by e-mail at ghoberg@rhsmith.umd.edu.