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5 years ago

* I would like to thank Frank Dobbin, Christopher Marquis, Peter ...

* I would like to thank Frank Dobbin, Christopher Marquis, Peter ...

profits, rent-seeking

profits, rent-seeking behavior from investors during the allocation process (spinning), and quid pro quo with institutional buyers of IPOs. Economic studies have shown that high first-day returns lead to increased volatility, translating into significantly increased trading profits for the lead underwriter approximating two percent of the offering during the first three months of the price support, or stabilization, period (Aggarwal 2000; Ellis, Michaely and O’Hara 2000, 2002; Ritter and Welch 2002). 12 As a senior trader at a large institutional buyer of IPOs states on the quid pro quo aspect: “The way it really works is like this. If . . . the investment bank keeps on pricing things that make no money, they fuck their clients [the IPO investors], their clients won’t trade with them, it has much bigger repercussions to other parts of the business. Right? So if they price it cheap, their clients make money, like put it this way. If [a leading investment bank] comes out with an IPO, I make money because day one it goes up 16 percent, what am I gonna do? I’m gonna give them a couple more trades and say thank you for the IPO, thanks for the allocation, right?” 13 Non-Bayesian investor models generally assume that underwriters buy and resell (hard underwrite) the offering to investors, the underwriting fee is their primary source of income, and post-IPO price support is costly. However, U.S. underwriters do not hard underwrite IPOs, but act as agents helping issuers sell shares on a best-efforts basis. Furthermore, the alternative sources of income from an offering (spinning, quid pro quo with investors, and stabilization profits) could rival or exceed that from the underwriting fee. Far from being costly, post-IPO stabilization activity generates significant trading volume and profit for the lead underwriter if the IPO experiences high first-day returns (Booth and Chua 1996; Aggarwal 2000; Ellis, Michaely and O’Hara 2000, 2002; Boehmer and Fishe 2004). These practices fundamentally 14

alter the profit-maximization constraints facing underwriters and the predictive efficacy of investor sentiment. 14 Economists note that fundamentals cannot explain second-stage return outcomes (first-day returns) and speculate that the cause remains hidden in first-stage return outcomes, in other words the “setting of the offer price, where the normal interplay of supply and demand is suppressed by the underwriter” (Ritter and Welch 2002:1803). Underwriters apply normative pressure on issuers to accept an “IPO discount” on the offer price. As a global divisional head at a leading underwriter explains: “There’s got to be some discount, right? The so-called IPO discount. IPO discount is a function of a few things, I think of it as sort of the price of admission . . . they’re [issuers] not in the IPO market everyday, so yeah it definitely requires some education about the whole process.” For the IPO discount institutional norm, a properly priced offering needs to be underpriced relative to comparable companies. The IPO discount has developed into common practice over time, resulting in mimetic as well as normative pressure for compliance. Importantly, setting a low price range to increase the likelihood of the offer price being priced above the range significantly impacts first-day returns due to the social good mechanism. For IPOs, the first and second-stage return outcomes are linked. Economists denote this as a positively sloping demand curve for IPOs, whereby excess demand in the first stage of pricing results in greater demand on the first day of trading (Loughran and Ritter 2002). Investors value stocks as a social good with investor demand dependent on the demand by other investors (Zuckerman 1999). This social good mechanism is a variation on the mechanism implicated in critical mass and tipping (Schelling [1978] 2006), threshold models of behavior (Granovetter 1978; Granovetter and Soong 1983, 1986), and Merton’s self-fulfilling prophecy: a belief- 15

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