By Yan “Anthea” Zhang (Rice University), Jin Chen (University of Nottingham Ningbo China), Haiyang Li (Rice University), Jing Jin (University of International Business and Economics, China)
In a mature stock market, reputation of underwriters signals the underlying quality of IPO firms to external investors. For instance, IPOs underwritten by more prestigious investment banks, such as Goldman Sachs and Morgan Stanley, tend to be perceived as having higher quality, and receive higher valuations and offer lower discounts to investors (i.e., lower IPO underpricing). However, an important prerequisite condition of this signaling effect is that prestigious underwriters primarily work with high-quality firms and vice versa. This quality-matching mechanism exists in a mature stock market as a result of a mutual selection process between underwriters and IPO firms. On the one hand, IPO firms prefer prestigious underwriters for their reputation and superior services. On the other hand, underwriters prefer high-quality firms as successful IPOs can enhance their reputation and bring in lucrative deals in the future.
Can we infer the quality of an IPO firm from the reputation of its underwriter in a nascent stock market? Probably not! A nascent stock market typically starts with weak regulations that are poorly developed and loosely enforced. The potential penalty costs for underwriters to take low-quality firms public thus are ill-defined. Therefore, underwriters, even prestigious ones, may work with firms of varying quality but seek returns in other forms to compensate for the risk of undertaking low-quality firms.
We propose that in a nascent stock market, underwriters and IPO firms may be paired through a pricing mechanism rather than a quality-matching mechanism. That is, more reputable underwriters charge higher underwriting fees, and lower-quality firms pay higher fees.
Pairing through a pricing mechanism
Underwriting fee is the price that an IPO firm pays to its underwriter for the latter’s services. In the U.S. market, underwriting fees converge on a similar level—7% of the capital raised. It has been reported that the underwriting fees were precisely 7% for more than 90% of the U.S. IPO deals in 1995-1998 (Chen & Ritter, 2000) and this convergence was even more prevalent in the U.S market from 1998 to 2007 (Abrahamson, Jenkinson, & Jones, 2011). However, it is important to note that the “7% solution” did not occur in the U.S. IPO market in earlier years (Hansen, 2001).
In a nascent stock market, there would be expected to have a wide range of underwriting fees. This was validated in our research setting—China’s ChiNext Stock Exchange (ChiNext). ChiNext is the Growth Enterprise Market (GEM) that the Chinese government launched on the Shenzhen Stock Exchange in October 2009, which offers entrepreneurial firms an avenue to raise capital. Table 1 presents the distribution of the underwriting fees paid by all 712 IPOs on the ChiNext in 2009-2017. The table shows a wide range of underwriting fees, from less than 1% to larger than 20% of proceeds raised.
Then, who charge more (less)? And who pay more (less)?
The period of 2009-2017 represented two distinct development stages of the ChiNext, divided by a 15-month IPO embargo. Due to some high-profile listings on the ChiNext, which significantly damaged investors’ confidence in China’s stock markets overall, the China Securities Regulatory Commission (CSRC) postponed all approved IPOs as well as deals under review, resulting in a sudden halt of China’s IPO market between October 2012 and December 2013. When the IPO market reopened, regulations on financial disclosures for IPOs were significantly improved.
We found that in the pre-embargo period (2009-2012), the reputation of an IPO firm’s underwriter has a positive relationship with the underwriting fee paid by the IPO firm to its underwriter. This result suggests that more reputable underwriters charged higher underwriting fees. We also found that in the pre-embargo period, the level of an IPO firm’s earnings management has a positive relationship with the underwriting fee paid by the IPO firm. If a firm had to inflate its earnings in order to meet the ChiNext’s listing requirements, the firm was of low quality. The result thus suggests that low-quality IPO firms paid higher underwriting fees.
In comparison, we found that in the post-embargo period (2014-2017), underwriter reputation or firms’ earnings management has no relationship with underwriting fee. Instead, we found that venture capitalists’ equity share in a firm has a positive relationship with the reputation of the firm’s underwriter. This result suggests that as the ChiNext’s regulations got significantly improved after the embargo, the quality-matching mechanism started to play a role in pairing more reputable underwriters with high-quality firms (e.g., those backed by venture capitalists).
What does pairing based upon a pricing mechanism mean to regulators and investors?
We examined how underwriter reputation and underwriting fee may be related to IPO performance such as valuation premium, IPO underpricing, and post-IPO sales growth. We found that underwriter reputation has no relationship with any of these outcomes. Instead, we found that higher underwriting fee is associated with lower IPO valuation premium, higher IPO underpricing, and lower post-IPO sales growth, particularly in the pre-embargo period. These results suggest that in a nascent stock market, underwriter reputation does not signal the quality of IPO firms. Instead, a higher underwriting fee suggests that an IPO firm may have lower quality (since the firm had to pay more to its underwriter for getting listed).
Our findings suggest that securities regulators need to pay close attention to how underwriters and IPO firms (or other important market participants) are paired in various regulatory environments and provide proper incentives or penalties so that important market intermediaries such as investment banks can sort out firms of varying quality. As of investors, they are at an informational disadvantage in their relations with firm insiders and tend to look for information cues to address the information asymmetry problem. Our results suggest that investors need to be cautious with regard to what can and what cannot convey information on the quality of IPO firms in a nascent vs. a mature stock market.
Chen, H.C., & Ritter, J.R. (2000). The seven percent solution. Journal of Finance, 55(3), 1105-1131. doi: 10.1111/0022-1082.00242
Zhang, Y.A., Chen, J., Li, H., and Jin, J. Who do you take to tango? Examining pairing mechanisms between underwriters and IPO firms in a nascent stock market. Accepted for publication at Strategic Entrepreneurship Journal.
TABLE 1. Distribution of IPO Underwriting Fees (% of proceeds raised) in ChiNext