The Seven Percent Illusion?

From 1995 to 1998, more than 90 percent of mid-range IPOs were charged underwriter fees, or spreads, of exactly seven percent, even though evidence suggests that economies of scale in the size of the offering should allow for lower fees. Chen and Ritter (2000) offer collusion as a possible explanation based on empirical analysis and observation. Alternatively, we investigate whether the spreads could be the result of non-cooperative behavior on the part of the underwriters. To that end, we build a model that captures several important characteristics of competition in the IPO industry. Specifically, we examine a two-stage game where several underwriters compete in prices for a large number of heterogeneous entrepreneurs. Underwriters are differentiated by prestige, while entrepreneurs vary in terms of the value and quality of the firms they represent. Underwriters are assumed to have convex costs in the number of IPOs brought to market. Therefore, they find it unprofitable to underwrite low quality firms, so employ a screening technology to identify high quality firms. In equilibrium, it becomes reasonable for underwriters to charge approximately the same spread to entrepreneurs of different valuations. As the ratio of the proportions of two different entrepreneurs converges to the ratio of their valuations, the difference between their spreads is made arbitrarily small. This condition implies that as the underlying distribution of entrepreneurs becomes increasingly skewed toward larger firms, prices for mid-range firms tighten, despite economies of scale. The intuition is that the shift in the distribution strengthens market segmentation along issue size and underwriter prestige, which forces less prestigious underwriters to react to increased competition, while more prestigious underwriters are able to exert increased market power. Thus, our model produces a pricing pattern that is consistent with observation, and does so in a non-cooperative environment. ∗This paper greatly benefited from discussions with Uday Rajan and Ron Goettler. Special thanks are also due to Rick Green, Michael Peress, Guillaume Plantin, and Fallaw Sowell. Comments from seminar participants at Carnegie Mellon and the 2004 IIOC at Northwestern were appreciated. Financial support from the William Larimer Mellon fund is gratefully acknowledged. Address: Tepper School of Business, GSIA Room 317A, Corner of Tech and Frew Streets, Carnegie Mellon University,Pittsburgh, PA 15213. E-mail: [email protected].