The Long-term Relationship Between Firms and Underwriters: The Seven Percent Solution Revisited

Recent evidence documents a clustering of gross underwriting spreads on initial public offerings (IPOs) at seven percent. This trend is puzzling for several reasons. First, if association with a high reputation underwriter is valuable, why don’t all firms select high reputation underwriters? Second, what incentives do underwriters have to engage in costly reputation enhancement relative to their peers? Third, how can uniform underwriting fees be reconciled with the expected cost differences across different offerings if underwritten by the same underwriter, or the same offering if underwritten by different underwriters? We address these questions by proposing a double-sided matching mechanism between firms and underwriters to explain how the market for underwriting services works, in which firms and underwriters pick each other based on criteria other than price. We show that, with uniform pricing, higher reputation underwriters will seek to underwrite higher quality firms, and higher quality firms will seek underwriting from higher reputation underwriters, leaving lower reputation underwriters and lower quality firms to select each other. Our empirical tests provide confirmation for this matching hypothesis. Selecting higher quality firms to take public is likely to result in lower marketing and reputation costs for high reputation underwriters. Moreover, we show that firms that hire more reputable underwriters at the IPO stage generate higher future cash flows for these underwriters from the security issues they undertake after the IPO. The spread on IPOs is only part of the compensation that high reputation underwriters receive when they establish a relationship with the firms they take public, and the higher rents they receive over time provide them the incentive to acquire and maintain their reputation assets. In addition to supporting matching at the IPO stage, our results also reveal that this matching persists at the SEO stage as well. Furthermore, by empirically examining the transition of firms from high to low and from low to high-reputation underwriters, we show that a change of underwriter from IPO to SEO is related to a change in a firm’s quality relative to other firms that used similar reputation IPO underwriters. It is particularly interesting that firms experiencing a relative reduction in quality also experience downward transitions in underwriter reputation. It seems likely that their higher reputation IPO underwriters refrain from underwriting their secondary offerings despite their prior relationship.