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What determines the level of IPO gross spreads? Underwriter profits and the cost of going public


Bartling, Björn; Park, Andreas (2009). What determines the level of IPO gross spreads? Underwriter profits and the cost of going public. International Review of Economics and Finance, 18(1):81-109.

Abstract

This paper addresses three empirical findings of the literature on initial public offerings. (i) Why do investment banks earn positive profits in a competitive market? (ii) Why do banks receive lower gross spreads in venture capitalist (VC) backed than in non-VC backed IPOs? (iii) Why is underpricing more pronounced in VC than in
non-VC backed IPOs? While each phenomenon can be explained by itself, there is no explanation yet why all three occur simultaneously. We propose an integrated theoretical framework to address this issue. The IPO procedure is modeled as a two-stage signaling game: In the second stage banks set offer prices given their private information and the level of the spread. Issuing firms anticipate their bank’s pricing decision and, in the first stage, set spreads to maximize expected revenue. Investors are aware of this process and subscribe only if their expected profits are non-negative. Firms’ equilibrium spreads are large so as to induce banks to set high prices, allowing
banks to make profits. Superiorly informed VC backed firms impose smaller spreads but face larger underpricing than non-VC backed firms.

This paper addresses three empirical findings of the literature on initial public offerings. (i) Why do investment banks earn positive profits in a competitive market? (ii) Why do banks receive lower gross spreads in venture capitalist (VC) backed than in non-VC backed IPOs? (iii) Why is underpricing more pronounced in VC than in
non-VC backed IPOs? While each phenomenon can be explained by itself, there is no explanation yet why all three occur simultaneously. We propose an integrated theoretical framework to address this issue. The IPO procedure is modeled as a two-stage signaling game: In the second stage banks set offer prices given their private information and the level of the spread. Issuing firms anticipate their bank’s pricing decision and, in the first stage, set spreads to maximize expected revenue. Investors are aware of this process and subscribe only if their expected profits are non-negative. Firms’ equilibrium spreads are large so as to induce banks to set high prices, allowing
banks to make profits. Superiorly informed VC backed firms impose smaller spreads but face larger underpricing than non-VC backed firms.

Citations

4 citations in Web of Science®
6 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Economics
Dewey Decimal Classification:330 Economics
Language:English
Date:January 2009
Deposited On:20 Jul 2009 04:27
Last Modified:05 Apr 2016 13:17
Publisher:Elsevier
ISSN:1059-0560
Publisher DOI:https://doi.org/10.1016/j.iref.2007.06.006
Permanent URL: https://doi.org/10.5167/uzh-19561

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