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| The Relationship between Investment Banks and Institutional Investors, Boosts, and Benefit Transfer in IPOs |
| SHAO Xinjian, WANG Xingchun, JIA Zhongzheng, LIAO Jingchi
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School of International Trade and Economics, University of International Business and Economics;
Institute of World Economics and Politics, Chinese Academy of Social Sciences;
Research Institution, Shenzhen Stock Exchange |
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Abstract Investment bank is one kind of the most important intermediaries in direct financing. As the representative of security issuer, an investment bank's competitiveness partly originates from its networks of relationship investors, which have been rarely discussed in the literature. Based on the complete records of institutional investors' participation in Chinese IPOs‘ book-building process, we have designed a new dynamic measure of the relationship between an investment bank and institutional investors. Furthermore, we have analyzed in detail how this relationship affects IPO pricing. The main results are as follows. (1) An investment bank can drive related investors to take part in the IPO process and submit high bids that are consistent with the underwriter analyst’s valuation. This implies that the investment bank can alleviate the uncertainty of investor participation in IPO auctions by its networking ability. (2) The boost from related investors can significantly increase IPOs' offering price and the under-writing fee paid to the investment bank. However, when the trading price converges to its intrinsic value gradually in the long run, the appearance of more related investors in the IPO process will predict lower long-term return to investors. (3) The relationship between the investment bank and institutional investors is reciprocal in essence. Once the investment bank is granted allocation discretion, it will be inclined to allocate money left on the table to its related investors. The stronger the relationship, the larger probability that bids will be considered affective. Given that their bids are judged affective, related investors' demand for new issues will be satisfied preferentially.
This paper makes three contributions to the literature. First, we present a new mechanism for interest distribution in the IPO process. The traditional literature usually assumes that the principal-agent problem exists between the IPO issuer and the investment bank (IB) responsible for the underwriting. The IB is inclined to underprice the IPO relative to its intrinsic value. Then, due to its allocation discretion, it will allocate the underpriced new issues to its connected investors, who will transfer part of the revenues to the underwriter, such as in the form of brokerage fees. This quid pro quo thus conflicts with the issuer's interests. However, if underwriting fees gained by the IB are positively related to the IPO offering price, the interest of the IB should be bundled with the IPO issuer and there will be no serious principal-agent problem. We find that the IB has a significant incentive to overprice the IPO according to the high bids of its connected institutional investors, so the issuer can obtain more IPO proceeds. In addition, the IB can favor connected investors over time. For example, once underwriting IBs are granted allocation discretion, they will allocate underpriced new shares to their connected investors who have supported the bidding of prior IPOs.
Second, this paper provides a new method to measure the relationship between investment banks and institutional investors, which considers both IPO issuers' participation and the relative bidding prices of investors. Based on brokerage fee data, the traditional method can only identify one special investor (fund)-underwriter relation. In contrast, our new method can measure underwriters' connection with all kinds of investors. Furthermore, compared to the method based on only participation frequency, our method also considers whether investors' bidding prices are consistent with underwriters' expectations, which means that connections can be more accurately measured.
Third, our findings extend the understanding of the efficiency of IPO auction methods. The classical literature usually concludes that auction methods lack efficiency in pricing IPOs because the underwriters have no allocation discretion, which is a key instrument to encourage investors to produce information on IPOs in the book-building process. One problem in IPO auction is investors' participation uncertainty. However, our empirical research finds that underwriters can solve this problem through their connections with institutional investors. It suggests that networks between IBs and investors can replace underwriters' allocation discretion to some extent. Furthermore, this paper shows that an underwriter will be inclined to allocate underpriced new issues to its connected investors once it gains allocation power. Thus, from the perspectives of fairness and efficiency, IPO auction methods will perform better than the traditional literature predicts if the function of the underwriter-investor relationship is considered seriously.
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Received: 17 January 2018
Published: 29 November 2019
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