The Impact of Underwriter’s Reputation on the Price of Capital, the Return and the Underwriter Selection

Bachelor Thesis, 2013

17 Pages, Grade: 8,0


Table of Contents

1. Introduction

2. How Reputation is Measured
2.1 Tombstone Announcement Measure
2.2 Market Share Measure

3. The Relationship between Underwriter Reputation and Issue Pricing
3.1 Overpricing, Underpricing and Asymmetric Information
3.2 The Underpricing Equilibrium
3.3 Price Support

4. Fees and Proceeds
4.1 Fees
4.2 Proceeds

5. Commercial vs. Investment Banks

6. How Are Underwriters Being Chosen and Why Do Companies Switch Underwriters?

7. Conclusion

8. List of References

1. Introduction

When companies want to expand or just sustain their business operations, they are likely to issue different kinds of capital. The two main categories of capital are debt and equity. Theoretically, it is possible for businesses to issue these financing vehicles on their own, but, in real-life, it is common for the firms to assign a bank, investment or commercial, to underwrite the issue of equity or public debt.

Consulting an underwriter for the capital issuance can have several advantages. Firstly, the underwriting bank has an established network of long time investors to which they can easily offer the product they are underwriting, Compared to that, it would be more difficult for the single company to set up a road show and offer the issue to investors solely. Another advantage of having an underwriter is, that they can account on expertise and information gained from doing repeat transactions with several companies over time. Furthermore, the underwriters enjoy economies of scale because of their repeat business, which is not possible for companies not hiring an underwriter.

Over the years, many of the big banks have established good reputations as underwriters and they can use that when issuing new capital, because investors are more likely to trust those prestigious banks. The existence of trust is crucial for the underwriting business because of the existence of asymmetric information of the issuer and the underwriter towards the investor. Only if trust exists, the investor will be confident that the price proposed by the underwriter is based on real and objective information and does not reflect any opportunistic behaviour of the bank.

This paper will try to elaborate on the different and sometimes mixed empirical results, testing the relationship between underwriter’s reputation and the price of the capital issue. Firstly, the two most cited and used ways of measuring reputation will be explained. Secondly, the relationship between reputation and issue pricing will be analysed from different perspectives. Thirdly, the existence of a relationship between reputation and fees as well as between reputation and proceeds will be proven. After that commercial and investment banks as underwriters will be compared and it will be shown that there are reasons to choose a commercial bank as an underwriter. Finally, the mechanics of how underwriters are being chosen and the reasons for switching underwriters will be analysed, before ending this study with a conclusion.

2. How Reputation is Measured

When trying to find a relationship between the price of an issue and the reputation of the underwriter, it is of importance to define at first how reputation can be measured. In the empirical literature, scholars have developed many different ways to measure and assess the quality and reputation of underwriters. In the following, the two most often used ones will be explained.

2.1 Tombstone Announcement Measure

The so-called tombstone announcement, also called Carter-Manaster Measure, is informing about a “pending public security offering” (Carter & Manaster, 1990). From the announcement, one can see the different underwriters associated with the issuance. The order in which the underwriters are mentioned, helps to derive their position in the underwriting process. So for example, in Carter and Manaster’s (1990) work the name mentioned in the topmost row to the left corresponds to the lead underwriter, next to it are the co-leads. In the rows following below, the other underwriters are sorted by importance. Carter and Manaster derive from this sequence of underwriter-mentioning a measurement of underwriter reputation, which is later used by them and several other scholars as the reputation variable for their research.

Each tombstone announcement is measured separately for every underwriter by giving it a score depending on the row it is in. When from one announcement to the other one, one bank is overtaking the row position of another bank, the latter is assigned a lower score. As Carter et al. (1998) put it, “the compilation of the CM (Carter-Manaster) measure is a fairly tedious process because each tombstone has the potential to impact the ordering of each underwriter’s relative position in the data bank”. This is also the reason for the fact that an underwriter cannot ascent in the overall ranking if it often does underwritings with companies that have a poor ranking, because there is no underwriter from which he could overtake a rank. So, in other words, in the Carter-Manaster measurement, the underwriter’s reputation is also being influenced by the reputation of the other underwriters in the syndicate.

2.2 Market Share Measure

After having discussed this ordinal way of assessing the reputation of the underwriter, the focus now turns to the second group of measurements. This group is of cardinal nature and uses “the market share of the underwriter in the market under study” (Narayanan, Rangan, & Rangan, 2007) to assess the underwriter’s reputation. Using market share as a measure of reputation has several advantages over using the tombstone measurement. One important aspect is the easiness to construct the variable. The required data can be easily obtained and from that the reputation variable can be calculated.

From an empirical standpoint, both ways of measuring reputation seem to be legit and can be trusted, because, as Fang (2005) has proven, the correlation between the market share measurement and the Carter-Manaster measurement is over 95%. For some capital classes it can be advantageous to decide to use just the one or the other. So for example Fang used just the market share measure, because when measuring the underwriter reputation in the bond market, the number of underwriters in the market is substantially smaller than in equity markets and so there is no need to construct a Carter-Manaster measure.

The different empirical results that will be shown in the following sections, have been applying both kinds of reputation measurements and any contradiction between the results can hardly be traced back to the choice of measurement.

3. The Relationship between Underwriter Reputation and Issue Pricing

Now the implications of an underwriter having a high or low reputation on the price that investors are willing to pay for a product will be analysed. There is a large body of academic literature existing that covers this relationship and this section will try to point out the similarities but also the differences between the results shown by the different scholars.

One has to know the process of how capital is being underwritten to understand why reputation, as a rather “uneconomical” influence, affects the price of the issue. What most of the researchers propose is, that reputation supports or determines the so-called “certification effect” (Gande, Puri, Saunders, & Walter, 1997).

3.1 Overpricing, Underpricing and Asymmetric Information

When capital is being issued by using an underwriter, it is possible that there exists a substantial amount of asymmetric information in the market and that is what investors fear when considering participating in a transaction. With asymmetric information, there is the risk that an investor will overvalue the price of the issue and so will agree to pay the underwriter an overstated price for the product. Since the investor is aware of this possible loss, this risk will be accounted for in the price assessment and so he will reduce the price he is willing to pay. This price assessment process is, as Booth and Smith (1986) put it, similar to the one described by Akerlof (1970) in his famous “lemons model”


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The Impact of Underwriter’s Reputation on the Price of Capital, the Return and the Underwriter Selection
Maastricht University  (School of Business and Economics)
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ISBN (Book)
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IPO, Initial Public Offering, Underwriter Premium, Underwriter, capital, cost of capital, return
Quote paper
Ricardo Falter (Author), 2013, The Impact of Underwriter’s Reputation on the Price of Capital, the Return and the Underwriter Selection, Munich, GRIN Verlag,


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