1. The Underwriting Spread in IPOs

2. What are the costs of IPOs for IB?
Risk of firm commitment underwriting: not selling all shares at a designated price and suffering a loss.
Costs of analyzing and administrating the issue.
Analyst coverage: often included in the underwriting contract.

3. 4. High effort to maintain reputation.
Compensation paid to syndicate members.
Price support: Aftermarket support of the stock to ensure a minimum of liquidity and to prevent a price slump due to some investors selling their shares.

4. Underwriting spread and costs Chen and Ritter (2000)
Facts:
Spreads in the US are much larger than in the rest of the world
At first sight, the fee structure does not reflect the existence of fixed costs
Investment bankers concede that there is no price competition

5. In 90% of cases, the spread of IPOs raising $20m-$80m is 7% (despite fixed costs). Spread is higher for IPOs below $20m (existence of fixed costs). (
Japan: average spread of 3-3.5%
Australia: average spread of 3.4%
Suggests that spreads are competitive for deals below $20m-$30m, but increasingly profitable on larger deals
This does not necessarily imply that fees are too high. There are indeed other dimensions in competition
(effort, analysts coverage, price support etc).

6. Competition and the spread Hansen (2001)
Potential explanations for the 7% underwriting spread:
Explicit collusion hypothesis: Joint agreement to fix the spread at 7%.
Implicit collusion hypothesis: Long-term competition between IB. Price cut may trigger price war and induce lower profits in the long-run.
Competition in other dimensions: underpricing, reputation, placement efforts, analysts coverage etc.
Hansen argues that the 7% spread is consistent with efficient
contracting. By fixing one dimension of the contract, the
competition is in the other dimensions. This also saves time.

7. Evidence on the state of competition
Concentration in the IB industry: The same as before the 7% era. Argues against collusion
Entry: New banks enter the market. Moreover there is volatility in IPO market shares. Argues against collusion
Effect of Department of Justice probe: No effect on spread. Argues against collusion
Profit: No evidence of abnormal profit when the spread is 7%. Argues against collusion

8. Evidence of efficient contracts:
7% spread IPOs are more frequent for firms with high
earnings volatility, high debt, i.e. firms that are risky and
difficulty to value.
The risk factors associated with the IPO placement
difficulty could explain the 7% contract use.

9. Ljungqvist and Wilhelm (1999)
The 7% spread in the US is competitive, otherwise US
firms would flock to non-US investment banks.
Many issuing firms are willing to pay a premium to have a US bank in the syndicate
The presence of a US bank in a syndicate may decrease by 17% the IPO underpricing