"Investment Banking and Securities Issuance" Chapter 9 of North-Holland Handbook ofthe Economics of Finance edited by George Constantinides,Milton Harris,and Rene Stulz,forthcoming 2002 Jay R.Ritter University of Florida ritter@dale.cba.ufl.edu http://bear.cba.ufl.edu/ritter September 16,2002 JEL classifications:G24,G32,G14 JEL keywords:Corporate finance;initial public offerings;seasoned equity offerings; underwriting;investment banking Abstract This chapter analyzes the securities issuance process,focusing on initial public offerings (IPOs)and seasoned equity offerings(SEOs).The IPO literature documents three empirical patterns:1)short-run underpricing,2)long-run underperformance(although this is contentious), and 3)extreme time-series fluctuations in volume and underpricing.While the chapter mainly focuses on evidence from the U.S.,evidence from other countries is generally consistent with the U.S.patterns.A large literature explaining the short-run underpricing of IPOs exists,with asymmetric information models predominating.The SEO literature documents 1)negative announcement effects,2)the setting of offer prices at a discount from the market price,3)long- run underperformance,and 4)large fluctuations in volume.In addition to long-run underperformance relative to other stocks,there is some evidence that issuers succeed at timing their equity offerings for periods when future market returns are low.When examining a large class of corporate financing activities,including equity offerings,convertible bond offerings, bond offerings,open market repurchases,stock-and cash-financed mergers and acquisitions,and dividend increases or decreases,several patterns emerge.In general,the announcement effects are negative for activities that provide cash to the firm,and positive for activities that pay cash out of the firm.Furthermore,the market generally underreacts,in that long-run abnormal returns are usually of the same sign as the announcement effect.In spite of the large expenditure of resources on analyst coverage,there is little academic work emphasizing the importance of the marketing of financial securities.Only recently have papers began to focus on the corporate financing implications if firms face variations in the cost of external financing due to the mispricing of securities by the market
“Investment Banking and Securities Issuance” Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides, Milton Harris, and René Stulz, forthcoming 2002 Jay R. Ritter University of Florida ritter@dale.cba.ufl.edu http://bear.cba.ufl.edu/ritter September 16, 2002 JEL classifications: G24, G32, G14 JEL keywords: Corporate finance; initial public offerings; seasoned equity offerings; underwriting; investment banking Abstract This chapter analyzes the securities issuance process, focusing on initial public offerings (IPOs) and seasoned equity offerings (SEOs). The IPO literature documents three empirical patterns: 1) short-run underpricing, 2) long-run underperformance (although this is contentious), and 3) extreme time-series fluctuations in volume and underpricing. While the chapter mainly focuses on evidence from the U.S., evidence from other countries is generally consistent with the U.S. patterns. A large literature explaining the short-run underpricing of IPOs exists, with asymmetric information models predominating. The SEO literature documents 1) negative announcement effects, 2) the setting of offer prices at a discount from the market price, 3) longrun underperformance, and 4) large fluctuations in volume. In addition to long-run underperformance relative to other stocks, there is some evidence that issuers succeed at timing their equity offerings for periods when future market returns are low. When examining a large class of corporate financing activities, including equity offerings, convertible bond offerings, bond offerings, open market repurchases, stock- and cash-financed mergers and acquisitions, and dividend increases or decreases, several patterns emerge. In general, the announcement effects are negative for activities that provide cash to the firm, and positive for activities that pay cash out of the firm. Furthermore, the market generally underreacts, in that long-run abnormal returns are usually of the same sign as the announcement effect. In spite of the large expenditure of resources on analyst coverage, there is little academic work emphasizing the importance of the marketing of financial securities. Only recently have papers began to focus on the corporate financing implications if firms face variations in the cost of external financing due to the mispricing of securities by the market
"Investment Banking and Securities Issuance" Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides,Milton Harris,and Rene Stulz,forthcoming 2002 Jay R.Ritter University of Florida August 22,2002 This draft has benefited from comments from seminar participants at Emory University,the University of California at Davis,Korea University,Chung-Ang University (Korea),the Hong Kong University of Science and Technology,and City University of Hong Kong,and from Alon Brav,Hsuan-Chi Chen,Raghu Rau,Rene Stulz,Anand Vijh,Kent Womack,and Li-Anne Woo. The comments of Tim Loughran are particularly appreciated,as is research assistance from Donghang Zhang 1.Introduction 1.1 Overview This chapter analyzes the securities issuance process,largely taking the choice of what security to offer as given.Extensive attention is devoted to the controversies surrounding long-run returns on companies issuing equity,including both initial public offerings(IPOs)and seasoned equity offerings(SEOs).For IPOs,attention is also devoted to the mechanisms for selling IPOs, where considerable variation exists in global practices.Theories and evidence regarding the first- day returns on IPOs are also covered. Most of this chapter is devoted to equity issues,even though fixed-income securities swamp equities in terms of the dollar value of issue volume.This is not because debt securities are unimportant,but because the pricing and distribution of fixed-income securities is generally much more straightforward.Specifically,credit risk is the main determinant of the relative yield on corporate bonds of a given maturity,and independent rating agencies such as Moody's provide credit ratings on bonds.In contrast,the payoffs on equities have substantial upside potential as well as downside risk,and are thus more sensitive to firm-specific information. External financing is costly.When a firm decides to issue securities to the public,it almost always hires an intermediary,typically an investment banking firm.The issuing firm pays a commission,or gross spread,and receives the net proceeds when the securities are issued.In addition to the direct costs of issuing securities,an issuing firm that is already publicly traded frequently pays additional indirect costs through revaluations of its existing securities(the "announcement effect").These indirect costs may,at times,be much larger than the direct costs. A major reason for writing this chapter is that the stock market's reaction to securities offerings conveys information about the firm's investment and financing activities.The interpretation of these reactions sheds light on broader issues such as market informational efficiency and the importance of adverse selection and moral hazard in corporate settings. 2
2 “Investment Banking and Securities Issuance” Chapter 9 of North-Holland Handbook of the Economics of Finance edited by George Constantinides, Milton Harris, and René Stulz, forthcoming 2002 Jay R. Ritter University of Florida August 22, 2002 This draft has benefited from comments from seminar participants at Emory University, the University of California at Davis, Korea University, Chung-Ang University (Korea), the Hong Kong University of Science and Technology, and City University of Hong Kong, and from Alon Brav, Hsuan-Chi Chen, Raghu Rau, René Stulz, Anand Vijh, Kent Womack, and Li-Anne Woo. The comments of Tim Loughran are particularly appreciated, as is research assistance from Donghang Zhang. 1. Introduction 1.1 Overview This chapter analyzes the securities issuance process, largely taking the choice of what security to offer as given. Extensive attention is devoted to the controversies surrounding long-run returns on companies issuing equity, including both initial public offerings (IPOs) and seasoned equity offerings (SEOs). For IPOs, attention is also devoted to the mechanisms for selling IPOs, where considerable variation exists in global practices. Theories and evidence regarding the firstday returns on IPOs are also covered. Most of this chapter is devoted to equity issues, even though fixed-income securities swamp equities in terms of the dollar value of issue volume. This is not because debt securities are unimportant, but because the pricing and distribution of fixed-income securities is generally much more straightforward. Specifically, credit risk is the main determinant of the relative yield on corporate bonds of a given maturity, and independent rating agencies such as Moody’s provide credit ratings on bonds. In contrast, the payoffs on equities have substantial upside potential as well as downside risk, and are thus more sensitive to firm-specific information. External financing is costly. When a firm decides to issue securities to the public, it almost always hires an intermediary, typically an investment banking firm. The issuing firm pays a commission, or gross spread, and receives the net proceeds when the securities are issued. In addition to the direct costs of issuing securities, an issuing firm that is already publicly traded frequently pays additional indirect costs through revaluations of its existing securities (the “announcement effect”). These indirect costs may, at times, be much larger than the direct costs. A major reason for writing this chapter is that the stock market’s reaction to securities offerings conveys information about the firm’s investment and financing activities. The interpretation of these reactions sheds light on broader issues such as market informational efficiency and the importance of adverse selection and moral hazard in corporate settings
Investment banking firms are intermediaries that advise firms,distribute securities,and take principal positions.In the course of these activities,information is produced.Most investment banking firms are vertically integrated organizations that incorporate merger and acquisition(M&A)advisory services,capital raising services,securities trading and brokerage,and research coverage.Although there are distinctions,this chapter will use the terms investment bank,securities firm,and underwriter interchangeably.In Europe,universal banks have been permitted to perform both commercial and investment banking functions.In the U.S.,the Glass- Steagall Act separated commercial and investment banking functions from the 1930s to the 1990s. Commercial banks were permitted to take deposits from individuals that are guaranteed by the government (up to $100,000 per account-holder,as of 2001).In return for the government deposit guarantee,commercial banks were prohibited from certain activities,including taking equity positions in firms and underwriting corporate securities.The prohibition on underwriting securities was gradually relaxed,first for debt securities and then for equity securities.In 1999,the Glass-Steagall Act was finally repealed,although deposit insurance remains. The key difference between commercial banks and investment banks in the corporate financing function is that commercial banks primarily act as long-term principals,making direct loans to borrowers,whereas investment banks primarily act as short-term principals.Since investment banks are selling to investors the securities that firms issue,the marketing of financial securities is important.This is a topic that has no reason for coverage in a Modigliani-Miller framework,where markets are perfect and there is no role for marketing.An important tool in the marketing of financial securities,especially equities,is research coverage(forecasts and recommendations)by security analysts.Since the investment banking firm providing research reports also underwrites offerings,this is referred to "sell-side"coverage.There is a perception that analyst coverage has become more important over time,partly because for many industries (i.e.,biotechnology and technology companies),historical accounting information is of limited use in discerning whether new products and services will create economic value added.At the end of 2000,the Securities and Exchange Commission's Regulation FD(fair disclosure)went into effect.This regulation may affect the role of analysts,for it requires that information that a corporation provides to analysts must be publicly disclosed to others as well This chapter updates and extends previous surveys of the investment banking and securities issuance literature,notably Smith(1986)on the capital acquisition process,Eckbo and Masulis(1995)on seasoned equity offerings(SEOs),Ibbotson and Ritter(1995)on initial public offerings(IPOs),and Jenkinson and Ljungqvist(2001)on IPOs.For those interested in a comprehensive analysis of the literature on IPOs,the Jenkinson and Ljungqvist book goes into extensive detail.Ritter and Welch(2002)focus on the recent IPO literature,especially papers dealing with share allocations.Both the Smith survey and the Eckbo and Masulis survey are grounded in an equilibrium market efficiency framework,and neither discusses long-run performance issues.The Eckbo and Masulis survey has an extensive discussion of rights issues (equity issues where existing shareholders are given the right to purchase new shares at a fixed exercise price).Rights issues will not be covered here,partly because rights issues are not common in the U.S.and their use in other countries has been rapidly declining,and partly due to the excellent existing analysis.Many other topics in security issuance are mentioned in passing or not discussed at all.For example,will technology change the securities issuance process? 3
3 Investment banking firms are intermediaries that advise firms, distribute securities, and take principal positions. In the course of these activities, information is produced. Most investment banking firms are vertically integrated organizations that incorporate merger and acquisition (M&A) advisory services, capital raising services, securities trading and brokerage, and research coverage. Although there are distinctions, this chapter will use the terms investment bank, securities firm, and underwriter interchangeably. In Europe, universal banks have been permitted to perform both commercial and investment banking functions. In the U.S., the GlassSteagall Act separated commercial and investment banking functions from the 1930s to the 1990s. Commercial banks were permitted to take deposits from individuals that are guaranteed by the government (up to $100,000 per account-holder, as of 2001). In return for the government deposit guarantee, commercial banks were prohibited from certain activities, including taking equity positions in firms and underwriting corporate securities. The prohibition on underwriting securities was gradually relaxed, first for debt securities and then for equity securities. In 1999, the Glass-Steagall Act was finally repealed, although deposit insurance remains. The key difference between commercial banks and investment banks in the corporate financing function is that commercial banks primarily act as long-term principals, making direct loans to borrowers, whereas investment banks primarily act as short-term principals. Since investment banks are selling to investors the securities that firms issue, the marketing of financial securities is important. This is a topic that has no reason for coverage in a Modigliani-Miller framework, where markets are perfect and there is no role for marketing. An important tool in the marketing of financial securities, especially equities, is research coverage (forecasts and recommendations) by security analysts. Since the investment banking firm providing research reports also underwrites offerings, this is referred to “sell-side” coverage. There is a perception that analyst coverage has become more important over time, partly because for many industries (i.e., biotechnology and technology companies), historical accounting information is of limited use in discerning whether new products and services will create economic value added. At the end of 2000, the Securities and Exchange Commission’s Regulation FD (fair disclosure) went into effect. This regulation may affect the role of analysts, for it requires that information that a corporation provides to analysts must be publicly disclosed to others as well. This chapter updates and extends previous surveys of the investment banking and securities issuance literature, notably Smith (1986) on the capital acquisition process, Eckbo and Masulis (1995) on seasoned equity offerings (SEOs), Ibbotson and Ritter (1995) on initial public offerings (IPOs), and Jenkinson and Ljungqvist (2001) on IPOs. For those interested in a comprehensive analysis of the literature on IPOs, the Jenkinson and Ljungqvist book goes into extensive detail. Ritter and Welch (2002) focus on the recent IPO literature, especially papers dealing with share allocations. Both the Smith survey and the Eckbo and Masulis survey are grounded in an equilibrium market efficiency framework, and neither discusses long-run performance issues. The Eckbo and Masulis survey has an extensive discussion of rights issues (equity issues where existing shareholders are given the right to purchase new shares at a fixed exercise price). Rights issues will not be covered here, partly because rights issues are not common in the U.S. and their use in other countries has been rapidly declining, and partly due to the excellent existing analysis. Many other topics in security issuance are mentioned in passing or not discussed at all. For example, will technology change the securities issuance process?
Given the burgeoning literature on various aspects of security issuance,any coverage that is less than book-length must,unfortunately,be selective. Many important issues in corporate finance and macroeconomics are driven by the assumption that external finance is costly.Examples include theories of conglomerates (internal versus external capital markets),the effects of monetary policy (bank "capital crunches"and the "bank lending channel"of monetary policy transmission),financial development and growth. and financial accelerator models of business cycles.Because this literature is discussed by Stein (2002)in his chapter in this volume,this chapter will not focus on these important issues.This chapter also is related to other topics in this volume,including Barberis and Thaler's(2002) chapter on behavioral finance and Schwert's(2002)chapter on anomalies and market efficiency. This survey is somewhat U.S.-centric,largely reflecting the existing academic research literature.Although this is clearly a limitation,it is less of a limitation than it once was because capital markets are increasingly globally integrated,and U.S.institutional practices(in particular, book-building)and institutions are increasingly common throughout the world.As examples, Deutsche Bank's investment banking is headquartered in London;Credit Suisse First Boston, while nominally a Swiss firm,in 2000 was the lead manager on more IPOs in the U.S.than any other underwriter;and Goldman Sachs leads the league tables(market share tabulations)for M&A activity in Europe. 1.2 A briefhistory ofinvestment banking and securities regulation Until the 1970s,almost all investment banking firms were private partnerships,generally with a limited capital base.When underwriting large securities offerings,these partnerships almost always formed underwriting syndicates,in order to meet regulatory capital requirements,distribute the securities,and share risk.Many investment banking firms had "relationships"with corporations.In the 1970s,the investment banking industry began to change to a more "transactional"form,where corporations use different investment bankers for different services,on an as-needed basis.Investment banking firms have grown in size and scope,largely through mergers,and most of the larger firms have converted to publicly traded stock companies.A reason for the increase in size of investment banking firms is the increased importance of information technology,with large fixed costs and low marginal costs.With their new-found large capital bases and distribution channels,the historical rationale for forming syndicates to distribute securities has largely disappeared.Consistent with this,the number of investment banking firms participating in a given syndicate has shrunk noticeably over the last few decades.A syndicate is composed of one or more managing underwriters and from zero to over one hundred other syndicate members.The lead manager does most of the work and receives most of the fees(Chen and Ritter(2000)).All of the managers usually provide research coverage.Indeed,this is the major reason why syndicates still exist.Frequently,after a deal is completed,a"tombstone" advertisement listing the syndicate members is published in financial publications such as the Wall Street Journal. As a consequence of distributing the shares in an initial public offering,the lead underwriter knows where the shares are placed,which gives a natural advantage for making a market later on,since the underwriter knows whom to call if there is an order imbalance(Ellis, 4
4 Given the burgeoning literature on various aspects of security issuance, any coverage that is less than book-length must, unfortunately, be selective. Many important issues in corporate finance and macroeconomics are driven by the assumption that external finance is costly. Examples include theories of conglomerates (internal versus external capital markets), the effects of monetary policy (bank "capital crunches" and the "bank lending channel" of monetary policy transmission), financial development and growth, and financial accelerator models of business cycles. Because this literature is discussed by Stein (2002) in his chapter in this volume, this chapter will not focus on these important issues. This chapter also is related to other topics in this volume, including Barberis and Thaler’s (2002) chapter on behavioral finance and Schwert’s (2002) chapter on anomalies and market efficiency. This survey is somewhat U.S.-centric, largely reflecting the existing academic research literature. Although this is clearly a limitation, it is less of a limitation than it once was because capital markets are increasingly globally integrated, and U.S. institutional practices (in particular, book-building) and institutions are increasingly common throughout the world. As examples, Deutsche Bank’s investment banking is headquartered in London; Credit Suisse First Boston, while nominally a Swiss firm, in 2000 was the lead manager on more IPOs in the U.S. than any other underwriter; and Goldman Sachs leads the league tables (market share tabulations) for M&A activity in Europe. 1.2 A brief history of investment banking and securities regulation Until the 1970s, almost all investment banking firms were private partnerships, generally with a limited capital base. When underwriting large securities offerings, these partnerships almost always formed underwriting syndicates, in order to meet regulatory capital requirements, distribute the securities, and share risk. Many investment banking firms had “relationships” with corporations. In the 1970s, the investment banking industry began to change to a more “transactional” form, where corporations use different investment bankers for different services, on an as-needed basis. Investment banking firms have grown in size and scope, largely through mergers, and most of the larger firms have converted to publicly traded stock companies. A reason for the increase in size of investment banking firms is the increased importance of information technology, with large fixed costs and low marginal costs. With their new-found large capital bases and distribution channels, the historical rationale for forming syndicates to distribute securities has largely disappeared. Consistent with this, the number of investment banking firms participating in a given syndicate has shrunk noticeably over the last few decades. A syndicate is composed of one or more managing underwriters and from zero to over one hundred other syndicate members. The lead manager does most of the work and receives most of the fees (Chen and Ritter (2000)). All of the managers usually provide research coverage. Indeed, this is the major reason why syndicates still exist. Frequently, after a deal is completed, a “tombstone” advertisement listing the syndicate members is published in financial publications such as the Wall Street Journal. As a consequence of distributing the shares in an initial public offering, the lead underwriter knows where the shares are placed, which gives a natural advantage for making a market later on, since the underwriter knows whom to call if there is an order imbalance (Ellis
Michaely,and O'Hara(2000)).Advice on acquisitions and follow-on stock offerings frequently follows as well.The underwriter almost always assigns an analyst to follow the company and provide research coverage.Thus,securities underwriting capabilities are combined with M&A advisory capabilities,as well as sales and trading capabilities.All of these activities are information-intensive activities."Chinese walls,"which are supposed to be as impregnable as the Great Wall of China,whereby proprietary information possessed in the M&A advisory function is not disclosed to stock traders,are supposed to exist.In the course of assisting in the issuance of securities,investment bankers perform "due diligence"investigations.In the M&A advisory role, they produce"fairness opinions."Investment bankers are thus putting their reputations on the line, certifying for investors that the terms of the deal are fair and that material information is reflected in the price (Chemmanur and Fulghieri (1994)). In the U.S.,federal government regulation of securities markets is based upon a notion of caveat emptor (buyer beware)with full disclosure.The U.S.Securities and Exchange Commission(SEC)regulates securities markets.In addition,self-regulatory organizations such as the New York Stock Exchange and the National Association of Securities Dealers impose requirements on members,and the threat of class action lawsuits on behalf of investors constrains the actions of issuers and underwriters.Prospectuses are required to contain all material information,with specific requirements for the amount and form of accounting disclosures.In Europe,there is no prohibition on underwriters producing research reports immediately preceding a securities offering.In the U.S.,firms going public and their underwriters are prohibited from disclosing projections that are not in the prospectus during the "quiet period,"starting before a firm announces its IPO and ending 40 calendar days after the offer.An exception to this is that limited oral disclosures may be made during"road show" presentations,where attendance is restricted to institutional investors.In 1999,the SEC started permitting certain qualified individual investors to have access to webcasts of the road show. Typically,the managing underwriters issue research reports with "buy"or "strong buy" recommendations as soon as the quiet period ends.Michaely and Womack(1999)present evidence that sell-side analysts affiliated with managing underwriters face conflicts of interest The conventional wisdom is that analysts have become"cheerleaders."The three reasons for this are that 1)they are dependent upon access to corporate managers for information,2)their compensation is tied to whether their investment banking firm is chosen as a managing underwriter on equity or junk-bond offerings,or as an advisor on M&A deals,and 3)the institutional clients that pay attention to a report are likely to be long in the stock.In 2002,new rules were announced in an attempt to limit the conflicts of interest and alert investors to the conflicts On the front page of a prospectus,the offer price and underwriting discount(commission) are disclosed.The underwriter is prohibited from distributing any securities at a price above the stated offer price,although if the issue fails to sell out at the offer price,the underwriter may sell 1A due diligence investigation involves quizzing management to uncover material information,some of it proprietary in nature,that is relevant for valuation purposes.A fairness opinion is a formal statement that the terms of an M&A deal or leveraged buyout are reflective of"fair"market valuation,including appropriate control premiums or liquidity discounts. 5
5 Michaely, and O’Hara (2000)). Advice on acquisitions and follow-on stock offerings frequently follows as well. The underwriter almost always assigns an analyst to follow the company and provide research coverage. Thus, securities underwriting capabilities are combined with M&A advisory capabilities, as well as sales and trading capabilities. All of these activities are information-intensive activities. “Chinese walls,” which are supposed to be as impregnable as the Great Wall of China, whereby proprietary information possessed in the M&A advisory function is not disclosed to stock traders, are supposed to exist. In the course of assisting in the issuance of securities, investment bankers perform “due diligence” investigations. In the M&A advisory role, they produce “fairness opinions.” Investment bankers are thus putting their reputations on the line, certifying for investors that the terms of the deal are fair and that material information is reflected in the price (Chemmanur and Fulghieri (1994)).1 In the U.S., federal government regulation of securities markets is based upon a notion of caveat emptor (buyer beware) with full disclosure. The U.S. Securities and Exchange Commission (SEC) regulates securities markets. In addition, self-regulatory organizations such as the New York Stock Exchange and the National Association of Securities Dealers impose requirements on members, and the threat of class action lawsuits on behalf of investors constrains the actions of issuers and underwriters. Prospectuses are required to contain all material information, with specific requirements for the amount and form of accounting disclosures. In Europe, there is no prohibition on underwriters producing research reports immediately preceding a securities offering. In the U.S., firms going public and their underwriters are prohibited from disclosing projections that are not in the prospectus during the “quiet period,” starting before a firm announces its IPO and ending 40 calendar days after the offer. An exception to this is that limited oral disclosures may be made during “road show” presentations, where attendance is restricted to institutional investors. In 1999, the SEC started permitting certain qualified individual investors to have access to webcasts of the road show. Typically, the managing underwriters issue research reports with “buy” or “strong buy” recommendations as soon as the quiet period ends. Michaely and Womack (1999) present evidence that sell-side analysts affiliated with managing underwriters face conflicts of interest. The conventional wisdom is that analysts have become “cheerleaders.” The three reasons for this are that 1) they are dependent upon access to corporate managers for information, 2) their compensation is tied to whether their investment banking firm is chosen as a managing underwriter on equity or junk-bond offerings, or as an advisor on M&A deals, and 3) the institutional clients that pay attention to a report are likely to be long in the stock. In 2002, new rules were announced in an attempt to limit the conflicts of interest and alert investors to the conflicts. On the front page of a prospectus, the offer price and underwriting discount (commission) are disclosed. The underwriter is prohibited from distributing any securities at a price above the stated offer price, although if the issue fails to sell out at the offer price, the underwriter may sell 1 A due diligence investigation involves quizzing management to uncover material information, some of it proprietary in nature, that is relevant for valuation purposes. A fairness opinion is a formal statement that the terms of an M&A deal or leveraged buyout are reflective of “fair” market valuation, including appropriate control premiums or liquidity discounts