The Surprising Association Between High-Reputation Underwriting Firms and Low-Quality IPO Firms in a Burgeoning Stock Market – Eurasia Review
In mature and growing markets, underwriters with a high reputation will prevail, as they will be able to choose their clients. The question becomes: who could they choose?
According to the new study “Who do you take to tango?” Examining Matching Mechanisms Between Underwriters and IPO Companies in an Emerging Stock Market” – authored by Yan Anthea Zhang, Rice University; Haiyang Li, Rice University; Jin Chen, University of Nottingham Ningbo China; and Jing Jin, University of International Business and Economics, Beijing, China—Client selection behaviors of highly reputable underwriters differ in a nascent stock market versus a mature one. Previous research has established that in mature markets, high-reputation underwriters are mostly associated with high-quality IPO companies. In a nascent capital market, however, highly reputable underwriters are working with IPOs of various qualities, good and bad, including those that have “cooked” their books to meet listing standards. in stock exchange.
Why would highly reputable underwriters choose to work with low-quality IPO firms if their reputation is at stake? The authors find that money plays an important role in matching underwriters to IPOs in an emerging market. Simply put, high-reputation underwriters charge higher fees than their low-reputation counterparts, while low-quality IPO companies pay higher fees than high-quality ones. The authors argue that because a nascent stock market typically begins with weak regulation, the financial and reputational penalties for underwriters accepting low-quality clients are not well defined, creating an incentive for underwriters to shift financial gains to short-term (high fees) before long-term reputation concerns.
“We contribute to the IPO literature by moving beyond the well-accepted assumption that high-reputation underwriters are associated with high-quality IPO firms and by proposing a matching mechanism alternative in a nascent stock market: the pricing mechanism,” the authors write. “By focusing on a nascent stock market, our study provides insight into how underwriters and IPO firms are matched before an effective contract, which best serves IPOs, emerges. in a capital market.
When regulations become stricter, the pricing mechanism collapses. The study finds that after the introduction of stricter regulations in a nascent market – and a few cases demonstrate that underwriters are paneled for endorsing low-quality companies – the overall quality of IPOs improves. More importantly, underwriters’ customer selection behaviors are also adapting. Reputable underwriters become more likely to work with high-quality IPO companies rather than ones willing to pay high fees.
This study offers important insights into behavior at all levels of market maturity, whether fairly relevant or well-established, and has implications for any financial institution looking to play in the market.