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# The role of investment banks in IPOs and incentives in firms [Elektronische Ressource] : essays in financial and behavioral economics / vorgelegt von Björn Bartling

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The Role of Investment Banks in IPOsand Incentives in FirmsEssays in Financial and Behavioral EconomicsInaugural-Dissertationzur Erlangung des GradesDoctor oeconomiae publicae (Dr. oec. publ.)an der Ludwig-Maximilians-Universit˜at Munc˜ hen2004vorgelegt vonBj˜orn BartlingReferent: Prof. Dr. Klaus M. SchmidtKorreferent: Prof. Sven Rady, Ph.D.Promotionsabschlussberatung: 21. Juli 2004AcknowledgementsFirst and foremost I would like to thank my supervisor Klaus Schmidt. This thesiswould not have been possible without his superb support, guidance, and encourage-ment. I am also much indebted to my co-authors Andreas Park and Ferdinand vonSiemens. The joint work with both of them was and continues to be a great source ofinspiration and motivation.Just as much I would like to thank my colleagues Brigitte Gebhard, Georg Geb-hardt, Florian Herold, and Susanne Kremhelmer. They all contributed in many waysto the completion of this thesis and provided an inspiring and very pleasurable envi-ronment at the Seminar fur˜ Wirtschaftstheorie. I received comments and suggestionsfrom many other friends and colleagues. My thanks extend to all of them { even moreso as they are too numerous to be all mentioned in name at this point.Finally, I would like to thank the Faculty of Economics and Politics at CambridgeUniversityandWolfsonCollegeCambridgeforhostingmeasavisitingPh.D.studentinthe academic year 2000/01. Financial support from the European Commission, grantno.

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The Role of Investment Banks in IPOs
and Incentives in Firms
Essays in Financial and Behavioral Economics
Inaugural-Dissertation
Doctor oeconomiae publicae (Dr. oec. publ.)
an der Ludwig-Maximilians-Universit˜at Munc˜ hen
2004
vorgelegt von
Bj˜orn Bartling
Referent: Prof. Dr. Klaus M. Schmidt
Promotionsabschlussberatung: 21. Juli 2004Acknowledgements
First and foremost I would like to thank my supervisor Klaus Schmidt. This thesis
would not have been possible without his superb support, guidance, and encourage-
ment. I am also much indebted to my co-authors Andreas Park and Ferdinand von
Siemens. The joint work with both of them was and continues to be a great source of
inspiration and motivation.
Just as much I would like to thank my colleagues Brigitte Gebhard, Georg Geb-
hardt, Florian Herold, and Susanne Kremhelmer. They all contributed in many ways
to the completion of this thesis and provided an inspiring and very pleasurable envi-
from many other friends and colleagues. My thanks extend to all of them { even more
so as they are too numerous to be all mentioned in name at this point.
Finally, I would like to thank the Faculty of Economics and Politics at Cambridge
UniversityandWolfsonCollegeCambridgeforhostingmeasavisitingPh.D.studentin
the academic year 2000/01. Financial support from the European Commission, grant
no. HPMT-CT-2000-00056, is gratefully acknowledged.Contents
Preface 1
1 IPO Pricing and Informational E–ciency: The Role of Aftermarket
Short Covering 14
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.2 The Benchmark: Oﬁer Prices Absent Aftermarket Short Covering . . . 18
1.2.1 The Model Ingredients and Agents’ Best Replies . . . . . . . . . 18
1.2.2 Derivation of the Separating Equilibrium . . . . . . . . . . . . . 24
1.2.3 An Intuitive Characterization of the Equilibrium. . . . . . . . . 27
1.3 The Impact of Aftermarket Short Covering . . . . . . . . . . . . . . . . 29
1.3.1 Overview of Short Covering and a Bank’s Strategy . . . . . . . 29
1.3.2 Equilibrium Analysis . . . . . . . . . . . . . . . . . . . . . . . . 30
1.3.3 How would the result change without signaling? . . . . . . . . . 34
1.4 Payoﬁ Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
1.4.1 Payoﬁ Comparison for the Investment Bank . . . . . . . . . . . 35
1.4.2 Payoﬁ for Issuer and Investors . . . . . . . . . . . . 38
1.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
1.6 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
1.6.1 Aftermarket Price Formation . . . . . . . . . . . . . . . . . . . 43
1.6.2 Threshold Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1.6.3 Approximate Closed Form Solutions . . . . . . . . . . . . . . . 46
1.6.4 Maximal Reputation Costs . . . . . . . . . . . . . . . . . . . . . 48
1.6.5 Omitted Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . 49CONTENTS ii
2 InvestmentBankCompensationinVentureandNon-VentureCapital
Backed IPOs 54
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.2 A Stylized Model of the IPO Procedure . . . . . . . . . . . . . . . . . . 58
2.3 Investment Banks’ Equilibrium Price Choice . . . . . . . . . . . . . . . 64
pendent Signal . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.3.2 Spreads Re ecting the Issuer’s Identical Signal . . . . . . . . . . 68
2.4 The Issuer’s Strategic Choice of the Spread . . . . . . . . . . . . . . . . 69
2.4.1 Equilibrium Spreads if the Issuer is Uninformed . . . . . . . . . 69
2.4.2 Spreads if the Issuer is Independently Informed . . 73
2.4.3 Equilibrium Spreads if the Issuer is Identically Informed . . . . 75
2.5 Results and Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . 76
2.5.1 Positive Proﬂts for Investment Banks . . . . . . . . . . . . . . . 77
2.5.2 VC Issuers set Lower Spreads than Non-VC Issuers . . . . . . . 78
2.5.3 Strong Commercial Banking Ties . . . . . . . . . . . . . . . . . 79
2.5.4 Underpricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
2.7 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
2.7.1 Aftermarket Price Formation . . . . . . . . . . . . . . . . . . . 82
2.7.2 Threshold Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 83
2.7.3 Approximate Closed Form Solutions . . . . . . . . . . . . . . . 85
2.7.4 Omitted Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
3 Working for Today or for Tomorrow: Incentives for Present-Biased
Agents 100
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
3.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.2.1 Present-Biased Preferences and Beliefs . . . . . . . . . . . . . . 103
3.2.2 Multi-Tasking with Immediate and Delayed Beneﬂts. . . . . . . 105CONTENTS iii
3.2.3 Combining Present-Biased Preferences and Multi-Tasking . . . . 106
3.2.4 Benchmark: Incentives for Time-Consistent Agents . . . . . . . 107
3.2.5 Incentives for Sophisticated Agents . . . . . . . . . . . . . . . . 109
3.2.6 Incentives for Naive Agents . . . . . . . . . . . . . . . . . . . . 111
3.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
3.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
4 Inequity Aversion and Moral Hazard with Multiple Agents 120
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
4.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
4.2.1 Projects, Eﬁort, and Probabilities . . . . . . . . . . . . . . . . . 124
4.2.2 Preferences: Risk- and Inequity Aversion . . . . . . . . . . . . . 125
4.3 Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
4.3.1 Benchmark: The Single Agent Case . . . . . . . . . . . . . . . . 127
4.3.2 The Two Agents Case . . . . . . . . . . . . . . . . . . . . . . . 129
4.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
4.4.1 Inequity Aversion Renders Team Contracts Optimal . . . . . . . 134
4.4.2 Inequity Aversion Causes Additional Agency Costs . . . . . . . 135
4.4.3 Inequity Aversion and E–ciency . . . . . . . . . . . . . . . . . . 138
4.5 The Nature and Size of the Firm . . . . . . . . . . . . . . . . . . . . . 144
4.6 Secrecy of Salaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.7 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
4.7.1 Rent Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . 150
4.7.2 Disutility from Being Better Oﬁ . . . . . . . . . . . . . . . . . . 151
4.7.3 Status Seeking . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
4.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
4.9 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Bibliography 159Preface
This dissertation is comprised of two parts. Chapters 1 and 2 address the role of in-
vestmentbanksininitialpublicoﬁerings. Chapters3and4analyzeincentiveprovision
when agents are subject to a ‘behavioral bias’.
In Chapter 1 we model the procedure of an initial public oﬁering (IPO) as a sig-
naling game and analyze how the possibility of potentially proﬂtable trading in the
aftermarket in uences pricing decisions by investment banks. When maximizing the
sum of both the gross spread of the oﬁer revenue and proﬂts from aftermarket trading,
investment banks have an incentive to distort the oﬁer price by employing aftermar-
ket short covering and exercise of the overallotment option strategically. This results
either in informational ine–ciencies or, on average, exacerbated underpricing. Wealth
is redistributed in favor of investment banks.
In Chapter 2 we address two puzzles of the IPO literature: (1) Why do investment
banks earn positive proﬂts in a competitive market? And (2) Why do banks receive
lower gross spreads in VC backed IPOs? The IPO procedure is modeled as a two-
stage signaling game. In the second stage banks set oﬁer prices given their private
information and the level of the spread. Issuers anticipate the bank’s pricing decision
and set in the ﬂrst stage spreads to maximize expected revenue. Investors are aware of
this process and subscribe only if their expected proﬂts are non-negative. As a result,
issuers oﬁer high spreads to induce banks to set high prices, allowing them proﬂts.
thenumberofco-managersoranalystcoverage. Weshowthatinequilibriumsuperiorly
informed VC backed issuers impose smaller spreads.PREFACE 2
In Chapter 3 we examine self-control problems { modeled as time-inconsistent,
present-biased preferences { in a multi-tasking environment. An agent must allocate
eﬁort between an incentivized and immediately rewarded activity (e.g. eﬁort at the
workplace) and a private activity that pays out only tomorrow (e.g. studying for a
degree). Present-biased agents take decisions that do not maximize their long-run wel-
fare, irrespective of the intensity of incentives. Sophisticated agents are never harmed
by incentives relative to the case where incentives are absent as they always receive
their reservation utility levels. However, naive agents are always harmed in the pres-
enceofincentivesastheywronglypredictfuturebehaviors. Furthermore,weshowthat
the loss to a naive agent can exceed the principal’s gain from providing incentives. In
this case social welfare is reduced if the principal provides incentives.
In Chapter 4 we analyze how inequity aversion interacts with incentive provision in
anotherwisestandardmoralhazardmodelwithtworiskaverseagents. Weidentifythe
conditionsunderwhichinequityaversionincreasesagencycostsofprovidingincentives.
We show, ﬂrst, that inequity aversion can render equitable at wage contracts optimal
even though incentive contracts are optimal with selﬂsh agents. Second, to avoid
social comparisons the principal may employ one agent only, thereby forgoing the
e–cient eﬁort provision of the second agent. We ﬂnally discuss the implications of
social preferences for the internal organization and the boundary of the ﬂrm.
The decision whether or not to conduct an initial public oﬁering is an important
decisionin the life cycle of a ﬂrm. The advantages of having shares in a ﬂrm quoted on
astockexchangearemanifold. Theownerofaﬂrmcanrealizepartofherinvestments,
it includes the ability to raise additional equity ﬂnance, or even the opportunity to set
up share option plans as incentive device for employees. However, there are also costs
of going public. In this context, initial underpricing is most extensively discussed.
Ritter and Welch (2002) report for 6,249 IPOs in the U.S. between 1980 and 2001 an
average ﬂrst-day return of 18.8 percent. It is usually argued that initial underpricing
constitutes a wealth transfer from the owner of the ﬂrm to the new shareholders, and
as such can be regarded as a cost of going public.PREFACE 3
seems to violate the fundamental tenet of ‘no arbitrage’. The most prominent ones as-
sumeinformationalasymmetriesbetween(oramong)someofthemainpartiesinvolved:
the issuing ﬂrm, the investment bank, and the investors.
Rock (1986) proposes a variant of Akerlof’s (1970) ‘lemons problem’. He assumes
asymmetric information between diﬁerent types of investors. Some are perfectly in-
formed about the intrinsic value of the shares on oﬁer whereas others are uninformed.
Given the presence of informed investors, uninformed investors face a ‘winner’s curse’.
Informed investors subscribe only to ‘hot’ IPOs. Assuming that shares are rationed,
uninformed investors stand a greater chance of being allocated shares in ‘cold’ IPOs
from which informed investors abstain. To however attract uninformed investors to
subscribe to IPOs, shares have to be underpriced on average.
Another strand of the literature assumes asymmetric information between the is-
suing ﬂrm and the investors. The signaling models by Allen and Faulhaber (1989),
Grinblatt and Hwang (1989), and Welch (1989) argue that underpricing can { in anal-
ogy to Spence’s (1973) job market signaling { be a signal for a high ‘quality’ of the
ﬂrm. AsinglecrossingpropertyisestablishedbyassumingthatsubsequenttotheIPO
asecondaryoﬁeringisconducted. Inbetweenthesetwooﬁeringsnewinformationmay
ariseandrevealalowqualityﬂrm’struevalue. Thisﬂrmwillthenbeunabletorecoup
thelossfromunderpricingitssharesbywayofasecondaryoﬁering. Aseparatingequi-
librium can thus be established in which only high quality ﬂrms underprice because
they can reap the gain from doing so in the secondary oﬁering.
1Apart from missing empirical support for signaling theories of underpricing there
is the question why ﬂrms would not opt for a diﬁerent, less costly signal? Booth and
Smith (1986), for example, put forth a theory of investment bank choice. Investment
banks as repeated players have reputational capital at stake and can thus certiﬂcate
the value of a ﬂrm. Other theories stressing the role of investment banks include Ben-
veniste and Spindt (1989). They assume asymmetric information between investment
1Helwege and Liang (1996) report for a U.S. sample of IPOs in 1983 that only 4 percent of ﬂrms
conducted a secondary oﬁering in the subsequent 10 years.PREFACE 4
and they are assumed to subscribe repeatedly to IPOs. Benveniste and Spindt design
a mechanism in which banks use underpricing and rationing to elicit investors’ infor-
mation prior to an IPO. If shares are underpriced, investors can be punished by small
allocations in subsequent oﬁerings of other ﬂrms if the post-IPO phase reveals that
material information was withheld.
The existing theoretical literature however almost completely neglects that the role
of investment banks does not end with the distribution of shares at the day of the
oﬁering. In fact investment banks pursue supposedly price stabilizing activities in the
aftermarket of IPOs that provide potentially proﬂtable trading opportunities. This
is where the model in Chapter 1 adds to the literature. We explicitly account for
stabilizing activities by investment banks in the aftermarket of an IPO and analyze
how this in uences the oﬁer price decision in the ﬂrst place.
The regulating authorities allow investment banks to establish a short position in
an IPO by selling more shares than initially announced. Aftermarket short covering
refers to the practice of ﬂlling these positions in the aftermarket of an IPO. This is
done if the market price falls below the oﬁer price. The idea is that ﬂlling short
positions stabilizes prices by increasing demand. The diﬁerence between market price
and oﬁer price is { along the way { pure proﬂt for the investment bank. If the price
instead rises, the bank is hedged by an overallotment option which grants the right
to obtain additional shares from the issuer at the oﬁer price. The U.S. Securities and
Exchange Commission (SEC) and the Committee of European Securities Regulators
(CESR)putforwardtheargumentthatstabilizingactivitiesensurean‘orderlymarket’
as sudden selling pressure can be countered. In their latest respective release the SEC
(1997, p. 81) opines that aftermarket price stabilization \promotes the interests of
shareholders, underwriters, and issuers."
InChapter1wechallengethisviewbyshowingthat{inthecontextofourmodel{
stabilizing activities result in either informational ine–ciencies or, on average, exacer-
bated underpricing. Furthermore, wealth is redistributed in favor of investment banks.PREFACE 5
We presume that these ‘side eﬁects’ will not be intended by the regulating authori-
ties. Even without trading oﬁ potential beneﬂcial eﬁects of stabilization against our
ﬂndings, a policy implication arising from the analysis might be the alert that current,
well meant regulation can be gamed to the disadvantage of issuers and investors.
We propose a signaling model of the IPO procedure in which both the investment
bank and investors hold private information about the intrinsic value of the shares.
The bank moves ﬂrst and sets the oﬁer price. Besides possible trading proﬂts in
the aftermarket, banks are directly remunerated for their services by a fraction of
the oﬁering revenue, the gross spread. In our model banks choose the oﬁer price
strategically to maximize their proﬂts form both the gross spread and trading proﬂts
in the aftermarket. A higher oﬁer price promises a higher revenue, it however reduces
the probability that the IPO is successful. An IPO gets called oﬁ if there are not
enough investors subscribing to it, and a higher oﬁer prices reduces the number of
2investors subscribing.
Asbenchmark,inasettingwithoutaftermarketactivitiesweidentifytheconditions
for the price equilibrium to be separating. In a separating equilibrium banks with
diﬁerent information set diﬁerent oﬁer prices. A bank with favorable information
about the value of the ﬂrm deems it more likely that enough investors will hold alike
information. Itwillthussetahigherpricethanabankwithlessfavorableinformation.
We call a separating equilibrium informationally e–cient since the bank’s information