The Effect of Underwriter Reputation on Long-Term IPO Performance - Does Firm Quality Explain the Positive Relationship?

Abstract

The purpose of this paper is to study the relationship between underwriter reputation and long-term IPO performance in light of firm quality. My main objective is to test whether the positive relationship documented in previous studies can be explained by the quality of firms going public. The research question stems from a common assumption in the literature: High-quality underwriters possess above-average skills to screen IPO candidates.

The sample consists of 8,000 firms that went public in the United States between 1980 and 2013. I use three methodologies in my analysis that are buy-and-hold-abnormal returns, cross-sectional regressions and calendar-time portfolio regressions. The quality minus junk (QMJ) factor by Asness, Frazzini and Pedersen (2013) is included in calculating factor-adjusted returns in the regression analyses to answer the research question. Post-issue performance is analyzed over a three-year period and updated Carter and Manaster (1990) underwriter reputation measures are used as estimates of underwriter quality.

I find that IPOs underwritten by high-prestige underwriters outperform IPOs underwritten by low-prestige underwriters when the QMJ factor is not included in the analysis. However, the results of the regression analyses change when the QMJ factor is included: The positive relationship between underwriter reputation and long-term IPO performance disappears in the cross-sectional regression analysis and the relationship is weakened in the calendar-time portfolio analysis. This suggests that the effect of underwriter reputation is partly the result of an indirect effect through firm quality.

This thesis complements the existing literature on the effect of underwriter quality on IPO performance. I provide further evidence of the positive relationship between underwriter reputation and long-run IPO returns. More importantly, I show that this relationship can be partly explained by the quality of firms going public. In practice, high-prestige underwriters underwrite issues that are, on average, of higher quality than the issues underwritten by low-prestige underwriters.