Underwriting Services and the New Issues Market

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Preface

George J. Papaioannou and Ahmet K. Karagozoglu

One of the most important functions of the financial markets is to facilitate the raising of capital through the issuance of equity and debt securities. This book is dedicated to covering the underwriting services of investment banks and the new issues markets in which these services take place. Despite the importance of the topic and the great body of literature it has spawned, there is a dearth of books that provide a comprehensive coverage of this subject matter.

Underwriting Services and the New Issues Market aims to fill this void by providing a resource that integrates the practice and academic theory as well as evidence on this subject. The exposition of theory and empirical findings presents information that has implications for the practice of underwriting without attempting to provide a critical appraisal of the existing academic literature. Although the conceptual and technical tools that apply to the issuance and underwriting of securities straddle various fields of finance, the book’s primary focus is on the activities and decisions that are directly relevant to the issuance process and the pertinent theory and evidence that help assess the consequences and efficacy of those decisions. Thus the book is designed to impart the reader a well-rounded understanding of the underwriting of new issues.

The material of the book is structured to follow the sequence of the various phases of the capital raising process and the activities underwriters perform in each stage of this process. Consequently, coverage of theory and empirical evidence follows this pattern rather than one that could be adopted in an academic research exposé.

The book covers the following topics: Chapter 1, The Underwriting Business: Functions, Organization, and Structure, and Chapter 2, The New Issues Markets, provide, respectively, an overview of the underwriting business and the major new issues markets around the world. Chapter 3, Regulation of the New Issues Market in the United States, reviews important laws and regulations that relate to underwriting services and the new issues markets. Chapters 4–7 discuss the mechanics of the issuance process as well as the activities and services of underwriters and review the various offering methods used around the world. Chapters 8–13 present the theories that have been advanced to explain the pricing of new issues as well as the empirical findings regarding the pricing of new issues and the stock price and operating performance of firms that conduct securities offerings. Chapters 14–16 analyze the decision to issue securities and discuss the choices faced by issuers in relation to structuring new offerings. Although the main focus of the book is securities issuance and underwriting services in the United States, the book provides ample details on offering arrangements in international markets along with the pertinent academic research.

The book is intended for use by practitioners in investment banking, financial analysts, regulators and policy makers, as well as by faculty and students in Master’s and doctoral-level courses in investment banking and capital markets. Depending on the reader’s objectives, the chapters of the book can be used selectively to study either the mechanics of the issuance process or the conduct of capital markets as it relates to new issues.

The book is based on a graduate course in investment banking taught by George Papaioannou, who wishes to acknowledge the contribution his students made through their thought-provoking and challenging questions and comments. He also thanks his student assistants, particularly Harsiman Singh, Will Gao, and Linshan Qu, for their valuable work.

The authors express their appreciation to Editor Scott Bentley and Editorial Product Manager Susan Ikeda at Elsevier for their encouragement and support in making this book a reality.

1

The Underwriting Business

Functions, Organization, and Structure

Abstract

Underwriting is defined as the intermediation service in the capital raising process that takes place in the new issues markets. This chapter describes the services underwriting firms provide to issuers and the functions these firms perform in the new issues markets. The chapter discusses the competencies and skills underwriting firms must develop and possess in order to compete successfully and how investment banks develop these competencies by running multifaceted operations in the primary and secondary capital markets. The chapter also examines the complementarities and synergies as well as conflicts of interest these operations engender as underwriting firms strive to balance their own interests with those of issuers and investors. Furthermore, the chapter reviews the structure of the underwriting industry, describes the factors that impact the structure of underwriting markets and reports information that sheds light on the structure of the industry in the United States and internationally.

Keywords

Underwriting; underwriting functions; underwriting competencies; supporting operations; industry structure; underwriting market competition; commercial banks; securities firms; domestic and international competition; IPO; SEO; investment banking

This chapter describes the underwriting business, the firms that provide underwriting services, how these firms organize the underwriting business within the broader scope of their operations, and how they compete in the market for underwriting services.

Functions and Organization

What Underwriters Do

Corporations as well as other entities (e.g., municipalities, universities, etc.) need to raise new capital for various purposes by selling financial claims, like stocks or bonds. Because these issuers come to the market only periodically they lack the expertise required to ensure the new securities are appropriately priced and successfully placed with investors. To overcome these disadvantages, issuers retain financial institutions that operate as investment banks to assist with the pricing, marketing, and placement of their new issues. In full-service underwriting arrangements, the intermediary also assumes the risk of placing the issue. It is this risk bearing service, akin to an insurance policy, that gives the name underwriting to these business arrangements and by extension to this business activity. In return, issuers pay underwriting firms a fee to compensate them for the range of services they receive. Underwriting of new issues is part of the activities that take place in the primary capital markets. This is the segment of the financial markets that facilitates the raising of new capital through the sale of financial claims, like stocks and bonds.

The Underwriting Firms

The firms that engage in the provision of underwriting services are called investment banks. Most investment banks are much more than just underwriting firms. They also run various other securities businesses, including brokerage, trading, wealth management, and corporate advisory services. They may operate as independent investment banks (e.g., Goldman Sachs and Morgan Stanley) or as divisions of other financial institutions, banks or insurance companies (e.g., Merrill Lynch is part of the Bank of America).

The Functions of Underwriters

As intermediaries in the capital raising process, underwriting firms perform several valuable functions that help issuers offer new securities at higher prices and lower cost than otherwise.

Valuation and Pricing

In many instances, a firm approaches the public capital markets for the first time. This is the case of a firm selling stock in an initial public offering (IPO) or the case of a firm issuing a bond for the first time. In these cases, there is no prior history to serve as a guide about the value of the firm. Even in instances when an issuer has publicly traded securities but lacks wide recognition and active trading of its securities there may not be full agreement on the value of the firm’s securities. By operating in the capital markets and engaging in repeat new issue deals, underwriting firms acquire the expertise to collect the appropriate information and arrive at a more credible estimate of value than the issuing firm. Arriving at an appropriate value is not, however, sufficient for the successful placement of a new issue. Even more important is to set the right price at which the new securities will be accepted by investors—i.e., the offer price. Informational frictions between sellers (issuer and underwriter) and buyers (investors) can cause the latter to be reluctant to pay the full value of the security for fear of overpaying—a condition called adverse selection. Valuing and pricing a new issue may also require that regular investors be engaged in the production of information relevant to the price discovery process. It is the function of the underwriter to organize this information production by incentivizing investors and finding efficient methods of compensation, as, for example, though price discounts.

Certification

The ability of underwriters to convince the market about the fairness of the offer prices of new issues depends on the underwriter’s reputation and track record. Since the underwriter’s revenue stream depends on repeat business, underwriters have an incentive to maintain a reputation as credible intermediaries. This is how they build reputation capital. The greater this capital is the greater the certification power of the underwriter. Thus, as certifiers of new issue values, underwriters facilitate the placement of new securities into the capital markets and contribute to the financing of new investments.

Marketing

Underwriting firms have extensive contacts and networks of retail and institutional clients to whom they can pitch the new securities. Through person-to-person contacts or group presentations in the so-called roadshows, underwriters can communicate vital information that helps investors to become informed about the new issue.

Distribution

The distribution of new offers is the culmination of the pricing and marketing activities of the underwriting process. Distribution includes both the sale of the new securities as well as the scope of investor clienteles to whom the new securities will be sold. The sale of new issues requires human capital, especially an experienced salesforce, and tangible assets ranging from brick-and-mortar facilities to information and computer technology resources. Investor networks are valuable in securing the sale of new securities to investor clienteles favored by the issuer or dictated by the conditions of the market.

Valuable Competencies in Underwriting

To perform the above functions efficiently and to succeed in the underwriting business, underwriting firms must possess several competencies.

Ability to Originate Deals

This is the most important competitive advantage an underwriting firm must possess. Receiving mandates to serve as the lead manager of new issues is critical in maximizing revenues from new issue deals and building reputation. Since the lead manager is engaged in all services under the underwriting contract and also retains the lion’s share in the allocation of the offers, he/she receives the bulk of the underwriter compensation. As lead manager, the underwriter also selects the comanagers and other syndicate members thus establishing the conditions of reciprocal invitations to participate in other deals. Investment banks develop the origination advantage by cultivating and maintaining relationships with many prospective issuers. Such contacts and networks are built on reputation and a wide-ranging scope of operations that can be of use to issuers (e.g., providing services in M&A deals and other corporate finance decisions and transactions).

Ability to Design and Price New Issues

Capital markets expertise enables successful underwriters to advice issuers on the appropriate type of new securities to offer (e.g., stocks or bonds) and design the terms of new securities so that they are compatible with market conditions and dynamics, investor appetite, and other institutional arrangements. This kind of expertise is most important in the case of bond issues. Debt instruments can have many different features in terms of maturity, callability, and convertibility to mention a few. Part of the ability to advise on financial instruments is also the ability to assess their relative risk-return appeal to different investor clienteles.

Ability to Place Securities

Underwriting starts with origination and ends with placement. Successful placement of the new issue under the terms of issuance (i.e., offer price and quantity offered) is the necessary outcome to prove the underwriter’s competence in organizing and executing the new issue mandate. Without access to investor capital even a firm strong in origination is likely to fail.

Ability to Intermediate Client Interests

The overarching ability of successful underwriting firms is to smooth out informational frictions and the conflicting interests of issuers and investors. Information frictions can prevent issuers and investors to come to terms on mutually acceptable prices for new issues. Issuers seek to maximize proceeds from the new issue by selling at the highest offer price possible, whereas investors seek to maximize returns by buying at offer prices below the fair market value of the new securities. Underwriting firms can ill-afford to disappoint either side of their clients since both are needed for survival in the underwriting business. This leads underwriters to strike implicit contracts with both sides that allow the parties to meet their goals, usually over several deals with the same underwriter. For example, an issuer may be willing to accept a lower offer price for the opportunity to get better quality analyst coverage in anticipation of a follow-on issue. Or investors may accept to buy less promising new issues for the opportunity to participate in future hot issues managed by the underwriter. These quid pro quo agreements are not explicitly articulated in the underwriting contracts but they are understood to have force because they are backed by the underwriter’s reputation capital at stake (Morrison and Wilhelm, 2007). To deliver on these implicit obligations and enforce nonopportunistic behavior, especially on the side of investors, underwriting firms need to have a steady deal flow. The implicit contracts can work if investors understand that violators will be frozen out of future good deals and lose their long-run benefits.

Supporting Activities for Successful Underwriting

Underwriting services are not organized and offered in a vacuum. To possess the competencies described above requires that investment banks run a number of secondary and primary market activities. These supporting activities can be profit centers on their own, but also engender significant synergies that benefit underwriting. In some of these activities investment banks assume the role of an agent, that is, they execute transactions for their clients without assuming any market risk, as in brokerage and asset management. In other activities, they act as principals, that is, they put their own capital at risk, as with underwriting, trading, and merchant banking.

Brokerage

Brokerage business involves the execution of orders on behalf of customers. This enables the firm to establish and grow networks of retail and institutional investors. These networks provide immediate access to an investor base to whom the new securities can be pitched and eventually sold.

Trading

Underwriting firms operate trading floors for the execution of trades for their account as well as the accounts of clients (investors). When they trade as a counterparty to a client’s order, they act as a principal and bear the risk that comes with price volatility. On the plus side, trading cultivates relationships with investors and offers the investment bank the opportunity to hone its valuation skills and develop a deeper understanding of market dynamics.

Market Making

Market makers stand between buyers and sellers and support one or the other side when there is an imbalance between buy and sell orders. This service places an investment bank in a strong position to provide and support liquidity in the early aftermarket of new unseasoned securities (like IPOs and first-time bond issues). Without the presence of market makers, trading on these issues could become possible only if buyers paid more or sellers accepted less, thus jeopardizing the liquidity of the securities.

Wealth Management

Advising or running mutual funds or managing other pools of money provides the investment bank with placement capabilities. Although there is a reputation risk at stake because of conflicts of interest, when well done, these activities can be of mutual benefit to the investment fund and the underwriting business in the case of well-priced securities. The investment bank gains access to new financial products, whereas the placement of new issues finds a more receptive investor outlet.

Analysis and Research

Successful underwriting firms are supported by strong research departments and top quality analysts. As with market making, research output and analyst coverage are extremely important in the aftermarket, especially for first time issuing firms. These firms need to build their investor base and attract attention to the firm’s business. In many cases, it is only the underwriter’s firm that provides analysis and recommendations that investors can use to consider investing in the firm. Since the mid-1990s, analyst quality and coverage have become critical factors in the issuers’ selection of underwriters. Accordingly, investment banks have used their strength in this area to gain entry into the group of comanagers which is the first step for eventually graduating to the position of lead manager (Ljungqvist, Marston, and Wilhelm, 2009). Reputable analysts are also prized for their power to attract new clients to the underwriting firm (Clarke, Khorana, Patel, and Rau, 2007).

Corporate Finance Services

Besides managing new issues and operating in the securities business, investment banks also serve as advisors to corporations in regards to various transactions on the assets and liabilities side. As such, investment banks advice clients on mergers and acquisitions, leveraged and management buy-outs, spin offs of assets and equity carve outs, stock repurchases, debt refinancing, and other corporate finance matters. The advantage of acting as a corporate finance advisor is the opportunity to maintain ongoing contacts with corporate clients and to promote the underwriting business when some of these corporate transactions require the issuance of new securities. Therefore, corporate finance services can be critical to the origination of underwriting deals.

Merchant Banking

Investment banks also risk their own capital by taking positions as lenders in bridge loans and as partners in private equity and hedge funds. Acting as lenders, investment banks facilitate the interim financing of corporate clients engaging in asset restructurings or M&A transactions. The bridge loans are eventually paid off through issues of securities in which the lending investment bank is very likely to serve as underwriter. In private equity funds, investment banks engage in the purchase and restructuring of promising private firms sold later through an IPO. Thus, both types of activities can generate synergies with corporate finance as well as underwriting. However, participation in private and hedge funds has been severely curtailed under the Dodd-Frank or Wall Street Reform and Consumer Protection Act of 2010.

Financial Engineering

Financial engineering is the design of financial instruments with new and unique features that help finance complex projects or overcome frictions on the issuer or the investor side. Financial innovation is vital to investment banks. It gives them the advantage to pitch new products to clients—both issuers and investors—and acquire skills in the design of securities.

Conflicts of Interest

The joint production of services can create serious conflicts of interest that diminish the potential benefits from operational complementarities. Conflicts of interest arise when a party acting as the agent of a client can take action that benefits the former but hurts the latter. For example, an investment bank that functions as an underwriter of new securities and asset manager can reduce its placement costs by placing low quality (e.g., overvalued) securities in the investment accounts of clients. Or a commercial bank acting as an underwriter can conceal the true value of the issuer’s securities in order to raise funds that are purposed to repay the client’s bank loan.

These conflicts of interest came to the fore in the years 1999–2000 when many IPOs of technology, especially internet-based, stocks came to the market at very high discounts relative to their ensuing market prices in the secondary market. Specifically, investment banks were accused for quid pro quo deals that favored their investors or the executives of issuing firms. These accusations were settled in the 2003 Global Analyst Research Settlement at a total cost of $1.4 billion. The settlement involved initially 10 and later 2 more of the biggest investment banks, including First Boston, Goldman Sachs, Merrill Lynch, and Morgan Stanley.

Two areas that have attracted interest in the study of conflicts of interest are analyst recommendations and the performance of mutual funds operated by investment banking firms. The promise and actual delivery of aggressive analyst recommendations has been used to attract to the underwriting business issuers eager to achieve better prices for their stocks. Dumping less promising new securities into mutual funds operated by the parent investment bank can facilitate the placement of these issues. Empirical research has produced evidence of conflicts of interest in both of these areas. Bias in recommendations by affiliated analysts has been documented in Barber, Lehavy, and Trueman (2007) and Kadan, Madureira, Wang, and Zach (2009), whereas Berzins, Liu, and Trzcinka (2013) find evidence of underperformance in mutual funds operated by investment banks.

Conflicts of interest can be mitigated by concerns of loss of reputation in the businesses entangled in the joint operations. For example, Ljungqvist, Marston, and Wilhelm (2006) find that the risk to their professional status and the standing of the parent firm restrains very reputable analysts from issuing aggressive recommendations to help the underwriting arm of their firm. Conflicts of interest can be also mitigated by competition from organizations with simpler business models that are free of conflicts of interest, like boutique investment banks. Another mitigating factor is the price discount clients can impose on the seller if the latter is known to mishandle conflicts of interest. Or investors aware of the bias in analyst recommendations may discount their impact on asset values. Closer monitoring by outside investors can also check conflicts of interest. For example, Ljungqvist, Marston, Starks, Wei, and Yan (2007) point out that the analysts’ behavior is restrained when stocks are held by the usually better-informed institutional investors. Analysts employed by reputable underwriting firms with more loyal underwriting clients are found to be less aggressive in their recommendations.

Chen, Morrison, and Wilhelm (2014) argue that the development of reputation follows a cycle that initially favors aggressive behavior which is followed by more restrained behavior in order to preserve the reputational capital of the firm. Thus, investment banks are more likely to place their interests ahead of those of their customers when the former need to develop a type of reputation for possessing certain skills in the execution of deals. Once this reputation has been established investment banks start to build behavioral reputation that puts the interests of the client ahead of those of the investment bank.

Industry Structure and Competition

Brief Historical Perspective

Throughout the 19th century and until the 1930s, underwriting was organized as part of the securities business run by commercial banks and independent securities firms. Following the Glass–Steagall Act of 1933, securities business was separated from commercial banking and as a result underwriting of corporate securities was exclusively left in the domain of the securities industry. The gradual relaxation of the Glass–Steagall Act started in the mid-1980s, when the Federal Reserve Board expanded the powers of Section 20 affiliates of commercial banks¹. Section 20 affiliates were permitted to underwrite and trade in debt securities in 1989 and a year later in equities as long as the revenue from these activities did not exceed 10% of the revenue of the Section 20 affiliate. This revenue limit was raised to 25% in 1996 and the same year the fire wall separation between the securities business and the commercial banking business was lifted. These relaxations were important because they afforded commercial banks greater scale and scope of operations. That is, the underwriting business had more room to grow and the communication between securities business staff and commercial lending staff gave banks an informational advantage over their security firm rivals.

The Glass-Steagall Act was finally repealed in 1999 by the Gramm-Leach-Bliley Financial Services Modernization Act.

Although the intent of deregulation was to expand the number of players in the securities business and the new issues markets, it ushered in a large wave of industry consolidation as the largest banks moved quickly to takeover established independent investment banks. Eventually, with the exception of Goldman Sachs and Morgan Stanley, all the large independent investment banks were absorbed into commercial bank conglomerates. Thus, for example, Salomon Brothers was absorbed into Citigroup, Merrill Lynch into Bank of America, Bear Sterns into J. P. Morgan Chase, First Boston and Donaldson, Lufkin and Jenrette into Credit Suisse (Switzerland), Paine Webber into UBS (Switzerland), and Alex Brown into Deutsche Bank (Germany). The acquisitive strategy followed by the commercial banks was primarily motivated by the difficulty commercial banks had faced in the organic (i.e., de novo) development of the competitive competencies required for expansion into investment banking.

Along with changes due to the evolving regulatory environment, underwriting firms and their parent investment banks underwent other significant changes over the years. The most important was the gradual abandonment of the partnership form of ownership in favor of the public corporate form. This change was driven mainly by the fast-rising need for capital as the securities business became capital intensive. This was the result of expanding volumes of trading and underwriting as well as the need to provide real-time analysis and execution through the use of elaborate information and computer technology. Also, the introduction of accelerated offerings through Rule 415 ushered in the practice of the bought deal². Underwriters had to commit to the purchase of a new issue before they had time to form a syndicate and canvass the market’s demand for the new securities. That meant putting large amounts of capital at risk that should be backed by a strong balance sheet.

An important consequence of adopting the public corporate form was the breakdown of the partnership model which in turn led to a more fluid labor force that was less dependent on mentoring by senior partners and less committed to the reputation of the firm for long-term compensation benefits (Morrison and Wilhelm, 2008).

Industry Structure

The makeup of the underwriting industry is a mirror image of the makeup of the investment banking industry. Underwriting (and investment banking) firms can be classified by various criteria.

By Affiliation

Independent securities firms: These are investment banks that remain independent of any affiliation with other financial institutions. As of 1985, all top US investment banks operated as independent securities firms without ties to banks. By 2015, almost all top ranked investment banks were controlled by commercial banks or operated as subsidiaries of banks. Currently, Goldman Sachs and Morgan Stanley are the only remaining independent firms among the top ranked investment banks (see Table 1.2).

Commercial-bank-controlled firms: These are investment banks that have either evolved organically within commercial banks or were acquired by banks. Top ranked investment banks that came under the control of commercial banks are: Alex Brown, Bear Sterns, First Boston, Merrill Lynch, Paine Webber, Salomon Brothers, Smith Barney.

Subsidiaries of other financial or industrial firms: These are investment banks owned by other types of firms, most usually, insurance companies. An example of such a securities firm was Dean Witter which was controlled by Sears, Robuck & Co. and later merged with Morgan Stanley. Prudential (an insurance firm) used to operate Prudential Securities before it sold it to Wachovia Bank.

By Ownership

Privately owned: These are investment banks that are privately owned and usually organized as limited partnerships. This was the traditional form of ownership before capital needs started to exceed the ability of partners to capitalize their firms. With the exception of First Boston, Merrill Lynch and Paine Webber, the top ranked investment banks were privately held as of 1985. As of 2015, all top ranked investment banks were publicly traded corporations (see Table 1.2).

Publicly owned: These are investment banks with publicly owned and traded equity. With few exceptions of small boutique investment banks, all major investment banks are now publicly held. The going public trend among large investment banks took hold in the mid-1980s as Alex Brown, Bear Stearns, Morgan Stanley, Salomon Brothers, and Shearson Lehman Hutton (predecessor of Lehman Brothers) went public within a few years. Goldman Sachs was the only holdout among top securities firms that eventually went public in 1999.

By Scope of Operations

Integrated investment banks: Integrated investment banks are firms that have integrated their operations across segments of the capital markets, investor clienteles, and sectors of the securities business. Traditionally, securities firms have been classified into national full-line firms and large investment banks. National full-line firms operate in all types of securities business, including brokerage, trading and market making, asset management, research and analysis, as well as underwriting and corporate finance. These firms were traditionally strong in retail securities business. Large investment banks were those operating in underwriting corporate finance and wholesale securities business (i.e., they catered to high-end clients). Over time, the lines between retail and wholesale securities firms have become less clear as investment banks pursued an integrative strategy that aimed at placing them in all areas of the securities business. Thus, Merrill Lynch started as a retail securities firm and later developed wholesale operations. Morgan Stanley integrated its wholesale business with retail business by merging with Dean Witter. Goldman Sachs is an example of a well-diversified firm that has retained most of its wholesale orientation.

The culmination of the integrated investment banking model in the United States has been the emergence of the commercial plus investment banking model as a result of the deregulation of 1999. Under this model, securities business (including underwriting) is combined with corporate lending thus creating new information advantages.

Specialized investment banks: There are limited scope investment banks, called boutique banks, which specialize in the provision of a limited menu of securities services, like advisory services in M&A (mergers and acquisitions) deals and underwriting of new issues in specific industries. These firms derive their market advantage from in-depth expertise in a few products, close relations with clients and the absence of major conflicts of interest that can afflict multiservice investment banks. As a result, they enjoy advantages in providing more objective research and analyst coverage and advisement in corporate finance deals. Examples of boutique investment banks are: Cowen Group, Evercore Partners, Morgan Keegan, and WR Hambrecht.

By Reputation

In past years, underwriting firms would announce their new issue deals in the form of the so-called tombstone advertisements that appeared in various print media. They were so named because they were very terse and matter of fact in their content due to regulations that prohibit the solicitation of buy orders prior to the approval of a new issue by the Securities and Exchange Commission (SEC). The names of the underwriting firms would be listed in order of importance in the syndicate, from the lead manager down to the smallest members of the underwriting syndicate. Based on this hierarchy, underwriting firms came to be grouped in order of reputation into:

Bulge (or special) bracket: These are firms that frequently appear as lead managers (e.g., Goldman Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers, First Boston, Lehman Brothers). Currently, the bulge bracket is occupied by the banks that acquired securities firms, like JP Morgan, Bank of America (Merrill Lynch), and Citi, in addition to Goldman Sachs and Morgan Stanley.

Major bracket: These are firms that usually serve as comanagers alongside the lead managers and receive large allocations of new securities for underwriting and placement. Examples of major bracket firms are: Jefferies Group, RBC Capital Markets, Wells Fargo, and HSBC.

Submajor bracket: These are firms that receive considerable allocations of new securities but have infrequent presence in the ranks of lead managers or comanagers.

Mezzanine and lower bracket: These firms receive smaller allocations of new issues and have infrequent participation in underwriting syndicates. Many of these firms are regional broker-dealer firms and have mostly selling responsibilities.

Industry Competition

The Impact of Scope of Operations

Expanding and integrating operations across different securities markets brings significant complementarities and synergies to the parent organization. As noted above, brokerage and trading help maintain networks of investors; market making, analysis and research support the creation of new secondary markets for newly issued securities; and corporate finance helps in the origination of new deals for the flotation of securities. The success of the underwriting business within an investment bank is critically affected by how the parent organization utilizes the different services to generate positive synergies and minimize costs from negative synergies that come mostly from conflicts of interest.

Client Relationships and Competition

Developing and maintaining relationships with both sides of the underwriting market, issuers and investors, are a critical component of intraindustry competition. Investment banks maintain relationships with issuing clients through corporate finance advisory deals and underwriting deals. Relationships with investors are being sustained through brokerage services, trading and market making and asset management. Traditionally, issuers would maintain relationships exclusively with a core investment bank or more eclectically with a core group of banks (Eccles and Crane, 1988). With greater competition among underwriters in relation to indirect services, like analyst coverage and market making support, relationships have become more fluid.

Following the entry of commercial banks into the underwriting business, a new type of relationship was introduced, that of corporate lending. As noted above, an investment bank that is also a lender can accumulate information and become much more knowledgeable about the operations, and, hence, the quality of the loan client. This inside information can then be used to more credibly certify the value of a new issue by a loan client than if an independent underwriter manages the deal. However, the dual role of the commercial plus investment bank can create the perception of a conflict of interest when the proceeds of the issue are used to repay the bank