Do Investment Banks Compete in Ipos?: The Advent of the '7% Plus Contract'

Abstract

In the 1990s, over 85% of all initial public offerings (IPOs) in the US paid a 7% spread. Two hypotheses that may explain this convergence to 7% are one, that investment bankers colluded to profit from 7% IPOs or two, that the "7% contract" is an efficient innovative response the standard firm commitment contract is tailored to better conform to the IPO. This paper reports results of testing these two hypotheses. The collusion theory is not supported: there is low concentration and has been much entry in the IPO market. Further, a 7% spread is found to be less profitable than normal. Nor has it been used less frequently after it was made know that collusion allegations had been raised against the banks. Further evidence is consistent with efficient contract hypothesis. I find evidence consistent with competition among the banks in terms of reputation, placement abilities, and in the underpricing the IPOs.