Investment banking revenues are derived from fees for services and price spreads from underwriting securities issues. Fees are charged for origination services when the investment banker is unlikely to handle the underwriting phase. For example, some issuers utilize competitive bidding during the underwriting phase to select the investment banker or syndicate that offers the best overall terms for underwriting and distribution. The investment banker who provided origination services is then compensated with a fee and may be excluded from bidding for distribution. On the other hand, the investment banker may provide origination services without charge when the relationship includes underwriting and distribution. Compensation for underwriting and distribution is typically in the form of price spreads.
Price spread is the difference between the price received by the issuing firm or Government and the price paid by the investor. The underwriter commits to pay the issuer a firm price and expects to sell the securities to investors at a higher price. The prices and spread are included in the prospectus filed with the SEC. For example, in one issue of 2 million shares priced to the public at $40, the spread was $1.60 per share (4 percent of the price). The spread was split among the participants of the underwriting. Investment bankers received 32 cents per share for risking their capital, and distributing investment bankers earned 96 cents for each share.
In all underwritings there is both an explicit and implicit spread. The explicit spread is the difference stated in the prospectus, as described previously. The implicit spread is the difference between the offering price and the market price. The implicit spread is important to investment banking management, because it impacts on the effort and risk of selling the issue. If the issue is overpriced (that is, the offering price is above the market price), then it will not sell quickly and the investment banking syndicate may need to stabilize the market. However, an offering price below the market price increases the implicit spread and assures that the securities are sold quickly. The investment banker reaps the benefits of large implicit spreads through reduced risk and distribution expenses. The advantages of large implicit spreads are great, and some observers assert that investment bankers set offering prices below market prices in too many cases.
Recent research indicates that new issues are underpriced. One-month holding period returns in excess of normal returns for a group of new issues underwritten from 1960 to 1963 are shown in Figure 13-2. The holding period is computed for each month after issue for a 5-year period. An abnormal return is one which is greater or less than the normal (risk-adjusted) return. Note that large positive abnormal returns (11.4 percent) are earned by investors who purchase the security on the issue date and then sell it from 1 to 4 months later. The high positive abnormal return implies that the offering price is low relative to the market, because the price tends to rise immediately after the issue date. The abnormal returns beyond the first few months are nearly zero, indicating that investors could not profit by systematically trading in and out of new issues after the first few months. The small positive abnormal returns were not sufficiently large to cover transaction costs of buying and selling. Only by buying at the offering could investors consistently earn abnormal profits from trading in new issues.
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Investment Banking
