The value of Reputation: Evidence from Equity Underwriting

The collapse of Lehman Brothers, and the near-collapse of Bear Stearns and Merrill Lynch, during the 2008 financial crisis have refocused attention on the importance of reputation in investment banking.As just one example, Goldman Sachs lead director James J. Schiro, in his April 12, 2013 letter to shareholders, wrote that "we continue to be very focused on the reputation of the firm."Investment banks provide a variety of services to client firms, but reputation should be especially important in the business of equity underwriting where the problem of "asymmetric information" makes it difficult for potential investors to distinguish between high-quality corporate issuers and low-quality issuers.But this is not the only information asymmetry problem confronting corporate issuers of equity.Such issuers also face uncertainty when choosing which investment banker to underwrite their offerings: issuers have to decide which of the many banks is likely to help them raise the largest amount of equity capital with the least dilution of value for their existing shareholders, while providing the most post-IPO support-all when balanced against the underwriter's spread that issuers would have to pay as a compensation to the investment bank.And it is this uncertainty faced by issuers when raising equity capital, together with the uncertainty about valuation facing the potential investors in such issues that are the most important reasons why most banks devote significant resources to building and maintaining their reputations.In this article, we report the findings of our recently published study that attempted to answer two questions: (1) do investment banks in fact earn a significant return on their reputational capital, in the form of higher underwriting fees from their corporate clients and ( 2) what, if any, benefits do these corporate clients receive in the form of higher valuations or non-price benefits in return for any reputational premiums that are built into the underwriting fees? 1These are interesting and important questions for finance scholars-but also presumably for corporate practitioners as 2 See, for example, Titman and Trueman (1986), Diamond (1989, 1991), Rajan (1992), and Chemmanur and Fulghieiri (1994).Brau and Fawcett (2006) find that CFOs view the use of a top investment banker as one of the most important positive signals of value in the IPO process.Full citations of all articles are provided in the References at the end of the article. 3 Chen and Ritter (2000), Hansen (2001), and Abrahamson et al. (2011) provide evidence of flat underwriting spreads in U.S. IPOs while James (1992) finds that higher reputation underwriters tend to charge lower percentage fees in IPOs.Fernando et al. (2005) find a negative relation between SEO percentage spreads and underwriter reputation. 4 A large literature documents how underwriter reputation is related to IPO underpricing.See