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Is There an Insider Advantage for Underwriters?


February 11, 2020

The majority of the world’s IPOs, or initial public offerings, are happening in developing economies. In supporting these offerings, underwriting banks typically have access to private financial information to a far greater extent than other investors or the public at large. Are these firms gaining an advantage and using this inside information for financial gain?

In a paper published in Management Science, TD Bank Endowed Professor of Finance Michelle Lowry investigated this potential insider advantage through analysis of pre- and post-IPO prices and company performance. Using Taiwan, an emerging economy, to represent the IPO market globally, Lowry and her co-authors analyzed a book-building sample consisting of 218 IPOs from October 2005 to February 2011, as well as an auction sample of 88 IPOs from 1996–2003. Data was provided by the Taiwan Securities Association, a self-regulatory organization of securities firms.

As Lowry explains, “The underwriting bank takes a position in the firm prior to the IPO, and after the IPO, they have the option to buy more shares, to hold the shares they have or to sell their shares.”

Analysis uncovers strong evidence that lead underwriter trades in IPO firms are significantly related to subsequent IPO abnormal returns, particularly among offerings in which underwriters’ information advantage is likely greater — specifically, trades in companies that are characterized by higher information asymmetry and trades by underwriters with more industry experience.

“The research suggests that companies should be cognizant of the extent of information that these entities have and the way they might be profiting off it,” Lowry says.

In contrast, Lowry and her co-authors find no similar relation for trades by other syndicate members, who are not involved in due diligence or pricing, or around auction IPOs, which are characterized by less underwriter involvement. Overall, the results are consistent with the joint hypothesis that underwriters of book-building IPOs gain unique insight on the values of these client firms, and that they trade on this information advantage. Lowry notes, however, that this activity is not illegal and may be the result of “soft” information gathered indirectly.

Noting that the United States is a more advanced market than Taiwan and has much stricter rules against insider trading, Lowry examined the issue within the US in other research. In a paper published in Review of Financial Studies, she and her coauthors examine the extent to which advisors to mergers profit from the inside information they glean from their client firms and similarly find that underwriters benefit from their inside information.

In sum, Lowry’s research indicates that in both a developing market (Taiwan) and a developed market (United States), investment banks that advise client firms have an information advantage over other players in the market, and this leads them to earn higher returns through their proprietary trading activities.