Relationship Markets and the Decision to Go Public
40 Pages Posted: 13 Sep 2006
Date Written: September 2006
The equity markets for smaller issues are characterized by close economic relationships between new issuers and the underwriters who bring the stock public. Underwriters sponsor new issues and often provide liquidity in the secondary market by acting as market makers. This paper analyzes theoretically the operation of so-called "relationship markets" and their role in facilitating capital formation. The model is consistent with stylized facts concerning both primary and secondary markets and yields several testable predictions. In particular, we show that smaller companies can lower their cost of capital by using relationship markets. However, for sufficiently large issues, a secondary market structure without a dominant primary market maker is preferred. We test the model using data on IPOs from 1996-2000 identifying post-IPO market making activity, using a choice model to control for endogeneity. The results support the conclusion that underpricing is related to anticipated secondary market activity by underwriters.
Keywords: IPO, underpricing, underwriting
JEL Classification: G24, G32
Suggested Citation: Suggested Citation