Centre for Economic Policy Research

2.3
The IPO boom of the 1990s
If there was potential to exploit conflicts of interest between research and under-
writing, the 1990s was an ideal decade because of huge opportunities for profit
from IPOs. When the stock market boomed in the 1980s, there was a wave of IPO
activity, averaging $8 billion per year in new issues. The rise and fall of the US
stock market as measured by the Dow Jones, S&P500 and Nasdaq Composite
indexes is depicted in Figure 2.1, and the surge in IPOs is shown in Figure 2.2. In
the first half of the 1990s, the average value of IPOs rose to $20 billion per year
and then $35 billion for 1995-98. In a last spurt it doubled to $65 billion per year
for 1999-2000 before falling to $34 billion in 2001 (Ritter and Welch, 2002). A
notable feature of the market was the tilt in the composition of IPOs towards 
technology firms, reflected in the rise of the technology heavy Nasdaq index.
8
In
the 1980s and early 1990s technology firms comprised only 26 and 23% of IPOs
respectively. By 1995-98, this rose to 37%, before hitting 72% in 1999-2000.
The market devoured the new issues, and the first day returns on IPOs climbed
16 Conflicts of Interest in the Financial Services Industry

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Investment Banking: Conflicts of Interest in Underwriting and Research 17
from 7.4% in the 1980s to 18.1% in the late 1990s before hitting 65% at the peak.
Also shown in Figure 2.2 is how this apparent underpricing left more and more
‘money on the table’, reaching a total of $65 billion out of gross sales proceeds of
$129 billion for 1999-2000. While IPOs sold each year earned significant returns
from three-year buy and hold strategies, they underperformed relative to the 
market for all of the last two decades save those purchased in 1997 and 1998. 
The change in the prima facie quality of the companies going public was
remarkable. According to Ritter and Welch (2002), top drawer investment banks
rarely took a firm public in the 1960s and 1970s if it did not have four years of
positive earnings. This benchmark was still the standard in the 1980s with only
19% of IPOs having prior negative earnings. The share of firms with negative 
earnings rose to 37% in 1995-98 and finally 79% in 1999-2000. While they may
have had long-term potential, few new IPOs had any immediate prospect of 
profitability. Furthermore, the age of the firms at the time of their IPO also
dropped. These seemingly poorer prospects did not reduce the first day returns. In
fact, during 1999-2000, firms with negative earnings experienced mean first day
returns of 72%, compared to 44% of those with positive earnings.
The underpricing of IPOs is an important anomaly in the finance literature.
9
One explanation for underpricing relates to the potential conflict of interest
between underwriting banks and issuing firms. Loughran and Ritter (2002) argue
that if underwriters are given discretion in share allocation, they may underprice
the issue and allocate shares to favoured buy-side clients. They point to evidence
that underpriced share allocations have been used for ‘spinning’, that is, the 
practice of currying favour of the executives of other prospective IPOs firms.
Spinning also implies a personal conflict of interest for the executives who receive
shares in return for their companies’ future business with the investment bank. It
is costly for their firms as underpricing raises the cost of capital.
While investment bankers and analysts have been blamed for exploiting the
conflicts of interest, it is important to point out that they have not been held 
primarily responsible for the bubble in the market. Whereas many rode the rising
market and some may have exploited it, the rising tide of stock prices took most
people on Wall Street by surprise. By most measures, many stock prices had
moved far away from their conventional relationships with fundamentals. The
number of companies not paying dividends rose sharply, as did price-earnings
ratios. Investors appear to have ignored these standard signals, giving more 
attention to target prices and other information, thus raising the reputation of the
most optimistic analysts.
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Outside of investment banking, there were great
enthusiasts who claimed that the economy had entered a new epoch of higher
growth and stability. They saw stock prices as justified by future higher earnings
growth or a decline in the equity premium (Glassman and Hassett, 1999; Heaton
and Lucas, 1999). This optimism echoes the optimism during the stock market
boom of the 1920s. Bankers then as now may have exploited some conflicts of
interest, but no serious scholarship today suggests that the boom was driven by
the behaviour of investment bankers.