The seven per cent solution (or why European capital markets beat those of the US)

It is widely believed, especially by Americans, that US capital markets are superior to those in Europe and elsewhere. But whatever the general truth of this may be, in one area the US client gets a far worse deal than in Europe. A company raising equity capital in an IPO (initial public offering, where a company lists for the first time on a stock exchange and sells shares to outside investors) pays a fee of 7% in the US and about 4% in Europe. So if you raise $100m capital, it will cost you about $3m more in the US than in Europe. This excludes the additional costs of lawyers, accountants, management time and so forth.

The remarkably consistent fee of 7% in the US was identified some time ago and referred to in the academic finance literature (Chen and Ritter 2000, Journal of Finance, 55, 1105-1131) as “The seven percent solution”. In the world of practice, inside the equity capital markets teams in investment banks, this has been so well known as to be obvious, not even needing an explanation.

A paper in the latest Journal of Finance (probably the most prestigious academic journal in finance) by Mark Abrahamson, Tim Jenkinson and Howard Jones of the Saïd Business School at Oxford University (note the absence of bias here) shows that US IPO fees are now even more tightly clustered around 7%, while European fees have fallen in the last decade. They show the lack of evidence for the usual half-hearted arguments made by US apologists (legal costs, retail offerings, litigation risk and sell-side analyst differences). Nor are US offerings under-priced less than in Europe (*).

In fact the only plausible explanation in an industry where there appears very little price competition is a lack of competition, reflecting barriers to entry around reputation. I’ve often in lectures referred to the US domestic investment banking sector as a non-collusive oligopoly. That is, they don’t actually get together in smoke filled rooms and do deals, because if they were caught the consequences would be disastrous (assuming the politicians they routinely pay for didn’t get them off the hook). But nobody has an incentive to win business by under-cutting on price and the mere attempt to do so can discredit the firm by making them look less professional.

Ignorant customers help: most people only do an IPO once. But there are plenty of repeat purchasers, in the form of private equity firms who regularly bring their investments to the stock market.

Abrahmason et al call their paper “Why don’t US issuers demand European fees for IPOs?” but don’t really answer that question. They hope their research will help US issuers negotiate lower fees but I’m doubtful about that. The continuing high profitability of the US domestic IPO market helps subsidise the US investment banks in their global operations. From 1998-2007, the period of their sample, the authors estimate that US firms paid about $11.4 billion more than if they had European levels of fees. And you wondered how Goldman Sachs made its money?

So, next time you hear somebody like Jamie Dimon (chairman of JPMorgan Chase) saying that the US has the best capital markets in the world, perhaps you’ll be less impressed than before.

(*) Under-pricing refers to the very common practice of setting the price of the new shares sold in the IPO at a level from which they rise on the first day of trading, effecting a transfer of wealth from the sellers to the new owners. This under pricing  means that the shares should have been sold at a higher price, to the benefit of the IPO sponsor, who is after all the client in this transaction, and the person paying the investment bank for the service. Under-pricing is routinely 10-15% and can be vastly more in “hot” markets such as the technology and internet bubble of the last 1990s, when most of the large US banks settled out of court with the SEC (regulator) on claims of corrupt practices that left the IPO sellers worse off, sometimes very much worse off. The rules have been changed to stop such practices, which were far less prevalent in Europe.

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