Do Investment Banks' Relationships with Investors Impact Pricing? The Case of Convertible Bond Issues

Abstract

This paper examines the role of repeat interactions between placement agents (investment banks) and investors in the initial pricing of convertible bonds. Under the assumption that attracting repeat investors can reduce search frictions in primary issue markets, we test the hypothesis that banks' relationships with investors actually allow more favorable pricing for issuing firms (in contrast to the favoritism'' hypothesis, under which banks use underpricing to reward favored clients). In the empirical analysis we also allow for a potentially important alternative channel through which search frictions might impact initial pricing: expected aftermarket liquidity. Using a sample of 601 Rule 144A issues for the years 1997-2007, we document robust negative relationships between at-issue discounts and both types of frictions. Our findings suggest that search frictions play a meaningful role in initial convertible bond pricing and, specifically, that intermediaries can add substantial value through repeated interactions with investors. Our results indicate that, with all other variables at their mean values, a deal with only 25% repeat investors will be priced at a 10.7% discount relative to fundamental value, while a deal with 75% repeat investors will be priced at a 7.1% discount. Given the mean deal size of $278 million, this translates to a potential savings of $10.2 million for the issuer.