Institutional loans have risen dramatically over the past couple of decades and have become one of the most important avenues for firms to obtain credit. The amount of new issuance of institutional loans increased from less than $100 billion in the early 2000s to over $600 billion in recent years. Underwriters (i.e., lead banks) play an instrumental role in this market by intermediating loans and locating institutional investors who are willing to provide capital. Participating institutional investors depend on the underwriter in conducting ex-ante due diligence and in continuously monitoring the borrowers after issuance. Lead banks receive fees for the intermediation service and a large number of underwriters compete for deals. However, the effect of underwriter competition on the pricing of institutional loans has so far remained unclear. What are the factors that determine how aggressively an underwriter competes for a deal? Does the intensity of underwriter competition affect the pricing of loans, and how? In our recent paper entitled “Underwriter Competition and Institutional Loan Pricing”, we aim to fill this research gap by investigating the relationship between underwriter competition and the loan pricing process.
Like many financial markets that involve the intermediation of underwriters (for example, the IPO market), the typical lending process in the institutional loan market involves an initial price (or, equivalently, an interest rate) proposed by the underwriter, a demand discovery process between the underwriter and potential investors, and the closing of the final deal. The initial price (or rate) is adjusted during the book-building process, and the received wisdom from the extant literature is that such price adjustments reflect information collected by underwriters from investors about the demand for the deal. Under this view, the initial price (or rate) proposed by the underwriter represents the underwriter’s best estimate of how well the deal will be received by the market.
We argue that an important yet overlooked factor in determining the initial price of a deal—and subsequent price adjustments—is the intensity of competition among banks pursuing the underwriting mandate. Under the assumption that an issuer prefers an underwriter who proposes a lower interest rate, more intense competition among potential underwriters drives down the initial rate and makes the subsequent rate adjustment more likely to be upward. Therefore, the rate adjustments observed in the underwriting process not only reflect the private information of investors discovered by the underwriter but are also the competition dynamic in the underwriter selection stage.
What, then, constrains potential underwriters from bidding down the initial rate to an exceedingly low level to win a mandate and subsequently adjusting up the loan rate to clear the market after winning the deal? We hypothesize that the issuing companies are averse to upward rate adjustments in the book-building process, which can be motivated by loss aversion in prospect theory. We document a novel empirical pattern that institutional loan borrowers are more likely to switch their lead arrangers when the interest rate of their previous deals has been adjusted upward during the previous syndication process, even conditional on the final spreads they eventually obtained. This relationship between rate adjustment and the possibility of losing borrower clients in the future creates a tension in banks’ strategy for competing for underwriting mandates: bid an interest rate too high, they risk losing the mandate; bid an interest rate too low, they risk adjusting the rate upwards in book-building and irking the issuer.
We build a stylized model to formalize these arguments and derive several testable implications on how underwriter market competitiveness affects interest rate setting and rate adjustment (“flex”) in the institutional loan market. Our model suggests that a more competitive environment for underwriters is associated with lower initial spreads and higher flexes (i.e., more positive loan spread adjustments).
We assemble a sample of institutional loan deals from 2000 to 2020 where we observe their initial spreads, spread adjustments (flexes), and final spreads. We examine how the level of underwriter competition affects the setting of initial spreads and subsequent spread adjustments. To measure the competitiveness of a given deal at the underwriting stage, we define segments of the institutional loan market based on credit ratings and industries of the borrower. We then proxy for the competitiveness of a given segment using the number of unique underwriters that have recently worked in the segment. Our premise is that, rather than all underwriters competing for all loans, a set of underwriters choose to specialize in certain industries and risk profiles of the borrowers, creating a segmented loan market. In addition, we use a Herfindahl-Hirschman Index (HHI) calculated from underwriter market shares within each segment.
We find that a higher level of underwriter competition is associated with lower initial spreads, controlling for credit ratings and deal characteristics. For example, a one standard deviation decrease in underwriter HHI is associated with a 5-basis-point reduction in initial spreads. Such a relationship is robust when we compare deals underwritten by the same lead bank, suggesting that the result is not driven by the reputation and certification ability of individual underwriters. Instead, initial spreads are lower in segments where there are more potential underwriters vying for the deal.
Intense underwriter competition pushes down the initial spread proposed by the winning underwriter but increases the probability that the initial spread needs to be adjusted upwards in the syndication stage. Consistent with our model’s prediction, we find that a higher level of underwriter competition is associated with higher spread flexes (i.e., upward spread adjustments). This empirical relationship is difficult to reconcile with the traditional view that price adjustments reflect only information production, as the underwriter market structure should not contain new private information about the demand for the deal.
Interestingly, even though underwriter competition negatively affects initial loan rates and positively affects rate adjustments, the two forces do not exactly cancel each other out. We find that a lower initial spread due to higher underwriter competition is only partially reversed in the later book building process, resulting in a lower spread in the final deal.
Taken together, our paper provides a conceptual framework and empirical evidence for how underwriter competition affects spread setting in the institutional loan market. We contribute to a growing literature examining the pricing in the institutional loan market.
Zheng Sun is an Associate Professor of Finance at the University of California – Irvine
Will Shuo Liu is an Assistant Professor of Finance at City University of Hong Kong
Qifei Zhu is an Assistant Professor of Banking and Finance at Nanyang Technological University
Chenyu Xiong is a PhD candidate of Finance at City University of Hong Kong
This post is adapted from their paper, “Underwriter Competition and Institutional Loan Pricing” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.