Afflated Mutual Funds and the Allocaton of Intal Publc Offerngs Jay R. Rtter and Donghang Zhang Current Verson: February, 006 Abstract We examne how nvestment banks use ntal publc offerngs (IPOs) n relaton to ther afflated mutual funds. The dumpng ground hypothess predcts that the lead underwrter allocates cold IPOs to ts afflated funds so that more deals can be completed when demand for these IPOs s weak. Afflated funds may also receve more cold IPOs because the lead underwrter uses allocatons of hot IPOs to unafflated funds to gan tradng commsson busness. The nepotsm hypothess predcts that the lead underwrter allocates hot IPOs to ts afflated funds to boost ther performance and thus attract more money. We fnd lttle evdence supportng the dumpng ground hypothess, although there s some evdence supportng the nepotsm hypothess durng the nternet bubble perod of 999-000. Rtter s from the Warrngton College of Busness, Unversty of Florda, Ganesvlle, FL 36-768, and Zhang s from the Moore School of Busness, Unversty of South Carolna, Columba, SC 908. Rtter can be reached at (35) 846-837 or jay.rtter@cba.ufl.edu. Zhang can be reached at (803) 777-04 or zhang@moore.sc.edu. We thank Dan Bradley, Shngo Goto, Inmoo Lee, Greg Nehaus, Erc Powers, Jonathan Reuter, Paul Schultz, Jason Smth, Sergey Tsyplakov, and semnar partcpants at Clemson Unversty, the Unversty of South Carolna, Pekng Unversty, the 4 th Asan Corporate Governance Conference, the 005 FMA Annual Meetng, and the 006 AFA Annual Meetng for helpful comments. We thank Renje Wen for helpful research assstance. Specal thanks also go to Tong Yu for hs help wth matchng the CRSP fund data wth the Spectrum data used n ths paper.
Afflated Mutual Funds and the Allocaton of Intal Publc Offerngs February, 006 Abstract We examne how nvestment banks use ntal publc offerngs (IPOs) n relaton to ther afflated mutual funds. The dumpng ground hypothess predcts that the lead underwrter allocates cold IPOs to ts afflated funds so that more deals can be completed when demand for these IPOs s weak. Afflated funds may also receve more cold IPOs because the lead underwrter uses allocatons of hot IPOs to unafflated funds to gan tradng commsson busness. The nepotsm hypothess predcts that the lead underwrter allocates hot IPOs to ts afflated funds to boost ther performance and thus attract more money. We fnd lttle evdence supportng the dumpng ground hypothess, although there s some evdence supportng the nepotsm hypothess durng the nternet bubble perod of 999-000. Keywords: Intal publc offerngs, mutual funds, IPO allocatons JEL classfcaton: G4
. Introducton Many nvestment banks underwrte ntal publc offerngs (IPOs) and also manage mutual funds. Durng 990 00, 36 dfferent nvestment banks were lead underwrters of U.S. IPOs, and more than 60 of them, ncludng almost all of the largest nvestment banks, had afflated mutual funds. For example, Goldman Sachs Asset Management and Securtes Servces had assets under management of $35 bllon as of December 3, 00. Goldman Sachs was also the lead underwrter on 33 IPOs wth total proceeds of more than $9 bllon durng 990-00. When an nvestment bank s both the seller and a possble buyer of a securty, a potental conflct of nterest naturally arses. Ths potental conflct of nterest s of great mportance for IPOs because of persstent IPO underprcng. Ths paper examnes how nvestment banks allocate IPOs to ther afflated funds. Ths topc s of more than academc nterest. Regulators have been concerned about the potental conflcts of nterest for decades. The Investment Company Act of 940 and SEC Rule 0(f)-3 set restrctons on a lead underwrter s allocatons of IPO shares to ts afflated mutual funds. Recently, Drector of the Dvson of Enforcement of the U.S. Securtes and Exchange Commsson (SEC) Stephen M. Cutler expressed concerns that asset managers afflated wth an nvestment bankng frm may feel pressured to nvest n companes underwrtten by the nvestment bankng frm (Cutler (003)). Solomon (004) reports that the SEC was nvestgatng whether nvestment banks have been pressurng ther afflated mutual funds to buy shares of ther clents ntal publc offerngs. The fnancal press has also rased concerns that nvestment bankng frms are usng purchases by afflated mutual funds to support the prce of cold IPOs. For example, Detz and Henkoff (004) report that mutual funds afflated wth large nvestment banks, ncludng Ctgroup, Credt Susse Frst Boston, Goldman Sachs, Merrll Lynch, and Morgan Stanley, nvested heavly n ther clents stocks whle other nsttutonal nvestors were reducng holdngs n these stocks amd performance concerns. As s the conventon, the proceeds fgure s calculated usng global proceeds excludng overallotment optons, and the number of IPOs excludes unt offers, closed-end funds, REITs, ADRs, IPOs wth an offer prce below $5, and banks and S&Ls.
Three factors play an mportant role when an nvestment bank determnes how t uses ts afflated funds n an offerng. Frst, the underwrtng dscount (the gross spread) gves the nvestment bank an ncentve to complete the deal. When demand s weak, the nvestment bank could use ts afflated funds to buy shares that otherwse would have found buyers only at a lower prce. Wthout the addtonal demand, a wthdrawn or downszed deal mght result, or a prce declne once tradng commenced mght occur. Second, the nvestment bank receves commsson paybacks when t allocates underprced IPOs to an unafflated fund (Nmalendran, Rtter, and Zhang (006) and Reuter (006)). Ths reduces the ncentve to allocate hot IPOs to afflated funds, because when the shares are allocated to unafflated clents part of the money left on the table n underprced deals flows back to the nvestment bank through commsson busness. The money left on the table s defned as the frst-day captal gan per share multpled by the number of shares sold, and measures the dollar value of the gans avalable to allocate to clents. Thrd, the frst two factors would result n more cold IPOs beng allocated to afflated funds. As a counter force, the nvestment bank also has an ncentve to allocate hot IPOs to ts afflated funds to boost ther performance. Better fund performance wll attract more money nflows. The ncentve would be even stronger f the nvestment bank could allocate hot IPOs to star funds n ts afflated fund famly, because a star fund that has exceptonally hgh returns can attract more money nflows both to the fund and to other funds n ts famly (Gaspar, Massa, and Matos (006), and Nanda, Wang, and Zheng (004)). It s the balance of these three factors that determnes an nvestment bank s optmal use of ts afflated funds n IPOs. Ths tradeoff leads to two alternatve hypotheses. The frst hypothess s that nvestment banks allocate more cold IPOs to ther afflated funds or pressure the funds to buy cold IPOs n the aftermarket as a means of prce support. Investment banks mght also allocate a hgher proporton of cold IPOs to ther afflated funds as a consequence of allocatng dsproportonately more hot IPOs to unafflated funds n order to attract more commsson busness. We call ths the dumpng ground hypothess. We use the term paybacks n the general sense that f an underwrter s allocatng underprced IPOs, rentseekng nvestors wll be wllng to offer commsson busness to the securtes frm f ths ncreases the chance of beng allocated shares n hot IPOs.
The second hypothess s that nvestment banks preferentally allocate underprced shares to afflated funds. The nvestment bank benefts f the resultng hgher performance attracts fund nflows and subsequent management fee ncome. We call ths the nepotsm hypothess. Because whether the dumpng ground hypothess or the nepotsm hypothess domnates depends on the relatve costs and benefts, market condtons could affect whch hypothess domnates. When the overall expected frst-day return of IPOs s hgh and attractng money nflows for the afflated funds s most mportant because of the greater performance-funds flow senstvty that exsts n bull markets (Karcesk (00)), we post that the underwrter would allocate more hot IPOs to ts afflated funds. Thus, we predct that the nepotsm hypothess wll be more mportant n hot IPO markets than n cold IPO markets, relatve to the dumpng ground hypothess. Of course, the dumpng ground and nepotsm ncentves could balance out for the same fund, or the underwrter could smply treat afflated and ndependent funds n the same way due to regulatory or ethcal concerns. In these stuatons there would be no detectable dfference n allocatons to afflated and unafflated funds. We examne mutual fund afflatons and a proxy for IPO allocatons from 990 to 00. 3 Durng 990-00,,57 IPOs are assocated wth one or more lead underwrters that had afflated funds. The mutual funds that were afflated wth the lead underwrter receved allocatons of 83 IPOs, where we use the frst post-ipo reported mutual fund share holdngs wthn sx months of the offer date as our proxy for whether the fund was allocated IPOs. We use ths proxy for the fund s allocatons, as does Reuter (006), because the actual allocaton data are not publcly avalable. The reported holdngs are from the Spectrum Mutual Funds Holdng database (often referred to as Spectrum &). The frst reported holdng wthn sx months s used because the requred reportng frequency s sem-annual. We denote the 83 IPOs for whch the afflated funds reported holdngs as the R ( Reported ) group of IPOs, and the rest of the IPOs as the NR ( Not Reported ) group of IPOs. We vew the R group as the IPOs that were allocated to afflated funds. 3 The mutual fund data are avalable snce 980. However, t s dffcult to determne the afflatons of mutual funds and nvestment banks for the 980s. Consequently, we focus on the 990s and later. 3
For the whole sample perod, the R group of IPOs has a 9% hgher ntal return than that of the NR group, where the ntal return s defned as the change from the offer prce to the frst-day closng prce. To capture the potental changes n IPO market condtons and the mportance of attractng money nflows for the afflated funds, we further dvde our sample perod nto fve subperods: 990 994, 995 996, 997 998, 999 000, and 00. The R group of IPOs has hgher average ntal returns than the NR group of IPOs n every subperod except for 00, durng whch the R group has an nsgnfcant 4% lower ntal return. The ntal return dfference s sgnfcant for 990 994 and 999 000. The unvarate comparson seems to support the nepotsm hypothess. Our multvarate analyss, however, presents a more complcated pcture than that n the unvarate analyss. For the nternet bubble perod (999 000), an IPO would have a 3% hgher ntal return f t was allocated to the funds afflated wth the lead underwrter, a much smaller dfference than the smple unvarate dfference of 35%. For the perods of 995-996 and 00, the IPOs allocated to the afflated funds have a statstcally nsgnfcant 4% or % lower ntal return, respectvely. For the perods of 990-994 and 997-998, the dfference s postve but nsgnfcant. We do not fnd any sgnfcant support for the dumpng ground predcton that afflated funds receve IPOs wth lower ntal returns. The publc and regulators are concerned wth dumpng cold IPOs nto afflated funds because many non-sophstcated mutual fund nvestors are nvolved. Our nablty to fnd sgnfcant support for ths hypothess wth the overall sample could be because we have not looked n the rght place. As a further attempt, we examne the relatve sze of allocatons to the afflated funds. When demand for an IPO s weak, the dumpng ground hypothess predcts that the underwrter would have the greatest ncentves to allocate more shares to ts afflated funds. For 995 996, an IPO would have a % lower return f there was a large allocaton to the funds afflated wth the lead underwrter. Durng 990 994, an IPO would also have a 0% lower return f there was a large allocaton to the afflated funds. Ths evdence s consstent wth the dumpng ground hypothess. We also compare the long-run performance of the R group and the NR group of IPOs. We use the three-year buy and hold return to measure IPO long-run performance. We use 4
three dfferent benchmarks: the value-weghted CRSP ndex, sze matchng, and style (sze and book-to-market rato) matchng. Our analyss suggests that there s no consstent underor over-performance n the long-run f an IPO s allocated to afflated mutual funds. To the best of our knowledge, ths paper and Johnson and Maretta-Westberg (005) are the frst to focus on how U.S. nvestment banks use ther afflated mutual funds n securty offerngs, although Ber, Yafeh, and Yosha (00) examne ths ssue usng a sample of 8 Israel IPOs, of whch are allocated to afflated funds. Johnson and Maretta- Westberg examne the role of managng underwrters and ther afflated mutual funds n the two years after a company goes publc for a sample of IPOs from 993-998. They focus on aftermarket purchases and sales by the funds that are afflated wth the underwrters. They fnd that lead underwrters use ther afflated funds to help secure follow-on equty deals, and that these nvestment banks also pass on nformaton to ther afflated funds so that ther afflated funds can engage n cherry-pckng for better performers. Unlke our paper, they do not dstngush between hot and cold IPO markets. The allocaton process of IPOs has recently attracted much attenton. Loughran and Rtter (00, 004) post that the objectve functon of the lead underwrter s not perfectly algned wth the ssung frm and the lead underwrter may use ts market power opportunstcally. Nmalendran, Rtter, and Zhang (006) and Reuter (006) provde evdence that the lead underwrter lnks allocatons of IPO underprcng benefts to both short-run and long-run commsson generaton. In ths paper we examne whether the lead underwrter also uses ts afflated funds to ether support an IPO or reap addtonal benefts. Ths sheds further lght on the agency ssue. Contrary to artcles n the fnancal press, our fndngs suggest that the use of afflated funds to support cold IPOs s not wdespread. The ncentves of the managers of the afflated mutual funds are apparently algned more closely wth the nterests of the fund holders than wth the nvestment bankers of the parent frm. Gaspar, Massa, and Matos (006) suggest that mutual fund famles strategcally allocate dfferent IPOs to dfferent funds n the famly as an ntra-famly subsdzaton. The reason for such ntra-famly subsdzaton s the asymmetrc relaton between fund performance and money flows. We also check the characterstcs of afflated funds and the allocaton of IPOs. A proft-maxmzng famly of funds would prefer to allocate hot IPOs to a 5
fund wth good recent performance, young age, small sze, and hgh fees. We fnd that an IPO would have a lower ntal return f t s allocated to afflated funds that have above-medan assets or generate below-medan fees wthn the fund famly. Strkngly, although afflated funds receved IPOs wth 3% hgher ntal returns durng the nternet bubble perod, an IPO would stll have a 6-8% lower frst-day return f t s allocated to a fund that s large or generates lower fees. We need cauton, however, f we try to lnk ths evdence to the dumpng ground hypothess. Snce, at least for unafflated mutual funds, the underwrter s allocaton of IPOs s at the famly level, t s not the underwrter s decson as to whch fund n the famly receves IPO shares. Thus, t s more lkely that the above evdence s merely a reflecton of ntra-famly subsdzaton rather than dumpng by the underwrter. The rest of the paper s organzed as follows. In the next secton we develop a model and the hypotheses. In Secton 3 we descrbe the data and report descrptve statstcs on IPOs and mutual fund holdngs. In Secton 4 we conduct the unvarate analyss. Secton 5 contans the regresson results for the overall sample. In Secton 6 we dscuss the use of the reported holdng wthn sx months of the IPO offer date as a proxy for ntal allocaton, and offer further tests that shed lght on the relatons of allocaton sze and fund characterstcs wth IPO frst-day returns. We report results on long-run performance and IPO allocaton to afflated funds n Secton 7, and provde some concludng remarks n Secton 8.. Mutual Fund Afflatons and IPO Allocaton A Model and the Hypotheses The Investment Company Act of 940 prohbts an afflated mutual fund from buyng any shares of a securty offerng durng the exstence of the syndcate f the fund s n any way related to any syndcate members (Secton 0(f)). The SEC adopted Rule 0(f)-3 n 958 to exempt certan types of transactons. The SEC amended Rule 0(f)-3 n 979 to allow an afflated fund to buy up to 4% or $500,000 of an offerng, whchever s greater, although n no crcumstance may the purchase be more than 0% of the offerng. Ths s called the percentage lmt. In 997 the SEC amended the rule agan to rase the percentage lmt to 5%, and the dollar amount lmt was dropped. The purchase, however, has to be done through a member of the syndcate other than the afflated underwrter. The SEC further 6
amended the rule n 003 to apply the percentage lmt only when the afflated underwrter s the prncpal underwrter. 4 The sprt of Secton 0(f) of the Investment Company Act s to prevent the underwrter from usng funds under ts control as a dumpng ground for unmarketable securtes. Rule 0(f)-3, however, gves nvestment banks flexbltes of usng ther afflated funds n securty offerngs. Thus, t s mportant to have a framework to understand how the dfferent ncentves that the underwrter faces can nfluence allocatons of IPOs between afflated and unafflated nsttutonal nvestors. In the rest of ths secton, we frst develop a model to shed lght on the underwrter s allocaton decson. We then develop the hypotheses based on the model for our emprcal analyss... A Model An nvestment bank (an underwrter we wll use these two terms nterchangeably n the paper) needs to determne the optmal allocatons of IPOs to two nsttutonal nvestors, an ndependent fund and an afflated fund. Ths long-term relaton covers two dfferent types of market cycles: hot and cold IPO markets. For each market cycle, there s only one IPO wth an offer sze of one share and an offer prce of one dollar. 5 For smplcty, we also make the followng assumptons: If a deal s completed, the underwrter receves a constant underwrtng commsson, the gross spread, of G. The ntal return (frst-day return) of each IPO, IR, whch s not known untl the allocaton, s an ndependent draw from a unform dstrbuton U ( u,u ). 6 The mean ntal return, IPO market, where u + u, takes the value of r H f t s a hot IPO market, and r C f t s a cold r > r. The state of the market s known, as well as the underlyng H dstrbuton, at the begnnng of the cycle. C 4 See SEC release Nos. IC-775, IS-095, and IC-5888 for more detal on the regulatory changes. 5 Alternatvely, we can assume that the number of IPOs s fxed. As long as the underwrter bundles IPO allocatons durng an IPO market cycle (Sherman (000)), the ntuton wll reman the same. 6 In practce the ntal return can not be determned wth certanty before the allocaton. However, the lterature suggests that the ntal return can be predcted usng some pre-ssue observable varables wth a hgh R. So t s reasonable to make ths assumpton. 7
Denote the allocaton to the afflated fund as A (IR), and for the ndependent fund as I (IR). Note that both allocatons depend on the ntal return, IR. We assume that { 0,} A,I. That s, the IPO share wll be allocated to ether the afflated fund or the ndependent fund, but not both. The partcpaton of the ndependent fund s necessary, and that the ndependent fund manager requres an expected return on ts IPO allocaton of no less than r over any gven IPO market cycle, where r > 0, r C < r < rh, and u < r < u for both the cold and hot IPO market cycles. But the afflated fund manager takes an ssue uncondtonally. 7 For the afflated fund, the management fee, whch s proportonal to assets under management, s the only source of revenue. The ntal return of an IPO, f allocated to the afflated fund, affects ts performance and hence money nflows from mutual fund nvestors. Everythng else beng equal, the present value of the ncremental management fees assocated wth the allocaton of the IPO s m[ E( A IR ) b], where m s a scalar representng the present value of fees (net of costs) attracted per dollar of excess performance, and b s a constant benchmark. Note that E( A IR) s the expected amount of money left on the table receved by the afflated fund, but, snce the offer sze s one share, t s also a return. Furthermore, we assume that E ( A) > 0. That s, the afflated fund s expected to nvest n certan IPOs underwrtten by the nvestment bank. Consequently, m[ E( A IR ) b] could be negatve. The afflated fund could be better off f t nvests the money E (A) somewhere else such as an ndex portfolo. The ndependent fund manager adjusts ts commssons based on IPO allocatons. The ncremental effect due to the allocaton of the IPO on commsson busness s k [ E I IR) r] (, where k s a scalar. That s, the commsson paybacks are proportonal to the underprcng benefts above r receved by the ndependent fund. The revenues for the nvestment bank from each IPO come from three sources: the gross spread, the management fee on the afflated fund s assets, and commsson paybacks 7 The afflated fund could also refuse to accept cold IPOs. Ths wll make the afflated fund behave more lke the unafflated fund. It s an emprcal queston as to what degree the afflated fund wll accept IPOs uncondtonally to help the parent frm. 8
from the ndependent fund. We can wrte the optmzaton program for the nvestment bank at the begnnng of an IPO market cycle as follows: 8 max A, I {[ G + m( E( A IR) b) + k( E( I IR) r) ],0} s. t. E E A [ I IR] [ A] > 0, I { 0,} r. A + I = The ndependent fund requres a mnmum expected return on ts IPO allocatons over an IPO market cycle. So t s obvous that some IPOs wth extreme low ntal returns have to be allocated to the afflated fund, f the nvestment bank forces the deal through. However, ths may hurt the performance of the afflated fund such that the loss n management fee domnates the underwrtng revenue. The nvestment bank may smply wthdraw the deal from the market, and take the zero proft. For smplcty, we further assume that the underwrtng revenue G always domnates and the deal wll always go through, and that the benchmark for afflated fund money flows, b, s the same as the requred mnmum return, r, for the ndependent fund. The smplfed optmzaton program s then as follows: max A, I [( m k) ( E( A IR) r) ] s. t. E E A [ I IR] [ A] > 0, I { 0,} r A + I = Now t s clear that how the nvestment bank allocates an IPO depends on the trade-off between the nternal management fee and the external tradng commsson ncome. If these two sources of ncome are equal, we assume that the nvestment bank wll favor ts afflated fund. The solutons of the model depend on the parameters. Below we analyze the four 8 Note that both A and I are functons of IR. Also, we assume that the afflated fund wll always channel tradng commssons to the nvestment bank. We also treat the mnmum ntal return requrement by the ndependent fund and ts commsson payback schedule as beng exogenously determned such that they guarantee the optmal outcome regardng the performance and money flows for the ndependent fund. Consequently, we do not model tradng commssons generated by the afflated fund and the money nflows to the ndependent fund. 9
dfferent cases generated by the nteracton of hot vs. cold markets and management fees vs. commsson paybacks to gan nsght nto the underwrter s allocaton problem. The solutons are summarzed n Fgure. Case : Cold IPO market cycle: E ( IR ) = r C Note that E( IR ) = r < C r, and that the constrant E( I IR ) r suggests that the afflated fund has to take more IPOs from the lower end of the dstrbuton. Ths does not necessarly mean that the afflated fund has to take all IPOs from the left end of the dstrbuton. But an IPO wth relatvely better performance for the afflated fund wll have to be offset by IPOs wth even worse ntal returns so that the resultng expected return for the ndependent fund meets the mnmum return requrement. For tractablty, we assume that the funds n ths case and the followng cases wll take IPOs startng from one end of the dstrbuton untl the optmal expected return s obtaned. Note that ths assumpton wll not change the expected return receved by ether fund for each market cycle. Case a: m < k. If the underprcng generates more commsson paybacks from the ndependent fund than management fees from the afflated fund, the underwrter obvously allocates all IPOs wth ntal return above r to the ndependent fund. That s, A * = 0 f IR f IR Case b: [ u,t ] a ( T u] a, and I * 0 = f IR f IR [ u,t ] a ( T u] a,, where T a = r. m k. The constrant E( I IR ) r becomes bndng when management fees exceed commsson kckbacks. Ths n turn ndcates that I * 0 = f IR f IR [ u,t ] b ( T,u] b A b * = 0 f IR f IR [ u,t ] b ( T,u], where the cutoff pont T = u r( u u ). Note that T b < r b and. That s, although durng the cold IPO market cycle the afflated fund has to take IPOs wth the worst performance, the ndependent fund wll also receve some IPOs wth an ntal return less than the mnmum requred expected return. The ntuton s that although the management fee revenue s hgher than the proft-sharng from commssons, the ndependent fund must be gven hot IPOs n order to nduce t to partcpate n the offerngs. Note that we assume that the afflated funds can not smply take all IPOs due to captal constrants and 0
regulatons, and that the partcpaton of the ndependent fund n a gven IPO market cycle s necessary. Case : Hot IPO market cycle: Case a: E ( IR ) = rh m < k. If the commsson paybacks domnate, the afflated fund wll stll take all the IPOs wth ntal returns below r. We have the same solutons as n Case a. That s, A * = 0 Case b: f IR f IR [ u,t ] a ( T u] a, and I * 0 = f IR f IR [ u,t ] a ( T u] a,, where T a = r. m k. The underwrter wll ask the ndependent fund to take the IPOs startng from the lower end of the dstrbuton because E( I IR ) r s agan bndng, and A * 0 = b f IR f IR u + u [ u,t ] b ( T,u] b = r and H > I r. The constrant * = 0 f IR f IR [ u,t ] b ( T,u] where the cutoff pont T = u + r( u u ). That s, IPOs wth better ntal returns wll go to the afflated fund. The ntuton s that the ndependent fund wll receve the mnmum number of IPOs wth postve returns to keep t wllng to accept all of the IPOs wth negatve returns... The Hypotheses The underwrter has ncentves to complete more IPOs n order to earn nvestment bankng fees. Condtonng on an IPO beng completed, we can use Fgure to summarze our model. IPO allocatons are drven by the nteracton of two factors: the IPO market condton and the relatve mportance of the afflated and unafflated funds n ther abltes to generate revenues for the underwrter. Two nterestng patterns then arse. Frst, durng a cold IPO market cycle, the expected return of the IPOs receved by the afflated fund s always lower. The nvestment bank needs to use ts afflated fund to complete more deals. Second, durng a hot IPO market cycle, the relatve performance of IPOs receved by the afflated and the unafflated funds depends on the relatve mportance of money nflows and the assocated management fees versus commsson paybacks. Our model then leads to two alternatve hypotheses: the dumpng ground hypothess and the nepotsm hypothess. The dumpng ground hypothess refers to the stuaton n whch b,
the underwrter allocates (dumps) more cold IPOs to ts afflated funds so that more deals can go through or more tradng commssons can be receved from unafflated nsttutonal nvestors (Cases a, b, and a). The underwrter s more lkely to ask the afflated funds to take more cold IPO shares to create more demand to support these cold IPOs so that other nsttutonal nvestors can share less of the burden. The nepotsm hypothess refers to the stuaton n whch the underwrter uses hot IPOs to boost the performance of ts afflated funds. If the mutual fund ndustry s rapdly expandng, the underwrter wll use hot IPOs to boost the performance of ts afflated funds to attract more money nflows and gan market share for ts asset management busness (Case b). If the underwrter smply treats all funds n the same way due to regulatory concerns, we would observe that both hot and cold IPOs are allocated to afflated and unafflated funds n the same way. Ths s our null hypothess. Once an underwrter has allocated IPO shares to a fund famly, the famly may then choose to allocate the shares to funds wthn the famly n a manner so as to maxmze the present value of the famly s total management profts. Wthn the same market cycle and wthn the fund famly, some fund characterstcs, such as fund sze, total fees, age, and yearto-date performance, affect how allocatons of IPOs nfluence the performance of the fund and ts money nflows (the parameter m n the model). Consequently, the dumpng ground hypothess and the nepotsm hypothess could co-exst, whle dumpng happens more often wth large, low fee, old, and underperformng funds because ther abltes to generate management fees are relatvely nsenstve to dumpng and nepotsm, and nepotsm happens more often for funds wth the opposte characterstcs. 3. Data and Descrptve Statstcs 3.. Data The Thomson Fnancal Securty Data Company (SDC) global new ssues database s used to dentfy IPOs from 990 to 00. We exclude all unt offerngs, Amercan Depostory Recepts (ADRs), Real Estate Investment Trusts (REITs), closed-end funds, partnershps, and banks and S&Ls. We also exclude IPOs wth an offer prce of less than $5. We use the 004 Center for Research n Securty Prces (CRSP) database of daly stock prces n our long-run performance studes, restrctng the sample to Amex, NYSE, and NASDAQ-lsted stocks. We
dentfy 4,6 IPOs from 990 to 00 after applyng these flters. Snce our focus s on how the lead underwrter allocates IPOs between afflated funds and unafflated funds, we further requre that for an IPO to be n our sample, ts lead underwrter(s) has afflated funds, and that at least one fund, ether afflated or unafflated, reported holdngs of the IPO wthn sx months of the offer date. Ths reduces the number of IPOs to,57, wth a pronounced tendency to screen out the smaller IPOs. We use the CDA/Spectrum Mutual Funds Holdng database, whch s often referred to as the Spectrum & database, to obtan reported holdngs for IPOs. Ths database covers all mutual fund flngs wth the SEC and an addtonal 3,000 global funds. The reported holdng for each stock s at the fund level, and s reported sem-annually. 9 We exclude all funds wth reported assets under management of less than $ mllon at the tme of reportng. We use CUSIP numbers for each stock/ipo to match each mutual fund s reported holdngs and our IPO sample. We use the frst reported holdngs wthn sx months of the offer date for each IPO as our proxy for the ntal IPO allocatons, snce the actual allocatons are not publcly avalable. 0 We wll dscuss why we thnk that ths s a good proxy for ths study n Secton 6.. The reported holdngs refer to the frst reported holdngs wthn sx months of the offer date n the rest of the paper, unless explctly stated otherwse. Throughout the paper we use reported holdngs and ntal allocatons nterchangeably unless the context suggests otherwse. We utlze the mutual fund drectory publshed by the Investment Company Insttute, Moody s Bank and Fnance Manual, and the webstes of the nvestment banks n our sample (when avalable) to determne the afflatons between mutual funds and nvestment banks. A 9 Thomson Fnancal also has another related fund holdng database called CDA/Spectrum Insttutonal Money Manager Holdngs. Ths s also referred to as Spectrum 3&4 or Insttutonal 3(f) Common Stock Holdngs database. The 3(f) data are from the 3F form fled wth the SEC and nclude holdngs at the fund famly level on a quarterly bass. We use Spectrum &, the fund level holdng data, nstead of the 3(f) data because our analyss requres nformaton at the ndvdual fund level. Also, for the 3(f) data, a fund famly only needs to report holdngs of a poston n a stock greater than 0,000 shares or $00,000. As reported n Panel B of Table, the average per stock holdng n an IPO s 85,460 shares or $.04 mllon. But the standard devatons are as hgh as 8,876 shares or $8.38 mllon (not reported n the table). Ths ndcates that the 3(f) data could exclude many smaller postons, whch may bas the results f used. It should be noted that t s unusual for a mutual fund, other than a small ndex fund, to hold a few shares, such as 500 shares or,000 shares, of many dfferent stocks. Instead, actvely managed funds typcally hold ether at least 40,000 shares or zero shares of a lmted number of stocks, perhaps because of the fxed cost of actvely payng attenton to each stock. 0 Note that the requred reportng frequency for the Spectrum data s sx months, although many funds report holdngs voluntarly on a quarterly bass. 3
manual name match s frst performed based on the presumpton that a prestgous nvestment bank would protect ts brand name and only allow ts afflated funds to use t. We then use the aforementoned sources to supplement and confrm the afflatons from the name match. There are some major mergers and acqustons among bg nvestment banks n our sample perod, and t s mportant, for example, not to lnk any Chase Manhattan funds to JP Morgan before ther merger n 000. We use the SDC Mergers and Acqustons database and corporate hstory publshed on the webstes of some nvestment banks to make sure the afflatons are tme senstve to mergers and acqustons. 3.. Descrptve Statstcs We dvde the sample perod nto fve subperods: 990-994, 995-996, 997-998, 999-000, and 00. Our model suggests that there are two forces nfluencng the allocaton of IPOs between afflated and unafflated funds. One factor s the IPO market condton, and the other s the mportance of attractng money nflows. We use the overall IPO market returns publshed on Jay Rtter s webste to determne the IPO market cycles. We use two dfferent crtera to determne f a month s a hot IPO market: whether the prevous month mean IPO ntal return s greater than 5%, and whether the movng average of the ntal return over the prevous three months s greater than 5%. Although these two dfferent crtera generate dfferent results (not reported), two perods, 995-996 and 999-000, have many consecutve months of hot IPO markets. As to the mportance of attractng money nflows, we report n Fgure the sze of equty-related mutual funds (equty and hybrd funds) and the annual money nflows nto mutual funds, measured n dollars and as a percentage of assets under management. Assets under management dsplay an upward trend and peak durng the nternet bubble perod. The numbers n Fgure suggest that the mutual fund ndustry experenced fast expanson n percentage terms durng 99-994. Consderng both the IPO market cycles and the mutual fund market expanson, we dvde our sample perod nto the aforementoned fve subperods. We report the summary statstcs for our,57 sample IPOs n Table. The underwrter reputaton rank s from Loughran and Rtter (004) and s defned as the prestge rank on a (low) to 9 (hgh) scale as n Carter and Manaster (990). There are on average 33.04 funds reportng holdngs of an IPO wthn sx months of the offer date, and the average 4
holdng by all funds s 33.80% of the total number of shares offered. Both the number of funds wth reported holdngs wthn sx months and the percentage of the publc float held by these funds dsplay an upward trend. The average reported holdng by all funds ranges from 8.90% n the early 990s to 4.40% n 00. Ths s hgher than the annual average mutual fund holdngs of 5-30% from 980 to 000 reported by Bnay and Prnsky (003) and the average 5% holdng for the perod from 980 to 000 reported by Feld and Lowry (006) usng the 3(f) data. The major reason for our hgher average holdngs by mutual funds s that we are reportng the means of IPOs condtonal on each IPO beng held by at least one reportng fund and the lead underwrter havng afflated funds. These screens remove many of the smaller IPOs that nsttutons are less lkely to own and that are taken publc by underwrters that are not large ntegrated securtes frms. We report the summary statstcs on mutual funds n Table. For comparson, we report mean assets and per stock holdngs (n both number of shares and dollars) for all reportng funds n Panel A. We frst aggregate the numbers for each fund over each report date. An observaton n Panel A s for one fund-report date combnaton, and each fund generates roughly two observatons per year. One notceable feature n Panel A of Table s the dramatc ncrease n the number of funds durng 999-00, as ndcated by the number of observatons for ths subperod. The descrptve statstcs for all funds that reported holdngs n IPOs are reported n Panel B of Table. Durng the sample perod, a fund on average reported holdngs of.96 stocks that had gone publc n the prevous sx months. The per stock holdng for IPOs averages 85,460 shares wth a market value on the reportng date of $.04 mllon, whch s much smaller than the per stock holdng of all stocks ncludng IPOs and non-ipos reported n Panel A, 45,86 shares wth a market value of $4.05 mllon. Ths s reasonable snce on average IPOs have a smaller publc float compared to more seasoned companes held by mutual funds. In Panel C we report descrptve statstcs for afflated funds that report holdngs of afflated IPOs. Ths panel sheds lght on the nvolvement of an afflated fund n IPOs underwrtten by ts parent company. The number of IPOs wth reported holdngs from the Some funds report voluntarly on a quarterly bass, and these funds would generate four observatons per year. 5
afflated funds s only.48 on average, smaller than that n Panel B. Note that the mean reported holdng, 75,495 shares or $.69 mllon per IPO, s smaller than those n Panel B. In all three panels of Table, we also report fund assets as a reference. 4. Who Receves Better IPOs? A Unvarate Analyss In ths secton we dvde the IPOs nto two groups: the NR group that has No Reported holdngs from the lead underwrter afflated funds and the R group that has Reported holdngs from the afflated funds. We compare the characterstcs of the IPOs n these two groups, and perform t-tests to study whether the afflated funds receve IPOs wth better or worse performance. The results are reported n Table 3. Through ts afflated funds, the lead underwrter nvested n 83 IPOs,.5% of the sample. The percentage ncreases from less than 0% n 990 994 and 995 996 to approxmately 30% n 999-000 and 00. Throughout the sample perod, the lead underwrter-afflated funds on average go wth the crowd when the afflated funds nvest n an IPO (the R group), we have reported holdngs from more funds, and the percentage holdngs by these funds (ncludng the afflated funds) are also hgher. On a per IPO bass, when the lead underwrter allocated an IPO to one or more of ts afflated funds, the average number of afflated funds that receved allocatons s two. Ths number s monotoncally ncreasng from.8 afflated funds durng 990-994 to 3. afflated funds n 00. Condtonng on the afflated funds havng receved shares, the average holdng s.30% of the shares offered. The average holdng decreases from 3.8% durng 990-994 to 0.70% n 00. The offer sze of the R group IPOs, measured by the dollar proceeds, s more than three tmes greater than that of the NR group IPOs. Ths s not surprsng, n that a large offerng presumably wll be held by more funds, and even wth no preferental treatment an afflated fund s more lkely to hold shares n a large offerng than n a small offerng. Ths dfference s much larger n the later subperods, and s not present n the early years. Frm For many years we fnd qute some non well-known funds wth assets that easly surpassed the sze of the Fdelty and Vanguard S&P500 Index funds. In the Spectrum database, assets are reported as $0, 000. The numbers for these non well-known funds clearly suggest data errors, probably the use of wrong unts. We set those assets numbers that are lkely to be data errors as mssng n calculatng the mean assets n Table. 6
sze, measured by the pre-ssue book value of assets, shows a smlar pattern. The reputaton rank of the lead underwrter for the R group IPOs s slghtly hgher than that for the NR group IPOs. Agan ths dfference comes from the later subperods, possbly reflectng the ncreasng domnance of hgh prestge nvestment banks durng our sample perod. We report the average ntal returns and ther dfferences for the R and NR groups at the bottom of Table 3. The p-values for the t-statstcs are reported n the parentheses n the last row. For the whole sample perod, the R group IPOs have a statstcally sgnfcant 8.6% hgher ntal return than the NR group IPOs. If we examne dfferent subperods separately, however, a much rcher pattern arses. The ntal return dfference between these two groups durng 999-000 s a statstcally sgnfcant 35.4%. Ths subperod, often referred to as the nternet bubble perod, s characterzed as a hot IPO market wth severe underprcng and aggressve commsson payments (Nmalendran et. al. (006)). The dollar amount of assets under management and the dollar amount of nflows nto mutual funds also reached ther peaks durng ths perod. As suggested by the model, t s not surprsng that the underwrters steered more hot IPOs to ther afflated funds. The 995-996 subperod s another hot IPO market cycle, but the ntal return dfference s only an nsgnfcant.9%. Ths s possbly due to the fact that the cash nflows to the mutual funds, as shown n Fgure, slowed down n ths perod, whch reduced the ncentve to mprove fund performance by allocatng hot IPOs to an afflated fund. For 990-994, the R group of IPOs has a statstcally sgnfcant 7.% hgher ntal return. For the other subperods, the dfference s nsgnfcant. Overall, the evdence from Table 3 s nformatve, but not conclusve. The afflated funds tend to receve better IPOs, although the dfference for three of the fve subperods s statstcally nsgnfcant. There are confoundng factors, however, that may account for some of the hgher ntal returns for IPOs that are allocated to afflated mutual funds. For example, when the afflated funds receve shares, the mean percentage holdngs by nsttutonal nvestors, ncludng both afflated and unafflated funds, s also hgher. The hgher ntal return of the IPOs that are allocated to afflated funds could be smply because nsttutonal nvestors were overall favored n these IPOs. In the next two sectons, we develop an emprcal model and run multvarate regressons to shed more lght on the hypotheses. 7
5. Regresson Results 5.. The Emprcal Model where It seems natural to consder a Probt model specfcaton as follows: AFA = X controls β controls + γir + ε () AFA s a dummy varable that equals one f the Afflated Funds receve Allocatons of IPO and zero otherwse, X controls represents the control varables, and IR s the IPO ntal return. 3 Such a model specfcaton could be msleadng, however, as we explan below. The ntal return and nsttutonal allocatons of an IPO are jontly determned. Buldng on Aggarwal, Prabhala, and Pur s (00) emprcal model, we propose the followng model: IR β α + ε = X IR IR + INST () INST j INST INST INST j ( AF X ) γ + AF γ η = X β + Y δ + + (3) = j In equatons (), (3) and (4), j INST INST j (4) INST INST j s the allocaton of IPO to nsttutonal nvestor j, and INST s the overall allocaton of IPO to nsttutonal nvestors (mutual funds). The ncluson of INST n equaton () captures prvate nformaton that nsttutonal nvestors could have but do not reveal n the bookbuldng process. It could also capture the assocaton between the ntal return of an IPO and the underwrter s decson of allocatng t to the afflated funds. X IR and X INST are vectors of IPO-related factors that jontly determne the j j ntal return and nsttutonal allocatons. X IR and X INST could be overlapped. YINST j s the vector of fund-related factors. AF j s a dummy varable that equals one f nsttutonal nvestor j s afflated wth the lead underwrter of IPO and zero otherwse (note that no 3 An OLS model, nstead of a Probt/Logt model, could also be estmated f we use the actual reported holdngs as the dependent varable. 8
allocaton s requred). If γ (a vector of coeffcents) and γ (a scalar) do not equal zero, t would suggest that the lead underwrters treat afflated nvestors dfferently. Now t s clear why we argue that the model specfcaton n equaton () could be msleadng. Note that prce) s one of the factors n IR (or ts premarket ndcators such as the adjustment of the offer X INST. The model n equaton () s smply a probt/logt verson of that n equaton (3). It s clear that the coeffcent γ n equaton () s jontly determned by the coeffcents on gve us a msleadng γ. IR and γ. When γ s zero, a postve/negatve coeffcent of IR wll One way to test our hypotheses s to estmate equaton (3). Unfortunately ths requres nformaton at the ndvdual fund level that s ether not publcly avalable or dffcult to measure. 4 We can, however, fnd an ndrect and parsmonous way to test f γ and γ equal zero. Let us plug equatons (3) and (4) back nto equaton (), and we have IR = X IR We can rewrte equaton (5) as: IR = X IR A X INST β INST + ( AFj X INST ) γ YINST jδ + β IR + α + ε + AFj γ + η j β A + α[ X INST β INST + YINST jδ + η j ] [ ( AFj X INST ) γ + AF j γ ] + ε IR + α The second term n equaton (6) captures the total nsttutonal allocatons due to the IPOrelated factors and the fund-related factors (except afflatons). If we assume that the only overall dfference between afflated and unafflated funds s the possble dfferent treatment they could receve from the lead underwrter, we can replace the terms n the frst bracket wth INST NA, whch s defned as the total allocatons to unafflated nsttutons, to capture any prvate nformaton nsttutonal nvestors may have, as suggested by Aggarwal, Prabhala, and Pur (00). The thrd term, α[ ( AF X ) γ + AFj γ ] j INST, captures the mpact of the (5) (6) 4 For example, t would be useful to have nformaton on how aggressve a fund s n bddng for an IPO and how nformatve the bddng s. Ths requres nformaton from the order book and the actual allocatons of an IPO. Cornell and Goldrech (00) and Jenknson and Jones (004) examne order books for some European IPOs, and shed lght on how the lead underwrter allocates shares to dfferent nvestors. They come to dfferent conclusons, however, regardng how much of actual allocatons can be explaned by nformaton-theoretc bookbuldng models. 9
dfference of the allocatons between afflated and unafflated funds. We can replace the terms n the bracket wth the afflated fund allocatons dummy, model nto Note that by usng the IR µ AFA, and then transform the = X IRβ IR + λinstna + θafa + (7) AFA dummy nstead of the reported holdngs, we gve up the nformaton n the sze of the reported holdngs, as well as the nose n t because t s an mperfect measure for allocatons. The nterpretaton of the model s straghtforward: f the nepotsm hypothess s true, we would have θ > 0 ; f the dumpng ground hypothess s true, we would have θ < 0. Equaton (7) wll be the regresson model we estmate n our followng analyses. But before we report the emprcal results, t s mportant to pont out that our emprcal estmatons of the reduced form n equaton (7) do not suffer from endogenety ssues. As revealed n equatons () (4), the endogenety of nsttutonal allocatons s because of the common factors that affect both IPO ntal returns and nsttutonal allocatons. For ths reason, Aggarwal, Prabhala, and Pur (00) use the unexpected nsttutonal allocatons to capture prvate nformaton. But ther study suggests that there s no reason to beleve that nsttutonal allocatons are strongly correlated wth the error term n the ntal return regresson. So statstcally there s no reason to beleve that ether INST NA or correlated wth µ. Consequently, the estmaton of θ would not be based. 5.. Regresson Results To estmate equaton (7), we need to determne the varables n AFA s X IR that we use to help explan the ntal return. Followng the lterature, we nclude four varables. The frst one s the pre-market adjustment, denoted as Adjustment and defned as the percentage premarket adjustment from the md-pont of the ntal fle prce to the offer prce. LN _ Assets, defned as the natural log of the nflaton-adjusted pre-ssue book value of assets, s also ncluded. We nclude the tech dummy Tech _ Dummy as the thrd control varable. Ths dummy s one for tech IPOs and zero otherwse. 5 The last varable, the Carter and Manaster 5 Tech IPOs are defned as those wth SIC codes of 357, 357, 3575, 3577, 3578, 366, 3663, 3669, 367, 367, 3674, 3675, 3677, 3678, 3679, 38, 383, 385, 386, 387, 389, 384, 3845, 48, 483, 4899, 737, 0
(990) reputaton rank of the lead underwrter, Lead _ Rank, as updated by Loughran and Rtter (004), measures the prestge status of an nvestment bank. 6 We use the frst reported holdngs wthn sx months of the offer date by all funds that are not afflated wth the lead underwrter to proxy for the allocatons to unafflated nsttutonal nvestors. Followng Aggarwal, Prabhala, and Pur (00), we use the natural log of the total number of shares. The model we wll estmate s then as follows. Note that to smplfy the notaton the superscrpt s dropped. IR = β + β * Adjustment + β * LN _ Assets + β * Tech _ Dummy 0 + β * Lead _ Rank + λ * INST 4 + θ NA * 3 AFA + µ We estmate the model separately for the fve subperods: 990 994, 995 996, 997 998, 999 000, and 00. We report the regresson results n Table 4. The coeffcents of all the control varables n our regresson have the expected sgns and are consstent wth what has been reported n the lterature. The pre-market adjustment varable, Adjustment, s sgnfcantly postve for all subperods, and t has the largest mpact on ntal returns durng the nternet bubble perod, consstent wth the evdence n other artcles. 7 We expect the coeffcent for LN _ Assets to be negatve snce large ssuers are less rsky and are more lkely to be seekng to maxmze the offer prce, and should be less underprced. The coeffcent for LN _ Assets s negatve and statstcally sgnfcant at the 0% level or better for all subperods. Technology companes tend to be more underprced, and consstent wth (8) 737, 7373, 7374, 7375, 7378 and 7379. We also gve IPOs defned as nternet companes a tech dummy value of one usng the lst of nternet IPOs on Jay Rtter s webste. 6 Because of the jont determnaton of underprcng and the lead underwrter, there s a potental endogenety problem wth usng Lead_Rank as an explanatory varable. In Loughran and Rtter s (004) Tables V and VI, where both OLS and nstrumental varables specfcatons are reported, there s almost no dfference n the coeffcents on a dummy varable for usng a prestgous underwrter. 7 The underprcng of IPOs jumped to a record hgh of 70% durng the nternet bubble perod (see Table ). Houston, James, and Karcesk (005) show that, durng the nternet bubble perod, underwrters frequently lowballed the fle prce range. Ths suggests that, for the nternet bubble perod, the varable Adjustment could be endogenous. To address ths concern, we also estmate a model wth control varables smlar to Loughran and Rtter (004). Specfcally, we drop the Adjustment varable as a control varable and replace t wth the logarthms of sales and frm s age, as well as a VC dummy (one f a frm s backed by venture captalsts and zero otherwse), the percentage of prmary shares offered n the offerng, and market share overhang (the rato of retaned shares to ssued shares). We keep the other control varables (LN_Assets, Tech_Dummy, Lead_Rank and INST NA ). The coeffcents for all the control varables are consstent wth what have been reported n Loughran and Rtter (004) and ths paper, and the coeffcents for the AFA dummy reman qualtatvely unchanged (results not reported).