Are IPO Allocations for Sale? Evidence from Mutual Funds

Combining data on explicit brokerage commissions that mutual fund families paid for trade execution between 1996 and 1999 with data on mutual fund holdings of initial public offerings (IPOs), I document a robust positive correlation between commissions paid to lead underwriters and reported holdings of the IPOs they underwrote. Moreover, I find that the correlation is limited to IPOs with nonnegative first-day returns and strongest for IPOs that occur shortly before mutual funds report their holdings, when the noise introduced by flipping is smallest. Overall, the evidence suggests that business relationships with lead underwriters increase investor access to underpriced IPOs. ∗Jonathan Reuter is at the Lundquist College of Business, University of Oregon. I wish to thank an anonymous referee, Reena Aggarwal, Daniel Bergstresser, Walid Busaba, John Chalmers, Randy Cohen, Diane Del Guercio, Glenn Ellison, Wayne Ferson, Denis Gromb, Dirk Jenter, Jonathan Lewellen, Alexander Ljungqvist, Tim Loughran, Robin McKnight, Wayne Mikkelson, Stew Myers, Eddie O’Neal, Megan Partch, Jeffrey Pontiff, Jay Ritter, Jorge Rodriguez, Antoinette Schoar, Donghang Zhang, individuals within the mutual fund and underwriting communities, and seminar participants at Boston College, the Federal Reserve Bank of Boston, the Federal Reserve Board of Governors, Harvard Business School, MIT Sloan, Texas A&M, University of Illinois Urbana-Champaign, University of Oregon, University of Southern California, U.S. Department of Justice, Washington University in St. Louis, the Second EVI Conference on Entrepreneurship, Venture Capital, and IPOs, the 2003 Pacific Northwest Finance Conference, the 2004 Western Finance Association Annual Meetings, the Tuck Conference on Contemporary Corporate Finance Issues III, and the Ohio State and Federal Reserve Bank of New York Conference on Agency Problems and Conflicts of Interest in Financial Intermediaries for helpful comments. The financial support of an NSF Graduate Research Fellowship and the MIT Entrepreneurship Center are gratefully acknowledged. Remaining errors are my own. During the hot initial public offering market of the late 1990s, the typical IPO was significantly underpriced and oversubscribed. The first-day returns earned by investors in these IPOs received considerable public attention. The source of these first-day returns and related questions about the practices that underwriters use to allocate IPOs across investors continue to receive attention from regulators and academics alike. A central question is whether U.S. underwriters use their discretion over IPO allocations to reward investors— either institutional or individual—for directing brokerage business to their investment banks. This question highlights a potential agency conflict between underwriters and issuers. To the extent that underwriters are able to use shares in underpriced IPOs to earn inflated brokerage commissions or attract additional investment banking business, they have an incentive to set offer prices below the levels that maximize proceeds for issuers (see, for example, Baron (1979) and Loughran and Ritter (2002)). In this paper, I test a key assumption of these agency conflict theories of IPO underpricing by asking whether lead underwriters allocate more underpriced shares to investors from whom they receive more brokerage business. Specifically, I analyze IPO allocations across mutual fund families between 1996 and 1999. Brokerage commission data unique to this paper allow me to identify the investment banks to which each U.S. mutual fund family paid explicit brokerage commissions (as opposed to bid-ask spreads), as well as the dollar amounts paid. Because data on IPO allocations are not publicly available, I use reported mutual fund equity holdings from the same period to infer the IPO shares allocated to each mutual fund family. Combining these data, and controlling for other potential determinants of IPO allocations, I find evidence of an economically significant link between the reported IPO holdings of mutual fund families and the level of the brokerage commission payments those families direct to lead underwriters each year. Traditional bookbuilding theories of IPO underpricing (such as Benveniste and Spindt (1989)) predict 1TheWall Street Journal began reporting on IPO allocation practices—and investigations into those practices—in December 2000, and Red Herring published a seven-part series on IPO allocation practices in May 2001. According to former SEC Chairman Harvey Pitt, “Participation in these IPOs became immensely valuable for both underwriters and customers, inducing aggressive conduct to gain this business. As a result, serious questions arose about the price setting process and the allocation practices of the underwriters of some of these offerings” (SEC Press Release 2002–127, August 22, 2002). In January 2002, Credit Suisse First Boston agreed to pay $100 million to settle an investigation brought by the SEC and NASD into the tying of IPO allocations to inflated brokerage payments. Subsequently, Robertson Stephens and J.P. Morgan agreed to pay fines of $28 million and $6 million, respectively. 2In related work, Loughran and Ritter (2004) argue that IPO allocations to venture capitalists and CEOs were used to increase investment banking business or reduce issuer incentives to prevent underpricing. Ljungqvist and Wilhelm (2003) argue that the increased underpricing during the Internet bubble of 1999 and 2000 reflected the reduced incentives of issuers to prevent underpricing, and they cite reduced CEO ownership shares and increased allocations of underpriced shares to “friends and family” as possible explanations for these reduced incentives.