Wednesday, January 12, 2005

SSRN-Are Trading Commissions a Factor in IPO Allocation? by Mahendrarajah Nimalendran, Jay Ritter, Donghang Zhang

What have you done for me lately? Buying favorite status prior to hot IPOs.

SSRN-Are Trading Commissions a Factor in IPO Allocation? by Mahendrarajah Nimalendran, Jay Ritter, Donghang Zhang

Short Version:

How investment bankers allocate hot IPOs is the focus of this paper by Nimalendran, Ritter, and Zhang. The paper presents evidence of abnormally high trading volume in other (non IPO) stocks PRIOR to the IPO. The authors posit that this trading is a means of buying favor with the investment banker so as to be allocated more shares in the coming IPO.

Slightly longer version:

The idea that investment bankers allocate hot IPOs is not new. Not only in academia (Ritter and Loughran 2002 and other papers) but also from the SEC settlements:
"For example, the January 22, 2002 Securities and Exchange Commission (SEC) settlement with Credit Suisse First Boston(CSFB) states that CSFB allocated hot IPOs to some clients and in return received commissions of up to 65% of the profits (money left on the table). The clients kicked back part of their profits by paying unusually high commissions on stock trading that in some cases had no other economic purpose. For instance,the usual commission for institutional investors is at most 6¢ per share, but CSFB's clients paid as high as $3.00 per share in commissions for block trades executed by CSFB brokers."
The current paper looks for more widespread evidence of this buying favorite status. As the SEC-CSFB settlement shows one way to buy favorite status is by paying high commission rates. The authors speculate that another way to buy into a hot IPOS is by trading frequently, and especially trading frequently in the time period immediately before the IPOs (i.e. when the trading will be fresh on the Investment Banker's mind).
"there should be a positive relation between the amount of money left on the table by IPOs and the trading volume of liquid stocks around the IPO dates."
Why liquid stocks? The short answer is because the transaction costs (other than commissions) associated with trading these shares is lower. (Note: I am not convinced of this as a reason. I think it may be easier to funnel money to investment banking firms in less active stocks--see below.)

  • The sample has nearly 3500 IPOs from 1993 to 2001.
  • The authors examine "the top 50 stocks for each trading day based on the rank of a stock's average trading volume for the past 20 trading days. We exclude stocks with high volatility or
    a price of below five dollars."
  • "Because of changes in IPO practices, we partition our sample period into three sub-periods: the pre-Internet bubble period (1993-1998), the Internet bubble period (1999 -2000), and the post-Internet bubble period (2001)."

The conclusion?

"For all three subperiods, each $1 billion left on the table during the six trading days beginning on day t generates abnormal volume in the 50 liquid stocks of between 2.7% and 4.0% on day t, although only during the Internet bubble period is this point estimate reliably different from zero."

This abnormal trading would lead to increased commissions:
"The commissions generated from the increase in the trading volume are economically important. During the internet bubble period, for a six-day window with only average IPOactivities, our point estimate suggests that IPO-related trading would cause an increase of 2% in the trading volume of the 50 liquid stocks, and would result in an additional $656,410 perday in commissions if we assume a 10¢ per share commission...."
I was sort of surprised by the small size of the abnormal trading. So too apparently were the authors who address this point by reminding readers that this is a lower bound for several reasons. These reasons include: there may be shifting of trades (eg. a trade that would have been executed on an ECN is traded through one of the underwriting firms), actual commission rates may change, and the firms may also trade less liquid stocks (where I would add there is presumably more ability to funnel money to the firm (ex. higher spreads).

In spite of the rather small findings, this is a really interesting (and important) paper. In fact it is one of those papers that made me sit up and take notice! You will want to read it!

Suggested Citation
Nimalendran, Mahendrarajah, Ritter, Jay Rial and Zhang, Donghang, "Are Trading Commissions a Factor in IPO Allocation?" (October 20, 2004). AFA 2005 Philadelphia Meetings Paper.


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