Quid Pro Quo? What Factors Influence IPO Allocations to Investors?

• Author: FELIX SUNTHEIM,HOWARD JONES,TIM JENKINSON
• Date: 01 October 2018
• DOI: http://doi.org/10.1111/jofi.12703
• Published date: 01 October 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 5 •OCTOBER 2018

Quid Pro Quo? What Factors Influence IPO

Allocations to Investors?

TIM JENKINSON, HOWARD JONES, and FELIX SUNTHEIM∗

ABSTRACT

Using data from all of the leading international investment banks on 220 initial

public offerings (IPOs) raising $160 billion between January 2010 and May 2015,

we test the determinants of IPO allocations. We compare investors’ IPO allocations

with proxies for their information production during bookbuilding and the broking

(and other) revenues they generate for bookrunners. We find evidence consistent

with information revelation theories. We also find strong support for the existence of

a quid pro quo whereby broking revenues are a significant determinant of investors’

IPO allocations and profits. The quid pro quo remains when we control for unobserved

investor characteristics and investor-bank relationships.

INITIAL PUBLIC OFFERINGS (IPOS)PLAY an important role in the financial sys-

tem, enabling companies to raise equity finance and providing investors with

a tradeable asset. Doubts remain, however, about how well the IPO market

operates for issuing companies. The IPO boom in the United States during

the dot-com period—in particular, 1999 to 2000—witnessed several scandals,

which involved laddering, spinning,1analysts’ conflicts of interest, as well as

heavily underpriced shares being allocated in return for excessive trading com-

missions (Liu and Ritter (2010)). These scandals were followed by a significant

decline in IPO activity for much of the 2000s, even before the 2008 financial

crisis (Gao, Ritter, and Zhu (2013)). Regulators responded by outlawing specific

∗Tim Jenkinson and Howard Jones are at the Sa¨

ıd Business School, University of Oxford. Felix

Suntheim is at the U.K. Financial Conduct Authority. We are grateful to Michael Roberts, the

Editor, and two anonymous referees for their many insightful comments, which substantially im-

proved the paper. We also thank Matteo Aquilina, Kirsten Donnelly, Robin Finer, Stefan Hunt,

Peter Lukacs, Ludovic Phalippou, Graeme Reynolds, Paul Richards, and various seminar partici-

pants for their suggestions, and Nadia Chernenko for her help with the data. This research formed

part of the Financial Conduct Authority’s (FCA’s) review of Investment and Corporate Banking,

and draws upon confidential information supplied by investment banks. The FCA reviewed the

paper to confirm that no confidential information relating to particular investment banks or in-

vestors has been included. The views expressed in this paper are those of the authors and not the

FCA. The authors have read the Journal of Finance’s disclosure policy and have no conflicts of

interest to disclose.

1Laddering is the practice of allocating shares on the understanding that investors will buy

additional shares in the immediate aftermarket. Spinning refers to the practice of allocating

shares to corporate executives in order to influence their decisions in future corporate investment

banking transactions.

DOI: 10.1111/jofi.12703

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2304 The Journal of Finance R

practices and requiring that investment banks implement policies to address

conflicts of interest. In the United States, concerns that financial markets were

not effectively serving the needs of growing companies motivated the passage

of the JOBS Act.2

In the United Kingdom, the Financial Conduct Authority (FCA) began a re-

view of wholesale financial markets in 2014.3This led to a market study of

investment and corporate banking. The research in this paper was conducted

together with the market study and benefits from data not previously available

to researchers. All banks with operations in the United Kingdom, which include

all of the leading U.S. and European investment banks, are subject to regula-

tion by the FCA. The FCA used its powers to gather detailed information on

bids, allocations, meetings before and during bookbuilding, fees, the economic

relationship between investment banks and their buy-side clients, and various

other data for all IPOs conducted from the United Kingdom between Jan-

uary 2010 and May 2015.4Since many banks’ European headquarters are in

London, the sample covers companies floated on most European exchanges.

The companies are from across Europe, as well as from Africa and the Middle

East. Our sample comprises 220 IPOs that raised $160 billion, which repre-

sents around three-quarters of the Europe, Middle East, and Africa (EMEA)

market, by value, over this period.5

The main question we address is how IPO allocations are determined. Un-

derpricing in IPOs is well documented and represents “money left on the table”

for the original owners of the company.6That money is picked up by those allo-

cated shares in the IPO that immediately trade higher than the offer price. We

test the extent to which IPO allocations and the money left on the table at IPO

are determined by information revelation or by the revenues generated for the

bookrunner by buy-side investor clients as part of a quid pro quo. The extent

of these revenues, which has not previously been documented, is considerable,

2The Jumpstart Our Business Startups Act of 2012 requires that the Securities and Exchange

Commission writes rules that facilitate cost-effective access to capital for companies of all sizes

while also promoting investor protection.

3This Wholesale Sector Competition Review began in July 2014 (FCA (2014)) with a discussion

document that invited responses from market participants on a range of issues. In February 2015,

the FCA issued a feedback statement (FCA (2015a)) on the views that had been expressed, and

announced that it would launch two market studies. The first focused on Investment and Corporate

Banking, and the second on Asset Management. The Terms of Reference for the former, to which

this paper is related, were published in May 2015 (FCA (2015b)), with questionnaires and data

requests sent out to relevant parties in June 2015. An interim report of the market study was

published in April 2016 (FCA (2016a)) and the final report was published in October 2016 (FCA

(2016b)).

4Conducted from the United Kingdom means all activities undertaken from or in the United

Kingdom, regardless of the location of the client or the legal entity into which the activity is booked

for accounting reasons.

5IPOs on the U.K. exchange constitute around one-quarter of our sample, by value.

6Jenkinson and Ljungqvist (2001) survey the academic evidence on underpricing, and Jay

Ritter produces a wealth of data for the United States and other countries on his website

https://site.warrington.ufl.edu/ritter/ipo-data/.

What Factors Influence IPO Allocations to Investors? 2305

averaging $37 billion per year across the banks in our sample.7By compari-

son, we estimate that IPOs generated investment banking fees averaging $437

million per year.

The information revelation and quid pro quo hypotheses are clearly not mutu-

ally exclusive: Investment banks may favor investors who submit informative

bids as well as those from whom they derive the highest revenues. One chal-

lenge researchers encounter is that not all of the interaction between investors

and investment banks is observable. We can observe, for example, bidding be-

havior and participation in road-show meetings, but we cannot observe more

informal interaction. Furthermore, it is possible that investment banks have

deeper relationships with their best (i.e., higher revenue) customers, and that

these result in more information revelation. Using our unique data set, we

are able to address these challenges by controlling for the impact of investor-

specific characteristics that are fixed across IPOs run by different banks, as

well as for any specific (non–revenue-related) investor-bank relationships.

Our main results are as follows. First, we investigate whether the way in

which investors bid influences allocations. Here, we analyze three bid charac-

teristics: whether they are price-limited, whether they are submitted early,and

whether the bids are revised during bookbuilding. Previous research interprets

these bid features as providing information and finds that bookrunners reward

such bids with better allocations.8Regarding price-sensitive bids, as opposed to

“strike” bids that demand a quantity of shares without specifying a price limit,

we find that such bids receive a slightly higher allocation across the whole

sample of IPOs. However, when we run our econometric models separately for

each of the leading investment banks, we find considerable variation. For some

banks, allocations are similar regardless of the type of bid that investors sub-

mit. We find little evidence that either bidding early or revising bids during

bookbuilding has a significant impact on allocations.

Second, we analyze whether bidder characteristics or actions during the

bookbuilding process affect allocations. We find that investors who participate

in meetings before or during bookbuilding receive more generous allocations.

Although it is impossible to know how much information flows from investors

to bookrunners during such meetings, participation may demonstrate more

active engagement with the IPO and the issuer, and the evidence suggests

that bookrunners reward such investors. Being a frequent bidder also has a

small, positive impact on allocations. Regarding bidder characteristics, we find

that allocations to hedge funds are scaled back significantly more than those

to long-only investors, although they still receive around one-fifth of all shares

across our sample of IPOs.

7These revenues vary by investor depending on the services they buy from the bank, such as

broking services (across equities, fixed income, derivatives, etc.), research (often bundled as part

of trading commission), currency hedging, and, in the case of hedge funds, a variety of prime

brokerage services.

8Following existing literature, we focus on allocations relative to bids, or “normalized

rationing”—the ratio of the proportionate allocation relative to the proportionate quantity bid

(at the issue price); see Cornelli and Goldreich (2001).