Many parts of the investment business have been democratized by a combination of regulation, technology and industry innovation. But one area in which an insider advantage still exists is in the allocation of coveted initial public offerings. Recent research in the U.S. suggests that underwriters use the IPO carrot to secure future business for themselves and to boost the fortunes of their firm’s mutual funds.

The business of bringing new companies to market is fraught with uncertainty and, therefore, presents both significant risks to and potential rewards for inves-tors. But those risks and rewards aren’t distributed evenly. Typically, small, retail investors hardly get a sniff of a sought-after IPO. Shares in these deals, which are virtually guaranteed to turn a quick profit, go to VIP clients and large, institutional investors. The deals in which small investors are allowed to participate are often the ones that haven’t proven popular and seem to carry more potential for risk than reward.

There’s nothing nefarious about any of this. While it isn’t exactly fair, it only makes sense that, faced with control of a scarce commodity, investment dealers are going to parcel it out in a way that best suits their long-term interests. Some recent research illustrates the ways in which underwriting firms make use of their IPO allocation powers to reward their friends and curry favour with current and, hopefully, future clients.

In a paper published at the end of 2007, entitled Corporate Executive Bribery: An empirical analysis, Jay Ritter, an eminent scholar at the Warrington College of Business at the University of Florida in Gainesville, Fla., and PhD student Xiaoding Liu looked at the effects of the allocation of hot IPOs to corporate executives in the U.S. during the tech bubble of the late 1990s. Essentially, the researchers found that giving company managers shares in highly sought-after IPOs paid off for both the executives and the underwriters — at the expense of issuers and the other shareholders.

In a sample of 56 deals from 1996 to 2000, Ritter and Liu found that for the transactions in which the executives of the firm going public received allocations of shares in a hot IPO (a practice known as “spinning”), those offerings were more acutely underpriced than comparable deals. Firms whose executives were involved in these hot deals saw their stock jump in early trading by an average of 18% more than that of executives involved in similar débuts whose IPOs weren’t as popular.

The implication is that the executive holders of hot IPO shares, in the deals in which the executives had been lavished with IPO profits, enjoyed big trading gains personally; the company making the share offering, however, left a lot of money on the table as a result.

A big first-day jump in a stock price suggests that the company could have raised a lot more money if its issue price had been closer to the ultimate first-day trading price (which reflects the true demand for the stock). The holders of IPO shares certainly welcome a big price run-up when a stock débuts, but the company should be kicking itself for not raising that money for its own purposes rather than leaving it on the table for the lucky few IPO shareholders to enjoy.

In the case of the executives of issuing companies who were lavished with hot IPO shares, the researchers found they may not be willing to play hardball with their company’s underwriters if they are getting preferential access to hot deals for themselves.

“During the IPO negotiation process,” the paper noes, “executives are less likely to seek the highest offer price in order to maximize shareholders’ value if they receive side payments from underwriters.”

Typically, the underpricing of IPOs has been less of a phenomenon in Canada than it has been in the rest of the world. Indeed, according to data collected by Ritter and Liu, the average initial returns on IPOs in Canada are among of the lowest in the world. From 1971 to 2006, the average return for Canadian deals was just 7.1%. Over the same period, only Austria generated a lower initial return (6.5%).

By contrast, U.S. deals have averaged opening returns of 18% for the 1960-2006 period. And many countries have generated far greater initial trading spikes than those in the U.S. In Japan, for example, the average initial return for 1970-2006 is more than 40%. And for India, for 1990-2006, the average return was almost 100%.

@page_break@While those first-day returns look impressive, that’s money to which the issuing company would have had access had its underwriters priced the deal closer to the initial market price from the beginning.

The beneficiaries of these practices, the researchers found, are not just the executives and other IPO shareholders — the underwriters themselves benefit, as well. The researchers also discovered that despite the fact that the companies left so much money on the table in their IPOs, issuers whose executives received hot IPO shares were much less likely to change underwriters for follow-on offerings. Indeed, only 5% of the firms whose executives received hot IPO shares changed underwriters in subsequent years, compared with 31% of other issuers that used a different underwriter in future deals.

“These results are consistent with spinning being used successfully by underwriters to influence the decision-making of corporate executives,” the paper says. “We find that spinning affected not only IPO underpricing but also the awarding of mandates on subsequent investment-banking deals. This paper demonstrates that the bribery of corporate executives accomplished its purpose: it affected the corporate decisions of executives who received hot IPO allocations.”

These sorts of allocation processes highlight the conflicting interests of issuers, executives and underwriters when it comes to IPOs. Other suspect players in this arena are proprietary mutual funds. With so many investment dealers now tied to asset managers, there have also been conflicting theories as to how these different parts of the business may interact when it comes to IPO allocations.

According to one theory, underwriting firms could use their connections to affiliated mutual funds to unload otherwise unpopular IPO shares. If other investors aren’t buying, the underwriter could, theoretically, get a struggling deal out of the door by appealing to affiliated fund managers to take the unwanted shares off its hands. Thus the underwriter would earn the underwriting commission — but at the expense of the mutual fund unitholders, who would see their fund’s performance suffer as a result.

Alternatively, it has been suggested that investment dealers could use their hot IPOs to boost the fortunes of their affiliated mutual funds by giving them preferential treatment in their best deals. This could win the dealer a greater share of the fund manager’s trading business and help boost the fund’s returns, thereby attracting more assets to the firm overall.

Both of these theories were examined by Ritter and Donghang Zhang, assistant professor of finance at the University of South Carolina’s Moore School of Business, in a paper called Affiliated Mutual Funds and the Allocation of Initial Public Offerings. Their research found little evidence to support the theory that, in the U.S., underwriters dump their lousy IPOs on their affiliated mutual funds. But they did discover that, when affiliated mutual funds do get stuck with dud IPOs, it’s usually the funds that have lower fees and/or larger assets that get these deals.

But Ritter and Zhang did uncover some evidence backing the idea that dealers try to favour affiliated funds with shares in their hot deals. The researchers found that in the 1990-2001 period, the average initial return for IPOs held by affiliated mutual funds was more than double that of other deals by the same underwriters not held by affiliated mutual funds. The deals held by affiliated funds enjoyed a 54.4% average initial return, vs an average of 25.8% for the other IPOs.

Given that the research found some evidence that affiliated mutual funds enjoy preferential treatment from their underwriting arms, yet didn’t find much evidence that firms try to foist their unpopular IPOs on the in-house mutual funds, the paper concludes that there’s little reason for regulators to worry that proprietary mutual funds are used as a dumping ground for lousy new issues.

The IPO market may be one of the few areas in which investor democracy has taken hold, but that can be instructive for retail inves-tors. It tells them that the deals they should buy are probably the ones they can’t get, as the good bets primarily go to big market players. At the same time, if they can get hold of IPO shares, they probably should take a pass. IE