Demise of the Small IPO and the Investing Preferences of Mutual Funds

Robert Bartlett and Steven Davidoff Solomon are Professors of Law at UC Berkeley School of Law, and Paul Rose is Professor of Business Law at Ohio State University College of Law. This post is based on an article authored by Professors Bartlett, Davidoff Solomon, and Rose.

The decline of the small initial public offering (IPO) has been well-documented. It has been less noted that this decline happened in the space of a few years. In 1997 there were 464 non-financial IPOs and 46% were small IPOs. By 1998, this percentage declined to 30%, which would decline further to just 10% in 1999. Small IPOs—once a mainstay of U.S. corporate finance—were quickly relegated to the margins. We explore the reasons for this sudden decline in our paper recently posted to SSRN: What Happened in 1998? The Demise of the Small IPO and the Investing Preferences of Mutual Funds.

We put forth a new “demand” side theory for the decline in small IPOs since the late 1990s that focuses on the investment preferences of large mutual fund investors. Our demand side theory posits that a principal reason for the persistent absence of small IPOs stems from a significant decrease in the demand for small IPOs commencing in 1998 among the largest quartile of equity mutual funds—a group that collectively controls more than 90% of mutual fund assets.

We theorize that the sharp drop in small IPOs in 1998 initially reflected a sudden shift in investment preferences among all mutual funds away from IPO risk in general. Beginning with the Asian financial crisis in 1997 and culminating with Russia’s devaluation of the Ruble and subsequent debt default in August 1998, what we refer to as the “Panic of 1998,” volatility within the global economic market prompted a wholesale flight to liquidity that had acute ramifications for investor demand for newly public firms. However, these events also had special significance for how large funds assessed small IPOs. Consequently, when mutual fund investors returned to the IPO market in subsequent years—in particular, from 1999 to 2000, from 2004 to 2007, and from 2012 to the present—a critical difference would be the noticeable absence of large mutual funds from the small IPO marketplace.

When the volatility scare of 1998 subsided, why did large mutual funds fail to return to the small IPO market? Our central hypothesis is that while mutual funds’ general appetite for IPO risk was sharply diminished in 1998, the events of 1998 also prompted a fundamental reconsideration among mutual fund portfolio managers about the liquidity risk of investing in small IPOs. In particular, the accelerated growth of the largest quartile of mutual funds throughout the 1990s and 2000s made liquidity risk ever more salient for portfolio managers given that, as shown in prior literature, portfolio managers typically deploy new fund inflows towards taking larger individual investment positions. Against this backdrop, when the Panic of 1998 induced a flight to liquidity and a related surge in mutual fund redemptions, the liquidity risks of funds’ larger positions were thrown into stark relief as portfolio managers grappled with liquidating large investment positions while witnessing a collapse in the market for small capitalization equities.

To test this theory, we examine mutual fund investments in 6,110 IPOs between 1990 and 2014 using portfolio-level position information for 37,052 individual mutual funds. Our primary empirical tests focus on several difference-in-differences estimators of how mutual fund size affected annual IPO investments following the events of 1998. In particular, we classify mutual funds into annual size quartiles to examine how fund size affected IPO participation levels over time. Holding constant year fixed effects and fixed effects for individual mutual funds, we find that the largest quartile of mutual funds invested in more IPOs per year than smaller funds both before and after 1998. Indeed, across all size quartiles, an increase in fund size is associated with more annual purchases of IPOs throughout the sample period. These findings are consistent with the basic fact that larger funds have more investment capital than smaller funds to deploy towards IPO investments.

In contrast, separate analysis of mutual fund investments in small IPOs (which we define as an IPO raising less than the inflation-adjusted mean proceeds of 1990) reveals a distinctly different pattern across the four size categories of mutual funds. Whereas prior to 1998 larger funds acquired more small IPOs than smaller funds, our difference-in-differences estimator reveals a reversal of this pattern following 1998, as predicted by our demand-side theory. More specifically, compared to their purchases of small IPOs in the period prior to 1998, we estimate that mutual funds in the first, second, third, and fourth size quartiles reduced their average annual investments in small IPOs after 1998 by approximately 23%, 73%, 89% and 100%, respectively. Overall, these estimates suggest a complete collapse in the demand for small IPOs among what had previously been a key component of the market for these offerings.

To isolate better the role of IPO illiquidity on mutual fund demand, we similarly examine how mutual fund size was associated with fund investments in illiquid IPOs. Using an interrupted time series analysis, we find that the peak of the Panic of 1998 resulted in a sudden, virtually discontinuous drop in the illiquidity of IPOs calculated using Amihud’s measure of illiquidity. We attribute this finding to the withdrawal of issuers from the IPO market except for those likely to generate significant after-market trading interest. Notwithstanding this overall decline in IPO illiquidity, however, our difference-in-differences estimator indicates that after 1998, smaller funds significantly outpaced larger funds in their acquisition of IPOs ranking in the top quartile of illiquid IPOs for the year.

Finally, we examine why the Panic of 1998 might have had such long-lasting effects on the small IPO market. We theorize that the flight away from small IPOs in 1998 due to concerns about small IPO illiquidilty likely contributed to a vicious cycle of illiquidity-begets-illiquidty for small issuers. That is, becaue liquidity itself is a function of investor demand, the rapid withdrawal from this market of funds controlling over 90% of mutual fund assets could only aggravate the illiquidity of small IPOs, further deterring large fund investors. Consistent with this theory, we find that while the median illiquidty of small IPOs declined with the overall market through 1998, this pattern reverses itself in subsequent years. By early 2002 the median small IPO had moved from being in the third quartile of market illiquidity to being solidly in the fourth quartile, thereby representing some of the most illiquid exchange-traded securities. The median illiquidity of larger IPOs, in contrast, generally reflected the decline in illiquidity within the general equities market since 1990.

At their most general level, these findings provide compelling evidence that policy proposals aimed at reversing the sustained absence of small IPOs since 1998 are unlikely to succeed without careful attention to the diminished demand for small IPOs among the largest mutual fund investors. These findings also highlight the considerable hurdles standing in the way of any such policy enterprise. That is, the accelerated rate at which the largest mutual funds have grown in AUM since the 1990s has only heightened for these funds the liquidity risk associated with investing in small IPOs. As such, secular changes in the structure of the mutual fund industry may accordingly impede anything resembling the pre-1998 market for small IPOs. Nonetheless, our findings suggest that “supply-side” reforms to the small IPO market are likely to be most effective when coupled with reforms that encourage large fund investment in small IPOs despite the liquidity risks they pose. For similar reasons, they also emphasize how pending efforts to enhance the liquidity of mutual funds, such as the SEC’s September 2015 proposal to require Liquidity Risk Management Programs for open-end mutual funds, may inadvertently impose significant barriers for small company capital formation.

The full paper is available for download here.

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