The Marketing of Closed-End Fund IPOS: Evidence from Transactions Data

 Essence of the article

We examine aftermarket transactions for closed-end fund IPOs and document large sell-to-buy imbalances ("flipping"), extensive price stabilization, and sharp subsequent price drops. The timing of the price drop is related to both the amount of initial flipping, and use of the over-allotment options.

 The extent of the flipping activity is related to the composition of the syndicate. Moreover, aftermarket buys (sells) are mainly small (large) trades. These findings suggest that lead underwriters price stabilize and manage the supply of shares in the aftermarket, and that closed-end fund IPOs are marketed to a poorly informed public.

 The Author's feel

The authors also provide evidence that underwriters manage the cost of stabilizing by creating a net short position in the number of shares issued during the pre-market. Selling imbalance in the first few trading days has predictive power for the timing of subsequent price decline: the faster the short position is covered through stabilizing purchases, the sooner the price drops. Funds that exercise the over-allotment option experience longer stabilization periods. The authors document that seller-initiated trades are both larger and more profitable than buyer-initiated trades in the after market period. Small investors who buy shares in the aftermarket engage in open market transactions that they believe are at unencumbered prices. The authors believe that their findings support a marketing hypothesis for closed-end fund IPOs. To protect their reputation and improve the likelihood of a successful offer, lead underwriters promise to stabilize prices in the aftermarket, essentially granting free put options with a strike price equal to the offer price.

 The stabilization bid provides the opportunity for some syndicate members to sell large blocks to flippers during the pre-issue period. The number and size of sell orders in the first few days of trading show that a sizable number of these traders exercise this options and flip their shares back to the syndicate. The size of the trades suggest that they are small, retail customers.

 The legality of this scenario appears to be within the guidelines of current securities regulation The authors speculate that flippers are wiling to participate because of other inducements they receive through their ongoing relationships with underwriters. On the cost side, underwriters may incur significant costs from flipping and protracted stabilization. However, the cost of stabilization may well be offset by the benefits of assuring a successful initial distribution. Small investors face substantial information processing costs and may be highly susceptible to "marketing" tactics. The authors believe their findings raise questions about the adequacy of current disclosure rules for IPOs, and the propriety of securities regulation that permit short term stabilization in closed-end fund IPO aftermarkets