Prior studies focusing on the U.S. market show that underwriters favor certain institutional investors in IPO allocation due to various reasons explained by book-building hypothesis (e.g., Benveniste and Spindt, 1989; Benveniste and Wilhelm, 1990; Spatt and Srivastava, 1991 etc.), agency problem based hypothesis (e.g., Loughran and Ritter, 2002; Reuter, 2006; Ritter and Zhang, 2007 etc.) and so on. In this study, we examine if and how the strength of prior business relationship between underwriters and institutional investors affects IPO initial allocation in Korean market. To address the issue, we use monthly mutual fund holding information and IPOs listed in KOSDAQ market during 2002 to 2012. To our best knowledge, this is the first study that examines the IPO initial allocation in Korean market. Studies on IPO allocation generally suffer from data availability since the allocation data is not publicly available. They all used either quarterly or semi-annual mutual fund holding information to proxy for initial IPO allocation to institutional investors, which has clear limitation. We try to overcome the data limitation by using monthly mutual fund holding information for the first time in the literature and applying additional screening procedures to identify initial IPO allocation to mutual funds. We measure the strength of prior business relationship by (1) the total investment amount by each mutual fund in IPOs underwritten by each underwriter, (2) the number of participation by each mutual fund in IPOs underwritten by each underwriter, and (3) the average investment amount by each mutual fund in each IPO underwritten by an underwriter, based on prior one and two years of IPO participation information by each mutual fund.
We find that about 78.4% of our IPO sample was allocated to mutual funds at the time of IPOs. The results show that underwriters allocate more IPOs to funds with stronger prior business relationship, especially when IPOs are more underpriced (positive initial returns). On the other hand, when IPOs are overpriced (negative initial returns), mutual funds with stronger prior relationship receive relatively less IPOs. On average, the higher institutional investors’ demands are, the smaller IPO allocation to individual fund is. However, even in IPOs with higher institutional investors’ demands, mutual funds with stronger prior business relationship receive relatively more IPO allocation.
In addition, consistent with Sherman and Titman (2002), we find that mutual funds that were allocated with overpriced IPOs (or IPOs with negative initial returns) in the past receive more underpriced IPOs in the current allocation. Park et al.(2011) argues that there is a higher probability that Korean securities firms allocate IPOs underwritten by themselves to their affiliated mutual funds. We find that underwriters, on average, allocate less IPO shares to affiliated funds. For underpriced IPOs, however, they allocate more shares to affiliated funds, which is consistent with the conflict of interests argument. Overall our results indicate that underwriters favor regular investors with stronger business relationship in IPO allocation in Korean market.