Hedge Funds and Their Prime Brokers: Favorable IPO Allocations

Abstract

Do hedge funds receive special treatment from their prime brokers in initial public offering (IPO) allocations? Using a comprehensive dataset, the authors examine investment banks’ allocations of IPOs to their hedge fund clients. They find that investment banks/prime brokers that have business relationships with hedge funds tend to allocate more IPOs to those hedge funds when the banks are the lead underwriters. Moreover, the size of allocation to hedge funds is larger when IPOs are underpriced, and allocations are larger during bear equity markets. The authors document that younger funds or funds with recent poor performance tend to receive relatively larger allocations of underpriced IPOs. The size of these allocations is determined by the strength of the funds’ relationships with their prime brokers, rather than by the level of their managers’ skill. This is supported by the finding that, even after receiving relatively large allocations of underpriced IPOs, these funds fail to generate significant alphas. <b>TOPICS:</b>Security analysis and valuation, exchanges/markets/clearinghouses, real assets/alternative investments/private equity, performance measurement <b>Key Findings</b> ▪ Investment banks that act as prime brokers for hedge funds and are lead underwriters of IPOs tend to allocate larger amounts of underpriced IPOs to their hedge fund clients. ▪ Investment banks tend to allocate a larger amount to their clients during bear equity markets, with younger funds and those with poor recent performance receiving relatively larger allocations. ▪ Investment banks reward those clients that have stronger relationship with them. The skills of hedge fund managers do not drive the favorable allocations.