What Happened in 1998? The Demise of the Small IPO and the Investing Preferences of Mutual Funds

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The decline of the small initial public offering (IPO) occurred abruptly. In 1997, the number of IPOs raising less than the inflation-adjusted mean proceeds of 1990 was nearly half of all IPOs. By 1999, this percentage had fallen to just 10%, remaining below this level for most of the ensuing decade. This paper presents a novel demand-side theory for the sudden and prolonged demise of small IPOs that focuses on the investment preferences of large mutual fund investors. We theorize that the rapid increase after 1990 in assets under management among the largest funds induced portfolio managers to take larger investment positions, heightening concerns about risk within their investment portfolios — concerns that naturally implicated smaller IPOs in light of their greater illiquidity. When global events in 1998 sparked a dramatic flight to liquidity and a surge in mutual fund redemptions, the amplified attention to risk caused demand for small IPOs to drop precipitously among the largest funds, prompting a vicious cycle of illiquidity-begets-illiquidity which has continued well past 1998. 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 central identification strategy exploits the sudden increase in concerns brought about by the Panic of 1998: an abrupt collapse in the demand for illiquid equities triggered by Russia's debt default in August 1998. Using a difference-in-differences strategy, we find that the largest quartile of mutual funds invested in more IPOs than smaller funds both before and after 1998. However, after 1998 the largest mutual funds invested in significantly fewer small IPOs and IPOs having a higher measure of illiquidity relative to investments by smaller funds, consistent with large funds being more sensitive to the risk of smaller offerings. Additionally, conditional on investing in an IPO, the largest funds also demonstrated a decisive shift towards purchasing larger, more liquid IPOs after 1998 than did smaller funds. In light of recent regulatory efforts to reinvigorate the small IPO market, our results highlight the need to consider more than supply side considerations such as regulatory burdens facing new issuers. Without first addressing the growing concerns of large institutional investors, efforts to revive the small IPO are unlikely to succeed.