IPO Allocation

IPO allocation is the distribution of the shares offered in an initial public offering among the investors who applied for them. When an offering is oversubscribed, meaning that orders exceed the shares available, not every investor can be satisfied, and someone must decide who receives shares and in what quantity. That decision affects the price at which the shares first trade, the make-up of the new shareholder base, and who benefits from any rise in price on the first day.

In most markets the allocation to institutional investors is made by the lead underwriters, known as bookrunners, in consultation with the issuer. Retail investors, where they are included, are usually allocated by a rule set in advance. Allocation is closely tied to pricing, since both are outputs of the same book building process.

During the marketing period, the underwriting syndicate collects indications of interest from investors, each stating a number of shares and often a price limit. The bookrunners assemble these into an order book, which shows total demand at each price. The issuer and bookrunners then set the offer price and decide allocations, normally on the evening before trading begins.

Allocation in this method is discretionary. Bookrunners commonly state that they favour the following.

• Long-term holders. Investors expected to keep and add to their position, as opposed to those likely to sell on the first day.
• Early and informative orders. Investors who engaged in pre-marketing, gave price-sensitive feedback or placed orders early, which helps price discovery.
• Size and quality. Large institutions able to hold a meaningful stake, balanced against a spread of holders that will support liquidity.
• Cornerstone and anchor investors. In some markets, investors that commit before the offer in return for a guaranteed allocation, often with a lock-up.

Orders are frequently inflated in the expectation of being scaled back, so bookrunners judge real demand from experience of each investor. The syndicate usually allocates more shares than the base offer and covers the excess through the greenshoe option.

• Fixed-price offers. The price is set first and investors apply. If the offer is oversubscribed, shares are allocated pro rata, by ballot, or by a scale that favours smaller applications.
• Auctions. Investors bid a price and quantity, and shares go to the highest bidders at a single clearing price. Allocation follows a rule and involves no discretion. Auctions have been used in several countries and in a few prominent US offerings, including Google's in 2004, but remain uncommon.
• Retail tranches. Many markets reserve part of an offering for individual investors and allocate it by lottery or in equal lots. Some provide for shares to be moved from the institutional to the retail tranche when retail demand is very high, a mechanism known as a clawback.
• Directed shares. A portion may be set aside for employees, customers or other parties chosen by the issuer.

Shares in initial offerings have, on average, risen on their first day of trading, a pattern known as underpricing. An allocation in a sought-after offering is therefore valuable, and the party that hands it out holds something it can trade for favours. Academic work offers two views. One holds that discretion allows underwriters to reward investors who reveal honest information about demand, which improves pricing. The other holds that underwriters use allocations to benefit themselves and their best clients at the issuer's expense.

Abuses came to light after the technology boom of the late 1990s. In spinning, underwriters allocated shares in popular offerings to executives of companies whose investment banking business they hoped to win. In laddering, investors were given allocations on condition that they bought more shares in the market afterwards, pushing up the price. These practices led to regulatory settlements, litigation and new rules.

In the United States, rules of the Financial Industry Regulatory Authority prohibit the sale of new issues to accounts in which broker-dealers and certain other restricted persons have an interest, and ban spinning and arrangements that tie allocations to excessive compensation or to aftermarket purchases. The Securities and Exchange Commission treats laddering as manipulation. In the European Union and the United Kingdom, rules under MiFID II require investment firms to have an allocation policy, to manage conflicts between the issuer client, investor clients and the firm's own interests, to involve the issuer in the process, and to keep records justifying each allocation. Firms may not allocate in return for disproportionate fees or other business.

The basis of allocation is described in the prospectus, and results for retail tranches are usually published. Some jurisdictions prescribe the split between investor categories and the method for retail allocation in detail, leaving discretion only for the institutional portion.

Allocation shapes early trading. A concentrated allocation to long-term holders leaves few shares available and can produce a sharp initial rise followed by thin liquidity, while a wide allocation to short-term traders can lead to heavy selling, known as flipping. Price support under the stabilisation mechanism interacts with allocation, since the extra shares allocated create the short position the stabilising manager uses. Dealings begin once listing admission is effective, and the wider process is set out under primary market issuance.