What determines institutional investors' holdings in IPO firms?

• Published date: 01 December 2021
• Author: Allen Michel,Jacob Oded,Israel Shaked
• Date: 01 December 2021
• DOI: http://doi.org/10.1111/irfi.12326

ORIGINAL ARTICLE

What determines institutional investors' holdings

in IPO firms?

Allen Michel

1

| Jacob Oded

2

| Israel Shaked

1

1

Questrom School of Business, Boston

University, Boston, Massachusetts

2

Coller School of Management, Tel Aviv

University, Tel Aviv, Israel

Correspondence

Jacob Oded, Coller School of Management,

Tel Aviv University, Tel Aviv, Israel.

Email: oded@tauex.tau.ac.il

Funding information

Ackerman Chair in Corporate Governance;

Back Bay Management Corporation; Henry

Crown Institute of Business Research; Jeremy

Coller Foundation; Raya Straus Center of

Family Business Research

Abstract

We investigate the manner in which institutional investors'

investments in IPO firms are related to IPO characteristics

and pre-IPO operating performance. We find that institu-

tions' initial holdings are strongly related to the public float

(the fraction of shares floated to the public), but are

unrelated to the ratio of primary-to-total shares issued. This

suggests that institutions prefer IPOs that are associated

with ownership structure change, and are indifferent to

whether the motivation behind the IPO is fund raising or

original owners' value liquidation. Moreover, initial institu-

tional holdings are unrelated to commonly used measures

of pre-IPO operating performance such as return on sales

and return on assets. We also find that institutions are pre-

disposed to invest in value firms rather than growth firms.

KEYWORDS

agency, equity issuance, institutional investors, IPO, operating

performance, ownership structure, public float

JEL CLASSIFICATION

G20; G30; G32

1|INTRODUCTION

The IPO sets the stage for the firm's future growth and sustainability. It provides capital to successful young firms

and enables the firm to leverage its scale of operations. Investors are able to share in the firm's success while letting

entrepreneurs off-load some of the risks and liquidate value. Typically, IPOs are associated with a major change in

the firm's ownership structure and provide voting power to new investors. Companies globally raised $221.6 billion

Received: 11 September 2018 Revised: 5 March 2020 Accepted: 1 July 2020

DOI: 10.1111/irfi.12326

© 2020 International Review of Finance Ltd (IRF)

1302 International Review of Finance. 2021;21:1302–1333.wileyonlinelibrary.com/journal/irfi

in 2018, up from $1.3 billion in 1980.

1

It is therefore not surprising that IPOs have been of great interest to

researchers of corporate finance. Indeed, various aspects of IPOs, including short-term and long-term price and oper-

ating performance, have been investigated extensively.

One important investor group that intensively engages in IPOs, and has also grown dramatically over recent

decades, consists of institutional investors (pension and mutual funds, insurance companies, etc.).

2

Institutional

investors are deeply involved in the book-building process, they are given priority in allocations, and their allocations

have been shown to be related to first-day returns (Aggarwal, Prabhala, & Puri, 2002; Brown & Kovbasyuk, 2017;

Jenkinson & Jones, 2004; Jenkinson, Jones & Suntheim, 2018; Ritter & Welch, 2002). They also trade aggressively in

the stock right after the IPO (Aggarwal, 2003; Boehmer, Boehmer, & Fishe, 2006; Hanley & Wilhelm, 1995 and

Krigman, Shaw, & Womack, 1999). It is also generally the investor group that takes the lead in shareholder activism

and monitoring of the firm (Aggarwal, Saffi, & Sturgess, 2015; Cornett, Marcus, Saunders, & Tehranian, 2007; Gillan &

Starks, 2000; Smith, 1996 and Stoughton & Zechner, 1998).

The economic significance of IPOs as a corporate finance tool on the one hand, and institutions as a major

investment group on the other hand, has stimulated studies about the manner in which institutions invest in IPO

firms. Yet, the focus of existing empirical investigations is information. Specifically, existing studies consider the man-

ner in which institutional investors exploit private information through their IPO allocations, their trades in the finan-

cial markets right after the IPO, and their gains based on stock price performance. Interestingly, to our knowledge

there has not been an earlier systematic inquiry into institutional investment in IPO firms for performance-based

value enhancement rather than short-term information-related stock market gains. Given the well-documented gov-

ernance power and skill with which institutional investors are equipped and their tendency to engage in activism on

the one hand, and the significant ownership structure change that IPOs engender on the other hand, one would

expect that institutional holdings will also be related to their ability to enhance operating performance.

In this study, we wish to investigate what determines institutional investor holdings (henceforth “II holdings”or

“institutional holdings”) immediately after the IPO. Moreover, unlike the earlier literature, we are not interested in

the manner in which they explore their information advantage to realize quick trading gains, but rather, we seek to

characterize the IPO firms in which they invest. Accordingly, the explanatory variables we focus on are IPO and firm

characteristics. Furthermore, unlike the earlier literature, we do not focus on the dynamics of institutional holdings

before and around the IPO. Instead, our investigation starts after the flipping and trading around the IPO date sub-

side. Most flipping (the practice of buying shares at the IPO and selling them in the market right afterward) happens

within the first few days after the IPO; see, for example, Aggarwal (2003), and Chemmanur, Hu, and Huang (2010).

With “IPO characteristics,”we relate to two important properties of IPOs: change of ownership and fund raising.

Accordingly, the IPO characteristics we consider are the ratio of shares sold to shares outstanding (henceforth, the

“public float ratio,”or the “public float”) and the primary-to-total shares sold ratio. The first IPO characteristic, the

public float ratio, is a measure of the ownership structure change. The higher the public float, the more significant

the ownership structure change and the dilution of the old shareholders' control. The second IPO characteristic,

primary-to-total shares sold ratio, captures the relation between primary and secondary shares in the public float.

Total shares sold include both primary shares issued and secondary shares sold. Primary shares are new shares issued

to the public, the proceeds of which go to the firm, while secondary shares sold are old shares sold to the public, the

proceeds of which go to the old shareholders, not the firm. The higher the primary-to-total shares ratio, the higher

the fundraising nature of the IPO. For example, Netscape's IPO was 100% percent primary shares (primary-to-total

ratio of 1) and hence all the funds raised went to the firm; Google's IPO was 100% secondary shares (primary-to-

total ratio of 0), and hence none of the funds raised went to the firm, but rather all went to the selling shareholders.

If the shares that Netscape sold were secondary shares rather than primary shares, control dilution would have been

higher, and if the shares that Google sold were primary shares rather than secondary shares, control dilution would

have been lower. In Section 3, we provide a numerical example that further demonstrates that it is the public float

that captures ownership structure change (original owners' control dilution) that gives institutional investors ability

MICHEL ET AL.1303

to impact governance, and that the ratio of primary-to-total shares issued captures both the fund-raising nature and

the control dilution nature of the IPO.

Our motivation of studying the link between the public float and institutional holdings is also driven by two

aspects documented in earlier empirical literature:

1. Institutions prefer large liquid stock (Gompers & Metricks, 2001; Schwartz & Shapiro, 1992), and it is the high

public float that creates liquidity (Ding, Ni, & Zhong, 2016; Hahn, Ligon, & Rhodes, 2013; Huyghebaert & van

Hulle, 2006 and Zheng & Li, 2008).

2. Similarly, it is the long-run horizon of institutional investors that drive high returns from governance (Gaspar,

Massa, Matos, Patgiri, & Rehman, 2013 and Harford, Kecskes, & Mansi, 2017) while at the same time high public

float is associated with positive long-run returns (Brau, Li, & Shi, 2007 and Michel, Oded, & Shaked, 2014).

Because our focus is investment to hold rather than flip or exploit private information, the firm characteristics

we focus on as explanatory variables are measures of pre-IPO operating performance. Here, we utilize commonly

used measures of pre-IPO operating performance: return on sales, return on assets, and return on assets-less-cash

(i.e., assets net of cash holdings). For robustness, we consider not only naïve operating performance, but also abnor-

mal operating performance relative to industry peers. While abnormal return is a standard measure for stock perfor-

mance, we also consider abnormal operating performance relative to industry peers (see, e.g., Jain & Kini, 1994, for

alternative adjustments of operating performance). Another commonly used operating performance variable that we

consider is post-IPO market-to-book ratio. We control for firm size and leverage in the year prior to the IPO as they

have been shown to be related to performance. Following Megginson and Weiss (1991) and Field and Lowry (2009),

we also control for firm age at the time of the IPO and for VC backing as these variables have been documented to

affect institutional holdings of IPO firm shares.

We find that immediately following the IPO, institutional holdings as a fraction of outstanding shares are

strongly related to the public float. That is, our findings suggest that institutions prefer IPOs that are associated with

a significant ownership structure change, perhaps because in these IPOs they can have more impact on governance.

We stress that this relation holds also after controlling for size, leverage, firm age, and VC backing. In particular, it is

well known that institutions prefer large firms, and hence controlling for size is important. Indeed, we find that insti-

tutional holdings are positively and strongly related to size. Nevertheless, the relation between institutional holdings

and the public float remains strongly significant regardless of the control variables used.

Interestingly, after controlling for size and leverage, we find no relation at all between primary-to-total shares

issued ratio. This, in turn, suggests that when coming to choose the IPO firms they invest in, institutions care mostly

about the degree to which ownership structure changes the IPO, reflecting their ability to impact the company. They

care less about whether the entrepreneurs are raising funds for the firm or exercising to realize value.

We also find that institutional investment is unrelated to pre-IPO operating performance. This result holds for all

performance variables we consider, both when we measure naïve performance and abnormal operating performance.

That is, institutional investors do not care if the firm has performed well before the IPO or not. Perhaps this is

because pre-IPO performance is already priced in the issue. We further find institutional holdings are negatively cor-

related with the post-IPO market-to-book ratio, suggesting institutions prefer value firms over growth firms in IPOs.

Control variables firm age and VC backing have no impact on the significance of IPO characteristics and firm perfor-

mance. However, our findings suggest that while firm age is strongly significant in explaining institutional holdings,

VC backing is not.

We also track the evolution of institutional ownership over the first year following the IPO. Our variable of inter-

est is institutions as a shareholder group regardless of when they acquired their shares. Here, we document that

institutional holdings increase dramatically in the first year of the newly public firm. The average holdings of institu-

tional investors immediately following the IPO is 24%, but by the end of the first year it reaches 36%. This growth

supports the hypothesis that institutional investors who are invested in the firm by the end of the first quarter are

1304 MICHEL ET AL.