Initial Public Offering Patterns in Closed-end Funds

Abstract

This paper offers an explanation to the puzzle of the closed-end fund's initial public offering. We show that CEFs belong to a sub-class of investment vehicles (the other members are Real Estate Investment Trusts and Master Limited Partnerships) that has a number of unusual characteristics. For example, buyers pay the IPO costs via IPO overpricing and underwriters provide prolonged aftermarket price support. (The latter is a necessary supplement to the IPO overpricing.) We show that these characteristics are not anti-competitive, neither are they predatory. Rather, they are a by-product of the peculiar features of this sub-class. We derive the no-arbitrage price-support schedule and argue that this type of price management appears to be legal. The predictions of the no-arbitrage price-support schedule guide our empirical analyses of new-entry patterns. We collected comprehensive 1986-2000 IPO data; it shows that new CEFs concentrate in a limited number of narrowly defined asset classes. Within this reference group, there is no irrationality in the new CEF's IPO and post-IPO behavior: new entry will occur when the proposed Fund is expected to trade in the near future at a premium and when existing same-asset Funds trade at a premium. Two groups of researchers (the Lee-Shleifer-Thaler team, and Katherine Hanley-Weiss and her collaborators) pioneered the intense interest of financial economists in the peculiar behavior of CEFs. Their work (as well as that of many others) contributed to our understanding of that complicated asset class. My current work is a direct extension of their previous efforts.