What is Reallowance
A reallowance is a fee paid to a securities firm which is not part of the underwriting syndicate bringing a new offering to the market. The underwriting group pays the reallowance fee. The fee provides an incentive to broker-dealer firms to sell shares of the new issue to its client base. The amount of the reallowance is typically a percentage of the underwriting spread.
BREAKING DOWN Reallowance
Most often, a reallowance happens when there is uncertain investor demand. The underwriting syndicate may wish to enlist an additional broker's to increase demand in the underlying shares of the new issue. The underwriting banks will set the reallowance bonus as a portion of the spread they receive for bringing the offering to market. The offering may be an initial public offering (IPO), debt security, or the release of additional shares of a traded company.
During underwriting, the issuing company will sell the new offer shares to the underwriters at a reduced price. The difference between the reduced price and what the share will earn at the market is the spread, which belongs to the underwriting banks. The reallowance can be a set percentage of the spread or might have a range of prices, based on the number of the new issue shares the non-syndicate broker sells.
For example, BigBag Holdings is going public, and the new issue shares have a market price of $30. The underwriting group reduced price is $27 for the shares. The reallowance fee is 25% of the spread, which is $0.75 per share.
Regulators require that such reallowances be disclosed in securities offering documents so that investors know in advance of such incentives.
Mutual Fund Reallowance can Sway Investors
Mutual funds often use reallowances as an added incentive to encourage brokers and dealers to sell shares of these funds to clients. Although disclosure of these fees should be in the fund’s regulatory documents, and usually do not add to the share price, the practice can encourage investment advisers to promote one fund over another. Given a choice of two funds, equally appropriate to an investor, the extra incentives received from one underwriting syndicate may sway a decision on which fund to recommend to the client.
Although reallowances do not impact the price of the cost of the new shares to investors, they do represent how various sales charges or loads are distributed and allocated to participating brokerage firms and dealers. The practice can be controversial if investors are not aware that selling brokers are receiving extra compensation.
Reallowances are common when funds are first introduced by new firms which have not yet established a relationship with the investment community. These incentives may encourage brokers to review the fund closely, and the broker may end up bringing the fund to the attention of clients. Even well-known and established mutual fund companies may use reallowances for funds that feature new investment strategies, approaches, or introduce new specialized sector funds.
There can also be a seasonal trend in reallowances. Because investors can make tax-deductible IRA contributions after the end of a tax year, but before the April 15 tax filing deadline, many choose to make contributions during the first three months of the year. This influx of funds into the market creates additional investor demand for investment opportunities.