What Is Reallowance?
A reallowance is a fee paid to a securities firm that is not part of the underwriting syndicate that is bringing a new issue to market. This fee, which the underwriting group pays, 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.
- In the field of securities underwriting, reallowance is a reference to the payment that an underwriting group pays to a securities firm that is not part of the combined group, but who is selling shares in the offering regardless.
- The issuing company gives the underwriters shares of the new offer at a lower price than what the shares will earn in the market. The difference between the two prices is the spread, which the underwriting banks can benefit from.
- The reallowance is either a percentage of that underwriting spread or a specific price based on how many shares the non-syndicated broker sells.
- Reallowances are often in effect as a means of increasing investor demand when that demand is uncertain.
Most often, a reallowance occurs when there is uncertain investor demand. The underwriting syndicate may wish to enlist additional (non-syndicate) brokers 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 the underwriting process, 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 in the market is the "spread," which belongs to the underwriting banks. The reallowance can be a set percentage of the spread, or it might have a range of prices based on the number of new issue shares that the non-syndicate broker sells.
A reallowance is essentially a commission that an underwriting firm pays a securities firm to market and sell shares of a new issue to its clients.
To illustrate an example, assume BigBag Holdings, a fictitious company, is going public, and the new issue shares have a market price of $30. The underwriting group's reduced price for the shares is $27. The reallowance fee is 25% of the spread, which is $0.75 per share.
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 for an investor, the extra incentives received from one underwriting syndicate could sway a decision about which fund to recommend to the client.
Although reallowances do not affect the price 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 that have not yet established a relationship with the investment community. Incentives like these 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 which introduce new specialized sector funds.
There can also be a seasonal trend with reallowances. Because investors can make tax-deductible individual retirement account (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.