Like so many Americans in the late ’90s, Laurie Krigman kept a close eye on the superheated IPO market.
Her interest, however, wasn’t from a burning desire to get in on the game–Krigman is a finance professor at Babson College in Massachusetts and a leading academic authority on initial public offerings. Like most individual investors, she said, she couldn’t have gotten her hands on the hottest shares at their offering price, even if she had wanted to.
“It’s much more fun to watch from the sidelines,” she said. “To play the IPO market as a retail investor is crazy–that much I know from my research.”
Although that’s one reason underwriters say they typically reserve scarce IPO shares for institutional investors and big clients, it didn’t stop little investors from trying to cash in. A few years ago, IPOs were part of the daily conversation for the Shareholder Nation: People desperately wanted in, but precious few did.
Now, many of the stocks that dazzled are in shambles, and the recriminations are surging.
Even though the IPO market has shriveled in recent months, the tens of billions of dollars lost–and made, possibly under dubious circumstances–have sparked investigations and a blizzard of investor lawsuits. Regulators, meanwhile, are looking at ways to prevent a repeat of the problems that have undermined the system.
About time, some experts say.
“It’s a shell game,” said Jeffrey Hirschkorn, senior research analyst at New York-based investment house Ehrenkrantz King Nussbaum and IPO Monitor.com. “Right now, the allocation process is extremely flawed.”
Indeed, much of the current attention focuses on how shares are doled out.
Securities and Exchange Commission Chairman Harvey Pitt last week proposed a high-level panel to review share allocation and pricing issues. Regulators and lawmakers are looking at some of the worst abuses of the ’90s–including brokerages using research to secure lucrative IPO business, and underwriters passing out shares in exchange for kickbacks from jacked-up commissions or to lure more business.
This week, for example, a House committee released documents from Salomon Smith Barney showing that executives and directors at one of its biggest clients–scandal-plagued WorldCom–received tens of thousands of shares in hot IPOs. New York authorities are also investigating whether former Salomon analyst Jack Grubman changed his ratings on some stocks to secure lucrative IPO business for the firm.
In the ’90s, when IPOs routinely soared on their first day of trading, access to shares at the offering price often translated into a fast–and more than tidy–profit.
Research from leading IPO authority Jay Ritter, a University of Florida finance professor, shows that from 1980-2001, IPOs had an average first-day advance of nearly 19 percent–including astonishing averages of nearly 72 percent in 1999 and more than 56 percent in 2000.
Long-term laggards
Ritter has identified 233 companies–of more than 6,300 IPOs from 1975-2001–whose shares doubled in their first day of trading; nearly 200 came in 1999 and 2000. But Ritter and other researchers found IPOs of that era have tended to underperform the market in the long run, with the biggest first-day gainers among the worst performers.
Illustrating the importance of how shares are allocated, a Tribune analysis of Ritter’s list shows that, during 1999 and 2000, roughly 20 percent of those stocks that soared out of the gate hit their all-time high on that first day of trading, and another dozen did so on Day 2–meaning that investors who were shut out at the offering price but bought in quickly after that probably lost money.
Although rules already are in place against many of the abuses–and more will surely follow–experts said the answer may well lie in disclosure.
“Nobody knows who gets the allocations,” Krigman said. “It’s a private world.”
If underwriters were forced to reveal how they distributed shares, and how long the recipients held them, it would discourage many of the practices that have made headlines, she said.
Still, even if more disclosure follows, experts say it’s unlikely individual investors will gain greater access to IPO shares.
Equally important as how shares are allocated, experts said, is how they are priced.
While the enormous first-day gains were great news for those chosen investors, they were a mixed blessing for the companies: They generated momentum and valuable analyst coverage, and could translate into millions for executives and employees with equity stakes, but they also represented vast amounts of cash that could have gone into company coffers–known as “money left on the table.”
Ritter found first-day IPO gains from 1980-2001 translated into more than $100 billion left on the table. Nevertheless, Krigman and other researchers have found most companies were satisfied with their underwriters.
Many experts see few solutions to pricing problems outside of the open auction system pioneered by San Francisco-based W.R. Hambrecht & Co. Its concept is simple enough–individual investors and institutions bid on equal footing to help set the offering price, and shares are distributed to highest bidders.
Even though it all but eliminates the prospect of leaving money on the table, few companies have signed up.
“That has us scratching our heads, too,” said Clay Corbus, a Hambrecht senior managing director, who notes many once-hot IPOs have fallen on hard times.
“I’m sure they’d love to have that cash on their balance sheet now.”
Corbus notes the current system took root more than six decades ago, and believes the current crisis offers an opportunity for real change.
As one possibility, he points to a process that incorporates open auction pricing, but allows underwriters to distribute a chunk of the shares at their and the company’s discretion.
But some experts are uneasy with the auction system.
Letting investor demand set the price of all IPOs is the “single-most destructive suggestion” to solve the current problems, said David Menlow, president of IPOfinancial.com.
“There has got to be some semblance of a financial model,” he said. “If the deals were priced to demand … we would have had $250 pricings.”
Both Hirschkorn and Menlow called the Hambrecht system “a great concept,” but Menlow said such auctions need to limit offering prices, especially in speculative markets.
Corbus noted the current IPO pricing process is “very much a black box,” and said concerns about sky-high offering prices may be missing the point.
“The market is going to set the price anyway,” he said. “Does the market set the price on the first day of trading, or does it do it at the pricing call?”
Other reforms proposed
Experts have floated other ideas to try to cut down on abuses, including steps to curb quick first-day sales, known as flipping; requirements that offering prices stay within the initial range proposed in regulatory filings; and erecting a solid wall between an underwriter’s investment banking and research operations.
But ultimately, they agree, there are no magic solutions.
Noting the difficulty in valuing new offerings, for example, Krigman said a Hambrecht-style auction method may be the only alternative.
“It’s a relationship business,” she said. “I don’t see a solution to it.”
