The revelation that former Worldcom executives received large allocations in hot IPOs has raised old concerns about the way that investment banks dole out shares in new issues. Bernie Ebbers, the former CEO of Worldcom, received allocations that generated a profit in excess of $10 million, largely because of the large price 'pop' on the first trading day. The difficulty that small retail investors had in receiving any IPO allocations at all highlights the reality that not all investors are created equal. The investment bank at the center of this IPO controversy, Salomon Smith Barney, denies that the allocations were designed to win the firm additional investment banking business from Worldcom, a practice known as spinning. Rather, according to SSB, the allocations to Worldcom execs were justified because the individuals were loyal, high net-worth clients.
The recent settlement between the New York state Attorney Generals' office, the SEC, NYSE, and Nasdaq with a dozen major investment banks is designed to resolve the conflict of interest problems afflicting the research departments at the banks. As part of the settlement the practice of spinning was also banned, in a further attempt to remove any hint of unfair practices at the banks. To some critics this small reform to the IPO process is only the first step in a necessary overhaul in the way shares are allocated in IPOs. During the glory days of the bull market there were rumblings that small retail investors were not given a fair chance at receiving shares in an IPO. The moribund state of the IPO market has caused that chatter to die down, but it is likely to resurface once the market recovers.
Are Auctions the Answer?
The reform of barring executives of potential banking clients from receiving IPO allocations does not seem to go very far in changing the IPO allocation rules. Wealthy investors who offer no potential banking business are still most likely to be favored simply because they generate more revenue. Nothing short of a complete change that opens up the allocation process so all investors are treated equally and fairly would be sufficient to some observers.
Before rushing to make changes for their own sake, it is worth asking whether the current system is really unfair and if potential changes will improve matters. The complaint that small retail investors are shut out from the IPO allocation process seems somewhat misguided. Any investor who does not receive an allocation in the IPO can easily buy shares in the aftermarket. In fact, retail investors are only really being denied access to the potentially lucrative easy money to be had from the first-day price 'pop'. It is not obvious why a random retail investor is any more entitled to this quick buck than any other investor.
But if, as a matter of policy, it is decided that retail investors should have fair and equal access to IPOs, how can this be achieved? One option might be to specify that a certain percentage of the offering-- say 15 percent-- is reserved for retail investors. Of course, this solution is only a small step towards achieving the objective of fairness and equality. It still gives the investment bank discretion in the allocation of shares, with many investors left empty-handed. The only mechanism that treats all investors equally is a uniform price auction. The mechanism requires individual investors to bid for a specific number of shares and to stipulate a maximum price he is willing to pay. The IPO offer price is the market-clearing price; all investors who bid a price equal to or above the offer receive shares on a pro rata basis. The investment bank W.R. Hambrecht + Co. is an exception in the IPO market in that its IPOs are conduced as uniform price auctions, called Open IPO.
In principle, an auction is optimal because the price is set to clear the market; there is no underpricing, the shares go to the investors who have the highest valuations, and investors are treated equally. An immediate consequence of using an auction process is the elimination of the first-day price 'pop'-- the very reason retail investors complain about being excluded from the initial allocation. A reasonable investor will not pay more to buy shares in the aftermarket than in the auction, eliminating the first-day gain.
A simple example can illustrate why an auction may not improve matters for retail investors. Suppose that an IPO using the current pricing and allocation method has an offer price of $10 and finishes the first trading day at $12. The aftermarket price of $12 is the equilibrium price when all investors are allowed to trade. If retail investors are excluded from the IPO allocations, their only option is to buy at $12 in the aftermarket. Now consider the outcome if an auction is used to sell the IPO. The auction price should reflect the fact that there are investors who are willing to pay $12 for a share, since we know they will in the aftermarket. The auction price will then be $12. Retail investors have a chance to purchase shares in the initial allocation when an auction method is used, but still end up paying the same $12 as before. Since an auction does not improve the situation for retail investors, they may not even want to participate in the first place.
A reasonable case could be made that an auction will be worse for retail investors than the current 'book-building' method. The perverse logic behind this conjecture is that if institutional investors no longer get special treatment from the investment bank, they have less incentive to participate in IPOs. Institutional investors face the practical problem of allocating their capital optimally among the assets in their portfolios. It does not make much sense to hold a small position of a few thousand shares in a portfolio worth hundreds of millions of dollars. If an institution cannot be guaranteed an allocation of sufficient size, it may not participate in the first place.
Auctions also eliminate the ability of the underwriter to intentionally underprice the IPO. The typical 10 to 20 percent first-day return is usually due to the bank leaving money on the table for the institutional investors. This is an outcome of an implicit quid pro quo relationship between the bank and institutional investors. The bank underprices in return for regular participation in their IPOs by the institutions and the commensurate trading commissions generated. Without the carrot of free money from underpricing, institutions may once again decide not to participate.
The lack of sufficient institutional participation in an auction may not cause problems initially, but it often does not bode well for the long-term success of the newly public company. When institutional shareholdings are low, investment banks have less incentive to cover the firm, produce research reports and issue recommendations. Interest in the stock is adversely affected, measured by the trading volume and bid-ask spread, which can keep the stock price depressed. An auction will provide retail investors with better access to IPOs, but both the short and long run returns from these offerings may not be very attractive.
The Bigger Picture
Much of the debate about reforming the IPO process involves current IPO allocation practices. However, it is important to keep in mind the overall objective of the IPO. An IPO allows a company to gain access to a large pool of cheap capital that can be used to finance the growth of its business. Government policy and regulation should be aimed at promoting mechanisms that direct capital efficiently towards high growth industries and new technologies. An optimal IPO mechanism satisfies the needs and objectives of the multiple participants in the process, including institutional and retail investors, the investment bank and of course the issuing firm.
Investors should ultimately care about designing an optimal IPO mechanism that maximizes the total wealth created. Individuals, either directly through mutual funds or indirectly in pension funds, supply the capital used by institutional investors to buy IPO shares. What individual investors lose as retail clients, they gain as investors in larger funds. Assuming that the costs and fees implied by different allocation processes are fixed, the issue of who receives IPO share allocations seems to be more of a political issue than an economic one.
An optimally designed IPO mechanism should also maximize the amount of money raised by issuing firms, and induce an appropriate number of companies to go public. It is a little ironic that a debate about an appropriate IPO mechanism is starting in the U.S. at the very moment when most other countries are implementing current U.S.-style book-building method. According to recent estimates, about 80 percent of foreign IPOs are now sold through the book-building method. In France, a country that until the early 1990s used auctions and fixed price methods to sell their IPOs, now relies almost exclusively on book-building. The same is true in Japan, which first allowed book-building in 1997 as an alternative to auctions. The adoption of book-building in these two countries was due in no small part to the active U.S. IPO market. The benefits of a vigorous IPO market extends to other parts of the economy, as there is a strong relationship between venture capital funding in start-up businesses and IPO activity.
In conclusion, an optimally designed IPO mechanism must take into account all parties affected directly and indirectly by the IPO process. Condemnation of the current system and calls for its reform needs to be tempered with an evaluation of the total impact of all proposed changes. Does the current system work perfectly at all times? Certainly not. But it does still appear to be better than the alternatives.
About The Author: Jason Draho founded IPOadvisory, an educational service on IPOs that provides investors access to the information produced by the most up-to-date academic research. He has written many articles on IPOs, and is author of the forthcoming book IPOs: Motivation, Preparation, and Performance.