Business Week e.biz -- Net Worth
Is the Street Lowballing IPOs?
Underpricing left $27 billion on the table from 1990-98
It's a rule as old as business: Do a great job, and customers come back for more; do badly, and they leave you. But when it comes to tech upstarts choosing investment banks as they prepare to go public, the old rule seems to have been forgotten. The top four investment banks--Goldman Sachs, Morgan Stanley Dean Witter, Merrill Lynch, and Credit Suisse First Boston--have seen their collective market share in investment banking rise, even though they don't seem to be doing a very good job of getting top dollar for stocks that go public.
The numbers are dramatic. The Big Four's share of the initial public offering lead underwriting market has risen to 63% from 46% since 1997. During the same period, all four have underwritten some of the most underpriced deals on the market. The average first-day gain in initial public offerings managed by Morgan Stanley hit 178% in early 2000 (through Mar. 7), up from 24% in 1997. That means the firm's clients collected a small share of the value the market placed on their stock on the first day of trading.
But other big banks aren't doing much better. Goldman pegged the price of its deals an average of 141% below what investors proved willing to pay, according to Thomson Financial Securities Data. Merrill's average deal rose 103% on Day One. And First Boston's first-day gains have been 78.5%. These kinds of big advances have become signs of success, not failure, which irritates Vinod Khosla, a general partner at venture capital firm Kleiner Perkins Caufield & Byers: "The banks even go out and tell clients how much they underpriced. It blows my mind."
And the damage is mounting up. According to scholars at Notre Dame and the University of Florida, IPO companies left $27 billion on the table between 1990 and 1998 because of underpricing by their underwriters. In those years, the average IPO rose only 14% on the first day of trading. Last year, the numbers exploded. Florida finance professor Jay Ritter says that 1999 deals that doubled on the first day topped 110--compared to 39 in the previous 24 years combined.
Why is pricing so far off the mark? Critics like Ritter say underwriters would rather please their institutional investor clients than give IPO companies a bigger cut. Large investors who get to buy at the offering price enjoy the benefit of a first-day runup. But there's a double whammy for startups: A study of IPO performance last year in the Journal of Finance showed that for stocks launched between 1988 and 1995, those that increased more than 60% on the first day were the worst performers over time.
You would think that startups wouldn't put up with this. But you would be wrong. "The economic analysis says companies should switch if there's too much underpricing, but that isn't it at all," says study co-author and Dartmouth College business professor Kent L. Womack, a former Goldman, Sachs & Co. executive. In fact, startups seem to ignore pricing, and choose their underwriters based on an entirely different set of criteria. The ability to help grab media attention is near the top of the list. "These days an IPO is a branding event," says Mark L. Walsh, CEO of Vertical-Net Inc., a business-to-business e-commerce portal whose stock nearly tripled on IPO day in February of last year. "I was interviewed on CNBC and you don't get that unless there's a first-day pop," he says.
Underwriters with powerful brands of their own have the best shot at creating buzz for their clients. According to Womack's survey of 62 companies that went public between 1993 and 1995, when startups switched underwriters for secondary offerings, they typically traded up to firms with tonier reputations--like Morgan, Goldman, Merrill, and CSFB.
Being associated with one of the white-shoe firms brings instant credibility to upstarts that typically have very short track records. Wall Street's giants can afford to employ large research and marketing staffs that track and promote a company's stock. They're particularly good at attracting attention to a stock on IPO day--boosting its chances for a strong takeoff.
But it's not clear that good PR is paying off for startups. Says Ritter of Akamai, an upstart with technology that eases congestion on the Net: "Akamai got a lot of publicity, but only $200 million in cash. But $600 million would have bought a lot of advertising." Dozens of e-tailing and Web media companies, which depend most heavily on branding, have stocks trading way below where they closed on IPO day.
Underwriters defend their IPO track records. They argue that the New Economy requires a less quantitative vision of what an investment bank does. More than simply raising money for the short term, they argue, an IPO banker's job is to position companies for a longer run in the public markets. Some even argue that with Net business models still in flux, Wall Street analysts should be valued more for their ability to grasp a vision than their skills at crunching numbers. "Issuers are looking for analysts who are good storytellers," says Paul E. Chamberlain, co-head of Morgan Stanley's West Coast technology investment banking group.
That doesn't mean newly public companies are easy to please, though. They often switch underwriters for their second offerings. More than 50% of the companies surveyed by the authors of the Journal of Finance study said they were only "relatively happy" with the IPO underwriter, and nearly one-third switched when they did a secondary deal. Even stellar stock performance over time doesn't guarantee loyalty. Of the 20 best-performing high-tech IPOs since 1997, five companies switched underwriters for a later deal. Tellingly, the companies whose IPOs were priced the lowest by their investment bankers have virtually all stood by their banks. They include Morgan Stanley client Vignette Corp. and Goldman loyalists eBay Inc. and DoubleClick Inc.
Why doesn't pricing matter more? Partly because CEOs market their shares over time, not just on the day of the IPO. That makes initial pricing less important. Vertical- Net's Walsh says companies can make up the money later, in a second offering at a higher price. He argues that it helps startups to have institutional investors on their side--even if that means a lower IPO price.
Typically, CEOs of startups whose IPO shares were underpriced don't fault the underwriters. They blame volatility instead, and say pricing low is a safe approach. "You don't know how much of it is being driven by day traders," says Commerce One Inc. CEO Mark B. Hoffman, who stuck with a $21 price despite the knowledge that the underwriting group led by First Boston had received 25 orders for each available share. The stock nearly tripled on its first day.
Still, a sizable number of newly public companies trade up to a more glittering underwriter when they go back to the market for secondary offerings--even when their stocks performed well during and after the IPO. For example, Network Solutions added Morgan Stanley to a team first headed by Hambrecht & Quist. "You ask yourself, how do we become a top-tier Internet company?" says Network Solutions chief financial officer Robert J. Korzeniewski. "Look at the top 25 and ask yourself how many are with Morgan and Goldman? It's a very high percentage."
Perhaps it's not that surprising that Net companies base investment banking decisions on image more than how effectively banks initially raise money. After all, on the Web, swapping early losses for long-term hopes is a way of life. But if expected shakeouts in dot-com industries arrive, some companies may wish they had grabbed the money while they could.By Timothy J. MullaneyReturn to top