Beware The Ipo MarketPhillip L. Zweig and Leah Nathans Spiro
Vermont Teddy Bear Co. in Shelburne, Vt., makes teddy bears, some of which actually say, "I love you." But when the company went to Wall Street, the message wasn't "I love you." It was "Buy our stock." Last Nov. 23, Vermont Teddy Bear went public in an initial public offering at a price of $10 a share. The stock that day quickly zoomed to $19. But for most of the small investors who wanted in on the deal, the $10 price was illusory. Most had to pay upwards of $16 during the first two weeks after the offering.
Those who did made a big mistake. In early December, Vermont Teddy Bear stock started declining steadily, and by Mar. 22, despite strong earnings, it was back to $9.75 What happened? "If I knew, I would be lying on a beach," says a company spokesman. Whatever the case, investors, probably pros, who bought at $10 at least have come out even. But the little guys who came in late are big losers.
LUCRATIVE DEALS. That's the way that things hften work in the IPO game, especially over the last several years as IPOs have produced a lush flow of lucrative deals. It's an open secret on Wall Street that when it comes to hot IPOs, most small investors stand little chance of playing the game, much less winning. But the Wall Street firms have done a much better job of guarding the mechanics of an informal but effective system of selling IPOs that is skewed heavily in favor of institutional investors and other professionals. "The IPO market is definitely rigged. It's rigged against the average investor," says Lynn A. Stout, professor of securities regulation at Georgetown University Law Center.
Wall Street syndicate managers estimate that institutions get to buy about 60% of the typical IPO deal and as much as 80% of the shares of certain hot deals.
As the most active IPO buyer, the biggest beneficiary of the system is Boston's Fidelity Investments, the largest mutual-fund company.
"After the institutions graze the market, there isn't a whole lot left," says John Markese, president of the American Association of Individual Investors. "We've basically suggested that if you can get [some shares in an offering], you probably don't want it." In allocating the relatively small portion of hot issues to be sold to retail clients, internal politics, gamesmanship, favoritism, and a variety of quid pro quos are the order of the day.
The so far ill-fated Vermont Teddy Bear offering was underwritten by Barington Capital Group Ltd., a small New York investment banking boutique. But even in much more successful deals sold by major Wall Street firms, the small investors usually have little chance of getting in on the ground floor.
Take the IPO for Amway Asia Pacific Ltd., which went public on Dec. 14, 1993. To Wall Street, it had the smell of a blockbuster: Armies of fervent Amway salespeople poised to start selling household cleaners, cosmetics, and vitamins in a China hungry for consumer products. Orders for 15 times the available supply of stock poured in to lead underwriter Merrill Lynch & Co. Shares began trading at the offering price of 18 and closed that day at 285 8, a 59% rise. On Mar. 22, it was selling at 41.
What were the chances of getting shares at the $18 offering price? If you were an Amway distributor or employee, you had a good shot at a sliver of a 600,000-share "set aside," or 7.5% of the deal. Institutional investors scarfed up 51%. While 41% was targeted to retail investors, some portion was likely acquired by professionals who specialize in selling their shares shortly after the offering. For the average individual investor, well, forget about it. Merrill Lynch offices got just a few hundred shares each. Says Thomas W. Eggleston, Amway Asia's chief executive: "A number of very small investors were able to get in at 26 to 30." Despite Amway's efforts to include small investors, for the little guy to get shares at 18, Eggleston admits, "it was difficult." Merrill, however, says it sold Amway Pacific stock at 18 to 6,627 retail investors.
Getting a hefty slice of the best offerings is only part of the advantages that institutions enjoy. They also have much more flexibility in trading their shares. Giving big investors a better break, of course, is not illegal or even unethical. And the biggest institutions, such as Fidelity Investments, use their clout on behalf of small investors. But some aspects of the big investors' favored position, such as their access to privileged information, raise questions.
IPOs have become one of the few remaining financial candy stores of the 1990s. With the Casino Society of the 1980s in eclipse, IPOs still hold out the promise of a quick buck for those favored investors who know how to play it. Access to a nearly guaranteed profit has become a new kind of currency used by brokers, underwriters, and issuers to reward good customers.
EVEN DIVISION. Wall Street underwriters certainly don't see it this way. They say that they go to great lengths to make sure the issuer is happy with the performance of its IPO. And they also claim they try to divvy up stock fairly to their retail and institutional investors. "At Merrill Lynch, we sell every stock to our retail customers," says Thomas W. Davis, managing director of equity capital markets at Merrill Lynch, which in 1993 underwrote three times as many IPOs as their nearest competitor. Often 40% of IPOs are set aside for retail investors, such as Monterey Pasta Co., which earmarked 75% of its 12.3 million offering for small investors. Other Street executives admit institutions get a break. But they say that's because institutions are the biggest buyers and holders of blocks of IPOs. Institutional participation in an IPO is critical to its success.
And even the market's critics agree that the U.S. IPO market is the envy of the world. In 1993, underwriters raised a record $57.5 billion for fledgling companies, up sharply from $40 billion the year before. "The IPO market is the most efficient allocator of capital ever devised in the world," says Chairman M. William Benedetto, of Benedetto, Gartland & Greene.
Yet all that said, the market still has some serious systemic flaws. In a two-month investigation involving dozens of interviews with brokers, hedge funds, syndicate managers, issuers, institutional investors, securities lawyers, and other key actors, BUSINESS WEEK found:
-- Institutional investors get better information during IPO offerings than individual investors get. Institutions are invited to attend elaborate "road shows" that promote the offering. There, officials often disclose important details about the company and the deal, investors say. Individuals are usually barred from road shows and must rely mainly on the prospectus.
-- The IPO "gray market," in which underwriters solicit orders for shares from investors before the offering, enables institutions to predict with some precision at what price a new issue will trade on opening day. Although there are news services that report on the IPO market, small investors seldom have direct access to the information institutions have.
-- Firms use devices called "syndicate penalty bids" to artificially prop up the post-offering prices of weaker issues--devices that go beyond routine market stabilization--and keep small investors in those deals even when the deals are stumbling. These restrictionsare less strictly applied to institutional investors.
-- Brokerage firms have special systems to penalize small investors and retail brokers who "flip" IPOs--turning a quick profit by selling hot IPOs immediately. But the Street allows institutional customers to flip with relative impunity.
At the retail level, some brokers claim, there are questionable practices, including favoritism, in the allocation of shares to brokers and clients. Brokers sometimes push less desirable high-commission deals on customers to boost their own chances of getting the hot ones and offer shares in attractive deals only to favored customers.
Last summer, the Securities & Exchange Commission launched an informal inquiry into the IPO market, including aftermarket performance and sales and trading practices. A team from the agency's market regulation unit questioned many key players. According to a senior official, the SEC so far has not uncovered pervasive "abuses," but the inquiry is continuing.
Perhaps the major advantage institutions enjoy in the IPO game is information. In addition to the prospectus, the main place where institutions get key information is from the road shows and one-on-ones with company management. Most underwriters exclude individual investors from these affairs, which are held at such places as New York's Plaza Hotel or "21" Club. For example, San Francisco-based Montgomery Securities says that its road shows are "only open to our institutional clients."
Underwriters also often bar the press from road shows, on the grounds that articles based on the road show could cause the SEC to question whether the company is soliciting publicity. But Louis Lowenstein, a law professor at Columbia University, sees things differently. "If the press is kept out," he says, "it makes you wonder if what's going on is consistent with the spirit and letter of the Securities Act of 1933." Securities lawyers say SEC rules don't bar the press from road shows.
KICKING TIRES. Institutional representatives who do attend often find them very informative. William M. Osborne III, president of McKinley Capital Partners Ltd., a $100 million fund that specializes in investing in IPOs and secondary offerings, says information he gleans from road shows is a key part of his decision to invest. "You get a chance to meet management and kick the tires," he says.
One big difference between the information in the prospectus and that available at the road show is that the prospectus contains no projections of earnings. At road shows and one-on-ones, however, investment bankers and company officials will sometimes discuss their expectations.
A peek into a road show suggests that there is sometimes more information available there than in the dry, history-laden prospectus. After being told by an official of Dillon, Read & Co. that the press wasn't welcome at its February road show of BioCryst Pharmaceuticals Inc., a BUSINESS WEEK editor identified himself to a senior executive of the underwriter at the Plaza Hotel luncheon and took a seat. Investment bankers and company officials described the company's results in preclinical trials of its dermal cream as "encouraging" and "favorable," and showed slides giving specific data on trial results not revealed in the prospectus. Charles E. Bugg, chief executive of BioCryst, said the company's dermal cream "could be on the market sometime in 1996." Dillon Read and BioCryst declined comment.
Even syndicate managers have trouble defending this informational double standard. Retail brokers occasionally get their own road shows. Otherwise, retail investors are out of luck. "You get a strong sense of management and what they think. The individual investor doesn't have that opportunity," admits David Weild IV, head of global equity transactions at Prudential Securities Inc.
Road shows are only one of the ways in which institutions get preferential access to useful information. Institutions often have close ties to syndicate managers who solicit "indications of interest" in an upcoming deal from prospective investors. This "gray market," as it is called, enables the institutions to get a feel for where the shares will likely open and close the first day of trading. Fidelity Investments is even able to dictate the prices of some deals, Street sources say. Fidelity denies this. "It would be wonderful if we could set prices. But that's overstating it," says William Hayes, chief operating officer for equity operations.
NO ACCESS. Retail brokers also pass along "indications of interest" information to customers. But most brokers don't have the close relationships with the syndicate departments needed to get a sense of supply and demand. Even brokers who do have access may not share the information with their clients.
Institutions also come out ahead when it comes to deciding who gets how many shares in an IPO deal. "By and large," says John Castle, chairman of Castle Harlan Inc., "those who control this today are institutions."
One accepted practice further reduces the shares left for ordinary investors. Corporate issuers use their IPOs to pay favors and can set aside from 5% to 10% of their shares for special buyers. For example, Synopsis, a software maker based in Mountain View, Calif., set aside 5% of its February, 1992, IPO for customers, vendors, and employees, says A. Brooke Seawell, the company's senior vice-president.
At the retail level, making allocations often amounts to gutter fighting. But predictably, some retail investors and their brokers come out a lot better than others. In the catbird seat sits the retail coordinator, who decides with the syndicate department how much stock of each deal gets allocated to retail branches, and often within those branches to which brokers. There is rarely enough to go around. But Merrill insists its allocation process works very well. "Any customer can get involved in any deal. What happens is, they don't get as much as they want of the hot deals," says Michael Sullivan, the syndicate coordinator for Merrill's largest retail office.
How much stock an office or broker gets depends in part on their syndicate rankings, which is a list of brokers and offices in order of how many new issues, good and bad, each broker and office has sold. "The way to move up on the syndicate ranking is to sell [new offerings of] closed-end bond and other funds," says Dennis O'Connor, a former Merrill and Shearson Lehman broker, now a money manager in Connecticut. Closed-end bond funds are high-margin, high-commission deals, a number of which have posted poor results in recent years.
Bren Sheehan, a former Merrill Lynch broker in the firm's Stamford (Conn.) office, complains that the allocation of new issues there was run by a small group of cronies who managed to get large portions of hot deals. "There were four or five guys who always seemed to do well," she says. Sheehan says she got a mere five shares of Boston Chicken, one of the hottest deals of 1993.
Says Daniel J. Donahue, Merrill's director for Stamford: "Bren's statement is inaccurate. We allocate shares based primarily on past participation in underwriting business, but we try to include all of our financial consultants on all our deals in which they and their clients are interested. I personally approve the allocation of hot deals, including Boston Chicken, in which 1,600 shares were allocated to 45 financial consultants."
Even after some IPOs have been sold, the jostling for position among retail investors can continue. Although many don't know it, their ability to buy stock in the aftermarket of some IPOs has already been determined by brokers, who base their judgments on the gray market. This involves a kind of price ladder, a schedule telling which retail customers are to be let in on the deal and at what price. So after a hot IPO opens at, say, 20 and goes to 27, one investor might be told he can get 100 shares at 27 that day, while another investor is told she has dibs on 100 shares at 30 the day after. "The whole schedule is laid out in advance of who gets in and at what time," says one government investigator about several IPOs he has studied.
Small investors who don't get in on the deal until the upper rungs of the ladder are not as likely to achieve good returns, because most IPOs see their biggest gain on the first day they are issued. Two professors from Texas Christian University and Indiana University, Christopher B. Barry and Robert H. Jennings, found in a 1993 study that, on average, 90% of the returns in common stock offerings are earned by the initial buyers of the shares on the first day. The main reason is that underwriters typically underprice IPOs by 15% to make sure that they sell well. "Thus, only original purchasers in the offering benefit from the underpricing of the IPO," Barry and Jennings conclude.
Long-term performance of IPOs is pretty dismal. If you bought IPOs and held them for five years, your average annual return would be only 5% per year, concludes Jay Ritter, professor of finance at the University of Illinois. That compares with the 16% average return that could be earned by investing an equal amount each year in companies of the same size that didn't issue stock.
IPOs do reasonably well for a while. But after that, things get dicey. "Standard operating procedure for anyone investing in IPOs is to be out within the first 90 days of trading," says Robert Natale, of Emerging & Special Situations, a newsletter published by Standard & Poor's Corp., a unit of McGraw-Hill Inc., which owns BUSINESS WEEK.
Why the sharp drops after a short time? Company insiders with restricted stock are typically prohibited from selling their shares until 180 days after the offering. Once these shares start filtering out, however, prices tend to weaken. Another reason is that most issues are timed by underwriters to coincide with peaks in market and industry cycles. It's often downhill from there.
BLACKLISTING. But probably the most troubling Wall Street practice that silently works against the small investor is what is called a "syndicate penalty bid." This is a penalty imposed on brokers who "flip," or sell their customers' IPO shares right after the offering. The practice, devised by a group of top Wall Street firms during Securities Industry Assn. meetings in the late 1980s, is used by underwriters to help prop up the stock price of an IPO in the sensitive weeks following its issue. Brokers whose customers flip risk having their commissions taken away, giving them an incentive to discourage customers from selling out. Sometimes, firms even blacklist customers who habitually flip. "It's a form of stock-price manipulation if you can get a customer to hold an IPO a month," says Georgetown's Stout.
Penalty bids present brokers with a clear conflict of interest between doing what's most lucrative for themselves and what's in the best interest of their customer. Syndicate managers dismiss that argument, saying brokers will do what is best for the client. Penalty bids are not used on hot deals, since these IPOs don't need any price support. Rather, they are used on weaker deals in danger of plummeting in price soon after they are issued--10% to 20% of all IPOs. An IPO with a penalty bid was Northwest Airlines Inc., say sources.
Institutional investors who flip are much less likely to be penalized than retail flippers. While a retail flipper may be banned from buying IPOs, institutional customers are seldom dropped because they flipped IPOs.
Wall Street firms go to great lengths to root out retail flippers, which include small investors and professional flippers. Prudential Securities, for one, has created a new automated system that lets syndicate managers identify retail flippers and their brokers. Flippers who are fingered can be cut out of future deals. "We're not going to tolerate systematic flipping on issues," says Prudential's Weild. Some prominent retail investors can flip. With the help of an investment adviser who was a high school friend, Speaker of the House Tom Foley garnered about $100,000 from 1989 to 1992 by flipping out of nearly all of his 42 IPO stakes, according to reports.
Underwriters defend the penalty bid system as a way to eliminate flippers, whom they see as parasites, much as risk arbitrageurs were seen in the 1980s. "I'll be damned if I can find anything socially useful" about a flipper, says Lawrence Auriana, co-portfolio manager of the Kaufmann Fund. Issuers, moreover, blame flippers for sabotaging their offerings. Perhaps the most damning argument against the professional flippers is that they hog the retail supply of stock. "The flippers take away stock from small investors," says Benedetto.
But in the opinion of flippers and other IPO players, Wall Street's campaign against flippers is misguided. Flippers claim they help the market. Says McKinley Capital's Osborne, who says he's a long-term IPO investor: "The flipper community gives immediate liquidity for people who wanted to buy stock." And trying to ban flippers, they say, is just an attempt to prop up the prices of weak issues while institutions cash out and individual investors--the "dumb money" as one underwriter put it--are left holding the bag. Wall Street firms are "manipulating the market" with the penalty bid, says Richard C. Urbealis Jr., a broker who left Merrill Lynch in 1992 after the firm took away commissions he earned as a broker serving clients who traded IPOs. "If the stock has real value there will be long-term investors. The market will dictate if it's good merchandise or not." A Merrill Lynch spokeswoman denies that it engages in market manipulation and said that as a matter of policy the firm does not comment on matters relating to former employees.
Letting the market determine the worth of merchandise is a process that is suppressed in the world of IPOs these days. The IPO market, for all its strengths, is being seriously distorted by practices that have too much to do with greed and too little to do with serving investors, both big and small. If Wall Street doesn't start dealing with these shortcomings by abolishing devices that discriminate against small investors--the IPO market could lose the confidence of the investor it needs to function--it's a good bet that the SEC will take over the job.