Commentary: IPOs: Getting the Price Right
By Mike McNamee
What's the best way to prevent the massive abuses that made initial public offerings of stock such a honey pot for investment banks and their friends in the late 1990s? Hefty penalties--such as the $100 million Credit Suisse First Boston paid--and the new NASD rules will help, but the way IPO stock is priced and distributed in U.S. markets needs a thorough overhaul.
During the boom, Wall Street's bankers systematically underpriced shares in the new companies they took public. With investors frantic for hot issues, anyone who could get shares at the opening price cleaned up. Some investment bankers exacted kickbacks and other quid pro quos from clients who got shares.
Securities & Exchange Commission Chairman Harvey L. Pitt wants to close the pricing gap. In an Aug. 22 letter, he asked the New York Stock Exchange and NASD to form a high-level committee to study the IPO process, "particularly price-setting." But the exchanges aren't likely to squeeze one of Wall Street's fattest franchises unless Pitt keeps the heat on. He needs to push an honest auction system that establishes the market price for new stocks and gives all buyers an equal shot.
The evidence of underpricing is clear (table). There has always been a bump in the price of IPOs on the first day of trading. But the average 7.4% gain in the 1980s exploded to 65% in 1999 and 2000, capped by the 698% first-day gain for VA Software Corp. in December, 1999.
Such enormous jumps turned IPO shares into a currency that some underwriters abused. CSFB allegedly handed out shares to customers who would kick back some of the gains through inflated commissions: The firm paid a $100 million penalty without admitting or denying the charges. Salomon Smith Barney on Aug. 26 admitted giving 100,000-share blocks of IPOs to execs at WorldCom Inc., a top customer. SSB denies, though, that this was an incentive for WorldCom to steer business to the bank.
The obvious losers were investors who bought during frenzied first-day trading. Underpricing also robbed the companies going public: At the height of the boom, they could have reaped an average of $79 million more in capital had their offering prices been closer to what the market would pay.
Investment bankers aren't the only ones in the IPO game who like the status quo. Managers in stock-issuing companies all too often benefited from the "friends and family" system. Insiders can't sell their own shares for six months, so they're often more concerned with staying on the good side of investment banks--and their all-important analysts--and creating buzz about their company. "Managers have many incentives to ignore the money they've left on the table," says University of Florida finance professor Jay R. Ritter.
The SEC should require the issuer's board to sign off on IPO pricing. More important, the securities cops should break the underwriters' lock on information about demand--namely, how many shares investors want and at what price. "The current system is totally opaque. There's no demand curve that issuers or investors can see," says William R. Hambrecht, chairman and CEO of WR Hambrecht & Co.
To get that information out, Hambrecht favors Internet-based auctions, which his firm uses to price IPOs. But it isn't the SEC'S job to design a one-size-fits-all auction model. It should require bankers to maintain an "open book" showing how many shares have been bid for and at what prices, and require underwriters to award shares proportionately to all bidders who offer a high enough price. Alternatively, the agency could let exchanges set prices by trading new-company shares before an IPO in a so-called "when-issued" market.
With demand and prices out in the open, Wall Street will have to prove that its crony system is better than an auction. Either way, issuers--and the vast majority of investors who lack insider connections--will win. There is no better way to prevent future IPO scandals than to get the price right from the start.
McNamee covers the SEC.