At What Price?

Perhaps no barometer of investor sentiment is more on target than the market for initial public offerings. And as stock market valuations exploded over the past few years, budding companies found that investors would reward their dreams with many dollars. In turn, gleeful investors coveted IPO shares as hot tickets to quick profits.

Actually, not all investors, as Jay Ritter asserts. The University of Florida finance professor is an expert on IPOs, and he charges that the Wall Street firms shepherding these young companies to market routinely underprice offerings and reward their best clients with a chunk of pre-public shares - "kickbacks," Ritter hotly contends. Most individual shareholders are left out. Ritter also is highly critical of mutual fund companies that trade these shares, and of brokerage analysts whose job it is to stir up investor interest and, not incidentally, future investment banking deals.

Ritter describes an IPO market that appears highly flawed and uneven. First-day returns in 1999 alone averaged roughly 70 percent - no prior year had seen more than a 21 percent gain. He adds that Wall Street encourages IPO shareholders to take advantage of this volatility and "flip" their shares, selling within days, or even hours, to lock in a fast buck. Not long ago, Ritter notes, IPO shares were seen as something to buy and hold, and then to buy more of once a young company gained its footing. Flipping was strongly frowned upon.

Ideally, this found money should line the coffers of the newly public company - not the pockets of lucky traders. Which leads Ritter to another interesting question: Why do issuers leave so much cash on the table? A company selling 20 million shares at $10 raises $200 million to help fund operations. If those shares double on the first day of trading, that company will have a market capitalization of $400 million - but it doesn't enjoy the extra $200 million valuation bonus.

Issuers could push underwriters to set a higher initial offering price for their shares, Ritter says. The fact that they don't leads him to a pair of important conclusions. The first is behavioral: a much-anticipated IPO could make management extremely wealthy, and they are reluctant to appear greedy. And second, he explains, some young companies use the IPO as a branding tool - a way to raise consciousness, not capital. Sure, that doesn't make much economic sense - but after all, when you're young, image is everything.

The market for initial public offerings over the past couple of years seems to have experienced a life of its own. Conditions now are less freewheeling, but are IPOs poised for a rebound?

First-day returns had just exploded. For the first six months of this year, the average return was about 70 percent, just as it was for calendar 1999. No previous year had been above 21 percent. Since June, returns have been lower. A year ago, business-to-consumer Internet offerings were warmly received; now there's no receptiveness. It's certainly not an auspicious time for those firms to be going public. On the other hand, Internet infrastructure and optical switching networks are hot. But I don't think the huge run-ups that became the norm last year or earlier this year are going to continue.

During times of high market volatility, do IPOs react more acutely than the broad market?

The IPO market has always been hypersensitive to stock price movements. In the wake of the 1973-74 bear market, for example, the IPO market virtually shut down for seven years. The total number of offerings from 1973 to 1980 was on the same order of magnitude as we've seen during one or two months in the last few years. The IPO market is never in equilibrium. It's either too hot or too cold.

Has the IPO market become too cold?

Until two years ago, it was a rare IPO where first-day trading volume exceeded the number of shares offered. In the past two years, that has not been unusual. Historically, when the IPO market has been buoyant, when there have been high volume and high returns, those companies going public have been prone to do poorly in the long run. When the market was cold and valuations weren't high, those IPOs tended to give investors good long-run returns.

That historical pattern has not played out well in recent years. Enthusiasm for tech stocks has been good for many IPOs, but there's no guarantee that's going to continue. In February 1990, Cisco Systems went public and at the end of the first day of trading had a market cap of $300 million. Now its market cap is about $400 billion. A few months ago, an optical switching company, Corvis, went public with no sales and was given a market cap of $30 billion. Well, what if Corvis is as successful as Cisco over the next decade and attains a phenomenal market cap of $400 billion? Since it's starting at $30 billion, it's already capitalized 100 times higher than Cisco was when it went public. That removes a huge amount of the upside potential. If Corvis were to go up eightfold in the next decade, the compounded annual return would be 25 percent a year, and that's an incredibly optimistic scenario.

So, at current valuations for tech stocks that have recently gone public, I think a lot of the upside is already built into the price. There's a lot of downside risk for investors. Technology is certainly an increasingly important part of the economy, but that doesn't necessarily mean it's going to be phenomenally good for the owners of capital in that sector. Certainly, returns in the future are not going to be anywhere near as good as they've been over the last 18 years.

In what important ways is IPO investing unique?

There have been dramatic changes in the way the IPO market works. In the '70s and '80s, it was rare for companies to go public that weren't already profitable. In fact, in the early '70s, it was rare for a company to go public that did not have five years of operating profits. In the 1980s, the market moved more towards technology stocks, where five years of profits seemed an eternity, but it was still rare for a company that wasn't profitable to go public.

Throughout the 1990s, there was a deterioration of that, but until 1999, at least 60 percent of IPO companies were profitable in the 12 months before going public. Last year that dropped to 25 percent; it was rare that a company was profitable before going public.

So in 1999, the overall quality of IPOs diminished even as their first-day returns soared. What else is different?

The other big change has been first-day return, which is referred to as "underpricing." In the 1980s, once you exclude penny stocks, the average first-day return was only about 5 percent. Many stocks went public and started trading flat, some dipped a bit, some went up 10 percent. But it was rare to see a company going up 20 percent, and it was unheard of to get companies doubling on the first day of trading. In the 1990s, first-day returns were higher. Until 1999 though, that average only crept up to 14 percent, where a company going public at $10 a share might trade at $11.40 in first-day trading. Indeed, in the 25 years between 1974 and 1998, a grand total of 39 companies doubled in price on the first day of trading.

In 1999, things completely changed. We might even date it to November 1998, when TheGlobe.com went public and shot up 606 percent on the first day of trading. A number of underwriters looked at that and said, "Institutions were a little concerned about the value of this company, which is why the underwriter actually cut its offer price. But there was this incredible retail demand and an awful lot of money was left on the table." TheGlobe.com sold, as I recall, at about $9 a share and at the close of the first day of trading was over $60 a share. For everybody who was allocated shares at the offer price, this generated a huge opportunity to flip and make a big profit. So what the underwriters found themselves doing was not just allocating shares but attaching $20 bills to each of the shares they were handing out. In TheGlobe.com's case, it was more like a $50 bill.

In hindsight, the IPO market in 1999 and early 2000 did display frenzied speculation and unusually high returns. But you contend that retail investors weren't the loudest partygoers.

In the last two years, the IPO market has moved away from a market where underwriters, in allocating shares, were interested in placing the shares with buy-and-hold investors - institutional investors who might hold the shares and even accumulate a larger position.

As underpricing has gotten so severe, underwriters, instead of worrying about the buy-and-hold investor, are instead just handing these out as ways to reward customers who provide a lot of profits through trading volume. Increasingly, IPO shares are allocated not based upon who is a buy-and-hold investor, but whom do we owe a favor to, who is directing business to us, and who do we give the kickback to?

Kickback?

"Kickback" is obviously a pejorative term, but the practice is increasingly analogous to that. Some underwriters, I've been told, are now basing allocations exclusively on how much business you have been doing with them. They've also dramatically changed their attitude towards "flipping." Instead of doling out shares and being concerned that investors might then turn around and sell them in the open market, they haven't been actively discouraging flipping if they think there's a good chance that the stock is going to jump. On the buyside, you no longer even have to have the pretense of being interested in buying and holding. Instead, it's just a question of, "Have I generated enough commission business to get these $20 bills that are being handed out?" And rather than take the risk that the price might drop later on, it's perfectly okay to flip.

Indeed, in many cases, underwriters actually have been encouraging flipping, partly to get those shares into the hands of retail investors and thereby keep the price from running up in an unsustainable way. By getting the shares into the marketplace, it increases supply and keeps the stock from overshooting. Underwriters would like the price to be reasonably stable. They don't want it to not move at all, but big movements - either up or down - raise a question of value.

For example, Akamai Technologies went public in October, 1999, at $26 a share and ended the first day at $45 a share. Then it went up to $345 a share over the next couple of months before falling recently to $45 a share. I'm sure Morgan Stanley Dean Witter, the lead underwriter, wishes it had not gone up to $345. If the underwriters had their way, if it's going to wind up at $45 a share, they probably would have liked it to have jumped from $26 to $40 on the first day and gradually gone up to $45 without the huge runup and the huge collapse. People complain when they buy something and it drops in price.

You're describing a free lunch.

It's free, but only if you've been generating enough trading volume. Fund managers have a choice: Do we pay 3 cents a share on an electronic communications network, or 6 cents a share and direct our volume to Morgan Stanley? Morgan Stanley has IPO shares to hand out; the ECNs don't. The ECNs are well aware that their market share would have grown even greater if it weren't for the kickbacks from IPO shares that major underwriters have available.

These are serious charges against Wall Street and its institutional clients. In their defense, fund managers often say that IPO gains don't contribute much to the total return of a diversified portfolio.

There's some truth to that for some money managers. But for some big mutual fund complexes, their allocation of IPO shares is based upon the whole family's trading volume. Then they've got to decide: Which of our funds do we allocate these hot IPOs to? If they have a large-cap fund with a big market value, throwing in some IPOs is going to have minimal impact on performance. On the other hand, if they also have a small growth fund, throwing in a handful of IPOs can have a big impact on performance because it's such a small fund. There is a temptation to do that, and then to market that fund, which because of the boost from IPOs has had very high returns. The Securities and Exchange Commission is aware of this, which is why there are regulations that require disclosure to investors that some of the past performance of a fund has been boosted by IPOs, which may not be repeated and is dependent on high returns from IPOs in the future.

Still, even in a small fund, can a few IPOs really make such a huge difference in return?

For the market as a whole last year, there were roughly $70 billion in proceeds from IPOs. The average first-day return was about 70 percent. Seventy percent of $70 billion is roughly $50 billion, and the U.S. market's capitalization at the start of 1999 was about $10 trillion. So we're talking about an extra 50 basis points of performance for an average fund if all IPOs were allocated randomly. And if we agree that a small-cap growth fund is getting more than its share of allocations, its performance could be boosted substantially over that. Recently I was at a conference of quantitative money managers, and people were telling me anecdotes of how last year certain funds got a 1,000-basis-point boost from IPOs. These typically were small funds within a big family complex. Though if you've got a big-cap value fund, there just aren't a lot of IPOs. With a small-cap growth fund, more of the companies going public are going to be in your style category, so you should be getting more, and it is going to have a disproportionate impact on growth funds versus value funds.

As you describe it, the IPO playing field seems highly, how shall I say it, irregular.

While I think there are some abuses in the IPO market, it's not clear to me that, aside from disclosure, there should be additional government regulation. The market does have a way of sorting things out. The only reason that so much money is being left on the table is that issuing firms are putting up with it. In terms of the first-day returns in the last two years, Morgan Stanley and Goldman Sachs, depending on exactly what periods you're dealing with, have been consistently at or near the top in terms of the average first-day return on their IPOs. But nobody's forcing the issuing firms to hire Morgan Stanley as their lead underwriter. BT Alex. Brown or somebody else could say that while we may not quite have the brand name that Morgan Stanley does, we're going to price IPOs more aggressively, get higher proceeds, and leave less money on the table.

One way of looking at these first-day return statistics is that if you have a chance to invest in a Morgan Stanley- or Goldman Sachs-led offering, your first-day return could be greater.

Yes. They've had the $20 bills to hand out.

How do Morgan Stanley, Goldman Sachs, and other major Wall Street underwriters respond in defense?

Many of the companies going public in the Internet and technology areas are young and highly speculative. They are concerned that the market's willingness to pay now may not be sustainable. And certainly Goldman does have a lot of egg on its face for the e-tailing companies they took public a year and a half ago that are now trading down in single digits. Another issue is that, by and large, issuing companies have not been real aggressive at demanding higher offering prices.

Why would the management of an issuing company leave so much money on the table?

One reason for the relatively blas? attitude is that so many of these companies are incredibly young, getting incredibly high valuations, and the principals say, "I have worked hard but I know how lucky I am that the market is willing to pay up for this." It's not as if we're dealing with a manufacturer that has been in business for 30 years, and they're going public with a P/E ratio of eight. Instead, you've got somebody who founded the company two years ago and they're suddenly looking at personal wealth of, say, $50 million. Why quibble to get an extra dollar on the offer price when it might turn out that you're going to be wealthy beyond imagination anyway?

But IPOs raise capital for the company to grow and expand. A young enterprise needs as much money as it can get.

Here's where management makes a big-time mistake. In the last two years, one viewpoint that became popular was the IPO as a branding factor. Go public, sell a small fraction of the company, you don't raise much capital, but the IPO is not mainly a capital-raising event. You do a follow-on offering to raise capital. That's a good strategy, provided the window is still open when you come back for that follow-on offering. What a lot of companies have discovered recently is that strategy doesn't work too well if the window is closed.

Is it important for investors to be aware of how an IPO is trading close to the expiration of the lockup period?

The simple answer is yes. When the lockup period expires, typically 180 days after the offering, insiders can diversify their portfolio and cash out on some of their shares. There is a tendency then for the stock price to fall. This has been especially true of tech stocks. The magnitude of the fall is on the order of 5 percent on average.

It's possible that this pattern will be changing now that it's getting publicized. There are at least five Web sites that list which IPOs are going to have their lockup periods expire this week. Because of that publicity, it's conceivable that some of this stock price drop is occurring earlier, so that when the lockup does expire, the impact may not be as big as it was.

One issue, especially in the last year, is that many of the high-tech deals sold a tiny fraction of the company in the IPO. The public float is quite limited. There might be some scarcity value associated with a stock for those six months, and short sellers will have difficulty getting shares until the lockup expires. In the last year or two there were a number of IPOs that I tried to short before the lockup period had expired, and brokerage firms had told me their stock loan department had no shares available; the short sellers had already borrowed them. So when the lockup expires and that's no longer a binding constraint, that might be one more downward pressure on the stock price.

Your research has found that underwriting spreads for IPOs in the U.S. are higher than other countries. Wouldn't investors be better served if commission rates were lower?

Maybe. When you look at different countries, American investment bankers charge more in terms of spreads. They charge more, but offer more services. Also, the role of analysts is important in touting stocks. Worldwide analyst coverage is becoming increasingly important, and U.S. securities firms have put a lot of emphasis there. With current lofty valuations, many foreign companies feel they can get a higher price if they can place some of their shares in the U.S.

If issuers were greatly concerned about the spreads charged when they chose investment bankers, spreads would be lower. It's just as if the issuing companies were greatly concerned about leaving money on the table, less money would be left on the table. Issuing firms by and large are concerned about analyst coverage, especially at the time when the lockup period expires, and underwriters are doing a lot of their competition based on analyst coverage. As long as the issuing companies want that, I don't think things are going to change dramatically.

Suppose I get three retail analyst reports about a company that has recently gone public. Two are from brokerages that have underwritten the IPO. One has not. Which report is most credible?

I would go with the non-affiliated analyst. After the quiet period, 25 days after the IPO, normally all of the co-managers of the offering are going to put out research reports, usually with "buy" recommendations. Occasionally you get a "neutral" recommendation, which is the equivalent of a sell. And it's not frequent that you get "strong buy" recommendations, especially if you've got a young company that went public at say, $14 and jumped to $40. The analysts, while not saying that at $40 it's overvalued, are not pushing either.

I should note, however, that unaffiliated analysts are not necessarily completely pure. If they think a company is likely to be doing a follow-on offering, and their firm would like to be a co-manager on that deal, putting out a positive recommendation certainly increases the possibility that their firm will be picked.

In general, are analysts' reports on IPO stocks less reliable than write-ups for more established companies?

I'm not aware of any scientific evidence, but I would say that for IPOs, the reports are less reliable. The reason is the higher probability of doing a follow-on offering. Analysts are partly pitching for being a co-manager of a follow-on offering. Whereas for a company that's already been public for a couple of years, their chances of doing a follow-on offering and paying big fees are pretty low.

Where can an investor turn for unbiased IPO information?

Ideally, to non-affiliated parties. There's a research industry unaffiliated with investment banking firms that are involved in getting fees for managing IPO deals, or doing M&A advice where your chances of being picked as an advisor on an M&A deal often depends on whether your analyst is saying bad things about management. This is a question about the structure of the investment banking industry. Why is it vertically integrated the way it is, with sales, trading, underwriting, and research coverage all under the same firm?