After Years Without Change, Cracks Appear in I.P.O. Process

The last few decades have wrought a revolution in finance. One thing, though, remains stubbornly the same. It is the control that investment banks wield over initial public offerings.

The way companies go public looks almost identical to the Ford Motor Company’s I.P.O. more than 55 years ago. A company hires lead underwriters, which serve as the company’s spiritual and logistical advisers, helping the company prepare the necessary regulatory documents and marketing the offering to potential investors. The lead underwriters, and sub-underwriters hired by them, then build a book of investors who buy the shares. Through this process, an I.P.O. price is set and the company’s shares are sold into the public market.

The goal of the underwriting process is to provide a steady channel for companies to go public, and a vetting procedure to determine whether a company is ready to do so.

But today, the I.P.O. market is heated, and there is the specter of a bubble in social media Internet stocks as well as a postbubble hangover in Chinese issuers. During this period, the flaws in the current system become more apparent. Some of these flaws are significant and hurt investors.

The first crack to appear is in the gate-keeping function. Underwriters are set up by the regulatory system to be gatekeepers. Underwriters pass on some companies and certify others that their I.P.O. is worthy for the public. Theoretically underwriters should be doubly incentivized beyond the regulatory requirements to bring good companies to market. Otherwise customers will refuse to buy shares in future I.P.O.’s underwritten by that bank.

The wave of Chinese and social media I.P.O.’s shows that this gate-keeping function can become weak. Companies are being brought to market with uncertain prospects or because they are in a hot space. If a company is characterized as such, its main quality too often seems to be whether it can be sold instead of whether it should be sold. This is a rerun of the technology bubble.

In this type of market, not only is the gate-keeping function diminished, but the banks appear to be captive of the issuers. Take LinkedIn, which had questionable corporate governance in the form of a dual-class stock and a staggered board. But LinkedIn also deliberately stoked its first-day price rise by offering only a small number of its shares at a low price. The lead underwriters for its I.P.O. were Morgan Stanley, Bank of America Merrill Lynch and JPMorgan Chase.

There is a debate over whether this jump in share price was the fault of the underwriters or LinkedIn, but the bottom line is that the underwriters did not appear to do anything to damp the enthusiasm. This raises another problem with the gatekeeper function. Banks appear not only as weak gatekeepers in a hot market, they also dilute any negative impact on their reputation by spreading the wealth.

The Groupon I.P.O. has four lead underwriters, including Morgan Stanley. Groupon just announced the addition of six more banks to help it with its I.P.O.. The world of major underwriters is small, and they share the wealth by ensuring that those not chosen as lead underwriters are included in the sub-underwriting group. In other words, the potential impact on any one investment bank’s reputation is limited since they are all involved.

The second crack in the I.P.O. process is in the sales process. The current system does not benefit retail shareholders. Instead, investment banks sell I.P.O. shares to bigger institutional investors and rich individuals who have a relationship with the investment bank. And the profit from these sales can be large. I.P.O. gains average 10 to 15 percent in normal years, and a hot-market I.P.O., like LinkedIn’s, can have first-day gains greater than 100 percent. These are gains that retail shareholders not only miss but actually subsidize, since they must purchase in the more expensive aftermarket.

These two cracks highlight problems with I.P.O.’s, but perhaps the biggest problem is with the ones we do not see. Under the current system, underwriters have abandoned the small-issuer market. In 1996, according to Dealogic, 309 initial public offerings raised less than $25 million each. This number declined to 13 in 2010. Small companies, those with a market capitalization of $20 million to $250 million, are essentially locked out of the I.P.O. market. And this isn’t a Sarbanes-Oxley phenomenon, as the number of small I.P.O.’s declined to nine in 2001, before the act was passed.

The current underwriting system works, but only if you are a larger issuer or in a hot market. It also fails to serve as a check on an overly bubbly market. Instead, underwriters race to the bottom as they serve the demands of companies. How can any banker pass up being underwriter to an I.P.O. like LinkedIn’s, no matter the terms or quality?

Around the time of the Google I.P.O. in 2004, there was talk of trying to create alternative systems. Google abandoned the underwriting model and adopted an auction style that was more similar to how European I.P.O.’s were conducted before the American investment banks arrived there. The Google I.P.O. worked, but just barely. During the I.P.O. boom, Hambrecht & Quist and some other smaller investment banks also tried to start an auction-style I.P.O. system. None of these alternatives has gained traction.

There are advantages to the auction model. It brings retail investors back into the process because they can freely bid on issues. It also solves a related dilemma, which is that like commissions for real estate brokers, I.P.O. commissions are stubbornly uniform. They have stayed steady at 6 to 7 percent for years despite occasional attempts by issuers to lower them. Still, issuers don’t seem to care about this commission, and are instead willing to pay them to ensure good service at a propitious time in the company’s life.

Another alternative way for a company to get a stock market listing is through a reverse merger.

There are on average over 200 of these a year, according to the Reverse Merger Report. The Securities and Exchange Commission, however, issued a report last week highlighting the special risks inherent in these types of transactions. One reason was the lack of an underwriting vetting process.

So while retail investors would benefit from other models, they could also be hurt more in the long run by investing in unprepared companies that come to the market outside the traditional I.P.O. process.

Despite the criticisms, there does appear to be value in the underwriter model and its certification process. People simply trust these I.P.O.’s more. And with reason: companies that go public through the underwriting process appear to be of better quality.

The real issue thus appears to be how to get banks to serve as better gatekeepers and monitors. There is also a desperate need to encourage more small I.P.O.’s.

In other words, in this I.P.O. boom there is one big issue: how do you get underwriters to actually perform their underwriting function?

http://dealbook.nytimes.com/2011/06/14/after-years-without-change-cracks-appear-in-i-p-o-process/