Burnt Offerings

The IPO market has learned useful lessons.

Initial public offerings, the tinder of the 1990s boom, are back. Sort of. On the one hand, 2003 was the slowest year for IPOs in a few decades, with 69 offerings reaping $15 billion. That’s lower than last year’s total and far below the figures posted in the late 1990s. On the other hand, December has seen more IPOs than any month since November 2000, and surefire blockbusters like Google and are slated for next year.

In this bipolar IPO market, for every newbie that booms, there’s one that busts. On Dec. 9, Chinese travel agent Ctrip debuted and rose a stunning 88.5 percent on its first day of trading. On Dec. 17, the IPO for the giant travel company Orbitz barely achieved liftoff. It priced at $26 but fell 4 percent on its first trading day. Indeed, plenty of IPOs have shared a similarly humdrum fate. In its 2003 year-end review, Renaissance Capital, a highly useful free site, reported that this year the average IPO rose by 13 percent on its first day. That’s not bad, but it pales in comparison to first-day returns in the boom years, as seen in the chart on this page. In 1999 and 2000, IPO average first-day returns were 72 percent and 56 percent, respectively.

Investors frequently view IPOs that fall flat as a disappointment. But the fact that new issues trade close to their offering price on the first day is actually a good sign. The Dow has breached 10,000, money is pouring into mutual funds despite the year’s run of scandals, and some of the willing suspension of disbelief that characterized investing decisions in the late 1990s seems to have returned. Yet recent IPO action shows that the exuberance is a bit more rational this time around. More important, it seems that IPOs are one of the few areas where post-bubble reforms have stopped unseemly 1990s-era practices.

In the late 1990s, being able to buy into an IPO at the official offering price was a license to make huge amounts of money. The emergence of this trend corrupted the IPO system. IPOs were supposed to be a way to allow young companies to gain liquidity and financing and give them a means of compensating their employees; IPOs were also designed to establish a currency for mergers and acquisitions. But these constructive objectives were forgotten as IPOs emerged as a vehicle for the enrichment of favored investment banking clients.

In theory, underwriters—the investment banks who shepherd IPOs to market—are supposed to gauge market sentiment, assess how many shares should be sold and at what price, and use their contacts and marketing skills to place the shares with mutual funds, large institutions, and individuals who will comprise a stable shareholder base. That’s why underwriters get the standard 7 percent underwriters’ fee.

But in the 1990s, when the retail investor population surged and there was a rush on new stocks like Netscape and, that sober mentality went out the window. Demand for IPOs—particularly technology IPOs—was such that shares would be priced (i.e., sold to the initial investors) and then open for trading at some multiple of the offering price. Those fortunate enough to get in on the offering at the original price could flip it within minutes for guaranteed profits. When went public in November 1998, its shares were priced at $9 but opened at $87!

The victims here were really the companies going public, who were deprived of the full-market value for their shares. In the case of, the initial value investors effectively placed on each share wasn’t $9, it was $87. Had market underwriters placed the initial value closer to the price investors were willing to pay—instead of underestimating it, as investment bankers routinely did at the height of the boom—the company would have reaped far more than $9 per share. To the extent value was created in the offering, it went disproportionately to IPO investors, not to the company. In this study, Univeristy of Florida finance professor Jay Ritter documents how much money companies left on the table because their IPOs were mispriced.

Naturally, those who picked the money off the table weren’t investors with a few thousand bucks in a Fidelity account; they were largely hedge funds, mutual funds, and investors with private banking accounts at the likes of J.P. Morgan and Credit Suisse First Boston. Investment bankers realized they could exploit IPOs to enrich favored customers. It became common to allocate hot IPOs to executives at bigger companies who would be in a position to decide, say, which investment bank the company would use for its next bond offering. The practice was known as spinning, and figures such as Ford Chairman William Ford and former WorldCom head Bernard Ebbers were among its many beneficiaries.

Of course, spinning has been exposed. The maestro of the art, former Credit Suisse First Boston technology banker Frank Quattrone, was indicted for allegedly directing employees to destroy documents relating to the allocation of IPOs. (His trial ended in a mistrial in October.) The SEC started a voluntary initiative under which companies are supposed to forswear the practice. The gadfly group Corporate Library has developed a tool that will allow investors to track IPO allocations to officers of publicly held companies.

In the late 1990s, the IPO market was exciting and yet utterly dysfunctional. The overwhelming majority of individual investors never had a chance to get in on a deal at anything close to the original price. And young companies frequently were deprived of the full value of their shares by their greedy investment bankers. Now, with shares generally being priced rationally, with spinning essentially banished, and with muted first-day action, you and I can get into IPOs on roughly the same terms as giant institutions. Meanwhile, the companies who cede both ownership and a portion of control to outsiders are getting the cash they deserve. That should be cause for celebration, not disappointment.