When the front page of the business section one day features
Internet trading infrastructure, and the next day highlights
talking about investing some serious money in developing an online brokerage capability, my ears perk up.
That's been followed by the Net bankers. Consider the wonderful PR generated by the upstart investment banking firm
, whose stated mission claims to be the fair distribution of IPOs via the Internet, as well as the annoying media blitz accompanying "e-" everything. Finally, it appears that
, the 2-year-old granddaddy of Internet investment banking, will make it as a going concern. I guess the online trading community has come of age.
But who is really going to benefit from the evolution of Internet finance? As is often the case on Wall Street, there remains the perennial issue of what's good for the goose not always being in the best interests of the gander.
I will not get into what exactly the marginal utility is to the individual investor of being granted a nearly costless transaction capability, compliments of the Internet. This is America, and people are entitled to do what they wish with the 50% to 70% of the money they earn and get to keep.
I will say, however, that the Internet will be a terrific driving force on Wall Street and the financial services industry in general. It will impart enormous efficiencies in back-office functions, which will reduce the time and costs of exchanging information between financial counterparts and customers. It has also provided access to very detailed information on whatever an investor thinks is important, ranging from years of history on the advance-decline line to competitive information on companies in an industry.
But I have a real problem with the flag being waved that proclaims the Internet will be used as the great democratic device: to take IPOs out of the greedy clutches of blue-chip investment banks and their faceless day-trading "institutional clients" and put them into the hands of Joe and Jane e-Pack.
Unfortunately, I certainly can't argue that the current system represents any signs of great intelligence and equitable treatment. Essentially, companies hire investment bankers to raise money for all sorts of reasons, some good and some not so good. The investment banker relies on the company's accountant to gauge the accuracy of private accounting statements and on the company's management for projections. A horde of analysts with MBA degrees then crank out the numbers and compare the company with some publicly traded peers to arrive at some rough values for the company's worth in the marketplace. A red herring is produced with a price range for the IPO, and the company is taken on a roadshow to convince generally institutional investors that the price is worth paying.
If the deal generates a lot of interest, there is naturally a lot of demand for relatively few shares. This puts the investment banker in a tight squeeze. If there is so much demand, how come the banker didn't see it and price the deal accordingly, putting more money into company coffers? The corporate client is ticked off that it's giving up money. The price can be adjusted upward and more shares sold, but there is an upward limit to this as the investment banker also has investors as clients. The trick is finding the right balance between enabling investors to get a fair shot at making money -- and therefore coming back for the next deal -- and maximizing the capital raised for the corporate client.
So who gets the shares? From the company's perspective, the shares
go to longer-term investors who understand the risks and rewards and want to "partner" with management to execute the game plan. Thus, the investment banker's job is to analyze individual and institutional customers and show the company to investors who would fit that bill.
Right! What happens, of course, is that the "hot deal" represents nearly free money in a bull market. Buy-siders enter orders for 10 times what their true appetite really is for the shares, knowing that they will get allocated a modest percentage of their request. Who ultimately gets shares is obvious: They include the best commission-generating accounts, the influential clients like high-profile athletes and very wealthy people who are in a position to remember the favor in the future.
At the risk of sounding like sour grapes, midsize "investment" firms like ours get little or nothing on a hot IPO. That's generally OK with us, given most of the deals we see. But what really annoys me is that we often can't get stock or even a meeting with a company on a secondary offering, even when we show up as one of the 10 largest institutional shareholders!
This malady develops when our commission generation to the investment banker on the deal is below "the threshold." We then have to resort to whining to the company's management, who often appear dumbfounded when we explain our IPO theories. What's even more annoying is that it barely helps those who do get the shares. The allocations are so small for a $20 billion mutual fund that, even if the fund owns 25,000 shares of an IPO that goes up fivefold on the first day, it's a blip on its performance.
So, how can the Internet improve on this? The plans I've seen floated seem to indicate a Dutch auction-like process whereby "anyone" can bid on what they think the company is worth. Technically speaking, anyone will be able to "e-participate" in what is arguably the easy money in IPOs. While I can support the libertarian principles underlying this classic free-market approach to determining corporate values in the marketplace, I must point out some huge flaws in this plan.
First off, is it in every company's best interest to go public in a wild speculative frenzy -- often driven by day traders who know nothing about the company other than that they may be able to game the IPO process and make a few bucks? Is this whom you want to own your company, Mr. CEO? What if rank-and-file employee stock options that are often priced at the IPO price are now at levels that will take seven years to earn out because of a wildly optimistic price? (Not that they won't be repriced in a year!)
And who gets the shares? I believe that potential investors will have to "qualify" by a certain process (to see why, read
Bill Hambrecht's OpenIPO Ready to Deliver ... Lots of Disappointment on the W.R. Hambrecht launch). This will reduce the pool to one only slightly larger than what the current system produces. And who is kidding whom if the new e-banks will
want to restrict shares to accounts that will be blowing them out with the next mouse click?
So where, I ask you, will be the improvement? It is academically correct that a true auction mechanism would be more accurate. Investors who really know the company and are more bullish than those who are just there to participate in a hot IPO may be able to bid higher and acquire more shares than they would under the current system. This would maximize benefits to both the seller and the buyer and eliminate the weaselly profits to IPO-flipping. It's difficult to believe that we will move to this system from the current system so long as Wall Street pay is based on both investment banking deal flow and the commissions that it generates.
Lastly, why should there be a clamoring at all to invest when IPOs -- as an asset class -- have been shown time and time again to underperform? The overwhelming majority of IPOs are companies dressed up for partial sale by insiders at prices that at best represent the north side of fair value, if not an awful lot more.
noted last week, in certain environments, investors will grossly overpay for the chance to win the lottery. This has obviously spawned the true spectacle of the recent Internet IPO market, and the e-bankers have taken this as a golden opportunity to reform the system. I just don't see how it will put more money in
Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At the time of publication, neither Bronchick nor RCB held any positions in the stocks discussed in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at