|Why are they smiling? Perhaps they got in at $45.|
NEW YORK ( TheStreet) -- LinkedIn ( LNKD) has doubled on its first day of trading, but most of those profits are out of reach of retail investors. In fact, the only way for a retail investor to have gotten a piece of the LinkedIn IPO at its $45 offer price would be to be a hugely profitable client for a full service brokerage firm.
In other words, if you are willing to throw away lots of money by having a full service broker and paying huge commissions, the broker may "reward" you by throwing you a few shares of LinkedIn. It's a bit like getting a "complimentary" dessert after you've spent $200 per person on dinner. "The North American approach to IPOs, and in particular 'hot' IPOs, is essentially they go to favored clients," says Ermanno Pascutto, executive director of FAIR Canada, a national investor advocacy organization. Pascutto says these "presidents list" clients often don't even have to put up the money to buy the shares at the offer price. The broker simply sells the stock at 100% profit and passes the profit on to the client. According to Jay Ritter, professor of finance at the University of Florida, LinkedIn's public offering was completed through book building, which is the most typical method for Wall Street to structure an IPO. By book building, IPO underwriters -- in the case of LinkedIn, Morgan Stanley ( MS - Get Report), JPMorgan Chase ( JPM - Get Report) and Bank of America ( BAC - Get Report), are able to price an IPO based on the "demand" from institutional investors. Because only the underwriters know what all the investors are willing to pay, issuers such as LinkedIn have to take their word for it on what the market deems the company to be worth. In the case of LinkedIn, the underwriters clearly undershot the market, meaning those with access to the IPO got a huge first trading day profit. If the initial offering price had been higher, that profit would have gone to the issuer -- LinkedIn -- instead, suggesting LinkedIn (ostensibly a client of the Wall Street firms) got a raw deal so the Wall Street firms could reward their other clients -- investors in the deal. Spokespersons for JPMorgan, Morgan Stanley and Bank of America declined comment. LinkedIn had no immediate comment.
Underwriters would be able to get a more accurate market price for IPO shares in an auction process, such as Google's 2004 public offering, but Ritter says the offer of first-day trading profit "candy" that can be handed out to a bank's favorite clients has become too enticing. In a typical IPO, there will be an institutional allocation and a "retail" allocation, with the retail side typically receiving 20%. "In a hot IPO, that may be a little bit lower. Maybe 15%," Ritter says. Even that may be too high, however. Although the allocation is officially classified as retail, the shares are actually doled out to the brokers as "candy" for their best, wealthiest and most profitable clients. For example, Morgan Stanley may receive 300,000 shares of a retail IPO allocation, which it would then hand out to every branch office, for example, of 1,000 shares each. Ritter says it is then up to the brokerage firm's office manager to further spread the IPO wealth, deciding to give one broker 100 shares but a poor producer 50. "The brokers then sell the underpriced shares to their best customers as a reward," Ritter says. "It's a very decentralized process, and compensates the best clients and gives them a reason not to go online and trade for $8.95." FAIR Canada's Pascutto has concerns about the inequity of this process. "Because it it essentially money for nothing there is the potential for inappropriate use of IPOs," Pascutto says. He adds that other countries, including Singapore and Hong Kong, have more equitable systems for IPOs. "Basically any investor can submit an application to buy shares," he says. If demand far exceeds the number of available shares, a lottery system is used to determine who gets the shares. Pascutto says the U.K. is embarking on important reforms in this area, and he sees a chance that the U.S. will make improvements to the system as the Dodd Frank legislation directs the Securities and Exchange Commission to examine whether all financial services companies it regulates should be required to act in the best interest of clients. Some companies, he notes, only have a duty to sell products which are "suitable."
"Suitable doesn't mean it's in the best interest of the client. It means something quite different," Pascutto says. The SEC has made some proposals in the area, though their outcome has yet to be determined. "We'll see where that comes out, but at least the Americans are actively thinking about and debating important reforms," Pascutto says. -- Written by Dan Freed in New York.