Counterpoint to IPO

In The Intelligent Investor, Benjamin Graham describes new issues as having a special kind of salesmanship behind them, which calls for a special degree of sales resistance. Brokers are typically rewarded with double and triple commissions for pushing new issues, and their firms earn handsome fees for advice, structure, pricing and support of the aftermarket.

Brokerage firms almost always push their own IPOs, and usually rather aggressively. In the aftermarket support function, advice to customers who have bought the stock is often one-sided. There is little evidence that issuing houses will make sale recommendations to customers who have bought the new issue even if such recommendations are warranted. And if an analyst forgets and does recommend an action counter to the distribution, that analyst will have new opportunities to explore the job market.
Studies have shown that expense control can be an important determinant of long-term investment return. But expenses tend to be ignored during exuberant markets, despite their importance, only attracting attention when markets are declining. And expenses are especially high for IPOs. By the time all underwriting and service expenses are accumulated, charges of 510% of an offering price are the norm. High sales charges are one of the incentives for sales people to push new issues and there are all the legal, accounting and corporate expenses that must be covered.

While privatizations around the world might seem attractive following investors' positive experiences with the UK, there are numerous complications with overseas IPOs on top of the regular difficulties of global investing. These include international differences in accounting practices and settlement arrangements; the identity and reputation of the sponsor; the language in which the prospectus is written; whether some issues are not available to non-residents; and the procedures for scaling down an application in the event of oversubscription. For example, if a German stock is oversubscribed, a non-euroland investor may suffer considerable exchange losses converting in and out of euros. In a great many countries, investors will have difficulty in getting the information needed, and a good broker heavily involved in this kind of business will often be hard to find.

New issues and privatizations in developing markets can cause additional conflicts. Brokering and banking may be combined so that an investment banking manager may have to offer interim financing to win the IPO business. Sometimes this link can bring down a top-notch firm like Peregrine in Hong Kong, which failed because it tied a $250 million loan guarantee to an Indonesian taxi company to tide it over until a share offer could be arranged. In between the loan guarantee and the planned share offer, Indonesia had a currency crisis and Peregrine had a balance sheet crisis.

It is conceivable that similar problems may arise as US banks get back into the new issues market. After the Depression, banking and securities were separated, but now they have come back together to meet international competition. It is possible that Goldman Sachs was close to going bankrupt in the British Telecom IPO because of a guarantee similar to that provided by Peregrine in Indonesia.

IPO analysis Guru: Ivo Welch

Finance professor Ivo Welch has an excellent ''resource page" of IPO data, literature and links on his website. One feature is an assessment of the twin phenomena of short-run underpricing and long-run underperformance of new issues. On the first point, Welch notes that the typical IPO underpricing the return from the offer price to the price when the market starts trading is about 10%, an astonishing figure for an average daily return. He asks why issuers "leave so much money on the table" and suggests a number of reasons:

When applying for shares in an IPO, you will typically get all the shares you requested if it is overpriced you are a victim of the winner's curse. But when an IPO is underpriced, you will only get shares on rare occasions, especially if you are not a favored client of the underwriters. As a result, you come out down on average and are unlikely to apply for shares in a fair-priced offering. So to get you to participate at all, issuers set a lower price, and while it appears that the average IPO leaves money on the table, the typical investor cannot profit from it.

Issuers like to donate some money to investors since they may want to return later for further funds. Investors will remember how good a deal they got with the IPO.

Underpricing solicits information from investors about their potential interest. Why would investors tell underwriters they like an offering unless they know that by doing so, the underwriter will give them more shares for a better price?

If one important investor defects, maybe all investors will follow. Hence, to ensure the first investor does not defect, it is better to play it safe and underprice.

There is an agency problem for the issuer: because underwriters naturally prefer easier to harder work (especially when the price is high, which makes selling difficult), it is best to make selling a little easier for them and underprice.

While IPOs can be very profitable for institutions with relatively short investment horizons and which have access to them at their offer price, this is rather like a quick payback for early support. For in the longer term, new issues are not attractive investments. A significant body of evidence indicates that on aggregate, they have underperformed the market, typically 3050% below comparable companies over three- to five-year periods. A study by Tim Loughran and Jay Ritter discusses some of that research and presents their own findings, which confirm IPOs' poor performance.

How can this long-run underperformance be explained? Welch explores the two most prominent explanations, the first of which is that corporate managers are smarter than the market and thus good at timing, taking advantage of overpriced stock. The second is that managers manipulate earnings, past and forecast, dressing IPOs up for sale. While analysts advising investors should spot these exaggerated figures, they are paid by firms in the business of selling IPOs.

Understanding IPO

One of the most seemingly attractive areas of investment is that of initial public offerings (IPOs). Buying shares the first time they are offered to the public has considerable natural appeal, especially in a bull market, tempting investors with potentially phenomenal short-term returns as well as exposure to exciting new companies and industries. And since the early 1980s, privatizations of state-owned enterprises around the world have become an additional source of new issues, providing investors with the opportunity to get low-priced stakes in big, stable businesses, often the dominant incumbents in core sectors of the global economy.

The objective of any new issue is to achieve the highest value for the issuer, while ensuring a buoyant start to secondary trading. Shares are generally offered at a fixed price, set by the sponsors of the issue, and based on multiples, forecasts of likely future profits, or a combination of multiples and forecasts. Alternatively, in countries outside the United States, like the UK, there might be a tender offer, where no price is set in advance, leaving it to the market forces of demand and supply.

Fixed-price IPOs are frequently underpriced, providing opportunities for stags, investors who buy in anticipation of an immediate price rise. Big instant profits may often be made if shares can be purchased at the offer price and sold soon after dealing begins returns in the order of 515% in one day, but with high variance across offerings. Understandably, such offers are often oversubscribed, leaving the sponsors to decide on the appropriate equity allocation: by ballot, by scaling-down large applications, or by giving preferential treatment to certain investors, typically their favored clients though in some cases the private investor. The method varies by country: in some countries, like the United States, it is discretionary; in others, it is mandated equal for equal submissions.
The UK privatization issues of the 1980s and 1990s tended to be markedly underpriced, sometimes coming with incentives for the private investor, and positively discriminating against the institutions in terms of allocation and even price. They have generally been regarded as a success in terms of investor returns, government revenues and improvement in corporate performance. Certainly, the UK program has inspired numerous other governments around the world to begin turning their public-sector companies into publicly quoted ones, though perhaps this is more inspired by the real performance of companies post-IPO than the amount raised at the IPO.

Like privatizations, private sector new issues are often viewed as a route to quick and easy profits, but for every ten or so successes, there is usually one that goes wrong or seriously fails to perform. Indeed, one study of the US market reveals that of nearly 5000 IPOs initiated between May 1988 and July 1998, nearly a third no longer trade their stock and 44% sell at a market price below their original offering price.

So private investors must always show great caution, being careful to study the prospectus, balance sheet and profit and loss account of any potential investment. Investing in IPOs is intrinsically risky and not for the faint of heart. Companies that have recently reported very good results or which are in fashionable industries with their best results at an indeterminate point in the future should be scrutinized especially diligently.

Investors should also note that conflicts of interest and potential abuses are rife in the distribution of new issues. IPOs are inevitably timed to benefit the seller not the buyer, aiming to extract the maximum value from the market. Indeed, several studies indicate that IPOs are usually not good investments, underperforming the market over the longer term. This may be a reflection of companies preparing the numbers for a couple of years, and underwriters overhyping and sales people overselling the shares. Such activities may be particularly prevalent in the late stages of a bull market.