MARGARET THATCHER, a grocer’s daughter from Grantham, knew a thing or two about selling. The privatisation of British Gas (BG) in 1986, on the back of an advertising slogan, “If you see Sid, tell him”, raised £9bn ($13bn), which at the time was the biggest-ever initial public offering (IPO). It wasn’t just Sid who lit it up. The Thatcher government hired Goldman Sachs to hawk BG to American investors. As privatisations spread, investment banks such as Goldman used a new technique called book-building to ramp up enthusiasm. Rather than only tapping retail investors, they allocated blocks of shares to money managers such as Fidelity Investments, increasing the pool of capital available. Since then, the American IPO model has conquered the world.
It has done so despite a sometimes tawdry reputation. The nadir in America was the dotcom boom in 1999-2000, when deliberately underpriced IPOs rocketed on their first day of trading, bankers doled out “hot” IPOs to executives in exchange for underwriting business, and new shares were “spun” and “flipped” for profit. This year the IPO process is under fire again. WeWork, an office-rental firm, cancelled a listing that bankers once valued as high as $104bn. Now SoftBank, its main backer, will throw it a $9.5bn lifeline that values the firm’s equity at a puny $8bn. Shares of Uber and Lyft, two ride-hailing companies, have slumped since their IPOs, a sure sign of overpricing. Meanwhile Beyond Meat, a trendy vegan foodmaker, soared by 163% on day one, suggesting the reverse.
In Silicon Valley venture capitalists are livid—even though they are as much to blame for mispricing the unicorns as Wall Street. But investment banks like Goldman and Morgan Stanley are contrite and asking themselves whether the traditional IPO, however lucrative for them, remains the best means to bring tech firms to market. This is healthy. Scrutiny of IPOs is long overdue. To critics, they are a classic case of cronyism. Even fans, such as Ann Sherman of DePaul University in Chicago, call them “legalised bribery”. The challenge, though, is to find anything better.
Most of today’s IPOs start with a roadshow in which executives of the firm going public and underwriters hit the road—or take private jets—in order to catch the attention of investors and elicit orders from them. The process is part of building the book. For the underwriter, the trick is to find an IPO price that satisfies the company but also stimulates buying—providing a “pop” on the first day of trading. The trouble with the “pop”, though, is that it represents money left on the table that should by rights belong to the company’s sellers, not its buyers.
Jay Ritter of the University of Florida says that during the past decade the underpricing of IPOs in America left a whopping $39bn on that table, or about 14% of the total sum raised. In theory, bankers have an incentive to minimise that amount because they earn fees amounting to as much as 7% of the value of the IPO. In practice, though, they often underprice the listing to favour big investor clients. Money managers pay higher trading commissions, or “soft dollars”, he says, in exchange for access to the hottest listings.
That makes IPOs look like a racket. But the rub is that until now companies have mostly turned a blind eye. One reason, acknowledges Mr Ritter, is psychological. The sellers usually pocket such a windfall from an IPO that they do not fret about how much more they could have made if it were priced optimally. But there is a bigger reason. Except for the best-known firms, the alternatives are seen as too much of a gamble.
Other than book-building IPOs, firms have two more ways of going public. Auctioning shares to the highest bidders, as Google did in 2004, or selling shares directly without underwriters and without raising capital, a route taken recently by Spotify, a music-streaming service, and Slack, an office-communications firm.
Notwithstanding Google’s success, auctions are unpopular. Ms Sherman and two fellow academics, Ravi Jagannathan and Andrei Jirnyi, have studied IPO auctions in at least 25 countries, including Singapore, Taiwan, Turkey and France, and found that they were abandoned in virtually all of them. In Japan they were mandatory in 1989-97. They vanished soon after issuers became free to choose.
Direct listings are now creating a buzz in Silicon Valley. Some big firms favour them because they already have lots of cash on their balance-sheets and have no need to raise more through an IPO. Furthermore, direct listings do not require an underwriter, so are cheaper, and allow the sale of piles of shares quickly. Investors are attracted by higher levels of liquidity than in an IPO. Banks are less keen. The fee pool is lower. Only Goldman and Morgan Stanley have shown much interest. Shares of Spotify and Slack have performed poorly since listing, which has been discouraging. Airbnb, a lettings agency, is considering a direct listing next year. The approach has yet to prove its worth.
The chief merit of book-building is that, as Ms Sherman puts it, it allows issuers in effect to buy attention from the market, hence the “legalised bribery”. Money managers know that if they appear at the roadshow and give reliable feedback, they will win for themselves a share of the IPO.
Tell Cicero, too
But it has never been easy to value companies. According to “Devil Take the Hindmost” by Edward Chancellor, as far back as Cicero’s time, buying new shares, or partes, in ventures fulfilling government contracts was seen as a gamble that risk-averse ancient Romans avoided. Richard Sylla of New York University’s Stern School of Business notes that America’s first public offering in 1781, of the Bank of North America, flopped. A decade later, that of the Bank of the United States surged like a “hot” stock. The values of both were determined by the backdrop of the time: the revolutionary war and its buoyant aftermath. However much anyone re-engineers the process, valuing companies will always be a shot in the dark. ■