Do Investors Recognise the Conflicts and Incentives in IPOs?
The process for initial public offerings (IPOs) is one of the most opaque areas of the market and is ripe for reform. The current IPO boom mirrors the excesses of the tech bubble a decade ago. That bubble resulted in fines and new rules, but it’s still not fixed.
It is clearly in the public’s interest to get pricing right. Better disclosure of IPO fees, allocation basis, and relevant conflict of interests are overdue. Investors should demand better IPO standards.
The first problem is the issue of pricing. Investment banks aim to set the right price at launch but often miss the mark spectacularly. Yet few complain because it is an extremely profitable area for the banks and those lucky enough to get allocations. Even those selling into a flotation are rarely able to challenge apparent mispricing, so mysterious is the process.
But there are losers.
IPOs that are underpriced not only miss out on some gain for founders and private equity backers but also usually reduce the cash that could have been raised by the company. Underpriced IPOs also encourage turnover of investors. When shares are underpriced and much sought after, the result is usually widespread fragmented distribution via small individual allocations. Not only does the gain tempt institutions to cash in, but also the allocated investments may simply not be material to portfolios. The small allotments can be seen as a nuisance, and fund managers quickly tidy up portfolios.
For some IPOs, the majority of shares can change hands within weeks of flotation. This means not only big rewards for some of those lucky enough to be allocated stock at the flotation price but also that a large portion of the investor base is now new. These shareholders will have higher expectations given the higher price paid but will likely have had less access to pre-IPO meetings and information.
In their defense, investment banks point to the difficulty of establishing an initial price when there has been no trading. They typically aim for a 10%–15% discount to true value and say it is easy to be wise after the event. In the current environment, investment banks have been able to float — and get high prices for — many technology businesses that are currently loss making. Time will tell whether the banks have got their sums right on these early stage businesses. The problem is that banks, initial investors, and in some instances, company executives collect their fees and rewards early, but the true value of advice and research may not be known until years later. Misaligned incentives can encourage the wrong behavior.
But pricing isn’t the only issue. The hidden danger is the potential for conflicts of interest. The major investment banks have got new issues down to a fine art. They know the ones they should bid for and how important it is to have the lead role. But the fees may not even be the best bit. The privilege of allocating much-sought-after shares around institutional investors can create a lot of patronage. The investment bank will benefit from the aftermarket business as initial investors flip their stock for a quick gain. And favored investors typically reflect their gratitude in other ways. Client interests can easily be compromised against this background of conflict. The situation needs more transparency — and possibly regulation.
There’s also the issue of timing. It is clear that many market participants believe that the current IPO process simply does not allow potential investors enough time to consider whether to invest and, if so, on what terms.
That problem is linked to the problem of asymmetrical information. This asymmetry has been particularly apparent in such issues as the float of Glencore in 2011. So many banks were signed up to work on that issue that there was almost no independent research, even though it was London’s largest-ever listing, raising around $11 billion. This risk would be reduced if the number of bookrunners on larger transactions was limited.
Such a limitation would also limit the potential for banks to be rewarded by vendors for unpaid past advice or simply to maintain lending relationships. However, even this step may not guarantee good research ahead of an IPO; there may still be insufficient incentive for brokers who are not involved in a deal to provide independent research.
There can also be a problem if independent directors are signed up late in the process. An independent board needs to be in place much sooner, well ahead of the “intention to float” announcement. Directors should take responsibility for the float process and adviser appointments, not just the prospectus. And they need to be on the board in time to fully understand the company’s prospects.
Much earlier engagement with potential investors — even up to a year ahead of a planned IPO — would help price formation. Independent analysis would also be helped by an earlier release of information. Clearly, the actual IPO price will not be known, but an early disclosure document would allow potential investors and others to start asking the right questions. And a key improvement would be greater transparency on fees. This might allow potential investors to assess the incentives for investment banks more readily.
The US SEC established a 2003 agreement that aims to ensure that IPO underwriting does not compromise research independence. However, the US agreement has not been mirrored in UK standards. Research should show conflicts, but much of what is issued in the United Kingdom by investment banks and stockbrokers is lightly regulated marketing commentary rather than certified independent research. That combined with the impact of social media also makes it much harder now to control information.
Although book building dominates, there are other IPO mechanisms, such as auctions. However, auctions fell into disuse in most markets in the late 1980s, with the United States and India as notable exceptions. Even in India, auctions are typically just a variation of a fixed-price public offer. Auctions have proved unpopular with equity investors; they are seen as complex and involving too much calculation of what others will pay. It seems that investors place a lot of trust in an underwriter. The major investment banks maintain relationships with a core network of regular investors, which speeds the process, and little specialist knowledge is needed by less sophisticated investors. But the key distinguishing feature of book building is that underwriters have substantial discretion over allocation and pricing. This needs scrutiny.
The current wave of IPOs undoubtedly has further to run. But they could serve up more excesses and embarrassment for all involved. If the problems of the dot-com IPO boom are not to be repeated, higher standards and greater transparency are needed now.
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