WSJ(11/3): Heard On The Street: IPO Money Left On Table
11/02/1999
Dow Jones Newswires
(Copyright © 1999 Dow Jones & Company, Inc.)
By Robert McGough and Randall Smith
Staff Reporters of The Wall Street Journal
Corporate America has left a record $23 billion on the table from IPOs this year - but no one's
going hungry.
The number represents the staggering gain generated in the first day of trading for all initial public
stock offerings this year through October. Translation: Corporate issuers could have pocketed a
total of $23 billion more had their IPOs been priced to demand.
So you would think the issuers - and the Wall Street underwriters that could have earned steeper
fees - would be livid.
Now, a new study shows why you would be wrong. The study, by professors Tim Loughran of
the University of Notre Dame and Jay R. Ritter at the University of Florida, concludes that issuers
are so thrilled by their sudden wealth that they basically don't care.
Meanwhile, for the Wall Street underwriters who take them public, there is an indirect - but very
tangible - benefit for the deals to be "underpriced." This is because institutional investors, in a bid
to be allocated a big chunk of IPO shares, will often do other kinds of business with underwriters,
the study says. The conclusions underscore the delicate balance in priorities for companies issuing
stock, their insiders and the investment banks that bring them public.
The paper is timely. Last month alone, the stocks of Akamai and Sycamore Networks each
soared by $1 billion more than their offering price on their first trading day. How juiced is the IPO
market these days? Newly public companies left a total of just $27 billion on the table in their
IPOs during the nine-year period ending 1998.
Here's how the process works: A company, and often its founding shareholders, sells some of its
stock through underwriters to investors at, say, $12 a share. But the stock starts trading at $36.
The company and its shareholders could have raised three times as much money as it did in the
IPO. And the underwriters, which often get a commission of 7% of the IPO price, could have
made gobs more in fees.
So why no complaints from the issuers? In most cases, the study says, underwriters already had
raised the IPO price of these highfliers. The result: These companies - and any selling shareholders
- already are getting much more money for their shares than they expected. Moreover, the value of
the shares they continue to hold soars on the first day of trading.
In such a situation, the researchers say, the company will focus more on the delightful surprise that
it is worth more than it anticipated - rather than on the dour mathematics that it could have eked
even more money out of the IPO.
"The natural human tendency is for people to pay attention to changes in their wealth," rather than
the absolute level, Mr. Ritter says. The phenomenon is predicted by a school of thought known as
"prospect theory."
Everyone seems to win. Companies often hire the same underwriters to do follow-on offerings;
and other companies seek out the same underwriters whose IPOs were priced so far below the
actual market demand for the stocks. And investors obviously are happy because many of them
have benefited from the quick oneday surge.
There are other factors. In July, Gadzoox Networks received $21 a share for the stock it sold to
the public - and saw the price of the stock close at $74.8125 on its first day of trading. Bill
Sickler, president and chief executive of Gadzoox, wasn't mad - he was thrilled. "It felt real good
that there was that much demand and support for what we were doing," he says.
Gadzoox, which makes equipment and software for storage-area networks, could presumably
have used an extra few million dollars to help market its products and develop the next generation
of products. Just getting the deal done was critical. "Yes you can price very high," he says, but
then you "risk being not fully subscribed."
Mr. Sickler's focus: Getting the company public, improving its future prospects and keeping the
business humming. In determining a price for the IPO, Mr. Sickler relied on his investment-banking
firm, Credit Suisse First Boston.
So why didn't CSFB seek a higher price? Victoria Harmon, a spokeswoman for Credit Suisse
First Boston, declined to comment. But some investment bankers argue that this is
"Monday-morning quarterbacking." In reality, they say they can't sell entire deals for the prices
they command at the end of the first day of trading.
Mr. Loughran, the study's co-author, concedes this may be true. But he says the huge rise in
prices does show that the deals were dramatically underpriced.
The study says that investment banks get paid indirectly when they underprice hot IPOs. If an
investment bank becomes known for offering a lot of hot deals, investors will want to do a lot of
business with the firm in order to be allocated the biggest chunk possible of these hot IPOs.
"They do this," the study says, "by trading with the capital-markets department of the underwriters
and overpaying for commissions."
Moreover, the study asserts - echoing prior academic studies - being known as a hot IPO
underwriter probably reduces the cost of marketing IPOs to investors. Investment bankers say
they don't underprice deals to generate other, indirect business for themselves.
Richard Kauffman, head of global stock capital markets at Morgan Stanley Dean Witter, says
handing out hot IPOs to favored institutions is meant "to compensate investors for the risks of
buying IPOs. While everybody remembers the latest hot tech IPOs, half the IPOs done since
1990 are below the issue price."
Why don't investment banks just price the IPOs at what the market will bear - and thus earn more
in underwriting commissions than they could probably earn in indirect business? One issue may be
that raking in enormous commissions on a fully priced IPO may be so unseemly as to turn off
prospective IPO clients and the public, Mr. Ritter says.
Also, underpricing a hot IPO is less risky for the underwriter if the IPO price turns out to be a
bubble, Mr. Ritter says. In that case, he says, squeezing out the highest possible IPO price today
could leave an investment bank facing "a lot of aggrieved investors a year from now."
Some investment bankers say they don't set IPO prices based on where the stocks may trade in
an offering's immediate aftermath in a frothy market. "We do not price deals to speculative
excess," Mr. Kauffman says. "A hot IPO can attract speculative excess, and so the test of how
much money is left on the table needs to be measured after that speculative excess has left the
market."
The amount of money "left on the table" may be harder to predict for IPOs of "companies that
represent paradigm shifts" than for companies "in relatively prosaic or mature business," Mr.
Kauffman argues.
Seeing how a stock trades after an IPO could give some investors greater confidence to pay up
themselves, he suggests. Says Mr. Kauffman: "Actually seeing the stock trade may encourage
them to pay more in the aftermarket."
(END) DOW JONES NEWS 11-02-99
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