CurrentOfferings.com Story:

IPOs return to make the rich richer -- again

Despite efforts to change Wall Street's practices, big investment banks still make sure their best clients get access to IPO shares, leaving out the little guy.

By Michael Brush, MSN/CNBC, November 9, 2004

Initial public offerings, those gold-spinning, instant-millionaire machines that also happen to bring companies public, are back. And it's not just the top dogs like billionaire Google (GOOG, news, msgs) founders Larry Page and Sergey Brin who are becoming filthy rich.

Anyone privileged enough to get in early on the right deals can make out like a bandit, almost like they did during the Internet bubble. Take Shopping.com (SHOP, news, msgs). In late October, this deal was priced by investment bankers at $18 a share, meaning investors with connections to the right Wall Street bankers could pick up the stock at that price.

Lucky for them, because the stock opened at $23 and finished its first day near $29, giving those fortunate insiders a 50% gain.

Or what about DreamWorks Animation SKG (DWA, news, msgs), run by Jeffrey Katzenberg, David Geffen and Steven Spielberg? The studio's hit movies like "Shrek 2" and "Shark Tale" teach that the world rewards good character. DreamWorks' IPO, however, sent the message that it's who you know that counts. The stock opened 38% above the offering price in its first trading day, lining the pockets of investors whose connections helped them buy shares at the offering price.

But what about deals for the average investor, the people without friends on Wall Street? Has anything really changed in the profitable yet shadowy IPO world since New York Attorney General Eliot Spitzer tried to clean up Wall Street? Will Google's efforts to break the mold make any lasting changes?

While the blatant abuses are gone and better-quality companies are going public, the IPO game unfortunately is still rigged to favor the rich and famous. And Wall Street's lock on the system, combined with a lack of willpower among regulators for bigger reforms, means it's not likely to change any time soon.

In short, there's good news and bad news, but the little guy still gets short shrift. Here's a closer look.

The good news

The quality of IPOs has improved. During the bubble, Wall Street had a running joke that "businesses" could get funding with little more than a PowerPoint presentation, even if investors who lost money on over-hyped companies didn't wind up laughing.

"Five years ago we were looking at a lot of concept companies with no revenues," says Jocelyn Arel, an attorney who does IPO work at the Boston-based law firm Testa Hurwitz & Thibeault. "Today we have gotten back to the idea that companies have to have fundamentals to access the public offering market."

One reason quality is up is that the economic downturn culled weak players from the current crop of start-up companies, says Tom Taulli, who tracks the latest IPO news at his Web site, CurrentOfferings.

The most blatant corruption is behind us. During the bubble, Wall Street dealmakers swapped shares of juicy IPOs with executives for investment banking business, a process known as "spinning." It's unlikely anything as blatant as that is going on now.

"I really think it has been cleaned up. There is a great deal of sensitivity to try and avoid some of the practices that got people in trouble," says Tom Hopkins, an attorney with the San Diego-based law firm Sheppard Mullin Richter & Hampton. Hopkins represents issuing companies including the recent IPO Jamdat Mobile (JMDT, news, msgs), which sells games, entertainment and ring tones online.

What's more, regulators aren't done yet.

A Securities and Exchange Commission official says new cases cracking down on recent IPO shenanigans will come out soon. We'll also see new rules from the SEC and the National Association of Securities Dealers, another market regulator, forcing Wall Street to shed more light on how it sets IPO prices and "builds a book" of buyers before a company goes public.

"More transparency would go a long way to ensure that spinning doesn't occur, but also that IPO shares don't wind up in the hands of politicians," says Linda Killian, portfolio manager at IPO Plus Aftermarket (IPOSX, news, msgs). The fund, run by Renaissance Capital, tracks IPO news at its Web site, ipohome.com.

The bad news

IPOs still go to the wealthy. Despite these improvements, things haven't changed much in the IPO market for the little guy, who remains frozen out of juicy deals. Instead, brokers at investment banks cooking up the best IPOs continue to dole out the shares to their wealthiest customers who produce the most commissions.

"At end of the day, IPOs are still going to be allocated to the best clients," says Barclay Corbus, co-chief executive at WR Hambrecht + Co., a San Francisco-based investment bank that handles a lot of smaller IPOs. "If their highest commission generators demand shares, it is difficult for the investment bank to say no."

Even if it doesn't seem democratic, that's their right, since they control the deal, say defenders of this practice. That would make sense, if funny business in the world of IPOs stopped there. But it doesn't.

IPOs are still being priced far too low. All you have to do is look at the one-day pops in IPO prices of 40% to 50% to see that something is amiss in how investment bankers price these deals. No one can prove it, but Wall Street critics suspect that investment bankers are deliberately underpricing deals so they can reward their best clients by allotting them cheap shares.

"There is more underpricing than is needed to sell the deal. Too many of the deals are still vastly oversubscribed, meaning people know they are getting a great deal," says IPO expert Jay Ritter, the Cordell Professor of Finance at the College of Business Administration, University of Florida. "The numbers are as egregious as they were a few years ago, when huge amounts of money were left on the table. There have been some changes in the IPO market, but largely it's business as usual."

Defenders of the system argue that IPOs have to be priced low to reward investors for taking positions in risky, unseasoned companies. But if this were true, why would Wall Street brokerages consistently spread the "risk" around to just their most lucrative clients?

Google didn't help

IPO experts don't expect any lasting changes to the system following Google's attempt to break the mold by using an auction system to set the price of its IPO. For one thing, the whole process did a lousy job of getting Google a good IPO price. The stock opened at around $85 and more than doubled in two months.

Besides, few companies have the cachet and broad consumer appeal that emboldened Google to take on the system. "I don't think you are going to see a real sea change in how IPOs get done," says Hopkins.

Still, retail investors do have a shot at a handful of small IPOs through WR Hambrecht + Co. All you need is $2,000 to set up a brokerage account at this San Francisco-based investment bank. This gives you the right to bid on IPOs in the "Dutch auction" it uses to set IPO prices. Once all the bids are in, Hambrecht determines the price at which all shares can be sold. Then it awards the shares to bidders on a pro-rata basis.

In theory, this practice does such a good job at setting a "fair" price for an IPO that there's not much chance you'll see anything like a 40% price pop on the first trading day. In practice, that's what you find. On average, Hambrecht IPOs rise 4% on the first day, says Hambrecht's co-chief executive Corbus. In contrast, so far this year on the first day out, the average IPO closed 8.5% above where the deal was priced, according to Dealogic, a New York-based firm that provides data and software systems to professional investors.

But that doesn't mean Hambrecht IPOs are bad for investors. Its deals like Overstock.com (OSTK, news, msgs) and Peet's Coffee & Tea (PEET, news, msgs) have more than tripled since coming out. A more recent one, New River Pharmaceuticals (NRPH, news, msgs), was up 50% in three months.

And you can make the case that Hambrecht's approach is better for the economy, too, because it puts more IPO wealth where it belongs. That would be in the hands of issuing companies that know how to put the funds to the best use possible, creating jobs, growth and shareholder wealth. Despite these advantages, Hambrecht still handles less than 2% of all IPOs, and you shouldn't expect its auction system to catch on anytime soon. There's simply too much money at stake for those in control to expect any real changes.