Seriously, what is going on with IPOs?
Rep. Darrell Issa, R.-Calif., wants to know. To find out, he submitted a 15-page letter to U.S. Securities and Exchange Commission Chairwoman Mary Schapiro, on behalf of the Committee on Oversight and Government Reform. In the letter, which The Wall Street Journal subsequently posted, Issa posed 34 questions about the initial public offering process for Schapiro to answer.
Yet there’s one question to which he already seems to know the answer: whether Facebook’s (FB) IPO indicates grave problems with the way the IPO market works. “The Facebook IPO taught us that, at a minimum, the IPO process suffers substantial flaws,” Issa said in the letter to Schapiro.
Larry Elkin wrote in this space not long ago about how investors have come to expect a “pop” that results from a substantially undervalued IPO. Such a jump in price immediately after the offering has come to be considered so standard that when it doesn’t happen, as it didn’t for Facebook, its very absence is seen as an indication that something is wrong.
Such a pop does not consist of free money, however. Companies have effectively left money on the table when they go public in order to create that gap. And while there are a variety of factors that influenced Facebook’s performance in particular (including a glitch at Nasdaq the morning of the offering), it seems strange to blame Facebook for getting investors to pay full price for the company, or perhaps a lot more.
The traditional IPO pop isn’t written in stone. Nor is this to say that the current process is without problems. My colleague Anthony Criscuolo recently examined the ways in which the present system effectively puts the real benefits of IPOs out of reach of all but the largest investors. And, as his article points out, the valuation pop that is expected today was uncommon until the 1990s.
There are other ways to go public, of course. In 2004, Google used a modified Dutch auction to sell shares of its IPO in an effort to find a valuation close to a fair market price. Though a series of mistakes, including a badly timed Playboy interview that drew the ire of the SEC, affected the initial share price, many Google (GOOG) employees have done quite well for themselves all the same.
However, the Dutch auction is still not a popular way to go public. Some companies may fear that the investment bankers who underwrite public offerings would be unlikely to stir much interest in companies that will pay them little in the way of fees. If you refuse to pay salesmen, no one is going to sell your product. For a big company like Google, this was less of a problem, but it could be a much larger concern for companies without such a high profile.
Issa mentioned the Dutch auction model in his letter as a better way to bring a company to market. Even if it is not widely used, a Dutch auction is perfectly legal under current regulations, and companies can choose it if they prefer.
The Dutch auction may or may not be the solution to the current problems with the IPO market. Regardless, I am unsure that the government mandating this change on the market – or any change on a similar scale – is appropriate. The Congressional committee, through Issa, argued that underwriters “dictate pricing while only indirectly considering market supply-and-demand.” However, as Suzanne McGee pointed out in her Fiscal Times column, “No one forced those investors to agree to pay $38 a share for a stake in Facebook. […] Had the demand not been there, the underwriters would have kept the price range exactly where it had been, rather than boosting it at the last moment.”
Investing involves risk, and the “outsized losses for ordinary investors” Issa cites in his letter are not, in themselves, a reason for direct government interference. I don’t think it is clear that Facebook’s failure to pop is a problem. Even if it were, I don’t think that governmental micromanagement is the solution.
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Before we consider mandating the auction method, we should look at how it has worked in other countries. Japan began requiring the use of auctions for IPOs in 1989 and had repeated problems. They later tried all sorts of changes, such as putting an upper limit on allocations because they thought perhaps that the problem was that not enough bidders were getting shares. Finally, in 1997, they began giving issuers a choice of methods, and auctions quickly dried up.
There had been hundreds of IPO auctions around the world before the method was used by Google. We Americans like to think that we invent everything, but it would be a lot smarter to pay attention to the long, long track record of this method globally.