"A few of my friends still believe it's good news whenever an IPO skyrockets. It's not-- it's the best indication that people are getting ripped off."

[Dave Farber <dave () farber net>]

------ Forwarded Message
From: Peter Wayner <pcw () flyzone com>
Date: Fri, 07 Mar 2003 14:18:34 -0500
To: dave () farber net
Subject: Re: [IP] Dan Gillmor: Quattrone clique disgraced Silicon Valley

 
Dave, I don't know if you've exhausted the IPO topic, but I spent some time
recently working through the IPO process. A few of my friends still believe
it's good news whenever an IPO skyrockets. It's not-- it's the best
indication that people are getting ripped off.

http://www.wayner.org/modules.php?name=News&file=article&sid=12

Let me know what you think.

_Peter

      
IPO Fraud 

Posted by admin on Friday, March 07 @ 14:14:22 EST

It looks like the SEC and the investment community may be going after Frank
Quattrone. Some may see this as a case of no good deed going unpunished
because the man brought such a flood of capital to Silicon Valley, but
others probably see it as a chance to punish someone guilty for ripping off
many people. I can't speak to the specifics of what Mr. Quattrone has done--
that's the job for the government, but I have watched the IPO world for long
enough to complain about the process in general. Enough of my friends worked
for these so-called hot companies and enough of them have been hurt by the
IPO process. It's time that things change.

The big problem comes when the shares soar on the first day. In the past,
most people have seen this as some wonderful, hypeworthy event. The hard
workers are getting rich. The initial investors are reaping big rewards.
Everyone should be happy and the press usually blathers away about the
strength of the IPO market.

Alas, that's so far from the truth. Many of the people are getting ripped
off because money meant to help the company achieve it's goals is heading
for the pockets of insiders. Yes, many of the great Dot Com companies were
silly and doomed to failure, but many of them never got all of the capital
the market intended for them. We'll never really know what was supposed to
happen because the money never reached the front line troops.

I believe that mispriced IPOs that skyrocketed on the first day are a real
moral and legal challenge for the technology industry and the capital
markets. While I'm sure that the laws have plenty of loopholes that may let
everyone escape to a life a leisure, I'm convinced that capital was
misdirected by this mechanism and this misdirection was one of the problems
that led to some of our major market failures. There are plenty of people
out of work because their companies didn't have the capital to complete
their business plans.

It's easy to work through the math and discover that much of the money that
investors intended to go toward a particular company went, instead, into the
hands of investment bankers and their chums. Let me take you through the
steps of some hypothetical company, call it ultrametabetaelectrotech or
UMBET for short. The bankers at J. Plutocrat and Fils convince the umbet
dudes that going public is the right step.

Here are key decision points along the journey:


*    1-- UMBET and Plutocrats file for an IPO including a document listing
all sorts of reasons why this is a truly risky venture that no one in their
right minds would ever buy.
*    2-- The marketplace ignores all of the warnings in (1) and concentrates
on the upside. The marketplace floods the Plutocrat firm with buy orders at
anywhere between 20 and 100 a share.
*    3-- The fils at Plutocrat look at this order book and decide that they
could sell 1 million shares at $40.
*    4-- The fils at Plutocrat ignore this reality and price the shares at
$20. 
*    5-- The dudes at UMBET decide to go along with this pricing. The
company will get $20 million minus the 7% commission paid to Plutocrat. Each
of the managers at UMBET don't really care what the price is because they
each have 10 million shares in their pocket. The market will assign a fair
price afterwards no matter what the initial price happens to be.
*    6-- The fils at Plutocrat start allocating the 1 million shares to
others. They know from their information about the order book that the price
will pop up to at least $40/share because of the demand. It might go higher.
That means that every share they give someone is probably equivalent to $20
bill. As such, they allocate shares to people in these classes:
*    a-- Great guys and gals.
*    b-- People they owe money or favors. Politicians have been some of the
lucky to get these shares.
*    c-- Mutual funds that want to move money between funds.
*    d-- Investors who want technology stocks and are willing to pay roughly
30% of the first day return back to the Plutocrats in inflated
"commissions". 
*    e-- Others with malice aforethought.


*    7-- The Plutocrats tell investors that one way to get 1000 shares at
$20 is to make a commitment to buy 1000 shares on the first day in the
aftermarket. Investment banks like deals like this because it shows
"support" for the shares.
*    8-- The IPO day arrives. The shares begin at $20. Investors start
buying and run up the price to $40. Everyone is happy. Everyone talks about
what a success the IPO is.

Here's why I think this hypothetical IPO was a fraud:

*    The company only ended up with $20 million in the bank to support
expansion and the pursuit of the business success despite the fact that many
of the investors thought it should be allocated $40 million.
*    People who bought on the day of issue paid $40/share, but only
$20/share went to the company. They lost 50% right off the bat. Other
investors flipping their shares walked away with it.
*    People who bought in step (7) paid an average of $30/share and only
lost $10/share to the "inefficiencies" of the IPO process. They may think
they've got a great 33% gain on their investment on the first day. ("Boss,
we paid an average of $30/share for this and it now trades at $40."
"Simpson, I like the cut of your jib.") This is a charade. There's only
$20/share left in the company. They've really suffered at 33% loss!
*    The mutual funds in (6c) are robbing the investors in one fund in a
family to reward another. These funds often generate outstanding returns in
new funds by allocating the underpriced shares to the new hot fund in the
family. The investors in the old, tired fund end up with shares priced in
the after market. 
*    The payoff recipients in (6b) are almost sure to recognize the
$20/share they receive as a pure gift. If they don't count it as a debt, the
Fils at Plutocrat aren't doing their jobs right.
*    There may be some truly great folks buying at step (6a), but I'll let
the readers decided the probable size of this group.
*    The umbet management dudes in (5) just let someone walk away company
assets (shares) worth $40 a piece for a price of only $20. If that's not a
breach of fiduciary duty, I don't know what is. To make matters worse, some
of the lucky folks are called "friends and family".
*    The Fils in step (4) ignore good faith offers of a higher price. That
sounds like a breach of fiduciary responsibility to me.

Recently, the news stories focus on prosecuting people for spinning or
destroying documents. That may be the right legal strategy because the legal
system probably protects the underwriter even when coming up with a
completely bogus price.

The sad fact is that there is a better way. Bill Hambrecht has been pushing
his OpenIPO concept for some time, but Wall Street resists it. Instead of
allocating shares to the lucky insiders, the system chooses the people
willing to pay the most money. The cash flowing into the company is
maximized and the fraud is eliminated.

I've discussed this topic with others in the industry. Some people agree,
but others tell me I'm flat out wrong. There needs to be the slop in the
system to reward everyone or else people won't buy the shares at all. I
don't believe this. It's been well known for some time that people who buy
IPO shares in the aftermarket are usually net losers, at least on average.
Most savvy investors know that the aftermarket is a sucker's game. The
practice of allocating shares to trusted insiders and investment friends was
hurting the aftermarket before the crash and now it's completely destroyed
the IPO business. There are no IPOs is because no one trusts the mechanism
anymore. 

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