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Debunking the IPO conspiracy theory

A recent scholarly article examined the IPO market's tremendous differences between offering prices and trading prices of new Internet issues, and asserted that wild returns could be explained by the nefarious and disreputable motives of evil investment bankers.

I read an article last week that would have been moderately amusing to me had it not been written by a professor at a prestigious Canadian university. We're all entitled to our opinions, but one could hope that those who influence young minds would attempt to be rational and balanced. At the very least, someone in a position of intellectual authority should present more than a slanted view of any particular issue.

The article at hand was about the investment banker-led conspiracy to increase volatility in the marketplace for Internet stocks. By such an endeavor, bankers hope to win the love and loyalty of institutional investors by allowing them unnaturally high returns on investments in IPOs.

Before we go any further, allow me to state that I work for one of those investment banks. There are two implications to that. First, I clearly have a vested interest in defending the profession, but second, and unlike Professor Loosecannon (as we'll call the individual), I actually know something about how and why decisions are made inside some of those institutions.

To continue, the article examined the recent behavior of the IPO market and the tremendous differences between offering prices and trading prices of new Internet issues. It is no longer all that surprising to see an IPO triple in the first few days, and the article's premise was that these wild returns could be explained by the nefarious and disreputable motives of evil investment bankers.

Apparently bankers, in an attempt to make their deals look better, are purposely mispricing transactions. That way, the deals are more likely to shoot up on opening day and will likely generate lots of headlines and chatter about the bank's hot hand. More important, with that strategy banks are able to provide unnaturally high, relatively riskless returns for their institutional clients, those who get the bulk of the shares of any new IPO.

One can see how this would be a popular theory: the evil banker and big institutions conspiring to somehow manipulate the stock market and short change the individual investor. (Never mind the fact that those big institutions grew large only because they have aggregated the investments of a very large number of individuals). Clearly, the scheme is based on some rational thoughts. Banks do like headlines and chatter and definitely like to boast about deal performance versus that of competition. Furthermore, investment banks do like their clients to prosper--happier clients generate more business. But that is where the rational part of the argument ends, because playing games with deal pricing is not a winning strategy.

For starters, were banks purposely underpricing deals in order to boost the performance of their institutional clients, they would be shortchanging, and violating their fiduciary responsibility to their other clients, the companies going public. In addition to being unethical, a policy of systematically underpricing deals would be just plain stupid. Investment banker fees are based on the size of the deal--the amount of proceeds generated for the company at the IPO price. It doesn't matter where the stock closes that first day, only where the deal is priced. How many folks honestly believe that bankers would purposely work to reduce their own fees?

Furthermore, an IPO is a modestly profitable transaction for an investment bank. The real money comes from the follow-on deals, secondary offerings, M&A work, and other advisory work. A corporate client who was short-changed on the IPO would be rather unlikely to use that bank for later work.

Secondly--and often overlooked in the current frenzy--is the mountain of evidence suggesting that those companies which have the best opening day performance generally underperform the market over the next six months. Savvy private companies trying to choose a banker look at the 6-, 12-, and 24-month performance of deals, rather than day one or week one, in assessing overall deal quality.

So if neither of the simple explanations are rational, how to explain the current market? Well, let's attack this issue from a different perspective. What if there were no conspiracy? What if the price printed on the front of the IPO document actually represented the combined efforts of the bankers and company to assess the company's prospects and risks? What if the filing range actually represented the best assessment, by those who had studied the company closely, of the entity's fair value? What if those charged with setting these prices were actually concerned with providing strong odds of reasonable returns for potential investors, not only this week, but over the next 12 months?

The pricing process is neither simple nor exact; mistakes happen. Business prospects change both for better and for worse, and stock prices are quick to reflect those changes. Furthermore, with Internet stocks, no one really knows what the future will bring--this is new territory.

Nevertheless, before placing a market order for the next hot IPO, stop to at least consider that the offering price was determined by a group of in-the-know bankers, lawyers, accountants, and members of corporate management, all of whom worked long and hard to set the pricing at a level that should both maximize revenue to the company selling stock and allow for a risk-adjusted reasonable return for investors.

Investors purchasing a stock up 100 percent or more above that suggested level are betting that they know more. Caveat Emptor.

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