The EconomistOctober 26th 2019 Business 61M
argaret thatcher, a grocer’s daughter from Grantham,
knew a thing or two about selling. The privatisation of British
Gas (bg) in 1986, on the back of an advertising slogan, “If you see
Sid, tell him”, raised £9bn ($13bn), which at the time was the big-
gest-ever initial public offering (ipo). It wasn’t just Sid who lit it up.
The Thatcher government hired Goldman Sachs to hawk bgto
American investors. As privatisations spread, investment banks
such as Goldman used a new technique called book-building to
ramp up enthusiasm. Rather than only tapping retail investors,
they allocated blocks of shares to money managers such as Fidelity
Investments, increasing the pool of capital available. Since then,
the American ipomodel has conquered the world.
It has done so despite a sometimes tawdry reputation. The na-
dir in America was the dotcom boom in 1999-2000, when deliber-
ately underpriced ipos rocketed on their first day of trading, bank-
ers doled out “hot” ipos to executives in exchange for
underwriting business, and new shares were “spun” and “flipped”
for profit. This year the ipoprocess is under fire again. WeWork, an
office-rental firm, cancelled a listing that bankers once valued as
high as $104bn. Now SoftBank, its main backer, will throw it a
$9.5bn lifeline that values the firm’s equity at a puny $8bn. Shares
of Uber and Lyft, two ride-hailing companies, have slumped since
their ipos, a sure sign of overpricing. Meanwhile Beyond Meat, a
trendy vegan foodmaker, soared by 163% on day one, suggesting
the reverse.
In Silicon Valley venture capitalists are livid—even though they
are as much to blame for mispricing the unicorns as Wall Street.
But investment banks like Goldman and Morgan Stanley are con-
trite and asking themselves whether the traditional ipo, however
lucrative for them, remains the best means to bring tech firms to
market. This is healthy. Scrutiny of ipos is long overdue. To critics,
they are a classic case of cronyism. Even fans, such as Ann Sher-
man of DePaul University in Chicago, call them “legalised bribery”.
The challenge, though, is to find anything better.
Most of today’s ipos start with a roadshow in which executives
of the firm going public and underwriters hit the road—or take
private jets—in order to catch the attention of investors and elicit
orders from them. The process is part of building the book. For theunderwriter, the trick is to find an ipoprice that satisfies the com-
pany but also stimulates buying—providing a “pop” on the first
day of trading. The trouble with the “pop”, though, is that it repre-
sents money left on the table that should by rights belong to the
company’s sellers, not its buyers.
Jay Ritter of the University of Florida says that during the past
decade the underpricing of ipos in America left a whopping $39bn
on that table, or about 14% of the total sum raised. In theory, bank-
ers have an incentive to minimise that amount because they earn
fees amounting to as much as 7% of the value of the ipo. In prac-
tice, though, they often underprice the listing to favour big inves-
tor clients. Money managers pay higher trading commissions, or
“soft dollars”, he says, in exchange for access to the hottest listings.
That makes ipos look like a racket. But the rub is that until now
companies have mostly turned a blind eye. One reason, acknowl-
edges Mr Ritter, is psychological. The sellers usually pocket such a
windfall from an ipothat they do not fret about how much more
they could have made if it were priced optimally. But there is a big-
ger reason. Except for the best-known firms, the alternatives are
seen as too much of a gamble.
Other than book-building ipos, firms have two more ways of
going public. Auctioning shares to the highest bidders, as Google
did in 2004, or selling shares directly without underwriters and
without raising capital, a route taken recently by Spotify, a music-
streaming service, and Slack, an office-communications firm.
Notwithstanding Google’s success, auctions are unpopular. Ms
Sherman and two fellow academics, Ravi Jagannathan and Andrei
Jirnyi, have studied ipoauctions in at least 25 countries, including
Singapore, Taiwan, Turkey and France, and found that they were
abandoned in virtually all of them. In Japan they were mandatory
in 1989-97. They vanished soon after issuers became free to choose.
Direct listings are now creating a buzz in Silicon Valley. Some
big firms favour them because they already have lots of cash on
their balance-sheets and have no need to raise more through an
ipo. Furthermore, direct listings do not require an underwriter, so
are cheaper, and allow the sale of piles of shares quickly. Investors
are attracted by higher levels of liquidity than in an ipo. Banks are
less keen. The fee pool is lower. Only Goldman and Morgan Stanley
have shown much interest. Shares of Spotify and Slack have per-
formed poorly since listing, which has been discouraging. Airbnb,
a lettings agency, is considering a direct listing next year. The ap-
proach has yet to prove its worth.
The chief merit of book-building is that, as Ms Sherman puts it,
it allows issuers in effect to buy attention from the market, hence
the “legalised bribery”. Money managers know that if they appear
at the roadshow and give reliable feedback, they will win for them-
selves a share of the ipo.Tell Cicero, too
But it has never been easy to value companies. According to “Devil
Take the Hindmost” by Edward Chancellor, as far back as Cicero’s
time, buying new shares, or partes, in ventures fulfilling govern-
ment contracts was seen as a gamble that risk-averse ancient Ro-
mans avoided. Richard Sylla of New York University’s Stern School
of Business notes that America’s first public offering in 1781, of the
Bank of North America, flopped. A decade later, that of the Bank of
the United States surged like a “hot” stock. The values of both were
determined by the backdrop of the time: the revolutionary war and
its buoyant aftermath. However much anyone re-engineers the
process, valuing companies will always be a shot in the dark. 7Schumpeter If you see Sid, tell him
ipos are a racket. But try finding something better