FOOL ON THE HILL
An Investment Opinion
Are Hot IPOs a Good Thing? Bill Mann (TMF Otter)
January 12, 2000
1999 will be remembered in investing as the year of the exploding IPOs. Actually, it was a trend that began in 1998 with such Internet companies as eBay (Nasdaq: EBAY) and theglobe.com (Nasdaq: TGLO) making their fiery debuts amid great fanfare and a near panic as average investors clambered to get on board as soon as the companies began trading. Can it really be that eBay has only been public for little more than a year? Yep, it's just a toddler, but in Internet time it seems like the graybeard on the block: spry, learned, mature.
The "pop" encountered by the market with some companies has been nothing less than staggering, but this phenomenon is entirely new. In fact, of the 12 IPOs with the largest first day gains, all have been within the last 13 months. This is a staggering concept. To my mind, it also points to something that is very, very wrong, something that the investors of these companies will end up paying for.
It even seems that IPOs are executed for the wrong reasons these days. IPOs are not and should not be held for the benefit of the insiders, nor the investment bankers, nor their best clients, nor the public. An IPO is nothing more than a tool that allows a company to raise money for itself for use in future operations. Raising money by selling equity. Companies could just as easily raise money by taking on additional debt.
Let me rephrase this. An Initial Public Offering is held to raise money for the company. Period. It's not some charitable event, some "let's give the common man some of our company" kind of largesse. Do you honestly think that companies want to deal with the likes of you and the level of reporting required by going public? No, they really don't, regardless of the irresistible charm you may possess.
By going public, a privately held company gives up a level of freedom it had and allows us to own shares. In exchange, the company gets extra headaches, extra disclosure requirements, extra scrutiny, extra costs, oh, and one more thing -- extra money. Several very large, established private companies made the decision to go public last year, most notably UPS (NYSE: UPS) and Goldman Sachs (NYSE: GS). You can rest assured that they did not do so for your benefit. They did it to raise money for the companies. (I'm sure that the insiders were not blind to their own personal gains from such a move, however.)
So companies that see their stocks go on a rampage the first day of trading all have one thing in common -- they have allowed a huge sum of money to walk off the table and into the pockets of someone else. And every time just such an event happens, I automatically question the wisdom of the management of the company.
Let's take Red Hat (Nasdaq: RHAT), for example. This is a company that IPO'ed in August and saw its shares increase 271% above IPO price that day. The way this works is as follows: Red Hat has an IPO price that is determined by the underwriters -- in this case, Goldman Sachs with E*Offering, Hambrecht & Quist, and Thomas Wiesel -- as being supportable given the company's business position. Upon the IPO, the underwriter and other investment banks are given shares to keep themselves or to offer to their own clients. Once these allotted shares are allocated, the company becomes available at the prevailing market rate to the public.
But who has benefited from the spread between the stated IPO price and the actual market price? None other than the underwriters and their select clients. So for Red Hat, the underwriter guided them to a reasonable market level that turned out to be about 70% TOO LOW. The funds represented in that 70% spread are monies that Red Hat does not have available for strategic and operational investments. How much are we talking about? Well, the gross of the 6,900,000 shares offered was $96 million at $14 per share. If the underwriters had perfectly predicted the market (a tall order, to be sure), the actual gross could have been $456 million, a pretty significant difference. Now, I know, this is a company with a market cap of $18 billion dollars, so the percentage that they left on the table is relatively small, right?
Wrong. Wrong, wrong, wrong.
Red Hat's IPO had the effect of giving $360 million dollars in proceeds to companies other than Red Hat. Not $360 million in value mind you, $360 million in cash. No wonder investment banks get frothy about doing IPOs. They end up controlling, in cases like Red Hat's, millions of dollars in marketable securities that appreciate instantly. Pretty powerful stuff, those 250% CDs with a maturation time of 30 minutes.
So what has changed about the marketplace that has skewed the IPO process to the edges of credibility? Greed, pure and simple. But what surprises me is that more companies doing these equity offerings don't fight this gross underpricing by the underwriters -- the companies that are supposed to be helping them raise capital in the first place. The conflict of interest for these underwriters is enormous. Help their corporate clients raise money, but at the same time, every dollar they can leave off the IPO price is another potential dollar that they can pocket themselves and spread to their cronies, in all the ways described above and more.
This type of atmosphere makes me, just for a second, feel bad for the retail brokers and the atmosphere in which they have to work. Can you imagine the stink that investors would make if a broker advised them to sell a security in the morning at $12 that shot up to $40 that same afternoon, and moreover, that the broker himself bought the security and then resold it for the difference? That broker's license would not be long for this world, for sure. In any other line of business, usurious practices such as these are the fodder for 60 Minutes exposes. Does the fact that the transaction is on a business-to-business level make it any different? Certainly, it shouldn't, particularly when the long-term losers in this transaction are the investors who must suffer dilution when the company requires additional funds for expansion of its business.
Eventually Red Hat, as a company running an operational deficit, will have to raise more funds, at which time they can either take on debt or hold a secondary offering, diluting the shares of all existing shareholders. Certainly at that point, the hundreds of millions of dollars that walked off the table during the initial public offering will seem much more substantial to its investors.
I applaud companies such as FreeMarkets (Nasdaq: FMKT), which, even though it had a significant "pop" at its IPO, was at least savvy enough to press the IPO price significantly higher. Freemarkets upped its price from $24 to an eventual offering at $48 per share, deriving substantially more funds for the company than it would have otherwise. Investors in the company with an even marginal interest in its fundamental growth potential would be well-served to recognize that by doing so the company has around 100% more cash in its coffers to bring about that growth. And that is a good thing.
TMFOtter on the boards.
- Freeedgar S-1 Registration for Red Hat
- Freeedgar S-1 Registration for FreeMarkets
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