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Wednesday, 7 July 2010

Are IPO’s Bitter Lemons?

In Used Car Dealers We Trust

The Initial Public Offering (IPO) market exposes investors to a classic problem of asymmetric information: there’s not much doubt that the insiders know far more about the true worth of their company than do potential purchasers. So, as outlined by George Akerlof in his classic treatise on the used car market, we would expect that the only companies on offer in this market should be the ones you really don’t want to buy; companies with sticky accelerators and malfunctioning brakes.

Traditionally there’s a way around this impasse, the use of trusted intermediaries whose skill and judgement can be relied on by potential investors to overcome the urge of company owners to maximise their gains and who can distinguish the dross from the jewels. Bizarrely the result of this intervention supposedly sees companies floating at valuations below their real value but, unfortunately, this comes with the ever-present risk of abuse by trustees. Situation abnormal, as usual.

Detecting Lemons

George Akerlof’s study of the effect of asymmetric information flows on markets is something we’ve looked at before. Briefly, what he showed was that, in some situations market mechanisms can breakdown leading to a market failure. In the case of used cars he pointed out that typically sellers know more about the car than buyers and that a seller of a good car will want a good price for it. Unfortunately buyers can’t distinguish between good and bad vehicles so won’t be prepared to pay top-dollar for if, sellers then won’t sell and the net result is that the only vehicles available in the used car market are duds – so-called lemons.

This type of breakdown in markets is possible anywhere we find sellers and buyers with different levels of knowledge – information asymmetries. Quite clearly the sellers of companies during IPO’s know a lot more than the buyers exposing both sides to these types of issue. The way around this is the classic one; to involve a trusted intermediary who can analyse the company properly and manage the creation of an orderly and fair market.

Such intermediaries generally have ways of signalling to investors that they’re reliable. Mainly this is done by setting themselves up for business in such a way that everyone can see that they’re in for the long-haul. This is why banks traditionally have such imposing premises: it’s a statement that they’re not likely to disappear overnight. This is essentially the model for large-scale motor vehicle distributors as well – it’s not in their interests to sell lemons to their customers because firstly they need repeat business and secondly knowledge of their lack of trustworthiness gets around.

IPO Book-building and Underpricing

As for cars, so for companies. Large brokerages set themselves up as intermediaries between the owners of the companies and prospective sellers, operating as underwriters, who are responsible for managing the IPO process. They then “build a book”: they try to figure out what the interest is in the company to be floated and develop a demand curve, which allows them to set a price at a level where demand exceeds supply. There’s risk involved in this because all bids are indicative and bidders can pull out at any point before they’re declared irrevocable, so the underwriters typically over-allocate stock.

Of course, over-allocation has the effect of potentially denying purchasers access to the stock they want which can lead to a short-term spike in price as investors try to buy the stock they want in the open market. The net result of this is rather odd – generally IPO’s end up being underpriced, a position which is clearly not in the interests of the people selling the company who, presumably, would like to get as much money as possible from the fruits of their labour. We can see this clearly from the change in price of IPO’d stocks during the first day of trading – they typically bounce as the demand exceeds the supply. Company owners have been leaving an astonishing amount of money on the table: $124 billion since 1990, over 21% of the first-day return.

Friends and Family

There’s also a secondary, potentially invidious problem because the underwriters can generally choose who to allocate stock to. Given the asymmetric information issues in the IPO market it’s absolutely critical that the underwriting brokerages act transparently and honestly in their dealings with subscribers. Failure to do so opens up all of the issues associated with Akerlof’s information asymmetry and would lead to the underwriters ending up with roughly the same reputation as the dodgy, fly-by-night car lot at the edge of town, rather than a dealership that manages its reputation with an eye to the next hundred years.

Of course, we all know which route many underwriters proceeded to take during the dotcom years, when market abuses became notorious. One of the favoured explanations for the underpricing of IPO’s relates to the use of underpriced IPO stock to reward “friends and family”.

As Richard Booth relates in Going Public, Selling Stock and Buying Liquidity:
“underpricing may be used by underwriters as currency for many other purposes. It can be use to reward good customers or to attract new business. Or it can be used as part of a package deal in which investors agree to buy other securities or services at prices that are less attractive. Indeed, such practices were at the core of much of the IPO litigation (both civil and criminal) that followed the dotcom bust”
Spinning, Flipping, Laddering

This isn’t the only reason for possible underpricing – it also reduces the risk for the underwriters of failing to get the issue away, lowers litigation risk and, potentially, it’s actually in the interests of the company owners to see the stock price roar away on the first day, especially if they’ve retained significant amounts of stock. So the people most likely to complain about the process may also have the most to gain from it.

However, brokerage practises such as “spinning” – offering IPO stock in one company to the executives of another company in return for their business – “flipping”, where recipients of IPO stock sell on the first day and then funnel part of the profits back to the underwriter as a form of profit-sharing and “laddering” where preferential stock allocation was given to investors prepared to commit to further purchases in the market after the floatation, thus creating an artificial first day market, have brought the process into disrepute, leading to some nasty publicity and large fines for perps.

One interesting idea, which Booth floats, is that the IPO first-day price pop is, in effect, the inverse of a premium for a takeover – it’s a discount to get a sale away. However, it’s entirely likely that the driving force behind first-day premiums has changed over time. Prior to the dotcom era Loughran and Ritter argue that it was driven by the people who initially buying IPO stock tending to overpay due to insufficient knowledge – the classic issue of asymmetric information. This behaviour, known as the winner’s curse problem, explains the apparent undervaluation of IPO’s by simply arguing that it’s not an undervaluation at all, just human misbehaviour.

Winner's Curse or Corruption Hypothesis?

On the other hand, the excessive first-day premiums during the late 1990’s and early 2000 seems to be evidence of underwriters using their discretion to allocate IPO stock using the various dubious methods described earlier to eliminate the winner’s curse: they find that this corruption hypothesis largely explains the large premiums generated during this era.

Presumably the fall in first-day premiums back a more normal range in the last decade is prima facia evidence that the IPO system is more or less working OK again. Which would be about right, even as regulators continue to introduce new rules to combat a set of abuses which probably aren’t a factor anymore. As ever, regulators fight the last battle; investors the latest one.

Related articles: Akerlof's Lemons: Risk Asymmetry Dangers for Investors, Basel, Faulty?, Finance: Where the Law of One Price Doesn't Apply

1 comment:

Rob Bennett said...

they find that this corruption hypothesis largely explains the large premiums generated during this era.

I see another possibility -- they could get away with it to a greater extent then than they can now.

That's not exactly corruption, is it?

People get sloppy in bull markets. All financial transactions are affected by the sloppiness.

It makes thing sound worse than they really are to refer to this as "corruption," in my view. The reality is bad enough!