Asymmetrical Information

He is almost correct. The people "in the know" on Wall Street still made out like bandits. Don't you think it is weird that they were bashing Google before the IPO and after the IPO had nothing but good things to say about it? Let's see, they could then pick up shares at $80+/share and sell them a few hours/days/weeks later for $110+. These Wall Street insiders are not stupid. If you don't let them take part in your IPO, they will still find ways to make their profit. Just a thought.........

Surowiecki is correct, of course. But there were all sorts of bogus reasons given for the underpricing of IPO's. The most laughable was that the big pop on the first day was good publicity for the company and meant the IPO was a "success," (for who?), but there were others.

The interesting thing is that these were not, by and large, challenged in the press or elsewhere. Instead the TV financial programs and the business press largely bought into it. What does that say about the quality of the financial news most people get?

Interesting post. I think many of us were fooled and I tend to agree with LB. So, is it time to short!?

It is interesting that they couldn't place all the shares at $108, but the stock was trading at $108 within 48 hours.

Let's remember, though, that making money on investments is not evil - it's the goal. Everytime someone makes a big gain, it doesn't mean a little guy got screwed somewhere...

Y'know, I remember sitting in an MBA class where one of the IPO managers for Credit Suisse went through the process of making the book, etc.

When the conversation turned one of the inconsistencies in IPO pricing, one of my classmates reacted with a "That can't be, it runs against efficient-market hypothesis". I couldn't resist a snigger, 'cos he we'd heard an explanation of the process where the agent-principal problems throbbed like a sore thumb.

The Google IPO was great; it's a shame that the founders weren't a bit more humble and less fumbling, and so then wouldn't have been rolled as much by Wall Street. And kudos to Bill Hambrecht for (potentially) changing the way Wall Street does business yet again.

"But the offering was also a success for another reason, which is that it forced institutional investors to compete, for once, on a level playing field. The problem with the current IPO system isn't just that companies end up leaving billions of dollars on the table when they go public, but that select mutual-fund and hedge-fund managers (as well as well-connected individuals) are handed what amounts to free money."

In fairness, though, there's another explanation for the sub-pricing in an IPO; that of the wide dispersal of information between the naive individual buyer and the more sophisticated institutional buyer, and the difference between information on performance between a newly listed security and existing securities in the market for which price history and volatility are well defined. I can't remember the argument exactly without mangling it, but it went along the lines that a "pop" in the shares shortly after the IPO kept both institution and individual buyers participating in IPO issues. Perhaps D^2 if he drops by can spell it out.

Tom,

Your recall is fairly accurate. The idea is that if you don't consistently underprice then individual investors will never participate, because they will believe that the better-informed institutions are hogging all the good deals.

There was, and may still be, a cottage industry of finance academics trying to justify IPO underpricing. Lots of theories, lots of papers published. I don't know if any very compelling explanation ever emerged.

"Your recall is fairly accurate. The idea is that if you don't consistently underprice then individual investors will never participate, because they will believe that the better-informed institutions are hogging all the good deals."

Ahh, yeah that was it. The same argument was made in an article in the FT today.

My view is (contra James) that the equity market never has, never will and was never intended to aggregate peoples' views on the fair value of equities. It aggregates capital, not opinions [1], and you understand pricing much better once you realise this and clear your head of muddled beliefs about information.

The IPO process is one by which people who own valuable but illiquid assets swap them for slightly less valuable but liquid claims. The IPO discount is the terms which "the market" sets for this valuable financial service. On average, those terms appear to be a discount of about 18%, which is what Google paid. What the Google IPO has actually proved is that the cartel of liquidity providers works reasonably well even without its agents (the investment banks).

[1] The proof of this is that there is one simple measure which could be enacted which would make the market a much better aggregator of information - to simply legalise insider dealing. However, this would have the effect of making the market less liquid, and the purpose of the market is liquidity, not information. QED.

dsquared,

OK, but 18% seems like an awfully big fee. Yes, there is Google, but that's one case.

What is puzzling is that the 18% is earned by selling your initial allotment at a profit to someone else. Without the someone else there is no liquidity, so it looks like you are being compensated for the risk that you will be unable to resell, that there are no fools in the market. That's not much of a risk.

As a general rule, when someone is making large amounts of money for a task that many people could do, that is neither particularly risky nor difficult, I tend to be skeptical of explanations that make it all seem wondrously sensible. Just a conspiratorial mindset, maybe.

It's not compensation for a service. It's the membership fee for a cartel. Look at it this way; if this auction mechanism is all that, then why would Google bother being listed at all? They could just keep the auction facility open, and all the Google shareholders could trade their stock over that.

But they don't want to do that, because they (correctly) suspect that this would lead to the stock being illiquid. Liquidity is scarce stuff, and if you want it, you have to go to where it is. One of the places where there is a lot of it is the NASDAQ, which is why Google wanted to quote there. But if you want to play in their park, part of the price of entry is that you get ripped off on the first slice.

It's not fair, but to be honest the distribution of spoils between capitalists is not a massive concern of mine.

I have no idea how the market is placing a value on the claims it is being offered on a company's future cash flow -- and this is what it's being offered, since shareholders don't get to walk off with pieces of the company if it's liquidated -- if it is not aggregating information about what that cash flow will be. Daniel says the market demands an 18% discount for an IPO. But an 18% discount to what? Fair market value? But what is that if the market is not an information-aggregation mechanism?

Would the market be more informationally efficient if insider trading were allowed? To some degree, probably. But insofar as it would reduce people's confidence in the markets and accentuate the principal-agent problem, it would also shrink the amount of work that outside investors would put into research and analysis, which would reduce informational efficiency. Recognizing that there's a balance to be struck between efficiency and liquidity doesn't mean that information is irrelevant.

Finally, given the number of institutional investors I know who run many billions of dollars and spend enormous amounts of time trying to figure out -- and who then make their investment decisions on the basis of -- reasonable projections of companies' DCF, I also think the assertion that the stock market is uninterested in judging the value of equities is empirically dubious at best.

I have a different take on this. As I recall before the tech craze we did not see these pops in IPOs, some would even trade down.

So why did this change during the tech craze? Maybe the banks did not rip off the companies they were taking public by leaving money on the table, maybe they were actually ripping off the public.

To do this the banks needed two things, to create a public demand, and to create credibility. Both of which could be done.

DEMAND: The banks started using their analysts to push these stocks as "strong buys" when the banks really knew that the stocks were almost worthless. Thus, they knew that they could create an articial demand for the stock by using their analysts to pump it.

CREDIBILITY: Pretty easy, if the institutional investors come in that is all you need.

So in the end you have a stock worth $2, that is priced initially at $20 and trades at $100 that day.

Why not price it higher than $20. Well, institutional investors are the ones taking the risk that the banks will succeed in creating that articical demand. They are the ones putting up the money so they get the big slice; however, in the end they have to split that with their friends.

This also assumes that the institutional investors know the stock is worth $2, which I would think they did. If all the fund managers could not figure out that eCrap was actually crap, then we would be talking about a lot of people who were really bad at their jobs.

In the end the stocks had to be priced at a point where the institutional investors were close to positive that individual investors would go gaga over how cheap the stock was issued and yell "Buy, Buy, Buy."

Now the last part of the puzzle is that the companies did not get ripped off at all. Quite the contrary, the original financiers of those companies, people we will just call VCs, got paid $20 a share for a stock only worth $2. The fact that it traded at $100 the first day might appear that the companies got shorted $80, but the truth is the $20 price was critical in creating that $80 shortage. One was the direct result of the other. No institutional investors would have bought the stock higher than $20 because they needed to be positive that they could sell it. Plus a company could not go public without those investors. So that was the fair market price, not for the stock that day, but for the one second that allowed the company to go public.

Then it all comes full circle. The institutional investors made a fortune, they banks were paid off by the Institutional Investors with a small fortune, and the VCs were paid off my the Institutional Investors with another small fortune for their risk. Split amongst three pigs, how nice.

And guess who paid for all of it?

Maybe I'm nutz!

Peter,

IPO underpricing existed well before the tech craze. Some of the papers on the subject use data at least as far back as 1960, and I think the phenomenon is even older than that.

James:

But an 18% discount to what?

To what it's prepared to pay on the second day. By the way, shareholders do so get to walk off with pieces of the company if it's liquidated; this is not particularly common with industrial companies but very common indeed with investment trusts and you can make a fair old bit of money (or alternatively, get your face ripped off) trading on this basis.

In fact, I submit the well known closed-end-fund anomaly as evidence that, DCF analysis aside, the market does not in general provide assessments of fair DCF value (for a closed-end fund, this discount could not arise otherwise). It uses DCF analysis to decide on what terms it will provide capital, but that's not the same thing. This is not completely unrelated, but it's not the same thing.

Would the market be more informationally efficient if insider trading were allowed? To some degree, probably. But insofar as it would reduce people's confidence in the markets and accentuate the principal-agent problem, it would also shrink the amount of work that outside investors would put into research and analysis, which would reduce informational efficiency. Recognizing that there's a balance to be struck between efficiency and liquidity doesn't mean that information is irrelevant.

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