Darrell Issa’s Misguided Push to Fix the IPO Process

Darrell Issa’s Misguided Push to Fix the IPO Process

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Griping about the process by which companies go public is a pastime nearly as venerable as the IPO itself. Indeed, it’s a rare deal that makes everyone – the company itself, potential and actual investors and the bankers being paid for undertaking the process – happy. A typical transaction usually results in at least one of the following: underwriters disappointed that they weren’t able to maximize (or hang on to) the fees they earned in the transaction; the company fretting that the IPO was mispriced or that shares are going to end up in the hands of hedge funds who will simply “flip” them; or investors upset that they never seem to get a large enough allocation of the hottest deals.

And then there was the Facebook (FB) IPO, in which pretty nearly everything went wrong. That’s why we now see the rare spectacle of a Congressional committee – the members of which always seem willing and eager to jump on any issue that will get them some headlines and face time on television during an election season – asking the SEC to address a series of questions about the fairness of the IPO process.

Do underwriters have too much discretion? Do affluent clients or institutional investors get an information “edge” over regular folks because of disclosure rules? Is the process of setting the price of an IPO, as it exists today, fair to all potential investors? Rep. Darrell Issa, a Republican from California who heads the House Oversight and Government Reform Committee, wrote a 15-page letter to SEC Chair Mary Schapiro, arguing that the nosedive in the value of Facebook’s freshly minted shares in the month since its IPO is a sign of a flawed process, one in which underwriters “dictate pricing while only indirectly considering market supply-and-demand.”

On the other hand, with the exception of the massive technological glitch at the Nasdaq on the first day of Facebook trading, one could argue that supply and demand worked just fine, thank you very much, and that complaints today about inadequate access to information are simply a way for investors unhappy with the way things turned out to find a respectable way to gripe about it. It’s not OK for them to say that they let their own greed and excitement run away with them to the point where they were willing to buy Facebook shares at the IPO price of $38 a share. But complaining about the IPO process itself is fair game.

The problem is that in this case, the arguments simply don’t hold water. Even if they weren’t among the elite crowd with whom research analysts shared concerns about forecasts for Facebook’s revenues, the warnings about the company’s slowing growth trajectory were all over the Internet. BreakingViews published an entire e-book devoted to the company’s history and business that included a section arguing that the company was overvalued even at $75 billion; the actual price put the value of the deal at north of $100 billion.

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Someone going out to buy a used car knows they need to get a mechanic to verify that the seller isn’t making exaggerated claims about the vehicle’s health; a potential investor who fails to do the minimal amount of due diligence on an IPO like Facebook (or who fails to heed the results of even a basic search for information) should be embarrassed to confess that publicly. There is an argument to be made that retail investors can be at a disadvantage to their institutional counterparts during the so-called pre-IPO “quiet period,” but Facebook is a crummy example to use in support of that argument, given the amount of debate and discussion surrounding the pricing. Back to the drawing board, please, Congressman Issa.

The Facebook IPO was all about greed running amok, and common sense taking a back seat – and a severe case of buyer’s remorse on the part of investors of all stripes and sizes. No one forced those investors to agree to pay $38 a share for a stake in Facebook. Morgan Stanley (MS) bankers with cattle prods weren’t standing behind them to demand that they place calls to their brokers demanding an even larger allocation. Had the demand not been there, the underwriters would have kept the price range exactly where it had been, rather than boosting it at the last moment. You can get away pushing the envelope on a smaller deal, but failing to hit on the right price for one as high profile as Facebook has led to the kind of public humiliation that no investment bank would knowingly risk.

The Congressional committee appears to believe that a Dutch auction – in which the price is initially set at a very high level, and then gradually reduced until it reaches a point where all the shares find buyers – is a more appropriate process. This approach has been promoted by the doyen of technology bankers, Bill Hambrecht, for the better part of two decades, and with more vehemence since the dotcom boom, during which fledgling technology companies routinely saw their share prices explode with giant “pops” after they began trading – an IPO priced at $15 a share might easily begin trading at $30 and end at $60 on its first day.

A Dutch auction-based process, Hambrecht has argued, ensures that an equilibrium is established between buyers and sellers; there isn’t a lot left on the table, but investors don’t feel they have been forced to overpay, since they helped shape the ultimate price. To date, the only major IPO conducted using a modified Dutch auction process was that of Google (GOOG), in the summer of 2004. Yes, bankers griped – but so, too, at the time, did many investors. And few of the large, high-profile companies to go public since – the kind of clients that have the power to tell their bankers exactly how they want their IPOs to happen – have opted to follow suit. General Motors (GM) didn’t. Burger King (BKC) didn’t. And Facebook didn’t. These companies aren’t foolish: they are very clear about who is in the driver’s seat in their negotiations with underwriters and aware that a Dutch auction-based IPO is an option. They each decided it wasn’t in the best interests of the company.

And that’s the most important element to remember here. An IPO is – or should be – a process that is conducted in pursuit of the best interests of the company. The company is seeking investors, and hiring bankers to raise as much capital as possible. During the process, it’s required to disclose a tremendous amount of information – just try printing out the hundreds of pages of a typical S-1 IPO filing, and you’ll see what I mean. It has to disclose the risks a potential investor runs, as well as years’ worth of financial data.

In return, investors are expected to do their due diligence. And the basics of behavioral finance reveal that those investors always believe that what they own is worth more than someone else is willing to pay for it, and that they, in turn, paid too much to acquire it.

In contrast, should the SEC be foolish enough to require that companies and their bankers adopt a specific process or model – such as the Dutch auction – that would be a violation of the free market principles the committee members appear to hold so dear.

By all means, probe the way that Nasdaq’s technology and high-speed trading appeared to contribute to the debacle that was Facebook’s debut – both offer valid cause for concern. It’s also worth taking a look at the way the distribution of relevant information is limited to select, privileged investors ahead of a typical IPO, although Facebook, given all the attention swirling around it, is a poor poster child for this issue.

But trying to remove greed, fear and buyer’s remorse from financial markets – and dressing that effort up in lofty phrases like “investor protection” and “preserving the integrity of the IPO process” – is a foolish use of the committee’s time and resources. Especially when torts lawyers are already eager to jump on any opportunity to sue an investment bank or a company for misleading investors.

The IPO process – like many others on Wall Street – is far from perfect. It has been improved over the years, with new rules to prevent analysts working for underwriters from hyping the stock their bosses are trying to flog to the public, and ones that require the IPO filings (along with other SEC filings) to be written in plain English rather than legalese. But it’s hard to figure out how the intervention of Congress and the SEC could do more than enrich a lot of lawyers, without making it any fairer.