What’s wrong with the market for initial public offerings is a lot like the problems with the system that exploits young basketball players: Most never make it to the big leagues and some people get rich while the average player’s dreams are dashed.
Now along comes a report from some practitioners of the IPO game, the folks at Midtown Research Group LLC in New York. Midtown established itself earlier this year as a boutique firm that researches and invests in initial public offerings.
Midtown’s principals–including Scott Sipprelle, who once was responsible for selling Morgan Stanley Dean Witter’s U.S. equity offerings–have unearthed some interesting statistics and offer a fresh perspective on IPOs.
In a report called “It Had to Happen,” Midtown contends that U.S. investment banks have abandoned whatever standards they once had regarding taking young companies public. Once upon a time, private firms that wanted to offer shares to the public–the “initial” means the shares haven’t been offered before– had to have sustainable and proven businesses before underwriters would suggest that their clients invest.
No longer.
“It is difficult to pinpoint when the rules of the game changed or even precisely what caused the change,” Midtown says. Some ideas: the decline of “relationship banking”; huge successes of Silicon Valley start-ups; explosion of mutual-fund assets; efficiency of venture capitalists at funding new start-ups to feed into the system, and cutthroat competition among investment banks themselves.
The result has been a wealth of deals with startlingly poor returns. Of 341 IPOs in 1997 that exceeded $20 million, 55 percent traded below their IPO price and 24 percent were down more than 50 percent at the time the study was conducted, according to Midtown.
“The response has been predictable,” the report says. “The IPO gate through which all aspiring enterprises must pass has become tarnished and tattered as a credible investment arena.”
Along with its scorn, Midtown offers some advice in the form of the “Ten Warning Signs of an IPO Time Bomb.”
Some are obvious, like the admonition to stay away from companies with a hastily arranged management team or where senior managers haven’t accumulated major stakes. Others are insightful, like being concerned if an IPO has been in registration with the Securities and Exchange Commission for too many months (that “can often signal an important due-diligence concern”) and avoiding the telltale “me-too transaction” of the third or fourth IPO in a hot sector.
One of Midtown’s warnings is downright shocking: It warns of the IPO supported by a “star-studded underwriting team.” According to Midtown’s research, over the last three years the median return on IPOs led by Morgan Stanley and Goldman, Sachs & Co. was 9 percent and 19 percent, respectively. But of the 33 deals in which the two banks shared underwriting responsibilities, the median return was minus 12 percent.
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It is as much fun for investors to watch smashing IPO successes as it is for sports fans to take in an NBA playoff game. Just be careful your money isn’t on the wannabes the hucksters are telling you are a sure thing.