IPO Risks – Initial Public Offering Programs

When you receive a get-rich-quick solicitation in your email inbox, you’re probably schooled to be skeptical. “Isn’t this sweet,” you say to yourself. “They have the secret of wealth, and instead of using it themselves, they want to share it with me, a perfect stranger!” You might do well to adopt the same attitude toward the initial-public-offering programs created recently by Charles Schwab, Fidelity Brokerage, E*Trade Group, and other brokers.

IPOs–the stock of companies going public for the first time–have long been the exclusive province of big institutional investors, which are typically solicited in advance by a deal’s underwriters to take large chunks of shares when the offering goes to market. When trading opens, the stock price may soar, as it did for Netscape’s 1995 IPO, handing a tidy profit to investors with an inside track. The brokerage’s new IPO programs are supposed to give “the little guy” a chance to share the goodies. In September, Charles Schwab struck distribution deals with three investment banking firms–Hambrecht & Quist, Credit Suisse First Boston, and J.P. Morgan–to get a piece of their IPOs. Fidelity Brokerage Services has formed an alliance with Salomon Smith Barney. And E*Trade has a deal with BancAmerica Robertson Stephens.

Risky IPOs

These arrangements will make the playing field a little more even. Don’t be too thankful, though. The IPO gridiron is still tough on small players. The biggest problem is that most IPOs do poorly. In a study of 3,186 deals, representing virtually all the IPOs brought to market in the 1980s, Porter K. Wheeler–the Jefferson Group’s chief economist at the time–found that “only 58 percent could be priced on a national market at the end of 1989, and only one-third could be shown to have a market value above their issue price.” Of those that could be priced as of December 31, 1989, only 57 percent showed a profit–this, during a boom period for the overall market. Only a quarter of the IPOs outperformed the Standard & Poor’s 500 index, and the S&P beat the IPOs’ performance in eight of the 10 years studied.

Weren’t some of the ones that couldn’t be priced taken over at a big profit to investors? Sure, but others just went bankrupt. In general, the IPOs that disappeared performed a little worse than those that stuck around.

Of course, a few big winners can make up for a good many hard hits. But institutional investors will likely find ways to keep the lion’s share of the truly hot deals. It will be hard for investment bankers to say no to the big banks, insurance companies, and mutual funds that bring them a river of commissions.

“There are absolutely going to be hot deals, like a Netscape or a Yahoo!, where everyone will want more than they can get,” says Tracey Gordon, a spokeswoman for Schwab.

To make sure it isn’t left out in the cold, Fidelity Brokerage has an agreement with Salomon Smith Barney assuring that it will be offered 10 percent of the shares in every deal. Schwab didn’t take that path, says Gordon, because it doesn’t want to feel obliged to sell a deal that is “not appropriate.” In theory, Fidelity can reject any dogs the investment bankers send its way. In practice, though, Salomon won’t be happy if the broker tries to skim the cream.

So far, Fidelity hasn’t turned down any deals. After all, selling stock is how brokerage houses pay their bills. So they may wind up having to unload some dog food on their customers.

Despite these problems, the IPO-access programs will probably work well enough to last. Nothing is as enticing as a closed door. If the big players can buy initial offerings, the little guys will want in too. And investors often make gains through short-term trading when they get in at the offering price.

A final thought: It is pretty late in the new-issue game for this market cycle. Investment banks have already sold much of the choicest merchandise, the most promising young companies. Now they will be hawking the remainder, and doing so in a market that looks toppy to many observers. Maybe the big investment banks are letting the little guy in because they need a new batch of suckers–er, customers.