Why Silicon Valley has failed (so far) to disrupt the IPO circus

Craig Coben is a former senior investment banker at Bank of America, where he served most recently as Co-Head Global Capital Markets, Asia-Pacific region.

Everyone seems to have a bone to pick about IPOs. Companies and owners think the banks price IPOs too low, allowing the stock to “pop” on the first day of trading and delivering a windfall for big asset managers. Investors fret about their informational disadvantage to company insiders, and that banks care more about earning underwriting fees than quality of offering. Retail participants believe that banks stiff-arm them on the attractive IPOs and stuff them with the bad deals. Even when they go well, IPOs can generate recriminations from all sides.

It’s not surprising therefore that over the years different parties have tried to improve the IPO process. The perception is — correctly or not — that looking after company clients will create conflicts of interest for investment clients, or vice versa.

This debate is at the heart of Dakin Campbell’s new book, Going Public: How Silicon Valley Rebels Loosed Wall Street’s Grip on the IPO and Sparked a Revolution. US technology entrepreneurs have been among the most vocal critics of the IPO process, and have championed initiatives to effectively limit the banks’ power over pricing and allocation. Campbell chronicles these efforts, such as Spotify’s 2018 direct listing.

It’s easy to understand the appeal of auctions and directed offerings. They remove discretion from the banks and purport to allow the market forces to set the price. The dream is to automate IPO pricing and allocation, reduce the sway of banks, and democratise distribution by giving retail investors as much access as the big institutions. Equity capital markets become digital capital markets.

Talk of “disintermediation” has persisted for several decades, and yet the IPO process remains largely unchanged. It still involves prospectus drafting, the dog-and-pony show of a management roadshow, gathering of investor orders at different price points (“bookbuilding”), and manual allocations decided by the banks and the company. As ever, most of the stock goes to large fund managers, and most of the big names have scarcely changed in the last decade. IPOs remain analogue.

The question remains why it has been so difficult to reform a process that leaves its clients dissatisfied.

Companies shied away from the Dutch auction after Google was forced to lower its IPO price range in 2004, only for the shares to pop on the first day of trading. Campbell thinks directed offerings — which bear many similarities to corporate spin-offs — mark a turning point, but it’s too early to say whether they will work beyond a narrow subset of issuers. Directed offerings are an option in favourable markets for larger or well-known companies, but most IPO candidates aren’t Spotify: they are small- and medium-sized companies whose story needs to be explained to investors and covered by research analysts to generate interest and liquidity.

These Silicon Valley innovations don’t really get at what makes most participants uncomfortable about the IPO process: the seeming lack of control. If anything, they aggravate the issue. The IPO is the one moment where companies have agency over the stock price and over who the shareholders will be. They don’t want to leave it to Hal 9000 or the unfettered market to decide the price or who will be getting shares.

Campbell describes the attempts to introduce some element of auctions into the process, giving a blow-by-blow description of the order-taking systems in the IPOs of darlings such as Unity and DoorDash. What’s striking is not so much that investors struggled to adapt to these systems (which was to be expected), but how the Platonic ideal of an unfettered auction — one that can’t be gamed by investors and that would provide price discovery — was compromised. Companies and banks sought to regain control over investor dialogue and to mediate between the interests of the various stakeholders. In the end, these modified auctions look a lot like traditional bookbuilding, with differences in mechanics that only an anorak of equity syndication can appreciate.

If the IPO process is to be improved, it must give players more control, not less. The stakeholders in an IPO are often highly successful people accustomed to having their way, and the IPO can be pivotal for their net worth. Yet once they embark on an IPO, they are thrown into the maelstrom of a process they can’t direct or manage. This is deeply unnerving.

At least in an M&A situation a management can negotiate a price and take it or leave it. There’s huge, visceral stress during negotiations, but you are still a master of your domain. You can walk away. And it will be many months, if not years, before you know whether you sold at too high or low of a price.

But IPOs are different. Once the intention to float is made public, companies have crossed the Rubicon: turning back is difficult (and publicly humiliating), and they are at the mercy of public (investor) opinion and fickle markets. They also don’t have a single counterparty with which to negotiate and forge an agreement. In a bookbuild they’re negotiating with a mob, or more accurately a blob, of investors they don’t really know, whose intentions are as opaque as they are changeable.

The gatekeeper for those investors are the underwriting banks they hire. But those investors are also clients in the markets divisions of those same underwriters. And so if the company doesn’t achieve the desired price or the stock pops too much in the after-market, it’s natural to ask whether the banks have looked after your interests enough. Banks make for an obvious scapegoat.

Investors also chafe at the lack of control. They don’t know how much stock they will be allocated and some investors (especially the less successful ones). They suspect that syndicate banks favour other investors over them. And if an IPO trades badly in the after-market, some might complain about being stuck with an overpriced, overhyped deal. Just as people look for scapegoats for their personal misfortunes, few investors blame their own judgment when they lose money. (Though if it trades well in the after-market, most investors will credit their own analytic nous.)

Part of the problem is also that it isn’t always easy to get the right outcome on an IPO. In my 25 years of investment banking, I worked on many successful IPOs that traded steadily in the after-market. High-fives all around! But I also worked on IPOs that popped, IPOs that flopped, IPOs that popped and then flopped, and IPOs that flopped and then popped. Market dynamics change, and there is no instruction manual.

Just as past performance is no guarantee of future returns for a fund manager, applying previous experience does not ensure success. Banker recommendations are not guesswork, but rather informed judgments subject to a real margin of error. It’s not that different from professional fund managers who do their homework and yet still call the market wrong and lose money on an investment.

And how do you even define success? Take the (infamous) 2013 privatisation of Royal Mail on the London Stock Exchange. The IPO, which was 25 times oversubscribed, priced at 330p and the shares jumped 38 per cent to 455p on the first day. Senior bankers from the global coordinators Goldman Sachs and UBS and the adviser Lazard were hauled before Parliament to be berated for short-changing taxpayers. Five years later the shares were trading below the IPO price, and today the shares trade just above 200p. What is the appropriate timeframe to judge whether the bankers got it right or wrong?

It’s this combination of lack of control and ineradicable fallibility that can grate. Some clients have tried to retake control by locking in cornerstone demand in advance, or hiring external advisers of their own to oversee the banks and vet their recommendations. These efforts have had mixed success. Cornerstones are hard to pin down, as public investors don’t like to commit to an investment weeks or months in advance. Indeed, the cornerstones in the recent Porsche IPO were mostly sovereign wealth funds. As for external advisers, they are mostly former bulge-bracket equity capital bankers working at M&A boutiques, and it’s hotly disputed whether these poachers-turned-gamekeepers have improved IPO outcomes or not (my totally biased view is: it depends whom we’re talking about).

It sounds exciting if IPOs could be offered, priced and allocated electronically or algorithmically — removing the room for misjudgement, saving on underwriting fees, and putting smaller investors on the same footing as the big funds. But such a scheme would force participants to forfeit whatever control and power they do have. They may find such a Brave New World to be its own dystopia.