The unicorns are filing one after another for initial public offerings and the excitement in the IPO market is taking me back to 1982, when I was working at a publication called Going Public: The IPO Reporter, the pre eminent journal tracking initial public offerings.
I joined the staff in late 1982, and the total tally of IPOs for the year was something like 300 deals. Then near the end of the year, a well placed venture capitalist predicted that next year’s haul would be something like 600 deals.
We were in shock. (And from my own selfish point of view, I was dismayed since I knew the thrifty company I was working for wasn’t going to add staff and they certainly weren’t going to double my modest — some said criminal — salary). But what the venture capitalist knew that we didn’t, was just how much venture money had been put to work over the prior five years and just how much of it was yearning for liquidity.
It turned out there were about 660 deals in 1983. His prediction for 1984 was more than 1,000 IPOs and it turned out to be about 1100 or so and I analyzed the prospectus for each one of them, an experience that has stuck with me.
Reading Wall Street’s Braille
In those days, investment banks syndicated their deals and when the offering was done, they published massive tombstone advertisements in the Wall Street Journal. Studying the tombstones over lunch, I could tell the allocation each investment bank got by seeing where it was bracketed among the names of the other underwriters on the tombstone. I could see which of the banks were punching above their weight by getting an allocation that was higher than their rank on Wall Street’s pecking order commanded.
It was also interesting to study the constellation of lead and co-managers for each deal. Sometimes a hybrid bank such as Allen & Company would be a lead manager with a bulge bracket firm like Morgan Stanley — or even, yes, E.F. Hutton — as the co manager which was noteworthy in some cases or unheard of in others. Or sometimes a regional bank would turn up on the right hand side of a tombstone as the co manager for venerable house like Smith Barney, and I would wonder if the regional bank was coming up in the world, or the bulge bracket firm was coming down.
The tombstones told stories in a cryptic code about the ways of Wall Street, and everyday the Wall Street Journal was full of these stories.
Where The Fees Are
Also noteworthy were the fees that companies paid to go public back then, which were out of this world. Since I had to report on the fees for each deal — and again, there were over 1,100 in 1984 — I was pretty familiar with them. There was the underwriter’s discount, i.e. the price at which they would buy the shares from the company which was typically 10% less than the offering price they sold them to their investors for, but for larger bulge bracket deals the discount was often 7% — still a huge number.
In addition, there was the underwriter’s accountable expense allowance of 3%, a non accountable expense allowance of 2%, and, in the lower tiers of the market, a three year consulting fee of $3,000 to $5,000 a month, payable all at once at closing. So full bore, the companies were paying fees north of 15%.
Also within the the lower tiers of the market, the underwriter often received warrants to purchase additional shares from the company at a set price for something like three years. These warrants were massive profit opportunities for the underwriters. If a stock was priced at $10 and was, say $20 a year later, the underwriter would sell shares short at $20 and cover their short by exercising their warrants which might have a strike price of $11. While this was all well and good for the underwriters, in my view, it represented a massive conflict of interest at worst, or bad manners at best since the bankers were literally short selling their clients.
And of note, the company got an additional slug of capital when the underwriters exercised their option to cover the short, but at below market rates. So an investment bank could have a BUY rating on a stock, which meant investors should buy it at prevailing rates, while the they were buying it at a significant discount. Again, very poor etiquette.
Costs have come down quite a bit. In Dropbox’s IPO, the underwriter’s discount was 4.45%, still a big number, but by historical standards quite low. Spotify, which went public in 2018 raising about $1.2 billion, an unheard of number back in the day, didn’t pay any underwriter’s discount and distributed shares directly themselves.
Much More Chill
One aspect of IPOs that has dramatically changed are statements made by company management before and after their deal. Back in the day the lawyers said any public statement made by a company after they filed was kryptonite that could kill the deal. “It’s preconditioning the market, and the SEC won’t stand for it!”
This sounded like specious reasoning to me. What, an auto components maker mentioning to Automotive News that they were going public to grow faster — which had the added benefit of being true — was somehow going to spread like wildfire across the panoply of analog media to create unnatural demand for their deal? Or that some SEC examiner was going to see a quote in Automotive News on his or her lunch break, and then go back to the office and scuttle their deal?
Then there was another sensitive area, known as the quiet period, that used to agitate the attorneys quite a bit as well. In the the so-called quiet period, which was the 30 to 45 days after an offering (it differed by attorney) during which no public statements could be made, again, to avoid conditioning the market. “No way, no how,” they said.
So I get a pretty good chuckle these days when I see a tech entrepreneur ring the bell and then head straight to the CNBC booth to do an interview with Jim Cramer. All those long-gone attorneys must be turning over in their grave now. But it turns out, having a CEO talk about their recently completed offering is not a bad thing, and quite the opposite, it can inform investors in ways that a prospectus never could.
One of the reasons there were over 1,000 IPOs back then, while 2018’s haul of 190 is seen as a good number, is because there used to be a lot more investment banks. And there were a lot more investment banks because trading securities — especially securities your firm brought public — was a lot more profitable.
This was before so-called decimalization, when securities traded in fractions. When the bid/ask spread was a quarter or an eighth — $0.25 or $0.125 — there was a lot more room to make a trading profit. Of course bigger deals were tighter and might trade in ‘teenies’ or a sixteenth which is $0.0625. Once decimalization came in, bid/ask spreads tightened dramatically and today, the commission that can be earned on a share is less than 2 cents on average, a dramatic contraction.
The narrowing of spreads was a deliberate policy initiative of regulators and it had noble aims. Wide spreads meant higher tradings costs for investors, and lower returns. However, the capital markets epitomize Newton’s Third Law of Motion, where every action prompts an equal and opposite reaction.
In this case, wringing the trading profits out of the markets, thinned the ranks of investment banks that would underwrite and support small public companies. Not only did this reduce the number of IPOs, but it changed the size and scope of the enterprises that could be publicly held and realize the benefits of public ownership. This void has not yet been filled completely as evidenced by the many provisions of the JOBs Act meant to channel growth capital toward emerging enterprises.
And it’s also seen in the fact that many of the IPOs that hit the market these days are large, swaggering tech companies that begin life as a public company as so-called mega-caps. And those stories told by the tombstone ads from another era? They seem almost quaint now.