Bills Point of View

September 2002

Fixing the IPO Process

I am sure most of you have seen the publicity surrounding several ongoing investigations into the business of investment banks' allocation of initial public offerings. As you probably know, our OpenIPO process was designed to address many of the abuses in the traditional underwriting process.
Bill Hambrecht CEO WR Hambrecht + Co

We believe the goals of an IPO should be to achieve a fair public offering price and to place the stock with real investors rather than short-term buyers looking for a quick profit on an underpriced issue. Commentators, securities regulators and the investing public increasingly agree that transparent, competitive price discovery and non-preferential allocations would be the answer to the current opaque and discriminatory IPO pricing and allocation process. Below is WR Hambrecht + Cos proposed solution. Let us know what you think at whambrecht@wrhambrecht.com. Thank you,

Bill Hambrecht

I. Information Asymmetry
Problem The current IPO process gives certain investors greater and more relevant information than other investors. The IPO prospectus focuses on historical facts and performance, while the markets price offerings on estimates about future performance. Institutional investors get estimates from Wall Street analysts (who may have been given special guidance by the issuers), while retail investors get no estimates until after the offering is over. Solution First, require issuers to include estimates in their prospectus. The SEC currently provides a safe harbor for issuers to publish estimates as long as they are not made without a reasonable basis or in bad faith, but few issuers actually publish them. Second, require the prospectus to list the companies the underwriters consider to be most comparable to the issuer and their trading multiples, much as investment banks are required to do in fairness opinions. Third, make the road show accessible to all investors, either through an electronic road show or public notice of road show meetings. Result These changes would likely result in more conservative, carefully constructed projections - with no need for analysts to tout the stock. Issuers would not be able to hide behind analysts. In addition, these changes would remove the incentive of issuers to hire underwriters based on which analyst is perceived to have

the greatest propensity to position the company well, a euphemism for projecting the highest earnings and multiples based on the most attractive comparables.

II. Access
Problem The traditional allocation of IPOs has been 80% institutional, 20% retail and was skewed even more to institutional investors in the recent bubble market. Even within those categories, share allocations generally have been limited to the largest institutions and highest net worth clients. Underwriters claim they exclude most individual investors in order to protect them from risky investments, but the existing regulations for broker-dealers already contain suitability requirements and other provisions that would permit much broader individual participation while protecting investors. This lack of access is of concern for three reasons. First, the system raises questions of fairness and legitimacy, as public securities are withheld from legally qualified buyers. Second, the ability of underwriters to selectively control access creates numerous opportunities for abuse. For example, underwriters are tempted to allocate shares to executives in exchange for investment banking business or to buy-side trading desks with the implicit requirement of above-market commission flow or even after-market buying. Finally, this lack of access results in the inability of underwriters to price offerings to reflect the full level of aftermarket demand, which leads to chronic underpricing (discussed in the next section). Solution Require underwriters to make IPOs available to any bona fide retail or institutional investor for whom such an investment is suitable under NASD rules. A potential investor could enter an order both the amount of shares they want and the price at which they are willing to invest. Final pricing would be based on the order information no longer would pricing be determined in the dark. Result Open access would provide a broader universe of potential buyers, which would allow issuers to determine the full demand for their offerings and undermine the ability of underwriters to underprice deals. Equal access with equal information would create a level playing field to match supply and demand.

III. Pricing
Problem The current system of underpricing and preferential allocation creates a guaranteed profit for select clients, which will almost always corrupt the system. Traditional underwriters' judgment is guided in large part by their economic selfinterest, specifically the high gross margins and steady commission flow generated by their business with institutional investors and potential future investment banking assignments. In hot markets, this trend is exacerbated, and some institutions (such as hedge funds) will actually bid for allocations with promises to the underwriter of above-market commission flow. Underwriters attempt to justify this underpricing by categorizing their pricing as conservative. In reality, this systemic guaranteed profit attracts trading-oriented accounts and major institutional investors, who are not interested in the company as long-term investors, but want a quick profit and invariably flip their shares after the run-up. In addition, in a typical underpriced IPO, the price tends to have a big immediate run-up. The run-up generates positive publicity for the issuer and attracts uninformed retail investors, who think that the run-up implies a special investment opportunity.* Hence, the public ends up buying the shares at the highest price. Solution First, require that underwriters use an open auction or some other mechanism that allows non-preferential allocation to determine the full demand

curve for an offering and to price the IPO based on that information. Second, provide strong legal penalties for all forms of allocation abuse, including: tie-in orders, in which underwriters require certain investors to purchase stock in the after-market (known as laddering); collusion among market makers and hedge funds; commission incentives, in which investors pay above-market commissions for IPO allocations; and placing shares with the underwriter's best clients, individual venture capitalists and corporate executives who may direct future investment banking business to the underwriter (known as spinning). Result An open auction combined with stiff penalties for allocation abuse would remove the temptation for underwriters to compromise their duty to serve the issuer and would protect individual investors by leveling the playing field for them vis--vis the large institutions.

IV. The Case for Cleaning up the IPO Process

History of Cycles IPO trading tends to be most volatile in severe boom or bust cycles, causing the most damage to smaller, individual investors. During 2001 alone, 312 lawsuits were filed alleging fraud in connection with the allocation of IPOs. These suits suggest that nearly $50 billion was left on the table by issuers based on the difference between the public offering prices of the IPOs and where the stocks closed on the first day of trading. In addition, individual investors and small institutions who did not get in on the IPOs and purchased their shares during the first day of trading lost nearly $100 billion between the end of the first day trading and August 2002. Many individual investors were devastated and lost more than 90% of the market value of their IPO investments in the after-market. Many would say that the market has corrected these abuses, as there are no hot deals in todays market. However, history would tell you that IPO speculation returns in almost every bull market.

V. Need for Vibrant U.S. Primary Issuing Market

It is critical that faith is restored in the U.S. IPO process because IPOs provide a number of essential functions for U.S. companies and the American economy. First, they allow equal access to equity capital for large and small businesses. Second, IPOs are the primary mechanism in which venture capital is recycled into the next generation of technology companies (now 15% of U.S. GDP). Without the IPO option, venture commitments would be substantially diminished. Third, they create jobs and a higher standard of living by promoting the growth of U.S. companies. Fourth, IPOs perform a critical role in moving capital to areas of potential growth. Cisco, Intel and Microsoft each needed the IPO market and were each relatively small when they first went public. Finally, the vibrant U.S. IPO process has always been a national asset, differentiating the U.S. capital markets from those of other nations. It can be that again, provided that it is perceived as a level playing field for issuers and all types of investors. Stories of insider allocations and commission kickbacks erode basic faith in the system. The market has no mechanism to punish the violators of trust until after the fact so it punishes the issuers of the future by denying access to most of the seekers of equity capital. That can be avoided by bringing transparency and fairness to the process.

* Historically, the more successful (the highest immediate rise) the issue appears, the more the average investor wants it.