Understanding Ipos and Ipo Scams

Topics: Stock market, Initial public offering, Stock Pages: 8 (2268 words) Published: January 28, 2013
Understanding IPOs and IPO Scams
You don’t have to spend too much time around the stock market to discover that there’s something fishy about many stocks’ initial public offerings, (IPOs).  The standing joke is that IPO really stands for “It’s Probably Overpriced”.  While that may or may not be true in any given case, there are a large number of pitfalls awaiting the would-be IPO trader or investor.  It’s a case of caveat emptor, and in order to be suitably wary you need to understand how an IPO works and how it can be manipulated to your disadvantage. An IPO is the means by which a private company is sold to the public.  The owners of the company will approach a major investment bank (sometimes referred to as a “bulge bracket” bank) to underwrite the IPO.  That bank will then create a syndicate of banks and brokerages to run the IPO.  Stock shares are then sold by the company to the syndicate and by the syndicate to the syndicate members’ customers.  The deal can be structured a couple of different ways, but in general the syndicate guarantees they will find buyers for the shares, accepting financial risk if they fail.  The syndicate sells the shares of the soon-to-be public company at a higher price then they acquired them.  This gap is set as part of the underwriting contract, and has historically been about 7%.  Once the shares have been “allocated” to the syndicate’s customers, the stock can begin trading on an exchange.  The bulge bracket bank which lead the IPO typically acts as the primary market maker or specialist for the new stock. There is nothing inherently wrong with this setup.  Yes, the syndicate and the bulge bracket bank anchoring it is taking a big cut.  But they’re also providing an army of salesmen to place the IPO with prospective customers.  Without those salesmen to drive demand, the shares might not be sold at all or might sell for a much lower price.  So they are providing a potentially very valuable service at an agreed upon price.  That’s fine.  But, as you might imagine, when there’s a lot of money moving around people get greedy trying to grab a bigger slice of the pie.  And when people get greedy sketchy things start to happen. The first thing that happens is the syndicate, and the bulge bracket bank in particular, don’t try to find the highest priced possible buyers for the stock.  Instead they allocate the shares at an intentionally low price to favored customers.  At first glance this doesn’t make any sense – since the bank is getting a fixed cut of the sale, they should want to sell for as much as possible. But as we’ll see in a bit, the bank can potentially make more money selling for less.  This practice of less than aggressive pricing pretty much insures that the price of an IPO will open above the allocation price when the shares start trading on an exchange.  This in turn represents a direct transfer of wealth from the IPO company’s ex-owners to the investment bank’s favored customers.  Those with allocated shares could sell as soon as the stock goes live an make a nearly locked-in profit. Now, if you know anything about investment banks it that they don’t just give away money. So why give under priced shares to their favorite customers?  The answer is that those customers are “favorites” because they are willing to overpay for other services offered by the investment bank outside the scope of the IPO.  In return for that patronage, the investment bank kicks them a nice block of IPO shares.  What this means is that all the money “given away” by letting shares out the door below cost comes back in the form of future banking fees.  So instead of the investment bank getting just a 7% cut, they basically get all that money back eventually, capturing the other 93% too.  Pretty sneaky. If the process stopped there, it wouldn’t have much effect on market dynamics once the IPO shares became exchange traded.  But there’s more to the story.  The bank can retain some of the IPO shares for...
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