In yesterday’s New York Times, business reporter Joe Nocera wrote an opinion column about investment bankers’ behavior in bringing companies public. It’s based on documents from an ongoing lawsuit between 1999 IPO star, eToys (which went into Chapter 11 in 2001), and its lead underwriter, Goldman Sachs. Mr. Nocera got the data from the New York County Clerk’s office, where they were supposed to have been under court seal, but weren’t.
eToys
No, it’s not the one with the sock puppet. That was Pets.com. eToys was an online toy retailer. Both made it into CNET’s Top Ten internet bubble flops, though.
The pricing range for eToys shares in the initial prospectus was $10-$12. The final offering price was $20. The stock closed on its opening day at $77. It peaked a few months later at $84. It was trading at $.09 when it went belly up.
The lawsuit: eToys contends that Goldman failed in its fiduciary duty to get the best price for eToys shares. Although it was losing money at the time of the IPO, eToys thinks that if it had raised, say, $400 million (an offering price just north of $50) instead of the $155 million it got, it would have been able to stay alive long enough to become profitable. This was basically the AMZN strategy. In eToys’ case, who knows what might have happened.
Goldman’s defense is apparently that it had no such duty.
the documents
Grammar and spelling errors aside, the Nocera documents shed some light on less well-known aspects of the IPO process. No one comes out looking especially good. For example:
–Goldman allocated 20% of the offering to “flippers,” that is, to brokerage clients who had no interest in owning the IPO companies. They just wanted to sell, or “flip,” the stock during first-day trading.
–one investment manager said he did large amounts of trades with Goldman simply to get IPO allocations. He also appears to me to have paid commissions at almost twice the then going rate. A cynic would say he got no services for this extra payout; he just wanted to make the payments fatter–and thereby get a bigger IPO stock allocation.
–an internal presentation argues that Goldman should look at first-day trading gains in an IPO stock as being an asset of the firm, one that Goldman should seek to maximize the return on.
–Goldman regarded first-day gains as a quid pro quo for two things–the size of a client’s commission business and his willingness to participate in “cold” IPOs. (“Cold” IPOs are ones with little or no upside; participation allows the underwriting syndicate to earn IPO fees at lower risk.)
–Goldman kept track of the first-day gains achieved by each client and informed at least some that it expected to receive 20%-30% of that figure back in increased trading commissions.
the underwriting fee/trading commission tradeoff
In the eToys IPO, the underwriters (I’m including the selling syndicate in here, too) received fees of $11.2 million, or 6.75% of the offering price of $20 a share. If we assume they received from all brokerage clients what amounts to a kickback of 25% of the first-day gains of $53 on 8.2 million shares, that would have amounted to $108.7 million.
If, on the other hand, the IPO had been priced at $50, the underwriting fees would have been $28 million. The commission “kickback” would be $47 million.
The total investment banking take at an IPO price of $20 a share would be $119.9 million; at $50 it would be $75 million.
This is Mr. Nocera’s point, and eToys lawsuit contention–that Goldman had every incentive to underprice the offering.
…let’s suppose that the underwriters could only collect from flippers, who made up 20% of the eToys offering. SEC-regulated money managers, after all, have a fiduciary obligation to get the lowest possible commissions. If so, the “kickbacks” would have amounted to $21.7 million and $9.4 million. The total investment banking take $20 a share would be $32.9 million; at $50 a share it would be $37.9 million. Not a huge difference.
And I suspect this is closer to the true state of affairs. Still, the tone of the documents Nocera unearthed suggests to me that Goldman felt it was missing a golden opportunity by not exploiting its underpricing better–not that there was something wrong with the underpricing strategy. It may also be they knew that firms with more Internet cred, like Merrill (whose famous analyst, Henry Blodget was subsequently barred from the securities industry for fabricating his research reports) or Morgan Stanley (Mary Meeker apparently convinced the SEC she really believed the crazy stuff she wrote) were better able to cash in.