IPO process a dark art and hazardous ride

20:19, Jul 31 2013

Canon fodder infantry are the core participants in human wave attacks, where massive waves of poorly armed, poorly trained, and ill-equipped soldiers are sent in a charging attack designed to overwhelm defenders with numbers rather than superior strategy, movement, or technology." Wikipedia

In the ever-present war within financial markets the untrained and undereducated private investor has become the cannon fodder of the initial public offer (IPO) process.

The investors and their accepting dispositions are increasingly being taken advantage of by investment bankers and vendors designing what Chalkie refers to as "eyes-closed" floats, where the small guy is not even allowed to know the price he is paying before committing to buy shares.

This newish style of float where the investor signs the application form and then finds out the price later has virtually replaced the old-fashioned fixed-price float where the gatekeeping broker endeavoured to price the issue so that the investor had a good time.

In Chalkie's opinion, investment bankers pandering to the wants of vendors means the IPO process is becoming a increasingly hazardous ride for private investors.

Yet still into the valley of death they charge.


How it works is that private investors are asked to make early bids, stating how many shares they want at the "clearing price" that is set later. It's devised from within a range indicated in the prospectus after a tender conducted by institutional investors.

These non-price-sensitive bids are a useful tool for the brokers and vendors in an IPO process as they can go to the institutions and tell them how strong this demand is, at what can be effectively deemed "top of the range" bids.

They can then threaten to give the instos very few shares unless they bid up in the price-setting tender.

It's no accident that Frucor, the first of these types of IPOs bought to the New Zealand market, had private equity vendors. Such vendors wanting to cut down on free lunches for investors are increasingly the norm in today's money-centric world.

For most vendors, listing a company is a one-off and, thus, the reputational issues of a failed float are small. Investors rely on the broker to get the pricing right but this key step is now abdicated to the institutional tender which can be subtly manipulated by the use of a large private investor application pool.

With many IPOs there is little transparency as to the clearing process - how big is the institutional tender pool? How does the price get set?

Chalkie suspects the odd private equity vendor has insisted that an IPO price gets set at the highest possible price at which there is enough demand to match the shares being offered, with no fat built in to allow a pop on listing day.

Some brokers (interested in looking after investor clients) may have demanded before taking on an IPO that the level of bids at the "go price" for an IPO needs to cover the number of shares offered two, three, four times etcetera.

But this is a dark art, with these types of arrangements and processes never spelt out. Chalkie feels for private investors who are putting their faith in such a murky system, with a range of pricing outcomes of which they have no control.

If you have rational institutional investors, this system can work because they should value the company appropriately and not bid above the price on the sharemarket post-IPO.

But in reality, the institutional investors used to set the price via their exclusive tender process are not infallible.

They can be manipulated by making their slice of the IPO offering small. Sometimes, like the rest of us, greed can light up their eyes and fast-talking management can overly excite them.

But the little investors have no say in what price the IPO goes off at unless a large percentage of them go on a buyers' strike, signalling they are not happy with the range and process.

Do people buy houses without knowing what price they are paying? Cars? Art? Then why shares? The only way a private investor can sensibly buy shares in a "eyes-closed" IPO is if they think the company is good buying at the top of range.

Besides, investors are generally more greedy than they are sensible. And too time-poor to actually read the prospectus cover to cover. They have been trained to trust in the system.

Not only do they suffer a risk on price, but at the end of the IPO their applications will normally be scaled. If the IPO is looking good, some brokers might aim a few more shares at their favoured institutional clients, who after all pay them the most brokerage.

If the IPO sees little demand from savvy instos then the private clients might get all the shares they asked for, signalling the post-listing party is going to be a flop.

Experienced private investors fear the call from the broker saying "you got all you were after". They know they have just been used as cannon fodder.

Meanwhile, the two regulators, the Financial Markets Authority (FMA) and NZX, stand by apparently disinterested in what is a key facet of financial markets. Chalkie is surprised the regulators don't seem curious as to why so many investors and advisers are exasperated with the modern IPO.

Surely they know buying shares without knowing the price is stupidity personified and should therefore see that it is unfair for one group of investors (the institutions) to be able to walk when they don't like the price while mum-and-dad investors have to go in at a price dictated by others.

The lack of independent research for small investors is another issue. What Chalkie sees as patently stupid rules prohibit the publication of research by involved brokers before a company has floated.

But the institutions all see such "non-published" research. Some floats like Mighty River are so big that most brokers are caught by these rules, while other IPOs are so small that only the sponsoring brokers are ever going to write research.

The NZX website on the exchange's regulatory role, first off the rank, says "all investors should be treated fairly and equitably".

The FMA says in its overarching mission blurb that it wants to "promote investment markets that are fair, efficient and transparent".

Fair, that one group gets access to research, one does not? Fair that one group gets to walk away if the price is not to their liking, the other one does not? Transparent, that the rules for setting a clearing price are not set out?

To borrow from Orwell: All investors are equal, but some investors are more equal than others. And there are layers in the inequality.

Professional investors get the right to tender and get research, sometimes rich investors (it was $100,000 minimum with Mighty River) get the right to tender but can't get to see research, and small investors get to hit and hope.

Even the Government took advantage of the stupidity of market practice to get top price for Mighty River by allocating so much stock to private investors that the institutional pool was left unnaturally short given the huge number of overseas investors interested in "green" stocks. Good luck with Meridian, guys, as a two-time vendor.

Investors only take part in these lopsided floats because experience has told them they will make money 70 per cent of the time. Chalkie reckons these odds may be changing and that in any event, it only takes two failures in a row for investors to lose heart for rolling the dice.

Even if the regulators have in the past looked at the IPO practice and thought it sensible - to do so you really have to believe in "efficient market theory" which is sort of like believing in the tooth fairy - they should have noticed that the practice is getting riskier for the private client.

Look at the table Chalkie has assembled on some old and recent examples of the eyes-closed IPO process.

The table shows that early on, there was a convention in these IPOs that the price range between top and bottom was about 15 per cent. The bigger the range, the bigger the risk for private investors bidding blind.

Post-GFC (global financial crisis) in a slightly riskier world the range started to creep up. The investment bankers, having pushed through the 15 per cent mark, now appear to be seeing how ridiculous they can set the boundaries in their clients' favour before someone balks.

At 29 per cent, 50 per cent and 29 per cent for SLI, Wynyard and Synlait respectively, Chalkie is balking.

These smaller floats like Wynyard and SLI can be got off the ground with a fair percentage of the institutional world ducking them, so Chalkie is cynical that the tender process will always bring up an efficient outcome.

Some advisers at broking firms are now starting to shy away from promoting IPOs to clients.

There is another story in the way the process rushes such individuals to "bid strong and early" for allocation without actually having firm bids from their clients to match their interest, but Chalkie also suspects these advisers are intelligent enough to see that it is actually not good practice to encourage their clients to be non-price discriminate, especially with horrendous price ranges.

So what to do? Ideally, broking firms either need to put private investors on the same basis as institutions in terms of being able to tender at a price, or turn the process around so that the tender takes place first and the private investors get a fixed price option. Chalkie is pretty sure this exact process has happened in the past and is the norm in Australia.

The rules also need to change so some research is available for private investors. Chalkie doesn't care whether this is the sponsoring broker putting a report up on the web (we all know it will be positive, we can adjust for that) or an independent research house being commissioned by the vendor or NZX.

And some transparency as to how the clearing price will be set would be an added bonus.

- Tim Hunter is on leave.