Sunday, July 15, 2007
Initial Public Offerings and the Failed Promise of Disintermediation, by CHRISTINE HURT, University of Illinois College of Law, was recently posted on SSRN. Here is the abstract:
At the beginning of this millennium, the future of initial public offerings conducted using an Internet-based auction method in the United States seemed very bright. The Internet, and web-based technologies, promised disintermediation in the IPO markets just as it had in other markets where producers could be linked with consumers without costly intermediaries. In a world in which a buyer would choose to pay a certain price (X) for a product, the producer of that product would prefer to capture as close to 100% of X as possible and not share unnecessarily with intermediaries. The market for initial public offerings is no different from other markets; a small number of investment banks and the underwriters and brokers they employ act as intermediaries that distribute and market offerings for a substantial fee, including a customary discount on the offering price that benefits the intermediaries. However, web-based auction IPOs have the potential of allowing issuers to avoid these investment banks and sell directly to the public at closer to the market price (100% of X), not the bookbuilding underprice (approximately 80% of X), minus the substantial underwriting fee.
However, the number of online auction IPOs each year is miniscule compared with the number of IPOs conducted in the U.S. using the traditional bookbuilding method. Although the market saw an increased number of auction IPOs in 2005, following Google's 2004 auction IPO, the market for online IPO auctions against stalled beginning in 2006. Proponents of these IPOs must explain why the auction IPO model has not challenged, much less replaced, bookbuilding as the dominant offering method in the U.S. This Article argues that although the Internet works well to eliminate intermediaries formerly necessary for distribution, the Internet cannot reliably eliminate intermediaries used by the public for creating demand networks and establishing third-party certification. Because of the power of investment banks and their demand networks, the base market price (X) of any product will be increased (X + Y). Therefore, an issuer must determine whether more profit is to be made by sharing revenues with Wall Street intermediaries and receiving 80% of (X + Y) than capturing 100% of merely X. In addition, to attempt to ignore these powerful Wall Street intermediaries comes with great risk. In certain cases, those who attempt to sidestep intermediaries may find themselves capturing not 100%(X) but 100% of a depressed market price (X-Z). Given this choice, rational issuers will choose the bookbuilding method, which promises .80(X + Y).