By John MassonSept. 25, 2012
It's not every day that the phrase "blood-sucking parasites" appears in an academic paper, much less in a paper proposing fundamental changes in the way American companies go public. But Michigan Law Prof. Adam Pritchard doesn't shy away from colorful language to lay out his proposal to do away with IPOs as we now know them, especially in the wake of the recent Facebook debacle.
"It's not so much the quality of the product—it's the quality of the market that is pricing the product," Pritchard said. The paper, "Revisiting 'Truth in Securities Revisited': Abolishing IPOs and Harnessing Markets in the Public Good," argues that, as currently regulated, the transition from private to public company will always be awkward and inefficient. Prof. Pritchard also details his proposal in a piece written for a more general audience, published this weekend in the Cato Institute's Regulation.
"Speculation and irrational exuberance, fueled by Wall Street marketing and media attention, grease the wheels for deals that have little to recommend them," as the system is currently constituted, Prof. Pritchard writes. So "[u]nsurprisingly, the market for IPOs falls far short of the economists' ideal of an efficient capital market." When the market is distorted in this way, Porf. Pritchard argues, the investors' risk-versus-reward assessments become unreliable.
"There's a buyer for every security," he said. "Some securities are riskier than others, but people are supposed to be compensated for the riskier securities by larger payouts."
Facebook provides a good example of what can go wrong. That IPO, much hyped by Wall Street and the general-interest media, was the third-largest overall IPO in U.S. history, with shares selling for $42 when they became available in mid-May. But the same shares closed Friday at $22.86.
The hype helps account for the stock's skid, Prof. Pritchard said. The opinions of investment professionals were overwhelmed by eager amateur investors who wanted to grab a piece of Facebook, without first acquiring a thorough understanding of the company's strengths, weaknesses, and potential value. The result was a stock that initially traded for more than it was likely worth.
"My basic intuition here is that markets are good, and salespeople are bad, and the better-functioning the market, the less influence salespeople have on it," Prof. Pritchard said. In fact, the "blood-sucking parasites" he refers to in his paper are the underwriters of the typical IPO, who take a standard commission of 7 percent for essentially acting in that salesman role.
The usual IPO doesn't follow the Facebook pattern, Prof. Pritchard writes. Instead, the more common problem is undervalue—short-term underpricing, combined with long-term underperformance. Stock prices start too low, depriving promising companies of much-needed capital, then fail to live up to performance potential in the longer term.
The remedy, Prof. Pritchard writes, is to create a two-stage, reversible system of "going public." Companies' shares would first be traded in a private market for a "seasoning period," with mandatory disclosure, before the general public would be able to buy them.
The system would both improve companies' ability to raise money and protect investors from Facebook-style post-IPO stock price declines.
"We're not trying to eliminate risk," Prof. Pritchard said. "Risk is good. You can't be last to the party, and in order to be first, you have to be willing to accept risk."
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