What is wrong with the way in which investment banks were doing business
during the bubble?
The IPO market, when it really heated up three or four years ago, created an
unsustainable volatile situation in the marketplace, where it became too easy
to raise money, and it became too easy to underwrite almost anything and raise
the money. On top of that, because it was such a hot market that gave such high
valuations to untested companies, it was very easy for underwriters to -- "take
advantage" is maybe the wrong word -- but I think underwriters' economic
agendas started to determine who would get the stock.
Instead of a situation where you're hired as an underwriter to place the stock
with people who are going to be the long-term shareholders, when you get into
volatile hot markets where you get this unusual first-day trading profits,
there's a tremendous propensity to give that stock to your best client. And
they in turn sell it and take a quick profit, and then the long-term buyer, the
guy you wanted in the first place, ends up buying it in the volatile
aftermarket.
And it happens only when you get into these really hot markets. But it also
creates an atmosphere where an underwriter's sales force is, in effect, giving
away guaranteed profit. And if you're giving away guaranteed profit, you
probably at some point in the food chain are going to have some deal made that
returns something to the underwriter.
What would that be?
It's classically been commissions. In other words, the best clients of
investment firms are firms who trade the most and in effect pay big commissions
in trades. So they would be naturally listed as the best clients of the firm.
But what's wrong with best customers getting the biggest allocations?
Nothing, if it's in the normal course of business. I think the SEC is on record
as saying that an underwriter has a perfect right to place the stock with his
good customers. I think what happens sometimes, though, is that it moves beyond
that to where it almost becomes a market, where there is a sort of rate of
return given back to someone who creates a certain amount of profit.
There's a very thin line that divides ethical behavior, and to move over into
behavior that's not in the best interests of the company or the final buyer or
even the underwriter. ...
Is this behavior something that you witnessed when you were in the
investment banking world?
Let me put it this way. The premium that a stock trades at after an IPO, I
always thought was a good idea. And going back 30 years, I would counsel a
company to say that when you do go public for the first time, it is in your
interests to start out as a winner. In other words, the best thing that can
happen to you is to have one of the big mutual funds buy your stock in their
fund and have it go up a little bit, because it makes them look smart. It makes
them feel like you're a winner.
So if you have to come back and raise money later, and a fund owns the stock in
a portfolio and it shows a profit, he's much more inclined to buy more. In
other words, he becomes a long-term supporter. And I think that's still true. I
still think starting out as a winner is a very good thing.
If you give too much of a premium, if suddenly the stock doubles or triples,
you destroy what you set out to do. Because, first of all, you give incentives
to other people to buy it for a trading profit. So a lot of accounts will then
come in and represent that they really want to own the stock long term, but
really what they want to do is trade it.
Flip it.
Flip it. And secondly, you know if a stock doubles or triples and you're a
money manager, you almost have to sell it. You look so foolish if you hold it
and it went back down. So I think the intent of getting good buyers to own your
stock for the long term works if the premium is reasonable, and it doesn't work
if it's too big.
But the public during this period of time, 1998-2000, was willing to step in
and buy those shares when they were flipped.
Right.
Explain that dynamic.
At the kind of valuations that were going on, and the kind of trading that was
happening in public markets, it was really fueled by what you would call the
"greater fool" theory. In other words, there has to be a greater fool than you
that buys it, or the whole thing collapses. Well, ultimately, you run out of
greater fools, and the system has collapsed. You don't get high-flying IPOs
now, and you have had markets return to more normal behavior.
I don't know, what creates speculative surges? That's a fascinating question,
and that's what it is. It's this volatile emotional behavior that gets set
loose in a marketplace, because everybody hears, "Gee, this is the way to make
money, trading IPOs." I think it was somewhat accentuated this time around,
because you've had the rise of the day trader, and the electronic brokerage
firms. There were a lot of new participants in it. So it's a complex subject,
but speculative surges happen.
...
What happens during an IPO like VA Linux [which had the biggest first-day
gain in Wall Street history]? Where does the money go?
First of all, by fiat and SEC law, all the stock has to be sold to public
buyers at the offering price. So all the stock is sold at that -- I've
forgotten the exact price, but it was $30 some-odd per share, something like
that -- suddenly you get this huge surge where the stock leaps seven times,
creates a billion dollars or a $1.2 billion of market value. That's profit to
the person who got the IPO allocation. And if you trace it out, I think you'll
find that anything that goes that high, almost all of it is [flipped], because
it just doesn't make sense not to. So effectively the underwriter parceled out
$1.2 billion of guaranteed profit to his clients. As you can imagine, that's a
very nice thing to happen.
That's not the public perception, though. I don't think the public during
this period of time understood that the institutional investors were buying in
and holding it for ten minutes or a day and flipping.
You are probably right. ... VA Linux was an unusual circumstance, because you
know, the Internet boom, it was looked on as the leader in open-source code.
...
There were a lot of IPOs, Akamai, Cacheflow ...
Right, but this was the hottest. I bet there were 100 really hot IPOs during
that period, probably even more. And there was just this whole speculative
atmosphere surrounding the Internet, surrounding the new companies that were
being formed -- in theory, to take advantage of the Internet and to build
significant companies.
The guys who went first, some of the early companies like AOL, Yahoo, eBay,
they did very well for customers, and people made a lot of money on them. So
there was this perception that, "Oh boy, I've got to get into these early-stage
Internet companies." Because the first wave of early-stage Internet companies,
starting with Netscape, did very well for customers.
Why did it begin in the first place?
Netscape was just one of those things. It just hits, suddenly. Suddenly it
seemed to be the symbol of change. Because they had the magic program that was
going to allow you to search the Internet, it looked like they had the key. And
it turned out they did have a very, you know, it was a very good product.
But it was amazing. Hambrecht & Quist was one of the underwriters, and it
was amazing how people just focused on [Netscape] as being almost a symbol of
technology change that was going to enable the Internet.
You remember the day when Netscape went public, and what were you thinking?
I wasn't working on the deal, so I wasn't intimately involved. But yes, we were
just amazed at how high it went. In all fairness to the underwriters, it's
pretty hard to predict in the beginning that these things were just going to
take off, because it was very hard to justify the price of it on any rational
economic benchmark that you usually use. I mean, the values were off the
charts.
One of the comments I've read is that IPOs are the final redoubts of old
discredited cronyism, in which prices are invented primarily to serve the
interests of the middleman.
I think what you will find if you look at any cross-section of market activity
[is] that the IPO market in the United States has been probably the best IPO
market in the world. And it has allowed for the recirculation of a lot of
venture capital money. And it has allowed, frankly, the whole financing of an
entrepreneurial climate. I do think, though, that what happened deserves
serious study, and I think you have to find another way to do it.
We at W.R. Hambrecht came to the conclusion that the only way you can ever take
the possible excesses out of the system is to have a nonpreferential way of
allocating the stock. It's got to be fair; it's got to be open. And in that
way, you get rid of the kind of things that leak into a system where you have
preferential [treatment]. That's why we came up with the [online] auctions.
Explain how the auctions take the preferential excesses out?
The auction allocates the stock based on somebody's willingness to pay a
certain price. A Dutch auction, as we use it in the IPO market, asks everybody
to bid. We go out to the world and say, "Here's company X, how many shares do
you want and what are you willing to pay?" ...
No allocation, no preferential treatment.
No under-the-table, no "You're my buddy, here's 1,000 shares." It doesn't work
that way.
No friends and family?
No friends and family. If the friends and family want it, they have to bid it.
...
That would give you no suasion with venture capitalists whose deal flow you
want to maintain.
I would say that, in a normal market, it helps the venture capitalist a lot.
... If you take the incentive to underprice out of it, that means more money
goes onto the balance sheet of the company, which of course helps the venture
capitalist.
But weren't the venture capitalists being spoiled by kickbacks of shares
from investment bankers that were allowing them to participate in big pops?
I don't know. You can't say categorically; at least I can't. But would they, in
the normal course of a hot deal, be allocated shares? Probably, if they had a
history of an account with a firm.
One investment banker told me he would go to places like Kleiner Perkins and
hear people talking about being allocated shares in a hot IPO all the time.
People would be comparing, "How many shares did you get?"
Well, candidly, it wouldn't really surprise me. ... But I think that's up to
the SEC or anyone else to figure that one out. ...
Spinning, they call it.
Spinning. Yeah. And I think the SEC came through it saying there's really
nothing illegal about it, as long as there is no absolute quid pro quo, there
is no illegal contract to kick back, if there is a gentleman's agreement where
you take care of your good customers, and your good customers take care of you.
That's kind of the way business is driven for us.
It's the way all businesses work. But there's a fine line between no quid
pro quo, explicit and implicit.
Exactly. And that's a very difficult line to define. Maybe you can successfully
define it enough to keep it out of the system. In our opinion, the best bet is
to have a nonpreferential allocation system, so it can't happen.
And explain how a Dutch auction would solve the problem of flipping?
Because there's no guarantee of aftermarket profit. ... In a Dutch auction
system, there is really no guaranteed profit, because you're pricing it very
close to the full demand in the marketplace. And some people might argue it's
too close to the demand; you don't even get a little bit of a pop. And we've
had to adjust to try and see if we could find a better way of doing it
sometimes.
But you know, what the academics will tell you who study auctions -- and there
are a lot of them who do -- a Dutch auction, in theory, should yield a 3
percent to 4 percent premium over the price. Because a fair number of people in
any representative transaction will end up buying shares at a lower price than
they were willing to get, and therefore, if they were rational economic people,
would put that money back into the market in the same deal.
So you would get a little bit of that. I'm not sure it really happens that way.
... But as long as you don't guarantee the market, in effect, a profit from
underpricing, you're going to discourage the flipper. Then it becomes a
decision like any other stock. ...
What about branding? ... What is this branding thing?
To me, it was ridiculous. Guys would say, "I left $200 million to $300 million
on the table, but look at all the publicity I got." So we used to calculate how
many Super Bowl ads you could buy with $300 million. You can buy a lot of
branding for that kind of money. Economically, it didn't make any sense. It was
a market atmosphere that just didn't make sense.
There are still a lot of believers in branding.
Probably less so today, because what good did that brand do later, when you
look at what happened in the aftermarkets of so many of those deals? And yes,
the branding of that, when you get into a hot market like that, and you had
maybe three or five deals a week, the branding event lasted about an hour, and
then they went on to the next deal. I think that there is no way you can
justify it as a branding thing.
You were watching all this going on from the inside, as an experienced
investment banker. What were you thinking as you saw these IPOs coming to
market so frequently?
It was frustrating. This was 1998, the month it was just starting to heat up.
And when it hit a fever pitch, there wasn't anybody truly that really wanted to
listen. I kind of felt like the designated driver at a New Year's Eve party, to
come in and say, "Hey guys, this isn't going to turn out well." And their
reaction was, "What could be better than this? I sell my stock at 10, and it
goes to 100, and everybody is rich, and who's lost? And isn't this a wonderful
thing?"
And it isn't until the aftermarket phase, and the people who bought it in the
aftermarket are left holding the bag, that's when the problem starts. Because
then, instead of the winner, you're a real loser. And you haven't captured all
that money on your balance sheet.
But the investment banks, Credit Suisse and Morgan Stanley and Goldman
Sachs, have all made their 7 percent. The venture capitalists, many of them,
got out early enough, or made enough profits early on to do well. Many of the
CEOs of the companies had selling programs in place where they sold a lot of
shares, and got out. I mean, the people that got hurt were the people that had
the least power.
Or probably, "the least knowledge" is a better way to put it. ...
I think probably there will be better disclosure, and when there's better
disclosure, ultimately, and better knowledge in the marketplace, things like
this shouldn't happen. But remember that book that [Bernard] Baruch used to
quote all the time about speculative excesses being as predictable as killer
whales in the Pacific returning to their natural habitat. There's a lot to be
said for that. In a price-driven free market, there will be excesses. Markets
always tend to overshoot, either way. They tend to go too high, or they go too
low. And yet in the long run, they usually deliver a pretty good result.
...
Let's talk hypothetically, if the banks are using the IPOs as a form of
bribery, to bribe people to give them kickbacks, is this just a form of
cynicism? Or how do we understand that?
First of all, if that's what they truly did, if that's all it was, if it was
just a straight kickback, I think it's very clear that that was illegal. You
know there is that prospectus requirement that an underwriter disclose all the
compensation he gets for an offering, both direct and indirect. So if nothing
else, you've violated a prospectus requirement.
But beyond that, I'd say it's unethical, and it's bad business practice, and I
don't think you'll find anybody at the SEC or the NASD that wouldn't say that,
if that's what happened, that that isn't illegal. The problem is there's this
thin line between that and taking care of your best customers. And I think
that's going to be up to the courts and the SEC and everyone else to decide who
stepped over that line or not.
And I don't know. That's going to come out in the wash. But, well, let me put
it this way: There are some very significant firms that I think will ultimately
use the auction with us, because I think, first of all, they want to run a
clean business. I'm sure they don't like what's going on in terms of the
investigation. I'm sure they're being surprised by what they've found that
happened out in the marketplace. So I think we will find people that for that
reason will start using it with us.
And even more than that, you know, the whole implication of the Internet is
bringing transparency and level playing fields to marketplaces. This is what
it's all about. And I think the big firms understand that, and ultimately know
that no matter how they want to fight to keep a cozy kind of relationship, and
keep transparency out of the marketplace, it just isn't going to happen.
Somebody is going to bring transparency to the marketplace.
That is the grandest irony of this whole thing. This Internet revolution
began with the idea that everybody could have equal access to all the insider
information that the big boys like Bill Hambrecht had access to. And then it
turns out that we're sitting here in the midst of an SEC/Justice Department
investigation of insiders taking advantage of little guys.
The frustration that we had when we went out there with this system in the
beginning, and we called on an Internet company, within two minutes, the guy
would say, "I get it." Yes, this is what I do in my business; we're
disintermediating a distribution, or we're bringing a level playing field to
something. I mean, everybody would read us, and we'd go out saying, "Boy, what
a great call."
Then it'd get to the board, and it'd get to the investors, and slowly but
surely they'd be drawn off and moved toward a conventional way, because the
conventional way looked like such a great deal. It looked like a terrific deal.
These were companies that had started a year or two years ago, and all of a
sudden were being offered these huge valuations. It was hard for them to say
no.
And executives and board members, many of them venture capitalists, were
making a lot of money.
It looked like here was a gold mine, and it was hard to say no.
And it was a gold mine. For a while.
For a while. Now the aftermath, like I say, the New Year's Eve party, you don't
really think about the hangover while the party is going on, not if you're
enjoying it. And I think that's what happened.
The public was also being seduced with a lot of very fancy advertising, and
a lot of media hype.
There was a lot of media hype, but my theory, for whatever it's worth, why this
thing took off the way it did and why it seemed to captivate people's
imagination, was that for the first time, it was technology that sounded
reasonable and understandable.
You would go home and you'd say, "Gee, I hear this idea." And you'd talk to
your kid who is sitting there on a computer, and he'd say, "Oh, yes, it's a
great idea." It just seemed to make sense. I mean, why wouldn't you do these
things on the Internet?
I must have seen 5,000 proposals, at least, at one point or another. Every one
of them sounded great. The real problem was that for every good idea, there
were about 500 people trying to do the same thing. So unless you were first,
and unless you got there quickly, and unless you executed flawlessly, it was a
very difficult place to build a business, because there was so much
competition.
But some of the smartest people I know in the investment business, I don't how
many of them would come up and say, "Gee, my son told me this deal, or my
daughter, gee, this sounds great." And for the first time, you didn't have to
have a scientific opinion about a black box. It was something that you could
sit down at a PC and try. And some of this is remarkable, what you can do with
it.
But what people didn't realize is, when you've got all that money chasing a
good idea, you'll get too many participants in the market, and if you get there
you're going to find a very crowded and competitive marketplace.
With all your experience in investment banking, how does this bubble rank
with others?
Oh, it's off the charts. I've never seen anything create value the way it did,
nor melt down as fast. The meltdown was incredible. The market for these stocks
probably went down 90 percent to 95 percent in a period of six months. These
weren't $10 million, $20 million market caps. These were multibillion market
caps disappearing.
One of the things that many people have told us is that what happened was
basically that you had a massive transference of risk to the public. And I've
asked a number of venture capitalists, was it appropriate for the banks and for
the venture capitalists to bring these companies public?
Well, the role of an investment banker is to find the best market to raise
money for a company. And if you were going to be an investment banker for the
Internet community, yes, you really had to do it, because it was the best
market to raise money. So you could have made a decision, no, I don't want to
do it. But if there was a willing buyer and a willing seller, that's what the
underwriter looks for.
But if you know that willing buyer is naive and foolish, if you feel any
responsibility to that buyer ...
How shall I put it? For the most part, most of the underwriters really believe
in the prospects of the company they're underwriting. I really do think that.
Mary Meeker, for example, really believes in the Internet; I honestly believe
that. ...
But that doesn't mean that they didn't think they were overvalued and being
sold at overvalued prices.
The only way you can be sure it's overvalued is after it's over. When you're
living in a market and you're seeing these stocks go up, and if you take the
position, "Well, it's overvalued," you're not in the market, and you miss it.
You miss the whole market. And it's hard to do.
But didn't you know that you were in some kind of massive speculative bubble
in which many greater fools were being created every day?
I thought that there was some real excesses going on. But hey, I held some
stocks all the way up and down too. Everybody is human. And I believe in the
Internet. And there's a propensity to say, "Yes, all the others are too high,
but not mine." I mean, that happens.
Right, I'm not going to buy B2C, I'll just buy infrastructure.
Yes, you rationalize it out and you say, "Well, I'm getting in at the right
price." It's hard to resist the kind of speculative bubble that the Internet
created. It was hard to resist.
So you think the anger that's directed at venture capitalists or investment
bankers is misplaced?
I think that we will always have speculative bubbles. They go back to the tulip
bulb craze. They've been with us forever. After one's over, there is always
this going back thing -- "Boy, we're never going to let that happen again."
Then there'll be another bubble that will be created by some new thing that
comes on the scene that captures the public's imagination.
I think the answer is not to say we'll never have it, but hey, clean up the
process, so that you get as much knowledge in the marketplace as you can get,
and have allocation systems fair so that you don't get a corrupting kind of
thing happening.
But free markets generally allocate assets better than any other process than
anybody knows about, certainly better than central planning. So I think this is
what you have to live with. And it isn't a question of getting rid of it. It's
a question of making sure you keep it clean, because markets, to be effective,
have to be trusted. And markets are going to go up and down; there's going to
be volatility. You have to keep it clean, and you have to have a system that
tells people, "You're not going to be cheated."
There's going to be risks, and people are going to take risks, and people are
going to make money and lose money. But there's a big difference between making
money and losing money, and being cheated.
Is this an act of conscience on your part, at this stage in your career, to
take this stand?
I don't know. I just feel that we have a great asset here. I think the equity
markets of the United States have created a flow of capital that has been a
very beneficial thing for our economy and has allowed us to become the
technology leader. It has allowed capital to flow in to form these companies,
not without -- you know, there's been a price to pay. Everybody didn't make out
on it. But it basically worked. And I think it's worth defending, and I think
that the whole marketplace has to be based on trust. Investors have to believe
in the marketplace.
I think this was something that had to be changed to keep the trust of
investors, and that's what we're trying to do. ...
What's the ultimate leverage?
The ultimate leverage is being able to include somebody or exclude them from an
offering that he thinks is attractive. It goes back, and again, I've never
forgotten how upset John D. Rockefeller used to be with J.P. Morgan because of
the size of his allocations. When you think about it, John D. Rockefeller could
have bought Morgan ten times over. But Morgan had something that Rockefeller
wanted that only Morgan could give him. At the very base of a lot of these
firms is that leverage of allocation. And that's why it isn't going to change
very quickly. It's hard for people to make that change.
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