That’s before investors realised its parcels business has a competitive disadvantage in a fast-growing but increasingly crowded marketplace. At 414p, down from about 600p last winter (and 565p at the time of our April sell tip), the share price is now only 25 per cent above the controversial 330p IPO price.
If one ignores the blame game, however, Lord Myners’ recent report to Vince Cable on the lessons of the Royal Mail flotation offers a fascinating anatomy of the London IPO mechanism. This revolves around the process of bookbuilding, whereby an investment bank collects share orders from investors – fund managers, traders and sometimes stock brokers acting for private individuals – on behalf of the business vendor.
Think of a house sale. An estate agent tries to draw offers out of buyers on behalf of the seller. Who ends up buying the house depends mainly on the offer. Compared to an auction, however, the so-called ‘private treaty’ sales process now used in most housing transactions lacks transparency; the agent has some discretion to set the price and take or ignore offers. Crucially, the main interest of the agent is to achieve a sale and therefore a fee. Achieving a high house price is of secondary importance.
The basic model for selling a company to the public is the same, with the investment bank or ‘bookrunner’ acting as estate agent. But there are complications. Valuing a business is usually a good deal more subjective than valuing a house, making the pricing process more unstable and subject to sudden shifts in sentiment. And whereas the housing market is dominated by owner-occupiers, who don’t buy houses regularly, the market for shares is dominated by institutional investors who trade shares all the time. That means investment banks, through their brokerage arms, have ongoing relationships with buyers – relationships they may be tempted to foster by offering IPOs at keen prices.
Another big difference between houses and public companies is that the latter are bought not by one buyer alone, but by a wide range of different investors in an allocation determined by the agent. That gives bookrunners a lot of scope for discretely currying favour with chosen clients in an opaque bookbuilding process. The report outlines plenty of academic evidence, mainly from the US, that such dubious practices do exist.
These conflicts of interest beggar the question why bookbuilding is used in most developed countries. Ironically, the method is relatively new, introduced to the UK after Margaret Thatcher’s Big Bang, which was supposed to do away with City old boys’ clubs. Bookbuilding replaced traditional underwriting, whereby the vendor fixed a price with a bank or investor as guarantor and then offered shares to retail and institutional investors at that price. The old system was transparent and ensured a sale, but judging by share-price increases on the first day of dealings IPOs are more accurately priced now, through bookbuilding. Underwriting was also very risky: banks and big institutions lost money in the BP (BP.) flotation of 1987, for example.
The third option is auctions, which theoretically combine the transparency of the fixed-price system with the pricing flexibility of bookbuilding. Lord Myners thinks it “inevitable that the bookbuilding process will transition to a more digital online auction based on binding bids”. On the face of it, that would be good news for private investors, who would once again find themselves on a level playing field with institutions.
But it’s not clear why auctions are “inevitable” – beyond a vague notion that the old system is ripe for digital disruption. Auctions were tried in the UK in the 1960s and 1970s, but never caught on, and the same pattern can be observed in other countries. That “can be interpreted as evidence that investment banks successfully lobby to stop auctions from becoming common (since the fees are higher with bookbuilding and because they can use discretion to their own advantage),” notes the report. The banks prefer to conclude that auctions work less well. Infamously, the largest IPO auction of recent times – that of Google (us: GOOG) in 2004 – was a flop, failing to raise as much money at as high a share price as expected.
Australia – where a hybrid system with an open bookbuilding process has developed – may offer a way forward. Is it coincidence that the Australian association for private investors is also one of the strongest in the world?
