Betrayal On Wall Street The credibility gap between investment banks and their clients has never been wider. Why? Just look at the IPO con game.
By Shawn Tully

(FORTUNE Magazine) – It's hard to imagine two business types more different than Felix Rohatyn and Scott Painter. One is old economy personified, a Wall Street sage who advised everyone from Harold Geneen of ITT to Lew Wasserman of MCA, and polished his establishment credentials as ambassador to France. The other is Mr. New Economy, a born company-creator who founded not only CarsDirect, a popular retailer that sells Fords and Chevys over the Web, but also Build-To-Order, an Internet automaker that plans to construct custom cars. Certainly, the 72-year-old Rohatyn and Painter, 32, represent a kind of boardroom yin and yang: pinstripes vs. chinos, Fifth Avenue prewar vs. L.A. chalet--and, oh, yes, Old World courtly vs. Left Coast brash. From their separate realms, however, they voice a common concern: They think Wall Street is in trouble.

For Rohatyn, the problem is that long-standing relationships between investment bankers and CEOs, the bands of trust he spent a career forging, barely exist today. Too often investment bankers serve mainly themselves, says Rohatyn. They reap huge fees--and bonuses--by persuading clients to do deals. No deal means no fee. So Wall Street compulsively pushes transactions, good or bad. "It takes a certain level of sanctity for a banker to say 'Don't do this acquisition' when the rewards are so high," Rohatyn laments. "Today Wall Street is driven by lead tables, promotions, and bonuses, not necessarily what's good for the client."

Painter, who views Wall Street from the customer side--as an entrepreneur hungry for cash--sees a betrayal of a different sort: Investment bankers, he gripes, seduce young tech companies with the lucre of initial public offerings and then quietly snatch much of the proceeds out from under them. Rather than raising the most money possible for the side they're supposed to be representing (the issuer paying the fat fee), investment firms use the IPO game to curry favor with their other major clients, institutional investors. In a nutshell, they ply mutual and hedge funds with artificially cheap shares from the offering and then get repaid in high-commission stock trades. Wall Street, Painter grouses, is serving both seller and buyer in the same transaction, a blatant conflict of interest. "The interests of the investment bankers run totally counter to the interests of the issuers," he says. "The entire system is obsolete."

Their charges, from opposite ends of the banking spectrum, raise a fundamental question: Can companies still trust Wall Street--or has the credibility gap in the post-bubble market widened too far?

Wall Street's chief role hasn't changed for more than a century. Quite simply, it is to put cash into the hands of corporate America. Investment banks also advise clients on how to use that cash, or their stock, to purchase other companies. But raising money for corporations is the main reason Goldman Sachs, Morgan Stanley, Salomon Smith Barney, and the other big investment banks exist.

In that primary mission, investment banks are failing. The evidence is overwhelming that instead of serving their corporate clients, they may be harming them by raising money at exorbitant cost--though one has to look carefully at the numbers to tell. In the past two years alone companies have collected $121 billion from IPOs. In exchange for that remarkable sum, newly public companies have spent over $8 billion in underwriting fees to investment banks--a figure that, upon first glance, looks modest in comparison.

But that $8 billion represents only a fraction of the true cost to the issuers. The banks priced their clients' shares far below their full market price--measured as the price they reached on the first day of trading. Instead of selling shares to those willing to pay the most, Wall Street handed the underpriced stock to a privileged group of institutions that trade heavily with the investment banks. Far from being the long-term holders the banks advertised, most of those buyers immediately flipped their shares for huge gains. Money that should have gone to the issuers flowed instead to the favored funds and other preferred clients in an enormous, historic windfall.

In 1999 and 2000, Wall Street's underpricing reached such egregious heights that companies left no less than $62 billion "on the table." Throw in the $8 billion to underwriters (more on that later), and that means that for every dollar corporate America raised, it paid an incredible 57 cents in fees and forgone proceeds. Today, equipment makers and dot-coms, running desperately short of cash or wallowing in junk bonds, are finally seeing the bill for those high-profile, surging IPOs. They could have been using that same money, they say, to fund R&D, launch marketing campaigns, or simply stay afloat. Not surprisingly, many entrepreneurs are fuming. "When a stock is underwritten at ten and opens at 30," says Painter, "the company got screwed."

And to be sure, during the final two years of the millennium, that screwing reached orgiastic proportions. To put the $62 billion figure in perspective, consider that it is more than twice the amount left on the table from IPOs for the previous 19 years combined. On average, first-day offering prices jumped 71% in 1999 and 57% in 2000, compared with an average 11% from 1980 to 1998.

It's no secret that something very big--something deep in the roots of Wall Street--has changed. Several things, really. First is the rising power that mutual and hedge funds have begun to exercise on Wall Street. The funds pay expensive commissions and trading spreads to buy and sell huge volumes of stock through the Goldmans and Merrills. That's nothing new, of course. Institutions have long paid a big premium for trading to compensate firms for research and better access to IPOs. By the mid-1990s, trading and commissions were a huge growth business, accounting for an increasing share of Wall Street's profits--an estimated 40% last year. "Trading simply became a much bigger part of the banks' profitability," says Scott Ryles, a former Merrill Lynch investment banker who heads Epoch Partners, an underwriter of IPOs over the Net.

But in the past few years this all-important revenue stream has come under assault, as Instinet, Archipelago, and other electronic communication networks have begun to offer a low-cost alternative. Institutions can now trade at less than a penny a share on ECNs. Compare that with the average of 5 cents a share that mutual funds (9 cents for hedge funds) typically pay the banks. "When they trade with mutual funds, 3 out of the 5 cents is profit to the firm," says Wayne Wagner, chairman of the Plexus Group, a Los Angeles consulting firm. That high-margin business is something the banks are loath to lose. Another recent threat has been that spreads on Nasdaq trades--the gap between bid and ask prices that generates profits--have shrunk since the SEC imposed a landmark 1999 price-fixing settlement upon the investment banks. This, too, has made the lure of IPOs more essential to the firms' bottom lines.

Although for decades it has been de rigueur for firms to hand the biggest goodies--or as the Street calls them, "frequent flier miles"--to their best customers, the new ECN competition has made currying favor with the major mutual and hedge funds even more critical. The frequent trader's bonus: the hot IPO.

The dreaded drought, however, never did come. Instead, bargain IPOs helped unleash a bonanza in trading revenues. The steady flow of risk-free IPO profits encouraged mutual and hedge funds to keep buying and selling big-cap NYSE stocks through the investment banks at fat commissions. What's more, the firms themselves cleaned up by trading shares in the companies they had just taken public. Explains Ryles: "Given the dollars involved, the most important thing became managing trading relationships."

So why would investment banks want to low-ball IPOs when they'd earn far bigger fees by pricing the shares much higher, closer to their opening trades? The answer is that trading revenues can far exceed the fees left on the table. During 1999 and 2000, firms typically allocated 80% of the offering to about 125 funds. But their first-day profits were so huge that the original investors had little reason to stick around. Within a week or two, all but ten or 15 had dumped their shares.

The flipping--a signature of cheap IPOs--was a boon for Wall Street. As a rule, the lead underwriter on each deal gets a near-monopoly on trading for the first week or two, because the grateful funds sell their shares back to Merrill, Lehman, or whoever managed the offering. "You're the only market-maker, so it's a license to print money," says Bill Burnham, a former CSFB analyst who's now a managing director at Softbank Venture Capital. "You buy all day at $20, knowing that the demand is at $20.80, say. It's like shooting fish in a barrel." Burnham estimates that by generating those fat spreads buying and selling new IPO shares, firms match or exceed the underwriting fees in trading profits. The take has been huge. From 1998 to 1999, revenues from spreads and commissions climbed from $44 billion to $66 billion--a 50% jump.

But the game changed in a subtler way as well. In the past, a combination of tradition and ethics managed to keep investment firms generally on the side of their corporate clients. One restraint was relationship banking a la Rohatyn. Your veteran banker may have been overpaid and overdressed, but you never doubted his loyalty. An even stronger harness was Wall Street's mania for guarding its upright image. "It was always a tradeoff between milking short-term fees and protecting long-term reputation," says Jay Ritter, a finance professor at the University of Florida and a leading researcher of Wall Street practices. "Until recently, reputation usually won."

During the tech-stock run-up, though, the financial stakes became so huge that greed overwhelmed tribal custom. "Wall Street has always attracted greedy, power-hungry people," says Michael Tennenbaum, former vice chairman of investment banking at Bear Stearns and now senior portfolio manager at Special Value Investment Management. "But people obeyed certain rules. Then the old rules fell away, and water went to the lowest level." Wall Street made a bad trade, tarnishing its hard-won reputation for a boost in profits.

Nowhere did practices change so dramatically as in IPOs. Until the late 1990s, the key concept was balance. "We tried to find the right point between keeping trading business and doing what was right for the client," says Philip Davidson, a former syndicate manager for Kidder Peabody who is now retired. Underwriters strove to sell offerings at just 10% to 15% below their estimated price once shares started trading. Mutual funds clamored for the cheap stock. But in return, the firms demanded they hold it for the long haul, usually at least several months. "If a fund flipped, banks wouldn't put them in the next IPO," recalls Scott Ryles.

In some ways the system worked. As a group, institutions bought about 80% of the offerings, and still held around that 80% a year or two later. And many of the original investors stuck, providing the issuer with a stable, supportive coterie of owners. Above all, a big "pop"--in which the stock soared on the first day of trading, handing a bonanza to funds--was strictly taboo. "We considered a major pop a black mark," says Davidson. Nothing was a clearer sign that the banker was exploiting its client.

Starting in 1999, the expensive but predictable world of money-raising turned surrealistic. Suddenly issuers were sacrificing tens of billions of dollars as Wall Street suspended the old rules, telling clients that forgoing money now was a ticket to eventually making more in the brave new economy. The artful balance between satisfying investors and issuers went totally out of whack. Overnight, it shifted wildly in favor of the funds. And amazingly, the docile startups mostly signed on--until the crash exposed their folly.

To be fair, part of the problem was that the new breed of profitless IPO candidates, and the unprecedented bull market, made it a challenge for Wall Street to value stocks accurately. In fact, judging by the spectacular collapse in tech stocks, it could well be argued that those first-day valuations were actually too high, not too low. Today three-quarters of the 779 IPOs of the past two years languish below their offering prices.

But such excuses aren't likely to placate companies that saw potential cash swirl down the drain. And Wall Street's cartel-like fee structure doesn't make it any more palatable. Remarkably, all investment banks charge the same 7% fee, with little regard for the size of the offering or how much it costs the firm to arrange it. The University of Florida's Jay Ritter studied 1,111 IPOs from 1995 to 1998. In no less than 91% of the deals, the banks charged 7%. That compares with 3.4% charged by banks in Japan and 5% in Europe.

When clients demand a reduction, investment banks dismiss the subject. It's not that the firms conspire to fix fees. Each one simply refuses to compete on price, and since Wall Street is a clubby enclave dominated by half a dozen players that regularly participate in one another's deals, it's hard for low-cost gatecrashers to break through. Cutting fees would mean reducing bonuses, which is anathema to Wall Street. But clients know that it doesn't take five times more man-hours to handle a $100 million offering than to do a $20 million deal. They want fees to reflect effort and costs. So the "no negotiations, zero discounts" stance enrages venture capitalists and entrepreneurs. As Todd Wagner, co-founder of Broadcast.com, now a unit of Yahoo, demands, "why should bankers take part of the deal, when lawyers get paid by the hour?"

Good question--and one for which the Wall Street firms have had a ready salve, if not an answer. For despite any confusion that they may have had over the new-economy valuations, they have perfected a new-economy sales pitch--tailored to clients ripe for the plucking. The firms knew that the VCs and founders couldn't sell their shares until a secondary offering six to nine months hence. The message was simple: Use the IPO to enhance the secondary, the El Dorado event that will make you incredibly rich. It became a branding event, with all the social imperative of a debutante ball. "The pitch was, 'This is your first date with Wall Street. You want it to go incredibly well,'" says Burnham. Translation: Sell your IPO shares cheap, and the funds will be so grateful that they'll pay royal prices for the secondary.

The IPO market became so surreal that the banks pledged to price the share--get this--at a higher fraction of their market value than their rivals received. By Wall Street's peculiar logic, getting 40% of what your stock was really worth was suddenly a coup, because your competitor got only 35%. The bankers even had a new scientific-sounding term for it: "percentage of stabilized value."

Some banks offered a special perk that may have further lowered resistance to Wall Street's snow job. To court business, they handed the founders or investors in still-private startups shares in other current IPOs, guaranteeing them a big, speedy profit--a practice called "spinning." This was tantamount to using what should have been another issuer's money to pay for the firm's own marketing expenses. But it didn't seem to matter. What counted were the deals.

"When they want your IPO, the banks get their private-client guys to call and say they'll put you into other companies' hot IPOs," says Painter. A former top executive at an investment bank that didn't practice spinning recalls meeting in 1999 with two venture capitalists who bragged of pocketing $500,000 each the day before, courtesy of a hungry banker. "VCs made tons of money on those deals," he says.

The argument that cheap IPOs would burnish secondary offerings was fallacious, of course. Putting more cash in the treasury through an IPO--or issuing fewer shares to raise the same amount--makes a company more valuable to future investors, not less. But the market soared for so long that many young companies did manage successful secondaries, so pure luck gave Wall Street's pitch a patina of truth.

Even billionaire entrepreneurs are miffed. Ross Perot was apparently outraged watching funds land a $180 million gift--the equivalent of 18% of Perot Systems' current market cap--when Morgan Stanley ran its offering in 1999. "Ross thought the shares were very underpriced," says CFO Russell Freeman.

No one is more incensed than renowned VC Donald Valentine, who backed Yahoo and Cisco: "The new company is not the customer," he says. "The bank's customer is the institutional investor. The victim is the small company that needs money."

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