Bankers who want to compete with Web brokers are seriously considering offering Internet-based initial public offerings (IPOs), if only because their rivals are doing so. Offering them, of course, would be helpful to a bank's image as a powerhouse in big-time investment banking. But they may want to reconsider: IPOs are one-shot deals that inherently restrict potential transaction volume. And early Web offerings are too limited to be lucrative. So why all the hype? Because consumers want in on the ground floor of the next Microsoft or Dell.

IPOs traditionally have been sold first to securities houses, which, in turn, sell them to their customers at a profit. But in the past year at least two small, Internet-based broker-dealers, IPO.Net, a division of W.J. Gallagher & Co., based in Pasadena, CA, and Wit Capital, based in New York, have offered new stock offerings directly to the public from the underwriter. Wit Capital, which opened for business in September, has gotten prominent play in the press; IPO.Net has been in business for about a year.

Ironically, the attention the idea's received from both the press and the

financial industry is way out of proportion to the actual performance of Wit Capital and IPO.Net in those IPOs. Both companies placed only about 5,000 shares of the offering they handled. And unlike common industry practice, neither IPO.Net nor Wit Capital were allocated shares they could guarantee to place; instead, they were allowed to offer shares on their Web sites by the underwriter-and if they sold any, well and good. In the grand scheme of things, this puny performance is no great endorsement for the benefits of the venue.

In the case of Wit Capital, the deal was Radcom Ltd., an Israeli manufacturer of network test equipment, underwritten by New York's Unterberg Harris. The Radcom offering totalled 2.25 million shares. Wit is now offering shares in C.H Robinson Worldwide, Inc., a U.S. logistics firm, underwritten by BT Alex Brown. Wit Capital deferred any comment on their role in the new offering to the lead underwriter, BT Alex Brown, which declined comment.

IPO.Net was allowed to offer shares in Javelin Systems Inc., a manufacturer of the soft screen displays found in restaurants; it offered to sell 850,000 shares in an underwriting by Meridian Capital Group, Inc., a West Coast securities house. IPO.Net has landed no deals since September 1996, concedes president Leo Feldman.

Feldman says that he's spoken to more than 20 companies in the past year about participating in their IPOs and has been turned down every time. Why? "Their biggest fears are that something might be released by e-mails or something else that would (prompt the Securities and Exchange Commission (SEC) to) step in and say they were gun-jumping or something," he says. "It's been like pulling teeth," says Feldman."Everybody is afraid. The underwriter's counsel are afraid, even though I have a No Action letter from the SEC (stating that it will not interfere with IPO.Net's Web IPOs); they don't think I can do this. When you talk to counsel of the issuer, you run into trouble, and (the same) when you start talking to counsel of the broker-dealer. Nobody wants to opine to the fact that this is legal."

Resolving compliance issues

That really wasn't the case, says Meridian evp Steven Spencer. "It wasn't a problem with e-mail communications. It was Blue Sky (disclosure) issues, for one thing. The problem with IPO.Net was there just weren't that many hits. You don't know who the customers are on the other end, per se, (and) you don't want to blindly offer shares-you don't know if they're flippers, or who they represent, or if they're qualified investors. (And) to me, those are basic compliance issues. I don't think the response at that point in time was big enough to encourage us to set up methods for dealing with these issues," he says.

Among the big firms offering IPOs on their Web sites, specific methods of dealing with these issues vary; some only allow customers to indicate interest in buying IPOs, and conduct the rest of the transaction through conventional channels, including telephone calls. Others allow customers to actually buy shares on the site, but say many of these compliance issues are addressed by the fact that they will only allow established customers with track records to indicate interest on their Web sites, and that those track records will identify and qualify the customer before they actually issue the shares to them.

This slow start isn't stopping the big Web brokers from leaping into the scrum, however. DLJ Direct, Fidelity Investments and Charles Schwab & Co., all offer their customers at least the ability to indicate interest in an IPO. Only DLJ Direct allows them to buy straight from their computers, although E-Trade is working on an offering similar to DLJ Direct's. Discover Brokerage, formerly Lombard Brokerage, acknowledges it's working on offering IPOs on its Web site, but declined to discuss its plans. DLJ Direct offers IPOs underwritten by its parent, Donaldson, Lufkin & Jenrette and Fidelity from Salomon-Smith Barney Inc.

Catching Web IPO Fever?

So far, only one bank is even somewhat connected to this phenomenon- Bank of America, which recently acquired West Coast securities firm Robertson, Stephens & Co. That firm, which specializes in underwriting new offerings for Silicon Valley companies, has plans to allow its IPOs to be offered by E-Trade to customers. Other banks are reportedly considering their options.

E-Trade and Robertson, Stephens announced they had signed a letter of intent on the deal in September, before Robertson, Stephens was acquired by BofA in October. But whether the BofA connection to E-Trade comes to pass was unclear at press time; a BofA spokesperson would only say that whether they would pursue it was "one of the things we'll be looking at" after the Robertson, Stephens deal closed. She refused to comment further.

According to both the SEC and the Office of the Comptroller of the Currency (OCC), the legal and compliance issues have already been addressed. The SEC has three separate publications on the subject, one of which, issued this May, runs to 125 pages. OCC officials say that they will go with the SEC's opinion on the matter. So assuming the regulatory light is green, the question is whether banks should join the fray. And while at first blush, the answer might well be, Why not?; the real answer is that it depends on whether the upside is big enough to risk the downside.

The naive argument, of course, is that IPOs are the exclusive preserve of Wall Street fat cats who are keeping all the goodies to themselves and making fortunes by snapping up fabulous IPO opportunities, while the poor schlemiels of the great investing public, forced to buy their shares from one of the big institutions after the stock opens, are left to make do with their leavings. Offering the general investing public IPOs at the offering price instead of reselling them at a profit, say some, is just economic democracy in action, leveling the playing field. And institutions that do so are the friend of the little guy.

If that were the case, every bank should jump in. But since that argument is exaggerated, at best, banks might want to pause and reflect before leaping into the business.

The problem? IPOs are speculative investments that often lose money. Banks, leaning heavily on a prudent image built up over decades, have been positioning themselves as investment advisors to whom people in need of trustworthy investment advice can turn. And, further, people who lose money on speculative investments tend to blame the loss on the people they bought them from. The specter of a big, nationwide bank defending itself against charges in a class-action suit filed by retired teachers, nurses and auto workers, claiming that they lost money investing in IPOs offered on a bank's Web site, is not especially in that bank's interests.

Playing trusted advisor

This is no small danger; under the law, one person can file a class- action suit, despite disclaimers included in an investment prospectus. "It clearly doesn't matter what you write in the prospectus, because you get lawsuits whether or not there's underlying liability anyway," says Wit Capital CEO Andy Klein, who practiced securities law at Cravath, Swain & Moore for seven years before launching a micro-brewing business and then on-line brokerage.

Speculative or not, IPOs are the would-be darlings of the hip-and growing-investing world. Articles about astounding successes of offerings like Ascend Communications, which opened on NASDAQ in 1994 at 13 and reached 80 1/4 this January, and about the boom in new offerings (new IPOs grew from 213 in 1990 to 874 in 1996, according to Securities Data Corp.) have plastered scads of magazine covers.

Latching onto that sort of performance makes it easy for IPO promoters to sound like friends of the little guy, and friends of the banks who want a piece of the action in a hot and growing market. But predictably, there's a little more to the story. Less well-reported than the upside, for instance, is that Ascend fell to 33 5/8 within five months, underperforming the steadily rising NASDAQ Composite.

Equally unremarked, although a well-established fact of financial research, is that most IPOs underperform comparable stocks over a three- to five-year period by anywhere from 30 percent to 50 percent. Indeed, two Prudential Securities studies indicate that fewer than 30 percent of IPOs outperform the NASDAQ in the long term (most IPOs are NASDAQ-listed) and that in any event, the fundamentals of IPOs generally decline in short order; in the second quarter after going public, the earnings of 23.2 percent of the 776 companies studied fell short of expectations-a percentage that grew to 32.5 percent by the fifth quarter.

This isn't to say that all IPOs successes are evanescent; offerings of established companies with strong market positions and earnings generally do pretty well. Start-ups with a new product and enthusiastic salesmen, on the other hand, generally don't. The trick is to understand what's on offer.

And this is where one of the problems is for banks that are considering a move into on-line IPO offerings. Being able to understand a company's financials, the underlying structure of the market the company plans to operate in, the strength of its management, the prospects of success for its main product, and a hundred other variables calls for a degree of financial sophistication not always found among people who rely on good advice for an investing strategy.

Of course, it's only fair to point out that the alternative to offering IPOs direct to the public is to stick to doing things the old-fashioned way-guaranteeing profits to some by allowing them to buy at the offering, and sell in the post-offering flurry of buy orders that typically follows. To say that small investors are not sophisticated enough to buy IPO product before the stock trades up is double talk, says Klein. "How smart do you have to be to know that it's better to buy at the offering price than to wait 'til it's traded up 18 to 20 percent?"

True as that may be, however, that's not enough of a reason to endanger a strong marketing position by risking bad publicity. And it's also no reason to spend good money buying market share in a market facing a decline-which the IPO business probably is.

This is because there's a strong correlation between IPOs and general market performance; hot markets mean plenty of IPOs and vice versa. This is unsurprising, since an IPO is a chance for an entrepreneur to cash out, and it's only natural for them to choose to do so in a rising market. But when the market declines, so do new offerings-for the same reason. So if, as many believe, the economy is slowing, in the process taking the bloom off the stock market's torrid performance, the pace of new IPOs will slow as well-leading some to ask why any financial institution would want to buy into what's probably going to be a crowded and declining market.

Promise over performance-for now

This is especially true if, as DLJ Direct CEO Blake Darcy thinks, offering IPOs on-line is just another Internet land rush. "In all of these things, there can be a herd mentality in terms of getting things onto the Internet, and in the brokerage arena, this has clearly been one of them," he says. "(But) if you're going after the high net-worth individual, and that's our target market, one of the things they'd be looking for is the IPO market, and if we didn't offer that, we'd have some difficulty claiming to be a leader."

Some banks might find that a convincing, albeit costly, reason to enter the IPO market. As Octavio Marenzi, a partner in Needham, MA-based Meridien Research, points out, there isn't all that much money to be made in the IPO business in the first place. "An IPO is a one-off event, so it's not one of the things that lends itself terribly well to making electronic," he says. "It only happens once, so it's not like trading IBM shares back and forth a thousand times. To make an electronic channel pay for itself, you have to have volume. Setting up systems is a fixed cost, and if you can't get enough people to use it, then it's just wasted money."

Enough of a reason to stick to one's knitting.

-reinbach tfn.com

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