Despite all the scrutiny of shady practices, back-scratching deals, and conflicts of interest in the initial public offering process, no state attorney general or federal regulator has questioned one of the most enduring, economically dubious customs of the IPO world.
Virtually all companies going public pay their underwriters the same commission. The underwriter gets 7 percent of the deal, regardless of the size of the offering, the company's prospects, or the success of the sale. You pay a lower per-share commission to buy 1,000 shares than you do to buy 50, but there's no volume discount on the IPO side of the business.
There were two IPOs on Nov. 21, 2002. The money-losing sandwich-shop chain Cosí raised $38,888,892 and paid a commission to William Blair & Co. of $2,722,222—exactly 7 percent. Safety Insurance, a profitable auto insurance company, raised nearly twice as much—$72 million—and paid a 7 percent commission. Last February, when big-box retailer Petco Animal Supplies raised $275 million—seven times more than Cosí's deal—the underwriter's take came out to 6.75 percent.
The predominance of the 7 percent solution is not prima facie evidence of collusion by the Wall Street underwriting cartel. But it surely indicates a consensus among Wall Street firms big and small that competing on price would be ruinous—even if their customers think they're being gouged.
When Colorado State University finance professor Patricia Ryan polled chief financial officers of companies that conducted IPOs between October 2000 and June 2002, she found that 65 percent deemed the underwriting fees "excessive," while 88 percent believed the underwriters should do better on pricing. Ironically, when asked whether their own company paid too much, only 46 percent said yes. (This is part of a strangely American dynamic in which we find overall systems to be rotten—i.e., Congress, public schools—but give high ratings to the components of those systems that serve us directly.)
Is a 7 percent flat fee excessive? It is plain that no rational relationship exists between the price charged and the service rendered. Selling a $1 billion IPO doesn't require 10 times the amount of resources, time, or manpower that it does to float a $100 million offering. Indeed, large stock offerings of blue-chip companies are often comparatively low-maintenance deals. Frequently, smaller, riskier transactions require the most intensive roadshows and arm-twisting.
And contrary to what one might expect in a functioning marketplace, commissions remain constant regardless of market health. In 1999, when Wall Street was stamping out IPOs, the commission remained about 7 percent. Now that IPOs are about as rare as J.D. Salinger sightings and big-name firms scramble after deals they would not have deigned to consider, the commission remains about 7 percent. Somewhere on Wall Street, isn't there a group of desperate investment bankers, peering into an empty bonus pool, that might consider slashing the commission in order to win business? Apparently not.
Of course, in many service industries, professional norms mitigate against stepping out of line in pricing. Like underwriting, residential real estate is a highly competitive business in which the commission is standard—6 percent—and doesn't fall noticeably as the price of the merchandise sold rises. But real estate is also a collegial, intensely local business in which an agent can survive only if other brokers are willing to work with her. If one broker in Chappaqua, N.Y., suddenly offered to sell homes at a 4 percent commission, it's doubtful other members of the guild would show the renegade's listings to their clients.
While IPO underwriting can be a collaborative industry—many deals are done by a syndicate of underwriters—much of the business is essentially a zero-sum game. Any deal for which Merrill Lynch is the lead underwriter is one less deal for Goldman Sachs. And given that Wall Street professional norms tend to be highly utilitarian—if it makes money, generally speaking, it's OK—we'd expect at least some price competition among highly motivated competitors.
So, what gives? Certainly, no Wall Street firm wants to initiate a potentially ruinous price war in what has been an enormously profitable business.
More broadly, the "consumers"—i.e., top executives at companies going public—aren't very demanding about getting a good deal. For them, the commission is only one factor. Good underwriters don't simply toss the stuff out into the marketplace. They provide all sorts of other services. Underwriters are supposed to ensure that the stock gets into the hands of institutions that might hold on to it for awhile. Or they might commit to supporting the stock so it doesn't fall embarrassingly below the offering price in the first trading days. Until recently, whether such promises were explicit or implicit, it was also presumed that the investment bank's research arm would provide friendly recommendations. Indeed, 92 percent of those surveyed by Ryan said that the reputation of the underwriter was an important factor in the perceived success of the IPO. So, even if an upstart offered to raise cash for a company with a 5 percent commission, many companies would still pay 7 percent for the privilege of using a bank with the market heft of Goldman or Merrill.
(Besides, Wall Street had other means to convince executives of the utility of doing business with them. The allocation of hot IPOs' shares to chief executives and chief financial officers—enriching them personally—was a powerful tool for investment banks.)
Underwriting isn't rocket science. And the extra benefits from hiring a Goldman may not always be worth the millions of dollars in inflated commission a company pays. But as we've seen, top executives frequently don't suffer as a result of Wall Street underwriting practices—the investors do. And here, again, the unwarranted persistence of the 7 percent commission effectively cuts the amount of IPO capital raised and reduces the value of the stock. It is the shareholders, who effectively pay the underwriters, who should be demanding a better deal.