Alibaba, the massive Chinese e-commerce company that is the functional equivalent of Amazon, EBay, Uber, PayPal and a bunch of other companies combined, made its debut on the New York Stock Exchange this morning. It was the largest initial public offering in U.S. history, raising over $21.8 billion.
It was also a powerful example of how Wall Street, oftentimes, is a rigged game.
Before the bell rang, Alibaba sold its shares at $68 to a variety of hedge funds, mutual funds and other well-connected investors. By the time ordinary investors had a chance to buy the stock, it was trading at $92.70. The privileged few were able to turn an immediate profit of 36 percent, if they so chose.
When companies issue an I.P.O., they partner with one or more “underwriters” — often investment banks — that go out and find investors for the company. These underwriters get paid a fee from the company for their service. In the case of Alibaba, the fee totaled more than $200 million. But underwriters are also able to use that position to provide access to the I.P.O. to favored clients, securing their business and generating more fees.
The underwriters’ dual loyalties — to the company offering the I.P.O., and to their investor clients — is an inherent conflict that is rife for abuse. Writing in the New York Times in 2013, Joe Nocera detailed the case of eToys, which launch its I.P.O. on May 20, 1999. The initial price was set at $20 by Goldman Sachs and ended the day at $77. eToys, which later went bankrupt, sued Goldman Sachs alleging “Goldman purposely set an artificially low price, so that its real clients, the institutional investors clamoring for the stock, could pocket that first-day run-up.” Then, “Goldman then demanded that some of those easy profits be kicked back to the firm.”
Emails obtained by Nocera at the courthouse during that case revealed “the Goldman sales force would call on clients, show them how much they had made from Goldman’s I.P.O. and demand that they reward Goldman with increased business.” According to the documents “it was not unusual for Goldman sales representatives to ask that 30 to 50 percent.” (You can read the entire trove of documents here.)
This preferred access has real consequences for ordinary investors, since it artificially drives down their returns on these stocks in the long run. It is essentially a slow-motion version of the issue highlighted by Michael Lewis in Flash Boys, where high frequency traders impose a hidden tax on everyone else by securing preferred access to markets.
While there is no evidence there was any kind of blatant misconduct in the case of the Alibaba I.P.O., it still raises the questions of why some investors are able to access the initial offering at a preferred price and others are excluded.
Recently, Triton Research Co-founder Rett Wallace — who has studied the value of the access and information provided to select investor in advance of an I.P.O. — was interviewed on Bloomberg TV. Wallace revealed that if investors simply bought shares at the price offered for all I.P.O.s in 2013 from underwriters and immediately sold them when the market opened it would have generated a 56 percent return. This huge, overnight return that is simply not available to an ordinary investor.
The interviewer then asked Wallace: “Do you consider that your game [I.P.O.s] is rigged.”
Wallace responded: “Anything that has scarce inventory… preferred access is valuable. And so there is very scarce inventory for these hot deals which is why managers spend a lot of time figuring out of which ones they really care about so they can try to get more.”
Which seems to be a very fancy way of saying: “Yes.”