How Investment Banks could be disrupted by Direct Listings

In an interesting article on the FT of last week, Michael Moritz, CEO of Sequoia, underlines how thisweek marks the 15th anniversary of Google’s initial public offering — the first concerted effort to break the hammerlock that investment banks have always held on stock offerings.

That attempt failed. But now, due to mounting frustrations, advances in technology and changes in the capital markets, investment banks are about permanently to lose the gatekeeping position they have jealously protected.

Google’s IPO was the first time a large technology company had expressed public frustration at the way investment banks cloaked IPOs in secrecy, making it impossible for either issuer or buyer to figure out what was happening behind the curtain.

Instead, Google’s management asked the banks to run an open auction — much as eBay conducts a sale — to determine an eventual price. No other company followed suit, largely because the banks closed ranks and succeeded, in a disinformation campaign worthy of the NRA gun lobby in the US, in portraying the IPO as a flop.

Now, years later, the groundswell of dissatisfaction is about to erupt into action. This new approach, dubbed a direct listing, has so far been employed by only three companies: the music streaming service Spotify and payments company Adyen (both of which started outside the US), and Slack, a San Francisco software company.

These direct listings, largely controlled by the company that is selling shares, occurred because the shrewd and the brave caught on to the idea that, for stock offerings, investment banks occupy the same position in the investment universe as a scalper does in the theatre world.

No actor, theatre owner, producer or audience member enjoys knowing that a ticket tout has run off with money that should belong to them. The same goes for the people involved with private companies. It took the backbone of Barry McCarthy, chief financial officer at Spotify (and previously CFO at Netflix), to buck the system, shining a light on the tactics that the banks have used to frustrate and exasperate everyone but themselves.

Bill Hambrecht, a San Francisco investment banker who helped take Apple public in 1980, spent much of the 1990s making similar arguments to Mr McCarthy — but he failed because his former competitors and collaborators made him a pariah in the manner that the mob treats a turncoat. Mr McCarthy’s complaints against traditional IPOs included an inflexible commission structure; a tendency to dictate how much money a company should raise; an arcane instrument known as the “greenshoe”, which allows the banks to raise more money than the company wants; gruelling two and three-week roadshows; and — the final indignity — selection of who is permitted to price and buy the shares. Buyers have been just as frustrated.

Genuine long-term shareholders wanting to buy large amounts of a company’s stock have been stymied because the banks allocated shares to their favoured clients the way fishermen chum the waters. The result: these buyers usually flip their initial shares for a short-term profit and wait for a market pullback to build the position they want. The world has changed. There has been a blurring between the public and the private markets. Young companies are staying private far longer than their predecessors: by now, many of the managements have ample experience raising large amounts of money without any intermediaries.

Similarly, the usual customers for IPOs — mutual funds and hedge funds — are seeking out independently the most promising private companies, and alternate market makers are raising their hands. Technology also favours the direct listing.

The traditional roadshow, during which management teams rush through 30-minute slide-decks in front of investors, look antiquated compared with comprehensive business reviews or lengthy YouTube videos — duly vetted by the US Securities and Exchange Commission and available for all. Some banks are mounting an action. They claim that only sizeable or well-known consumer companies have the heft and following to stage a direct listing. They cling to the vain hope that less high-profile businesses will be unable to manage for themselves or that managements without a lot of cash on their balance sheets will lose their nerve.

This is despite the fact that hundreds of companies operating in obscure niches are publicly traded. During the next couple of years, companies already well advanced with plans to go public will probably use the conventional approach. But, for all others, the choice of a direct listing or a traditional IPO has become a test of two attributes: courage and intelligence.