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INSIGHT: Uber and the Day the IPO Died

June 6, 2019, 8:01 AM

One of the most widely anticipated IPOs in stock market history was dead on arrival on the floor of the New York Stock Exchange. Could this be the start of a “lemons market” on Wall Street?

Uber, the giant ride-sharing platform that disrupted the taxi business worldwide over the last decade, recently offered shares of common stock to the public at $45 per share. But by end of the first day of trading, the market was only willing to pay $41.57 per share, a 7% slide.

The falloff in price continued the following week with another decline of nearly 11%. The bankers leading the deal intervened to stabilize the price collapse, but it remains what Wall Street calls a “broken IPO,” because the stock is trading below its IPO price.

Instead of the $120 billion valuation first suggested last fall by Goldman Sachs and Morgan Stanley, who were competing to lead the IPO, public investors valued Uber at just over $62 billion, almost half the price Wall Street’s two leading underwriters thought possible.

Morgan Stanley won the pole position as Uber’s lead underwriter, likely based in part on its optimistic valuation. It is probably now fielding calls from angry clients and holding on to hundreds of thousands of unsold shares after acting as the stabilization agent during the IPO.

Uber is not alone. Other “unicorns,” —companies that reached valuations of more than a billion dollars when privately held—have also run into trouble. Lyft, Uber’s sister ride-sharing firm, has seen its shares fall to one third below the IPO price.

Even social media platform Pinterest, which initially looked to be an exception to this pattern, has come back to earth as the “quiet period” ended allowing Wall Street analysts to publish their views of the company’s prospects. Of the 12 banks that underwrote the Pinterest IPO, only two were optimistic about the company’s valuation. The stock is now trading 25% below its high.

What’s Going on Here?

Why are the highly touted unicorns turning into lemons when they finally go public?

In theory, the long wait to go public should allow investment banks to price these firms more accurately. Instead, Wall Street is getting it wrong. Defenders of the Street and of Silicon Valley will likely claim these are short term hiccups. Maybe.

But we think there is a deeper problem: The stock market may be turning into a “lemons market,” a concept devised by Nobel Prize-winning economist George Akerlof, on how markets can fail. Many people have forgotten about the possibility of market failure because we have assumed for a long time that competitive forces could accurately align stock market prices with fundamental value. That was true, and could be again, but not without a recognition that quality markets need the right rules to function well.

In a lemons market, buyers abandon a market for fear of buying a low-quality good, or “lemon.” Bad or unreliable information about the goods for sale leaves buyers in doubt about the value of those goods. In response, sellers of high-quality goods leave because buyers are unwilling to pay the right price for their products. When buyers and sellers of high-quality goods slip away, all that’s left are lemons.

SEC Regulations Studied

But the lemons market is also a cautionary tale. Markets that solved the lemons problem centuries ago are vulnerable to collective amnesia about the very existence of a lemons problem.

For example, until recently, underwriters like Morgan Stanley and Goldman Sachs were able to defeat the lemons problem, especially at the non-profit, member-owned New York Stock Exchange, where they wielded significant influence. They imposed stringent rules on top of SEC regulations, including high standards for firms that wanted to sell their shares, and rules that ensured fair treatment from floor brokers and specialists. The result was good quality information about listing firms and orderly pricing in both bull and bear markets.

Several changes have eroded that lemons solution. The first of these was a set of rules called Reg. NMS, put in place by the SEC, that uprooted underwriters’ longstanding control over the NYSE.

We studied the impact of those new rules and found, in a study published recently in the International Review of Law and Economics, that “spreads"—the price difference between offers to buy and offers to sell—widened significantly for NYSE-listed stocks due to trades executed on platforms other than the NYSE, suggesting the new rules were creating uncertainty about the price of those shares.

Next, the JOBS Act cut back disclosure requirements for some firms. The SEC has further weakened some of those requirements and is proposing to relax audit requirements at smaller public firms. Policymakers claim that looser rules save companies money and encourage them to go public.

What regulators have failed to reckon with is that low-quality information creates doubt for investors, doubts that grow with IPOs looking increasingly like lemons. Ultimately, any money companies might have saved is outweighed by lower stock prices and a higher cost of capital. It is time for regulators to face up to the risks they have created in our most important financial market, the stock market.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Stephen F. Diamond teaches securities law at Santa Clara University School of Law.

Jennifer Kuan is an economist and a research fellow at the Kenan Institute for Private Enterprise (at UNC-Chapel Hill).