Where banks really make money on IPOs

Every time an IPO has a big pop on its opening day, the same tired debate gets reprised: did the
investment banks leading the deal rip off the company raising equity capital? The arguments on both
sides are well rehearsed -- I covered them myself in no little detail, for instance, after LinkedIn went
public, in 2011.
Back then, I had sympathy with the bankers:
If the large 7% fee does anything, it aligns the banks' interests with the issuer's. If the banks felt
they could make millions more dollars for themselves just by raising the offering price, it's
reasonable to assume that they would have done so. I'm sure that the institutions which were
granted IPO access are grateful to the banks for the money they made, but that gratitude isn't worth
a ten-figure sum to the ECM divisions of the banks in question.
Today, however, I have to take all of that back. And it's all thanks to Joe Nocera, who has a great
column this weekend, where he uncovers a bunch of documents in one of those interminable
securities lawsuits against Goldman Sachs. The documents should have been sealed; they weren't.
And now, thanks to Nocera, we can all see exactly where Goldman makes its money, when it comes
to IPOs. (It's fantastic that he put those documents online, although it's hard to read them in the
browser; here's the download link which the NYT weirdly removed from its own site.)
The lawsuit in question concerns the IPO of eToys, back in 1999. The company sold 8.2 million
shares, raising $164 million; Goldman's 7% fee on that amount comes to $11.5 million. If Goldman
had sold the shares at $37 rather than $20, it would have received an extra $10 million -- and what
bank would willingly leave $10 million on the table?
What Nocera has discovered, however, is that Goldman was not leaving $10 million on the table.
Instead, it was making more than that -- much more -- in kickbacks from the clients to whom it
allocated hot eToys stock.
Goldman carefully calculated the first-day gains reaped by its investment clients. After compiling the
numbers in something it called a trade-up report, the Goldman sales force would call on clients,
show them how much they had made from Goldman's I.P.O.'s and demand that they reward Goldman
with increased business. It was not unusual for Goldman sales representatives to ask that 30 to 50
percent of the first-day profits be returned to Goldman via commissions, according to depositions
given in the case.
eToys opened at $78 per share, which meant that Goldman's clients were sitting on a profit of $475
million the minute that the stock started trading on the open market. In most cases, the clients
cashed out -- which was smart, because eToys didn't stay at those levels for long. But if Goldman got
back 40% of those profits in trading commissions, then it made $190 million in commissions,
compared to that $11.5 million in fees.
If Goldman had raised the IPO price to $37 per share, then yes its fee income would have gone up by
$10 million, to $21.5 million. But -- assuming the stock would still have opened at $78 -- its clients'
opening-tick profits would have come down to $336 million, and Goldman's 40% share of that would

also have come down, to $135 million. Total income to Goldman? $156.5 million, rather than $201.5
million. If the IPO price were higher, Goldman's total take would have gone down by about $45
million.
All of these numbers are hypothetical, of course, but the bigger point is simple: if Goldman manages
to get kickbacks, in terms of extra commissions, of more than 7% of its clients' profits, then it has a
financial incentive to underprice the IPO. And Goldman's clients were desperate to give it kickbacks:
they didn't just route their standard trading through Goldman, since that wouldn't generate enough
commissions. Instead, they bought and sold stocks on the same day, at the same price. Capstar
Holding, for instance, bought 57,000 shares in Seagram Ltd at $50.13 per share on June 21, 1999 -and then sold them, on the same day, at the same price. Capstar made nothing on the trade, but
Goldman made a commission of $5,700. Capstar's Christopher Rule says that in May 1999, fully 70%
of all of his trading activity "was done solely for the purpose of generating commissions", so that he
could continue to keep on getting IPO allocations.
Goldman, of course, revealed none of this to eToys. Instead, they pitched eToys with a presentation
saying, on its first page, in big underlined type, "eToys' Interests Will Always Come First". On the
page headlined "IPO Pricing Dynamics", they explained that the IPO should be price at a "10-15%
discount to the expected fully distributed trading level" -- which means not to the opening price,
necessarily, but rather to the "trading value 1-3 months after the offering". After all, this was the
dot-com boom: everybody knew that IPOs were games to be played for fun and profit, and that the
first-day price was a very bad price-discovery mechanism.
If you look at the chart of what happened to the eToys share price in the first few months after the
IPO, the price fluctuated around $40 a share -- which means that by Goldman's own standards, it
really ought to have priced the IPO much closer to $37 than to $20. And this was no idiosyncratic
mistake on Goldman's part: Goldman's other IPOs all fit the same pattern. For instance, look at the
three deals run by Lawton Fitt, the Goldman executive in charge of the deal, before the eToys IPO.
First was pcOrder, which went public at $21 and opened at $55.25. Then there was iVillage: that
went public at $24, and opened at $95.88. Finally, there was Portal Software, which went public at
414 and opened at $36. When eToys went public at $20, Fitt knew exactly what was going to
happen: indeed, she bet her colleagues that eToys stock would hit $80 on the opening day. She knew
her market: it actually traded as high as $85.
Some big names jump out from the documents here -- none more so than Bob Steel, who was then
Goldman's co-head of equity sales, and who went on to put out financial-crisis fires for Hank Paulson
at Treasury before going on to become the CEO of Wachovia. Steel wrote a detailed email to Tim
Ferguson, the chief investment strategist at Putnam Investments, saying that he would try to help
Putnam out "with regard to IPO allocations". At the same time, however, he added that "we should
be rewarded with additional secondary business for offering access to capital markets product".
Which, in English, means that if Putnam got access to Goldman's IPOs, it would have to steer more
soft-dollar commissions to Goldman.
Meanwhile, if you didn't toe the investment banks' line, they would cut you. Toby Lenk was the CEO
of eToys, and in a 2006 deposition he was asked whether he ever "voiced any displeasure" with
Goldman about the fact that they left so much money on the table. He said no -- and added "a little
story" about why it was never a good idea to annoy a big investment bank. In 2000, Lenk explained,
when eToys was desperate for money, it raised some cash through a convertible debt offering:
We initially selected Merrill Lynch to be our lead convertible debt underwriter, and Goldman Sachs
came in and put a strong foot forward to take that away, and Merrill Lynch we kept as a secondary

underwriter in the secondary position and kept them in the deal. They were in the deal, and I believe
it was the morning of the deal going into the marketplace, or the night before, or right around that
time, Merrill Lynch's lead internet analyst, Henry Blodget, downgraded our stock as that was going
into the marketplace, and made it extremely difficult for that placement to happen.
The investment banks have punitive power over us. We need them to raise capital. You don't go
complaining to investment banks because they will crush you, and that is a perfect example. We got
penalized by Merrill Lynch. We got slapped hard, and it nearly sank that offering, and I can tell you
that nearly sank the company.

This is just the flipside of pumping up companies in order to get investment banking business: if you
lose that business, then you do the opposite, and downgrade the company just when doing so causes
the most pain. As a result, as Lenk says, you didn't cross the bankers -- and you certainly didn't cross
Goldman.
All of which puts Goldman's 7% fee into very interesting perspective. Goldman likely made much
much more money on the eToys IPO from its buy-side clients than it did from eToys itself. Indeed, it
could have offered to run the IPO for free, the IPO would still have been very lucrative for Goldman.
But of course eToys would never have given Goldman the IPO mandate if Goldman had offered to
run it for free -- because then it would have been obvious where Goldman's loyalties resided.
The real purpose of the 7% fee, it seems, was to make eToys think that it had hired Goldman and
that Goldman was working for eToys -- and also to tie eToys into a close relationship with Goldman.
(Lenk, for instance, became a personal client of Goldman Sachs shortly after the IPO.) As Andrew
Clavell once put it:

If you claim you do know where the fees are, banks want
you as a customer. You don't know. Really, you don't.
Hang on, I hear you shouting that you're actually smarter
than that, so you do know. Read carefully: Listen. Buster.
You. Don't. Know.
The 7% fee is a very large shiny object, which diverts
everybody's attention from where the real money is made
-- or at least did, back in 1999. Have things changed
since then? Here's Nocera:
The documents are old. Some will dismiss them as relics
of another era. But I continue to believe that the mind-set created by the I.P.O. madness of the late
1990s never really went away. To this day, an I.P.O. with a big first-day jump is considered a
success, even though the company is being short-shrifted. To this day, investors know that they are
expected to find ways to reward the firms that allocate them hot I.P.O. shares. The only thing that is
truly different today is that few on Wall Street are so foolish as to put such sentiments in an e-mail.
That's the one point at which I'm willing to disagree with Nocera. Nothing ever changes much on
Wall Street, including the degree of professional foolishness. I'm sure if a determined prosecutor
went hunting for similar emails today, she could probably find them. But I don't know what the point

would be. Because there's nothing illegal about asking buy-side clients to send commission revenue
your way -- or even about explaining to them how much money you've helped them make. eToys'
creditors might ultimately win this case against Goldman, or they might not, or the two sides might
settle. But whatever happens, the implications for sell-side equity capital markets desks will be
minuscule. Because the amount of money they're making right now will always dwarf any potential
litigation risk 15 years down the road.