John Ince Interviews Bill Hambrecht, Founder of WR Hambrecht and Hambrecht and Quist
Bill Hambrecht, 64, is Chairman and CEO of WR Hambrecht + Co, a financial services firm headquartered in San Francisco that he founded in January 1998. Bill resigned as Chairman of Hambrecht & Quist in December 1997, the investment banking firm he co-founded with the late George Quist in 1968. WR Hambrecht + Co leverages the internet and the auction process to bring transparency to capital formation and securities exchange processes. The firm’s earliest and best-known innovation is OpenIPO, an auction-based model for initial public offerings. WRH+Co is expanding the use of the auction to high-grade corporate debt offerings and other capital markets. He currently serves as a director for numerous private and public companies including KQED, Inc., San Francisco’s public radio and television station and Beacon Education Management, which manages charter schools. Mr. Hambrecht graduated from Princeton University.
Ince: What was your original business model?
Hambrecht: The original business model was to see if we could put together the breadth and power of the web with an auction process. The reason I thought we needed both was that the web was obviously a very efficient, cheap and quick way to communicate with a large group of people. It was obvious that this could be a great mechanism for distributing securities to affinity groups or retail customers. But I also felt that there was no way this would happen unless you had another pricing mechanism that took away preferential distribution. As long as there was preferential distribution, the IPOs or any attractive new issue merchandise would flow to the best brokerage customers. That’s the way the business is driven. So I felt that we had to do both. I knew that the really difficult thing would be to get a different pricing mechanism in a market that was used to negotiated pricing.
Ince: How has that business model stacked up against reality? Do you still feel it’s a valid model?
Hambrecht: Oh yes. Definitely. As a matter of fact, I think it’s almost a classic destructive technology in Clay Christensen’s (Harvard Business School Professor and WR Hambrecht Board Member) model. Effectively what’s happened is that we’ve done four IPOs and one debt auction and we have a number coming along. It been greeted with skepticism and a lot of competitive heat against it, because it’s clearly going to change the economics that accrue to the managing underwriter in a traditional deal. It seems to me that the competition has reacted just as Clay Christensen’s model suggest they would. They added more services, more analysts and more functionality in an effort to stave off what is inherently a more efficient and cheaper process.
Ince: How will it change the underlying economics?
Hambrecht: In two ways. First of all, there is really no justification today for the traditional 7% spread for an IPO. It was a historical spread that used to be paid when you really needed salesman to sell a new issue. But in the last 10 years new issues are priced so much below the market that they get allocated, not sold. And they get allocated to the best commission clients. So the second form of profitability, which not obvious to everybody, but is very much there, is the tremendous reciprocal flow of commission business to the underwriter, who delivers a guaranteed profit to the institutions.
Ince: How does that work?
Hambrecht: No one will admit to it, but effectively at some point or another an underwriter, salesmen or somebody will count up how much guaranteed profit they’ve given to an institution and will want a certain flow of commission business back. My own gut tells me that the commission kickback to the investment bank is about 20%.
Ince: Can you give an example of this?
Hambrecht: If you take a 1999 average IPO. It was a $50 million deal. The underwriter’s commission was 7%. The stock price doubled and it basically created $50 million in guaranteed profit for the institutional investor that was in on the initial stock allocation. The managing underwriter, who determines where about 90% of that stock goes into the institutional pie, will probably get about $10 of commission flow back.
Ince: The skeptics that you refer to suggest that your Dutch auction process is insufficiently sensitive to the aftermarket for the stock. Do you agree?
Hambrecht: It depends what you want out of the aftermarket. If you are distributing an offering where you are implying to the buyer that it going to have a big premium over the offering price, then yeah you want to set it up to create as much irrational demand in the marketplace as you can. And you do that by creating this image of great demand and very little supply. You do it subtly, but you do it. It goes out and jumps dramatically on the first day. This gets in all the newspapers and everybody says, “Gee this is a great deal.” To maintain that price, it has to bring in a lot of interest from day traders and aggressive trading accounts, because they think this is something very hot. The problem with that is that it doesn’t last. This is what gives the big institutions an opportunity to flip the stock and have a guaranteed profit.
Ince: How will the Dutch auction change all that?
Hambrecht: What we try to do is have an aftermarket that first of all, the foundation is set by a group of buyers that bid for the stock they own. In other words, this group of people in effect have helped set the price. There is no expectation of a big runup on the first day. So instead of this huge of amount of trading that you get on the first, second or third day, there is very little trading. Because there is really very little need to turn it over. We think that our system finds people that really want to own the stock as an investment rather than a trading vehicle.
Ince: So which system has a better pricing mechanism.
Hambrecht: An auction delivers a price that is a lot closer to the real market demand, than an artificially negotiated price that is really negotiated to create this big runoff and this big emotional frothy aftermarket.
Ince: In doing this, are you alienating some of the “loyal” institutional investors?
Hambrecht: Maybe, but that should have nothing to do with the placement of the underwriting stock. The company pays you a spread to place the stock with long term shareholders. Whether the underwriter gets a kickback of commissions or not, should have nothing to do with where that stock goes. If you’re doing the job that you get paid to do, you should place it with the best possible long term buyer. What has happened, because of the guaranteed profit in this business, 95% of the stock gets turned over the first day. So the company isn’t getting what it’s paying for. The underwriter is getting a lot more profit than even the company realizes, because it’s done in this reciprocity rather than in an open spread.
Ince: But the underwriters suggest that their financial incentive is to price the stock as high as possible. Is that true?
Hambrecht: No, the underwriter’s real incentive is to price it as low as they can, because the indirect payment comes from the big premium that is placed on the stock in the aftermarket. Our system does get them the highest possible price commensurate with the market level. In other words, it should be true demand, not emotional demand.
Ince: So what is the ultimate potential of the Dutch auction? Others suggest that it at best will be a niche market? Do you think it has larger potential than that?
Hambrecht: On August 15, we our first debt offering using the Dutch Auction. It was a $300 million debt offering for Dow. It went extraordinarily well. We think that Dow ended up with a price that was about as close to the true market level as you could come. It’s trading now about one basis point away from where it came out. It also got a much bigger mix if buyers than you normally get in a debt offering. We think it will spread very rapidly in that market.
Ince: Do you see the other investment banks picking up on this?
Hambrecht: Well, they’re going to have to respond in some way. It’s created a lot of interest.