Thursday, March 19, 2009

How to Cature Rents Without Seeming To

In many cases, one has something of value, but it is considered impolitic to seize this value. Over on Offsetting Behaviour, Eric Crampton notes that bands face a quandry in that front row seats sell for $1000 for top bands, yet bands do not want to appear to charge this much. Trent Reznor of the band Nine Inch Nails, explains that in practice the ticketing agents have already made a deal with the scalpers to split the surplus without appearing like jerks by having high posted ticket prices. The band, meanwhile, negotiates with the ticketing agents, and this ticket agent revenue is factored in the negotiations. (He then goes on to note his particular band is willing to give up this money to get real crazed fans in the front row, a logical reason to let the front row keep the consumer surplus).

This method of capturing value without seeming to reminds me of how investment banks capture the value from initial public offerings (IPOs). The IPO game is basically a way for brokers to capture the one-day pop in IPO prices. IPO’s predictably generate 12% return on their first day of trading, and most IPO investors sell in the first couple of days (though, of course, their broker discourages this to little avail).

For the broker issuing the IPO, by giving these only to clients who pay extra commissions, that first-day return is all capturable. Generally, in 2001 a hedge fund might pay 0.1 cents a share for bare bones trading, and 3 cents a share for trading bundled with ‘research’ and ‘trade ideas’. Of course, this research is worthless on average and the hedge fund knows it, but it leads to getting on the IPO list. Thus, the investment bank capture the one-day pop via the implicit overcharge on commissions to get access to the IPO.

To summarize: the investment bank captures the 12% one-day spike in the IPO price via overpriced research sold to a fund, which is known worthless. This quid pro quo is needed because the equity issuing firm would not appreciate paying the broker an 8% fee plus giving them the benefit of the first-day pop. The hedge fund trades commission dollars for the one-day return from IPOs because it is a basically even trade, and generally helps the portfolio manager point to 'great trades' useful for narratives about their savvy investing prowess, whereas the commissions are spread like string beans on a kid's dinner plate.

There are lots of trades like this, and often, like in the IPO trade, a key to participating is to never acknowledge to anyone in the chain the blatant logic at work. That is, a hedge fund would never ask explicitly for this quid pro quo, or if one did, one would not get a positive response. One merely recognizes the game and then smoothly joins, asking about IPOs say a couple months after paying for 'research'. As disgraced former Illinois governor Blagojevich found out, the first rule of trading favors to avoid explicit payment schemes is never to say or write this is what you are doing. It is a feasible equilibrium because as a repeated game, one can punish cheaters.

1 comment:

Anonymous said...

does this mean that google did the right thing? if yes, why dont more do like them?