Interest in MLP IPOs is on the rise. Six new MLPs went public in 2010, raising nearly $1.6 billion–the best showing since 2007. All six of these names traded above their offering price at the end of 2010, leaving little doubt that we’ll see more MLPs list their shares in 2011.

— Elliott Gue, MLP Profits

Social networking is powerful phenomenon that is taking the Internet world by storm. Last year I wrote about Facebook and Groupon, but I should have also written about LinkedIn (NasdaqGS: LNKD).  The website that connects white-collared professionals with each other for industry news, job openings, and peer recommendations had its initial public offering (IPO) yesterday (May 19^th) and its first-day performance was simply amazing.

LinkedIn IPO Was Badly Underpriced

LinkedIn’s IPO price was initially planned to be between $32 and $35, but the investment banks underwriting the deal (Morgan Stanley, Bank of America, JP Morgan) discovered such strong institutional demand during the road shows that the price was raised to $45. It turned out that the banks should have raised the IPO price much, much higher. When the stock began trading yesterday, it opened at $83, rose as high as $122.70 and closed at $94.25, up more than 109% on the day. Since 2001, LinkedIn’s first-day IPO performance is the fifth-best ever:

Based on the table above, LinkedIn has about a 50-50 chance to go up from here over the next 12 months. But this is a very small sample size that should not be relied upon. Instead, I would look at the academic research, which concludes that the average IPO significantly underperforms in the first couple years after the first-day pop.  For example, a 2009 paper concludes on page 27:

To summarize, we can answer the initial question of whether the stocks of IPO firms underperform those of more mature companies with “yes”. However, our results indicate that IPO underperformance is most pronounced during the first two years after the IPO.

As I write this on Friday morning, the stock is at $102.40, up another $8 in its second day of trading. Don’t even think about jumping in and buying now. The valuation of LinkedIn’s stock is outrageously high. Look at page 10 of LinkedIn’s registration statement: Earnings per share in 2010 were only $0.17. That equates to a P/E ratio of 594!

Was the LinkedIn IPO a Success?

Most people would probably call LinkedIn’s IPO a huge success but when you think about it, LinkedIn’s shareholders left a lot of money on the table. Remember, the corporation only received $45 per share. The real winners of the IPO were the institutional buyers who bought the stock at the IPO price of $45 and flipped it for $100.  Why would investment banks under-price the IPO so badly and why would LinkedIn’s management team go along with it?

Investment banks typically get a 7% commission of the total deal price for underwriting IPOs. Since roughly 9 million shares were sold (assuming the over-allotment option is exercised), the commission is about $28 million [(9 million shares * $45 per share) * 7%)]. Split this three ways among the three main underwrites brings the per-bank commission to about $10 million. Not chump change, but these banks want to maximize the number of deals they do rather than maximize the commission they get on a single deal. 

Investment Bank Double-Dealing

By offering institutional clients a sweetheart deal on IPOs, they are essentially bribing these clients to continue trading with them, as well as to list with them if their firms ever decide to go public. The problem is that the banks are paying for these bribes with money that should be going to LinkedIn’s shareholders! A 2008 study by WP Carey on IPO underpricing concludes:

It is in the interest of investment banks to underprice an IPO because it nurtures ties to institutional investors, who are often repeat customers of the banks and who benefit directly from the underpricing. Venture capitalists are looking to cash out as quickly as possible, and to do so need to maintain good relations with the underwriters. For this reason, venture capitalists, who are on the boards of many of the IPO firms, also are motivated to support underpricing.

This dynamic can be harmful to companies. Fifteen percent of all these ventures is a lot of money on the table. It’s all going to institutional investors who usually flip the shares in the first couple of days.

Investment banks need to remember that their client is the share-issuing corporation, not the flippers.

IPO Spinning Hurts Shareholders

The management teams of company’s going public can also benefit from IPO underpricing to the detriment of their own shareholders. A 2004 study (page 32) found that corporate executives have often been bribed by investment banks to permit IPO underpricing in exchange for receiving other underpriced IPOs in their personal brokerage accounts. This nefarious activity is known as IPO spinning:

Analyst coverage became a more important factor for issuers choosing a lead underwriter, due to higher valuations than in the 1980s. Since underwriters do not charge explicit fees for providing analyst coverage, issuers pay through the indirect cost of underpricing.

Second, the spinning hypothesis argues that venture capitalists and the executives of issuing firms were co-opted through the allocation of hot IPOs to their personal brokerage accounts. This gave these decision-makers an incentive to choose a lead underwriter with a reputation for leaving money on the table in IPOs. Although the excessive dilution that results from underpricing their own IPO lowers their wealth, they gain on personal account when other hot IPOs are allocated to them. Since the profits from these other IPOs are imperfectly correlated with their undiversified paper wealth in their own company, the decision-makers are willing to accept excessive underpricing when their own firm goes public.

Furthermore, take a look at pages 8 and 122 of the registration statement. Less than 9% of total shares outstanding are being sold in the IPO. This limited supply is overwhelmed by demand, which causes the price to skyrocket.  LinkedIn CEO Reid Hoffman only sold 0.6% of his shares at $45 in the IPO, which leaves him with 99.4% of his initial stake to benefit from the scarcity-induced price pop. 

Dutch Auction IPO is the Ethical Way to Go

If I was a private shareholder in Facebook or Groupon and saw the $49 per share that the underwriters deprived LinkeIn shareholders from receiving in the IPO, I would insist that these underwriters not be involved. A Dutch auction process for IPOs is fairer to all parties involved. It was used by Google and Morningstar and I commend them. Both companies’ stocks have performed very well despite having shunned the investment banking ripoff machine.

Find the Best Tax-Advantaged MLPs with the Help of MLP Profits!

MLP IPOs are much more reasonably priced than these speculative Internet moonshots. I would be much more inclined to jump on board an MLP IPO than an Internet IPO.

Roger and Elliott spend all of the waking hours studying the MLP industry. The recommended portfolios in their market-beating MLP investment advisory, MLP Profits, includes only the “best of the best” energy-based MLPs – those that keep raising their cash distributions. Roger recently wrote to subscribers that MLPs remain outstanding high-yield investments:

It’s still possible to buy high-quality MLPs yielding between 5 to 9 percent, and these companies are poised to grow those dividends anywhere from 5 to 10 percent.

Over the long term MLPs’ unit prices follow distributions higher. As a result, dividend growth for our favorites adds up to annual returns of 10 to 19 percent. That’s superior to almost anything else I can think of, particularly anything that’s tax-advantaged, as MLPs are.

To find out the specific names of the energy MLPs Roger and Elliott like best right now, give MLP Profits a try today!