Prices, like everything else, move along the line of least resistance. They will do whatever comes easiest.
—Edwin Lefèvre, Reminiscences of a Stock Operator
MAY 18, 2012
The news coverage surrounding the IPO, even from the supposedly savvy tech and financial press, was a reminder of that harsh lesson of life: there are those who write headlines about money for a living, and then there are those who make money. “Facebook IPO Blunder” announced Fortune; “Mark Zuckerberg’s Big Facebook Mistake,” thundered Forbes; “Facebook Disappoints on Its Opening Day” intoned VentureBeat, a Valley insider rag that should have known better.
Despite such headlines, Facebook’s IPO was not a fiasco; it was without question the most successful tech IPO in financial history. If you don’t understand why, then you don’t understand how IPOs work, and you should read on.
What’s an IPO, exactly? A company decides it wants to “float” part of its equity on the public markets, allowing employees and founders to sell private shares to pay them off for years of service, as well as sell shares out of the corporate treasury to have some money in the bank. Large investment banks (such as my former employer Goldman Sachs) form what’s called a “syndicate” (“mafia” might be a better term) wherein they offer to effectively buy those shares from Facebook, and then sell them into the capital markets, usually by pushing it via their sales force onto wealthy clients or institutional investors. That syndicate either guarantees a price (“firm commitment”) or promises to get the best price it can (“best effort”). In the former case, the bank is taking real execution risk, and stands to lose money if it doesn’t engineer a “pop” in the stock on opening day. To mitigate the risk, the bank convinces the offering company to expect a lower price, while simultaneously jacking up what real price the market will bear with a zealous sales pitch to the market’s deepest pockets. Thus, it is absolutely jejune to think that a stock’s rise on opening day is due to clamoring and unexpected interest. Similar to Captain Renault in Casablanca, Wall Street bankers are shocked—shocked!—that there should be such a large and positive price dislocation in the market they just rigged.
As proof of the complete charlatanism at work in most IPOs, let’s ask ourselves a question: Are there other situations in the financial world in which the banks are responsible for setting, ab initio so to speak, a fair market price, and in which that routinely works out?
Why, yes, in fact. It happens every morning when thousands of stocks start trading on the public exchanges. How does the first price of the day in IBM get set? Back in the days of floor traders, the “specialists” responsible for trading that stock weighed the amount of buying versus selling interest, and calculated a reasonable “midmarket” price. They then offered to buy at slightly less, and sell at slightly more, than that price when the market opened, supplying the liquidity they’re paid to provide via the narrow bid-ask spread they pocket on every trade. Modern electronic exchanges have replaced the manual process with an algorithmic one, but it’s essentially the same. On opening, trading initiates smoothly from a stew of overnight speculation and imaginary price movements into real trades and shares changing hands. How often does one see 20 to 30 percent price changes on opening in US exchanges? Never, basically, other than after catastrophic events like market meltdowns or 9/11.
Given Wall Street banks’ consummate skill in (usually) running orderly markets when their money and reputations are on the line, isn’t it a wonder that they should suddenly find it impossible to engineer an IPO in which the price doesn’t pop 20 percent on open? Even assuming there were some ever-present estimation error, isn’t it striking too how they always manage to underestimate the price on the first day, making themselves a fortune, rather than overestimating and causing themselves a loss?
Facebook shredded the usual IPO script.
The stock opened at $42, and closed at $38.37, which put the financial press in a howling tizzy of complaint, and which nicely screwed the bankers.
The negotiations were way, way, way above my pay grade, so I have no idea how David Ebersman, Facebook’s then CFO, managed to coerce or cajole the bankers into offering a high and fair price, essentially screwing themselves in the process. But he and whoever else on the Facebook side deserve the Nobel Prize in economics for doing so. They even squeezed the bankers on fees. Oh, yes: in addition to fleecing you with overt price manipulation, bankers are paid a flat fee for their exertions. Facebook’s syndicate accepted a modest fee of just over 1 percent, rather than a more typical fee that sometimes runs as high as 7 percent.
While the press jeered about the “disastrous IPO,” the feeling inside the company was one of utter triumph. Facebook had gone public without getting skinned alive, and it now had a mountain of money to recruit the best engineers, acquire budding competitors, and outspend rivals on product development, all with minimal dilution of the shareholders (i.e., of us, the employees).
Here is your lesson from the Facebook IPO: whenever you see the headline “Stock X Pops on First Day of Trading and Declared a Success,” instead think “Founders and employees just got completely screwed, and the bankers and their wealthy clients made fortunes.” Because that’s what happened, and didn’t happen, in the case of Facebook.