Initial public offerings

Much interest has been shown by financial analysts in the so-called ‘underpricing’ of shares offered through IPOs. Underpricing is evidenced by the price of shares rising (often sharply) in the immediate aftermath of the launch. Many traders try to take advantage of this common phenomenon.

If a fixed-price method is used for an IPO, then the lead bank (or co-leads) leading the offering will set the offer price at a level at which they are confident that all the shares will be sold to investors. This will mean that the banks underwriting the issue will not have to purchase a large proportion of the offer. Investors, knowing that the lead banks want to see a successful launch, may indicate a low price to force the issue price down as far as possible. Therefore, this often results in an unmet demand at the final offer price, with a surge in the traded share price on and after the launch date.

On 18 May 2012, Facebook held its IPO. By raising over $16 billion it became one of the largest IPOs in history. Quite surprisingly, there was no underpricing. On the first day of trading, the stock closed flat at its offer price. Many commentators described Facebook’s IPO as a ‘failure’ for the market.

Figure 6 NASDAQ welcomes Facebook’s listing

Just four days after it went public on the stock market, Facebook became the centre of intense attention both on Wall Street and in Washington DC as shares hit $32, well below the initial offering price. Watch this video entitled ‘Facebook’s “botched” IPO: what went wrong and why?’ from 1.31 to the end.

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Transcript: Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?

INTERVIEWER

And we tackle some of the questions and investigations surrounding all this with Anant Sundaram, he teaches business administration at Dartmouth's Tuck School of Business, and Rob Cox, US editor of Reuters Breakingviews, a financial news website. Well, Rob Cox, so when we start to look at what went wrong, start with Morgan Stanley and the other underwriters. What's their role, and what questions are there now for them?

ROB COX

Well, in any IPO, what you try to do is balance the demand for the stock from institutional investors like big pension funds and hedge funds, and some retail investors. You try to get the right balance so that you price it appropriately so that in the first day of trading, it doesn't go way up in the sky and pop like it used to back in the big internet IPO days of the late '90s, but also sort of doesn't decline like we've seen with Facebook. And it's a really delicate balance, it's a very difficult job. But generally you try to get it right so that everybody's happy at the end of the day. You don't have four days later, everybody talking about a botched IPO, a problematic IPO. You don't have Mary Schapiro and the SEC and all sorts of regulators jumping in on it. And that clearly didn't happen in this case.

INTERVIEWER

Anant Sundaram, what would you add - these questions about what the underwriter has to tell potential investors, when, what kind of information is important? What would investigators be looking at in a case like this?

ANANT SUNDARAM

It is at this moment alleged that there might have been some information asymmetry that might have been exploited by some with favoured access to that information. I have only seen allegations so far. But let me first say that yes, there is a lot of criticism about this IPO and Morgan Stanley. But from an issuer standpoint, we have to recognise that this was a huge success. And Morgan Stanley's job, we should recognise, is to maximise the proceeds to the issuer. So to some extent, I find that part of the commentary a bit baffling.

But back to the information asymmetry issue, what is being suggested is that perhaps in the last minute, there was some information that might have been given to analysts at Morgan Stanley and a couple of other underwriter firms, that might have enabled them to revise their forecasts in their valuation models, thereby making institutional investors pull back on their demand for the IPO.

Now I find it extremely surprising that something like that would happen. But we don't know what the facts are. But I will say this. Facebook filed many amendments to its prospectus right up until the final date of the IPO, which I think was May 18. And they explicitly stated that their revenue has been declining from 155% all the way down to 45%, and that they continued to see declines.

Now it is not clear to me what an investor looking at that would have guessed, other than to say, well, they expect it to decline further. So it's a bit of a fine line, but we don't have all the facts.

INTERVIEWER

Well, Rob Cox, help us out here. What is the problem, then? Where do you look at with what Facebook did say or didn't say, or Morgan Stanley did or did not say?

ROB COX

Look, I take your point, Anant, about the idea that the issuer in this case, Facebook and the venture capitalists and the people behind Facebook with earlier supporters, had sold woohoo, 38 bucks a share, $16 billion of stock. But on day two, Mark Zuckerberg, the CEO and founder, who only sold stock in so far as he was dealing with tax issues, and all the 3,000 some odd people who are at Facebook, they've got to live with this company going forward. So what might have been a quick win for the backers of venture capitalists here, I think it's a real loss for Facebook.

We're sitting here talking about how Facebook is sort of up there with Morgan Stanley and the Wall Street money grubbers, as it were, rather than how Facebook is connecting 900 million people around the world, our ex-girlfriends, our old bosses, our parents, all those kinds of things. The very thing that Mark Zuckerberg tried to avoid by really taking himself out of the frame with the IPO. And remember, he said all along, I'm only doing this for my investors and my employees who want liquidity with the stock.

In a sense now, he's got more distractions than he bargained for. He's got lawsuits, he's got litigation. He's got Mary Schapiro, he's got the SEC, he's got us talking about it on television. And we're not talking about what a great creation it is, but what a botched IPO it is. So I just sort of would balance yes, it was a great deal financially for a few people. But on the broader term, this is not a great thing for Facebook going forward.

INTERVIEWER

Well, Anant Sundaram, what does history tell us about these kinds of IPOs, if there is any good analogy? Is it too early to tell about its success or failure?

ANANT SUNDARAM

Yes, it is too soon to tell us about its success or failure. But we do have considerable evidence on long run performance of IPOs in the academic finance literature. In general, on average, IPOs underperform over a three to five year horizon, it actually turns out. But actually, if the evidence again, on average, is to be believed, that the empirical evidence is pretty strong, that it's the stocks that are large IPOs such as Facebook that actually tend to outperform, and also stocks that are taken public by higher quality within courts, in which bankers, such as Morgan Stanley or Goldman Sachs, are supposed to sort of second tier. And with some bankers, the evidence shows that the extent of the underperformance is less.

My personal view is, six months from now, one year from now, which is really what an investor should care about from the point of view of his or her holding and wealth creation, and what the intrinsic value of this business is, six or seven months or ten months or one year from now, I think we will have forgotten the first few days. And the focus really will be on whether they're executing their strategies as they need to, and the fundamentals of where they are implied by this valuation.

INTERVIEWER

Well, Rob Cox, briefly, what do you think? We use the word investors. Let me put it in sort of small investors that we're talking about. What do you think small investors should learn from all this?

ROB COX

Well, there is a two tiered market in this country. And $100 billion of value was created before this thing went public. It was created for about 1,000 people or institutions. And retail investors were really not one of them. The retail investors are getting a bit of the drag of the market, because you can keep funding these companies through their best growth cycle, and they're not getting a great deal. I would say for IPOs it's a bad game to play if you're a retail investor generally. Wait it out as an onset. In a year, we'll see whether Mark Zuckerberg is able to execute on his strategy to make money from this fabulous creation of his.

INTERVIEWER

All right. Rob Cox, Anant Sundaram, thank you both very much.

End transcript: Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?

Video 3 Facebook’s ‘botched’ IPO: what went wrong and why?

What factors discussed in the video do you think are the most likely to have caused Facebook’s ‘botched’ IPO?