Granted, it was 20 years ago, but I ran a Syndicate group at an emerging growth investment-banking boutique and had previously worked in a Capital Markets group at a large investment bank. Syndicate/Capital Markets is responsible for managing an IPO. Many wonder why, after all the hype, Facebook really did nothing in trading on Friday. Perhaps my antecdotes will shed some light…
Before companies even start the process, they must file an S-1 with the SEC. On that S-1 is a price range. For companies with a history of financials and earnings, investment bankers tend to set that price at a 15% or so discount to the company’s valuation so that investors get some return on the first day of trading. Why? So that investors feel good about the investment and that sentiment will remain with them for the next offering. Generally, when companies go public, they only offer a limited amount of stock to whet the appetite of investors, and anticipate doing a follow-on offering sometime in the future.
For a “normal” IPO, a company that goes public in the normal course with little media attention, the first step is to build a strong “book” of orders for the offering. If a company wants to sell, for example, one million shares to the public, the order book needs to exceed that one million by some multiple. Back in the less frenzied days in less frenzied industries, having order demand exceed supply by 3-5 times was a good book. The reason why the demand had to exceed supply was that accounts that really wanted the stock would put in inflated orders to make sure they got “filled” on what their true demand. With this level of demand, underwriters would be confident that there would be enough demand in the after market (once the stock begins trading) to support the offering price.
For IPOs that have a lot of interest, the order book can get out of hand. In our first lead-managed IPO at the boutique, our order book was 26 times oversubscribed. This was back in the early 1990s and the company was an innovative technology company. At this level of exuberant demand, the offering price had to be increased because otherwise the company management would be certain to feel that they weren’t getting a fair deal. Companies don’t love to price their stock at $15 and see it open for trading at $30. That said, sometimes there are constraints on how high a IPO can be priced, regardless of demand, because institutional investors may have a limit on the valuation they can pay (ie, on some metric such as a multiple of projected earnings per share). So pricing a “hot” IPO is a bit of a balancing act to determine the “real” order book at what price.
The “book” comes together, generally, on the road show. The road show is usually a week-long tour of the country’s institutional investors with one-on-one meetings for the big accounts (ie Fidelity) and group lunches or breakfasts for the smaller accounts. It is grueling, often with 8 meetings each day. (It used to be that management teams wore suits on road shows…and I was a tech banker.) And, of course, there is retail interest that comes in through investment banks’ syndicate desks but, usually, retail investors get very little IPO stock.
It is important to know the book because pricing and the initial trading is so important. If the stock is priced too high and there is not enough demand to support it at its offering price, the underwriters should “stabilize” the stock, which is to say, put their own capital behind buying the stock to maintain offering price. So, when stocks trade at their IPO price, chances are that the underwriters are supporting the stock, and that there is insufficient demand for the stock at this price. It could mean that the stock was priced too high.
If the stock skyrockets, then many investors who received stock on the IPO feel compelled to sell or “flip” the stock. Once upon a time, flippers were considered a menace and were penalized by not being allowed to participate in subsequent IPOs. I believe that many retail investors who placed orders on Facebook’s IPO were asked to hold their stock for 30-60 days with this implicit penalty looming. Yet, if the stock trades up substantially, underwriters will need to have some flipping in order to have an inventory of stock to sell to those who want to build long-term positions once a stock begins to trade. Again, pricing is a delicate balance between knowing the real order book and what trades will be placed once a stock begins to trade.
What inferences can be drawn for the Facebook IPO?
It suggests that the underwriters priced the IPO at the highest price it could, leaving nothing to create buying interest after the stock began trading. Underwriters should have a view of at what price the stock can trade where there will be buying interest, and price accordingly to ensure that the stock can trade on its own the first day.
It appears that the underwriters had to pay for pricing Facebook at its limit. Because the stock closed at $38.23 on the first day, despite reported enormous retail interest, it suggests that the stock had to be supported by the underwriters in addition to retail buying. It suggests that institutions probably put in orders larger than they wanted to ensure they received IPO stock, but sold out of the offering when the stock didn’t pop. Institutions got out at whatever profits they could lock in (the stock did trade at $42) and retail investors bought in.
It brings into question institutional support, since many institutions were able to buy Facebook prior to the IPO on the private market.
This does not bode well for trading next week. Without a strong finish on the first day of trading, institutional and retail investors alike will approach the stock with trepidation and will most likely take a wait and see attitude. After all, according to Barrons, at $38, Facebook trades for 76 times projected 2012 profits of 50 cents a share and 89 times 2011 earnings. Without a buying interest, the stock could languish until it can engender investor confidence with strong earnings. The next earnings report is three months away.
