May 22, 2012
Was the Facebook (FB) IPO bungled by the banks? Certainly, given the chaos that surrounded the first day of trading in the company’s shares on Nasdaq last Friday, followed by yesterday’s nosedive in the value of those shares beneath the $38 IPO price, there’s plenty of egg on everyone’s face.
Blaming Nasdaq OMX Group (NDAQ) for the exchange’s technological snafus is legitimate (sure, those pesky high-frequency traders really mess things up, but Nasdaq should have been prepared for that; it’s hardly classified information). But blaming the banks that underwrote the deal, while it might make investors feel good, really isn’t legitimate. Of course they pushed the envelope and tried to whip up demand for the stock among potential investors – that’s what Facebook and its owners hired them to do. Of course they did their duty to their client by raising the price range when it appeared they could place even more shares with new investors at an even higher value, thus maximizing the proceeds of the deal.
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There was a lot of Monday-morning quarterbacking going on throughout the day yesterday. Morgan Stanley (MS), pundits advised, should have limited the size of the offering; if it had been smaller it would have closed yesterday north of $40 a share instead of languishing at $34. But that analysis depends on a lot of unwarranted conclusions, including one that Morgan Stanley – presumably in pursuit of the largest possible fee – urged Facebook to ramp up the size of the issue despite the risk that it might go “pop” in entirely the wrong way. And that ignores the fact that it’s not the underwriters’ job to deliver an aftermarket “pop” to investors in the wake of an IPO.
For all that a big upward jump in the stock price now is increasingly described as a kind of “freebie” for investors – a gift with purchase of sorts – reflecting the fact that buying into a new company comes with all kinds of risks, those pops are also the source of a lot of tension and conflict between bankers and their clients. No company wants to feel that their investment bankers underpriced its shares to make the bank’s buy-side clients happy with a big fat profit on day one. Just ask the myriad technology companies that went public in the late 1990s what they think about that. Indeed, veteran Silicon Valley banker Bill Hambrecht heard so many complaints about the process of a $12 offering becoming a $25 stock within hours of making its debut that he tried to launch an alternative “Dutch auction” IPO format. The truth is that bankers have an obligation to their client – in this case, the company going public – not to the investors who are hoping for a chance to flip the stock.
The two groups most responsible for the fact that Facebook shares now trade more than 10 percent below their offering price after only two days as a public company are Facebook’s executives themselves and the investors or traders who expressed so much enthusiasm for the stock only a few days ago.
In the days leading up to the IPO, I heard from brokers concerned that they weren’t going to win a large enough allocation for their clients. One financial advisor, who understandably asked not to be named, confessed he had directed all his trading to Morgan Stanley in recent weeks, in hopes of being rewarded with a large allocation.
The underwriters may have fanned the hype, but had the orders been phantom ones it’s unlikely that those bankers would have increased both the size and the price of the deal almost on the eve of the issue. There was no incentive for them to do that, other than to keep clients like that financial advisor happy.
Meanwhile, there was plenty of information out there to make an investor become more wary about Facebook at the kind of valuation underwriters were seeking. Even before General Motors (GM) announced its decision to yank all its spending on Facebook because its ads there weren’t attracting new customers, the financials made it clear that the company’s growth rate was slowing. There simply aren’t that many people left for most of us to “friend,” and it seems that we don’t like being pitched vacation villa rentals or liposuction treatments when we’re trying to chat with those we have “friended.” Reuters Breakingviews published a detailed analysis of the company, its financial position and its strategy that was available for at least two weeks before the IPO as an e-book. In it, the authors concluded that the company likely had a fair value closer to $65 billion than the $104 billion price tag it commanded on the IPO date. Everyone vying for stock in the company last week could have paused to read and think that through instead of being caught up in the hype.
Similarly, Facebook could have avoided being caught up in its own hype. The company, as the premier social-networking company out there and subject of an Oscar-nominated feature film, was always going to be an iconic IPO. It didn’t need to be valued at quadruple the level that Google was when the latter made its debut on the public markets in 2004. The company has plenty of savvy backers and employees who were in a position to say, “Waaaait just a second. Let’s be sure this is handled properly, so that the stock not only fetches the maximum possible price.” Sure, those insiders who sold as part of the deal wanted to maximize their return too. But most of them own more stock in the company that they likely will find themselves trying to sell at lower and lower prices, as lockups are removed in three to six months’ time. They could have said “no” when Morgan Stanley and other underwriters suggested raising the size and price, if that is what happened. Or they could have refrained from asking underwriters to make those changes, if that’s the way the scenario played out.
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The real culprit, of course, is short-term thinking. The company figured out it would be able to sell its stock at a record valuation; investors figured that they’d make money “flipping” their shares to those unlucky enough to be shut out of the initial allocation and desperate enough to pay up for the stock in the first few days of trading. The bankers, hired to do a job, focused on the short-term rewards of that job, ranging from the kudos that accrue to anyone lucky enough to steer an iconic company through the IPO process to the tangible reward in the shape of fees (which go up along with the size of the deal). While the buck stops with Facebook, could those bankers have warned more forcibly against the potential risks of boosting the deal size and value? Almost certainly. Could the bankers have done greater due diligence on buyers to ensure they wanted to own the stock and not flip it? Probably, although it would have helped to hook those investors up to a polygraph machine when asking their questions.
The certainty is that everyone was seduced by Facebook’s allure and the hype that surrounded it. The result is that everyone now will pay the price – including the bankers. Indeed, just as investors are watching the value of their Facebook holdings slump, the bankers are paying up to keep the price as high as it is. Right now, Morgan Stanley is doing the buying, but expect the bills to start going out to J.P. Morgan (JPM), Goldman Sachs (GS) and the other members of the team any day; bills that will eat into the fees they earned.
Facebook? Well, it has damaged the chances of its insiders to sell out down the road, and its own chance to raise new capital later on, if it needs or wants to do so. Investors are angry, and while they’re most irate with the banks, the entity they can take that fury out on most readily is the company itself. Oh yes, and hapless Nasdaq will also have its day of reckoning.
There’s plenty of blame to spread around, as tends to be the case whenever greed trumps fear. The IPO snafu just means that it’s going to take longer for Facebook’s shares to settle down and find their “real” trading range, the level at which both buyers and sellers are comfortable meeting to transact. That means that there will be no winners here….at least for now.