Wednesday, May 30, 2012

As Long as the Right People Get Shot

Do ya feel lucky, punk?  Well do ya?
“A man’s got to know his limitations.”

— Magnum Force

I like John Hempton, O Dearly Beloved. I truly do. The man is smart and principled, and he has attracted a global audience as a direct result of his fearless application of these two qualities to the analysis of investment opportunities and economic realities. I do not link to his work more often here because 1) macroeconomic topics and specific trading opportunities are not my focus or concern, either in these pages or in my professional life, and 2) accordingly I do not pretend to an expertise in such matters which would enable me to judge the quality of his analysis and advice. I value his reputation on the recommendation of others whom I respect.

But every man has his limitations. I am sad to say that, with his latest post, Mr. Hempton has overstepped his. This is what he says:

In an IPO an investment bank takes a fee from a business to place that stock in financial markets.

Or, more precisely, they take a fee from a business to sell part of that business.

Their customer is the company doing an IPO and they have a legal and moral obligation to get the highest price for the company they are selling. No more. No less.

However investment bankers have, as a practical matter, a desire to expand and improve their franchise. Their franchise consists of a huge number of buy-side investors (some retail, some institutional) who will buy from them whatever they sell so long as it comes in a prospectus.

Investment bankers expand that franchise by making sure the things sold in a prospectus have excess demand. If they can sell for $38 they chose to sell for $33 to guarantee a stag. Every time they do so they build their own franchise as an investment bank at a cost to the client to whom they owe a legal and moral duty and who is paying them fees.

The buy-side customers of investment banks have got used to playing in this little game of theft. We – as buy-siders – like to be able to buy IPOs and have instant stag profits. Indeed in the 1990s the game of giving favours to investment banks in exchange for instant stag profits became the way business was done on Wall Street.

The moral corruption of investment banks not only became accepted but we redefined morality around what investment banks did rather than what they should do. We though the process of systematically ripping off the sellers of IPOs in order to build the buy-side franchise of the investment bank was right-and-proper.

It is not right-and-proper and it never was right-and-proper.

Bullshit, John. Bull. Fucking. Shit.

* * *

Now for what it’s worth, the principal target of Mr. Hempton’s post seems to be buy-side investors who are screaming bloody murder in and with the eager support of the press that they did not receive what they appear to hold as their god-given right to a substantial IPO price “pop” once Facebook’s shares were released to trade freely. And in this I am in full agreement with him. Nowhere is it written that the price of an initial public offering must appreciate by a certain percentage after the offering, nor indeed that it must appreciate at all. It is even true that—heaven forfend—there is no divine prohibition that the price of an IPOed company’s stock cannot decline after the offering, as Facebook’s has done. As I will explain below, investment banks which underwrite IPOs normally prefer most IPO stock prices to rise modestly post offering (because their clients do), but nowhere is it written that any such outcome must occur.

So in this respect I agree with Mr. Hempton’s larger point: that the buy-side, institutional and retail alike, have no leg to stand on to criticize lead underwriter Morgan Stanley, Facebook’s CFO, or indeed anybody involved in Facebook’s IPO that the stock price has declined as precipitously as it has. Facebook’s IPO—as the most anticipated and hyped initial public offering in years—was a possible/potential/highly likely train wreck long in coming, and any moron who bought on the offering, or, worse, in the aftermarket, deserves every heart palpitation and shooting pain that’s coming to him. Caveat fucking emptor, people. Jesus. I have absolutely no sympathy for you.

However, where I do take extreme umbrage and exception to Mr. Hempton’s scribblings is in his characterization of Morgan Stanley’s purported acquiescence to Facebook’s CFO’s request to upsize the offering and price it at the top end of the indicated (revised) range as uniquely or particularly “ethical”; in contrast to what he styles as Wall Street’s typical “theft” and “moral corruption.” For it is clear that Mr. Hempton’s moral judgments hinge critically upon the ineluctable fact that, in this instance at least, he doesn’t know what the fuck he is talking about.

* * *

Virtually all IPOs in the modern era are done on a “best efforts” basis. This means exactly what it sounds like: underwriters contract with an issuer and selling shareholders (if any) to place its newly issued shares in the marketplace at a time, a price, and in a quantity which they are able to secure by exerting their best efforts to sell same to potential investors. IPO underwriters do not have any obligation—legal, moral, or contractual—to deliver any final terms to the issuer. Our job—the job which every potential IPO issuer hires us to do—is to help them take their offering to market and achieve the best possible outcome, which includes and is entirely contingent on the market accepting the final offered terms and buying the IPO. Nowhere in this arrangement, understanding, tradition, or even the contractual Underwriting Agreement which governs the underwriters’ and issuer’s mutual obligations to each other is anything said, guaranteed, warranted, or promised about the “highest price.” For what it is worth, by the same token nowhere it is contractually required that the issuer must agree to the final terms which the underwriters are able to deliver. If the issuer doesn’t like the final deal offered, it can tell the underwriters (and public market investors) to pound sand. No deal, no offering. Buh-bye.

Now there is a longstanding tradition, rule of thumb, heuristic—whatever you want to call it—in IPO underwriting that issuers should sell their shares in an IPO at a discount to intrinsic or fair value. In normal, healthy markets, this discount is normally discussed in a range of 10 to 15%. In today’s unsettled, Facebook-/Europe-/Presidential-election-addled markets, this discount can be as wide as 25 to 30%. The intended purpose of the IPO discount is twofold: 1) to help place the relatively large bolus of shares which an IPO represents with investors who have alternate potential uses for their money1 and 2) to bolster positive demand in the marketplace for follow-on buying. You see, an issuer of an IPO is not, unlike a company which is selling 100% of itself, trying to maximize total proceeds for existing shareholders (and fuck the newcomers). It is trying to attract a new set of shareholders who will be co-owners of the company for at least some non-trivial period of time. An IPO issuer only sells a minority of the total ownership position in the firm, and it wants to develop a positive, receptive marketplace for future stock sales in the public markets. (After all, how can the company raise future equity finance money and inside shareholders sell down their holdings in the future if public market investors are hostile to them? Oops, Facebook.)

As I’ve argued before, the IPO discount—which is well and truly disclosed, discussed, and argued over from the very first day competing investment banks pitch to underwrite an issuer’s proposed IPO—is the cost of going public. It is no secret. The issuer knows about it, understands its purpose, and agrees to it from the very first moment it agrees to proceed with the offering.

So here’s the deal, John:


It’s pretty fucking simple.

* * *

Now that you understand why IPOs are typically priced at a discount to intrinsic or fair value, it is no burden for me to admit that underwriters are not unhappy that we have these bargains to pass around to our friends and relations. Of course giving access to IPOs at 10 to 15% discounts to fair value is valuable currency for us to share with investors who trade with us, direct business to us, and generally bolster our bottom lines. We are in business, after all, and we have every right to treat some customers better than others if it promotes our own welfare. This is not moral corruption, it is business. But it falls out of the marketing imperatives which drive the successful placement of IPOs; it does not drive them.

And investment banks’ business, for those of you, like Mr. Hempton, who seem to get confused about the matter, is to be a middleman. We straddle the markets for issuers and investors of capital, and both issuers and investors are our clients. We are unavoidably riddled with conflict of interest because we serve two masters, and the masters we serve have conflicting interests. Other things being equal, issuers would like to sell shares high; investors would like to buy shares low. Our job, as underwriters, is to make those desires clear in the middle, and execute a transaction that equally satisfies—or equally dissatisfies—both parties. That’s our job. Everybody knows this.

So, if, on the other hand, you own a company and want to receive the highest possible price for your ownership stake, you should stay the hell away from the IPO market. Because I and my peers will be the first ones to tell you you can get a better price in the M&A market.

And we can help you with that transaction, too.

Oh. And Chesterton’s fence.

Lieutenant Briggs: “You’re a good cop, Harry. You had a chance to join my team, but you decided to stick with the system.”
Harry Callahan: “Briggs, I hate the goddamn system! But until someone comes along with changes that make sense, I’ll stick with it.”

Related reading:
Jane, You Ignorant Slut (May 21, 2011)
Dan, You Pompous Ass (May 22, 2011)
Chesterton’s Fence (March 5, 2012)

1 Forget the novelty of an IPO, which represents a new stock in an unknown company without an active trading market or established market price. IPOs usually represent a substantial amount and percentage of the issuer’s stock being offered all at one time. (Facebook’s IPO totalled $16 billion.) For established public companies, the analog would be a secondary offering or a very large block trade. Guess what, bubeleh: each of those clear the market at a material discount to the existing market price, too. When you’re trying to place a big block of stock—newly issued or not—you’ve got to offer a discount. Think WalMart, or buying in bulk. It’s really not that complicated.

© 2012 The Epicurean Dealmaker. All rights reserved.