Sunday, May 22, 2011

Dan, You Pompous Ass

Frequent visitors to this site know to discount my more fearsome moods and expostulations as simple proof of passionate engagement with my various subjects. Nevertheless, I am always pleased to receive constructive criticism when and where appropriate. Therefore, it is with gratitude that I acknowledge a pair of interlocutors who observed helpfully yesterday that I failed to directly address one of the principal charges which Joe Nocera leveled in his ill-considered jeremiad on the LinkedIn IPO. I can only excuse myself by noting that I must have gotten caught up in demolishing the silly accusations of Mr. Nocera's partners in disinformation.

For your convenience, I will repeat the core of his argument here:
[I]n reality, LinkedIn was scammed by its bankers.

The fact that the stock more than doubled on its first day of trading — something the investment bankers, with their fingers on the pulse of the market, absolutely must have known would happen — means that hundreds of millions of additional dollars that should have gone to LinkedIn wound up in the hands of investors that Morgan Stanley and Merrill Lynch wanted to do favors for. Most of those investors, I guarantee, sold the stock during the morning run-up. It’s the easiest money you can make on Wall Street.

As Eric Tilenius, the general manager of Zynga, wrote on Facebook: "A huge opening-day pop is not a sign of a successful I.P.O., but rather a massively mispriced one. Bankers are rewarding their friends and themselves instead of doing their fiduciary duty to their clients."

Now, I think I rather conclusively eviscerated the notion that LinkedIn's underwriters "absolutely" knew the stock would more than double on the day of pricing in my previous post. They had no idea, other than LNKD was a hot IPO; therefore, all bets were off. Furthermore, even if they strongly suspected something like that would happen, there was very little they could do to forestall it, if LinkedIn's executives and current shareholders did not want to offer substantially more shares.

So Nocera's remaining allegation—echoed by Zynga's GM—is that the underwriters took advantage of the expected pop in the company's shares to hand risk-free trading profits to their friends and best customers. There are two answers to this accusation, one based on the facts of how investment banks allocate shares in IPOs and another based in common business practice. I will address them both in turn.

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First, lets examine the facts, as they are known in the reality-based community.

Once a company launches the investor marketing phase of an initial public offering—consisting of management trotting around to dozens of one-on-one management presentations and rubber chicken lunches in front of hundreds of institutional investors—its underwriters commence a direct outreach program to these very same investors. As the actual offering date approaches, a more intense program commences known as bookbuilding, in which the investment banks survey the buy-side investors as to their appetite for the stock, including preferred number of shares and price limits, if any. The twofold objective is to build a book of indicative orders that exceeds the anticipated size of the offering—to create conditions for a sustained level of demand support after the stock opens for trading—and to build this book with investors who do not have hard limits on the price they are willing to pay.

Now, every underwriter worth its fees will do its damnedest to build what we call a high quality book of orders. In other words, we want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket. These are the type of investors virtually all of our issuer clients want: investors, not traders; buy-and-hold accounts, not fast money hedge funds. Of course, the stronger the demand for the deal, the more selective underwriters can be in our allocations. The stronger the overall demand, the more likely it is that we can exclude buy side accounts who traditionally flip on the offering from the deal entirely. And believe you me, we know exactly who the fast money accounts and IPO flippers are. We track every deal, and we keep records.

The other material point to relate is that virtually every investment bank makes this process as transparent as possible to its issuer clients. As we approach the pricing date, underwriters hold calls with company management and selling shareholder representatives every day—and often several times a day—to relay investor feedback and update the status of the order book, including requested allocation sizes, limit orders, etc. While it is saying too much to assert every company has a detailed grasp of its IPO order book prior to pricing, it is almost never the case that the sellers are surprised in any material way by its final makeup.

Unfortunately, hot IPOs can disrupt underwriters' and issuers' carefully laid plans to build stable, supportive, long-term investor bases. Even buy-and-hold investors with the best intentions can yield to the temptation to flip their shares when an IPO doubles in price on the first day. We underwriters can look sternly at them, and ostentatiously put a black mark next to their names in our offering records, but it's hard for us not to understand the compulsion they feel. It also makes it harder for committed investors to add to their positions, as many of them prefer to let the stock settle down to a dull roar before they commit more funds to the investment.

But that, as they say, is a champagne problem to have. Most companies are so delighted with a strong IPO performance that they don't mind having a few more hedge funds and fast money accounts in their shareholder base for a while. After all, those guys' money is just as green as Warren Buffett's.

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Second, I find it absolutely ludicrous that kibbitzers feel compelled to criticize investment banks for passing around favors in our gift and treating friends of the firm well. For one thing, investment banks by their very nature straddle both the buy- and the sell-side of markets. We have corporate clients and their inside shareholders who sell stock and institutional investor clients who buy it. Yes, we serve two client bases with potentially competing interests, but that is the very reason we are able to underwrite securities in the first place. We are middlemen, and it is the essence of what we do all day to balance the competing interests of our clients for the benefit of all. All our clients are fully aware of this.

For another, what business of any kind does not treat some clients better than others on occasion? Do you really think a midsize manufacturer gets the same attention and economic terms from Microsoft that General Electric does? Do you really think it is not in the very nature of business to trade favors for increased business, for better terms, for new business? Of course investment banks horse trade with certain buy-side investors; of course we give certain accounts bigger than normal allocations in IPOs; of course we give a hedge fund we owe a favor to access to a hot IPO. By the same token, we earn a lot of favor ourselves for giving accounts access to such hot IPOs. The horse trading goes both ways. And because we owe an obligation to underwrite a successful offering for our issuing clients, all the competing pressures from the institutional securities side of our house are generally and pretty successfully kept in check.

This—for those among you who might be unfamiliar with it—is commonly known as business.

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Frankly, I have always suspected that the stentorious outrage about special favors and secret deals investment banks allegedly dispense on IPOs really boils down to simple envy. Nine times out of ten, I suspect the person whinging is just pissed off he did not get shares in a hot IPO himself. There is a name for such people in my business: retail flippers. And we never allocate shares in hot offerings to them if we can possibly help it.

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