Saturday, September 14, 2013

Go Ask Alice

Like a box of chocolates
One pill makes you larger
And one pill makes you small
And the ones that Mother gives you
Don’t do anything at all
Go ask Alice, when she’s ten feet tall

Jefferson Airplane, “White Rabbit”

“Life’s a box of chocolates, Forrest. You never know what you’re gonna get.”

— Forrest Gump

Well, Children, it’s silly season again. Yes, that’s right: Twitter just filed an initial registration statement (or S-1) for its long-awaited initial public offering. Confidentially.1 And commemorated it with a tweet on its own social media platform, of course:


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This of course means every numbnuts and his dog are currently crawling out of the woodwork and regaling us with their carefully considered twaffle about what Twitter is doing, what it should do, and how much money we’re all going to make buying and selling Twitter’s IPO shares when and if they ever come to market. A particularly amusing sub-genre of said twaffle consists of various pundits of varying credibility and credulousness pontificating on what Twitter is actually worth, as if that is a concrete piece of information embedded in the wave function of quantum mechanics or the cosmic background radiation, rather than a market consensus which does not exist yet because, well, there is no public market for Twitter’s shares.2

But there seems to be something about IPOs that renders even the most gimlet-eyed, levelheaded market observers (like Joe Nocera, John Hempton, and... well, just those two) a little goofy and soft in the head. Perhaps they just can’t understand why such an obvious and persistent arbitrage anomaly as the standard 10 to 15% IPO discount on newly public shares—which everybody seems to know about even though they can’t explain it—persists as it does. Or why, given how many simoleons the evil Svengalis of Wall Street get paid to underwrite IPOs, there are so many offerings that end up trading substantially higher (e.g., LinkedIn) or substantially lower (e.g., Facebook) than the offer price they set once shares are released for trading.

So, out of the bottomless goodness of my heart—and a heartfelt wish to nip some of the more ludicrous twitterpating I expect from the assembled financial media and punditry in the bud—I will share here in clear and simple terms some of the explanations I have offered in the past.

* * *

First, the famous IPO discount.

I have written:

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%. ... 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 money 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.

Now this is a critical point, so I’d like you to focus on it carefully. In virtually no instance I am aware of do the existing (pre-public) shareholders sell a majority of either i) the firm’s newly created, “primary” shares or ii) their own already existing, “secondary” shares in a IPO. For one thing the underwriters would strongly discourage it. Why? Because it looks bad. Here you have this brand new, shiny, exciting, expensive company coming to market, and the people who know it best, the insiders, want to sell out big time? Danger, Will Robinson! Institutional investors aren’t (usually) that stupid, for one thing, and for another we Wall Street underwriters typically have to deal with our clients on the buy side of the house much more frequently and for a longer time than our intermittent issuers on the sell side. We have no interest in intentionally selling Fidelity, Vanguard, or anybody else a lemon IPO, no matter how much Sleazebag LLC wants to pay us in underwriting spread. We are middlemen, remember? We have a reputation to uphold, believe it or not.

So in normal circumstances Wall Street banks encourage issuers to make primary company shares, which raise money directly for the company, the entirety or vast majority of its initial offering. That way, new investors feel they are coming into the ownership structure as relatively equal co-owners of the firm alongside existing insiders.3 If demand is strong enough, we can often slip a relatively minor slug of insiders’ secondary shares into the IPO also, usually in the form of the underwriters’ 15% overallotment option, or “green shoe.” In some instances, the company may not need any primary proceeds, and the IPO is actually done as a precursor to selling insider shareholdings over time (as, for example, in the case of a firm owned by a private equity investor). But even in such cases, investors are much happier to see the company raise primary proceeds by issuing new shares, even if the principal use of proceeds is to repay a loan taken out to fund a pre-IPO dividend to the inside shareholders. In any event, nobody—underwriters or new investors alike—likes to see senior company executives or large, controlling inside shareholders sell down much more than a modest percentage of their remaining holdings on the IPO itself. IPO investors want to see the rats invested in the ship they’re buying passage on, too.

And the reason for the discount itself is simple, as I stated before. You are selling a large slug (often hundreds of millions or billions of dollars) of a brand new, unproven investment to new investors all at once. Like most new product introductions, it should not be that surprising to see sellers offer an initial discount off the expected sale price to incentivize buyers to try their unproven product. And, as I hope I have explained to you above, the owners of newly public companies are trying to establish a receptive market for future share sales, whether primary or secondary. Surely a little dilution (eighty-five cents on the dollar for primary proceeds or a minor portion of your existing secondary shares) is a small price to pay to establish a healthy public market for your future fund raising activity, no? And the discount is not pocketed cost-free by investors, either. Underwriters make sustained efforts to allocate discounted IPO shares to investors who indicate strong demand to buy more in the aftermarket, and who promise to do so. And we do keep track, and punish backsliders and reward those true to their word in future, unrelated IPOs and security offerings. This is one of the core reasons to employ underwriters in the first place, no matter how sophisticated an issuer may be: we play a long game with the buy side, and we have the opportunity to enforce behavior helpful to our issuers by the way we play it. Intermittent issuers simply don’t have this kind of market power.4

* * *

Of course, all this focus on the IPO discount might give the naive observer a comforting sense of precision and predictability about the post-offering performance of the shares. But this is unwarranted. When I wrote that underwriters suggest a 10 to 15% discount to the “intrinsic or fair value” of IPO shares, the alert among you should have immediately cried, “Bullshit!”

And you would be right. We are guessing:

Before they ever approach the market, investment banks do a lot of work evaluating new issuers to come up with a price which they think the company will be worth once it is trading normally in the marketplace. They do this based not only on the company’s own historical and projected financial results but also on the trading multiples and profiles of comparable companies already public. ... Now, you can see that this exercise is an art, not a science. Investment bank IPO pricing is the epitome of (very) highly educated guessing. We often get it wrong, but, on average, IPO pricing is normally pretty accurate. After all, it’s our job, and we do it well. The picture gets complicated, however, when the company in question, like LinkedIn, does not have any comparable peers among listed public companies. Our guesses become much less educated and much more finger-in-the-air type things. There is no cure for this but to go to market and see what investors themselves tell you they are willing to pay.

You see, investment banks try to guess what the market will pay for a stock. But, to be completely honest, we have no idea.

... once we go to market, the issuer and the investment banks essentially hand the steering wheel over to investors. We pitch, and wheedle, and cajole, and praise the company to the skies, but it is investors who set the price, initially in individual conversations with the underwriters’ salespeople—where they indicate the number of shares, if any, they want to get in the offering and any price sensitivities or limits they may have—next when the banks set the final price for the offering, and finally—and, by definition, definitively—when they bid up the price in the aftermarket after the shares are released for trading.

Let me make this perfectly clear: Investment banks do not set the ultimate price for IPOs; the market does.

And sometimes, as in the case at hand, you get what we call in the trade a “hot IPO.” Investors work themselves into a buying frenzy, the offering becomes massively oversubscribed (e.g., orders for 10 or more shares for every one being offered), and the valuation gets out of control. Underwriters have a limited ability to respond to these conditions, which typically emerge during the pre-IPO marketing or “bookbuilding” process, including revising estimated pricing up, like LinkedIn’s banks did (+30%), and increasing the number of shares offered. But eventually you just have to release the issue into the marketplace and let the market decide what the company is really worth.

Investment bankers are not idiots. We have tons of experience and expertise to bring to bear on valuation, and we are in constant contact with institutional investors on the buy side to gauge market demand. We work with the issuer’s financial and operating metrics (like the ones nobody has seen for Twitter) and the market trading multiples of comparable companies, which are similar social media darlings, to derive a normalized trading value for the firm. But we cannot say whether the market, in its infinite, obscure, unexplained wisdom, will agree with us or not.

And it is the market which decides:

Don’t like that? Have some cake.

Related reading on IPOs:
Jane, You Ignorant Slut (May 21, 2011) – The LinkedIn IPO kerfuffle, part 1
Dan, You Pompous Ass (May 22, 2011) – The LinkedIn IPO kerfuffle, part deux
Size Matters (March 21, 2012) – The JOBS Act and why we see fewer IPOs nowadays
As Long as the Right People Get Shot (May 30, 2012) – No, John Hempton (inter alia), underwriters do not have a moral or fiduciary obligation to get the sellers of an IPO the highest price

1 Which novel-ish practice is allowed under the JOBS Act for what the SEC characterizes as “Emerging Growth Companies,” or tender little start-ups with less than $1 billion in sales. The JOBS Act, by the way, has done virtually nothing to create jobs. Sic transit the Legislative Branch.
2 Yes, yes, I know there is some sleazeball outfit selling participation units backed by previously sold Twitter employee shares (all other shares being prohibited from trading in advance of the IPO). But if you think you can establish the post-IPO trading value of the company based on illiquid trading in such a derivative gray market, I encourage you to meet me next Tuesday at the Manhattan entrance to the Brooklyn Bridge. I will then and there be delighted to sell you the deed (or rather a deed to the Deed) to this magnificent cultural artifact for the bargain price of $200 million in cash. Small, unmarked bills, please.
3 Yes, I also know there is a disturbing tendency, particularly among hot technology issuers, to sell IPO investors second-rate stock which does not carry the same voting rights as insiders’ shares. This is a reprehensible tactic which guts the potentially important corporate governance function fully voting shares convey, but it is a bull market phenomenon many issuers love to take advantage of if they can. For what it is worth, most underwriters don’t like it, but we hold our noses all the way to market. Hey, nobody made you buy Google or Facebook shares, did they, bub?
4 This is why caviling by several of my previous interlocutors about the unseemliness of Wall Street dispensing favors to the buy side on IPOs is both shortsighted and dense. It is because we dispense favors, and try to make our buy side customers happy too, that we have the power to twist their arms when we need to, and attract their attention to those issuers which do not have every newspaper in Christendom bloviating about their offering plans. Middlemen, duh.

© 2013 The Epicurean Dealmaker. All rights reserved.