IPO arcana: underwriting vs. sales, and the over-allotment. Who knew?

As I mentioned in an earlier post about FB, it’s surprising to see how little the financial media understand about how IPOs work–whether it be newspaper reporters and their firms’ related blogs, or the talking heads on cable.

Two aspects:

the over-allotment

In the case of FB, it was 63.2 million shares (the number is on the front cover of FB’s registration statement).   As noted in the sentence that gives the over-allotment number, this amount of stock is not included in the 421.3 million share figure listed in bold.

What is it, then?

The over-allotment is a kind of insurance or safety precaution that the company issuing stock and the underwriters build into the offering.  The company agrees to sell a specified amount of extra stock to the underwriters at the IPO price if the underwriters ask for it.  In the FB case, it was 62.3 million shares.

When the underwriters divide the stock up and sell it to clients, they distribute the larger amount.  So the FB stock sold to the public amounted to a total of 483.6 million shares (421.3 + 62.3).

If the issue goes well and the stock stays at a price higher than the IPO level, the underwriters purchase the extra stock from the company and deliver it to clients.  That’s the usual case.  For FB, that would have meant an additional $2.4 billion from the IPO.

If, on the other hand, the issue goes badly, the underwriters can buy stock in the open market at the IPO price up to the amount of the over-allotment, without taking any financial risk themselves.  Don’t ask me why, but underwriters are legally allowed to do this for a short period after the IPO is launched.

The underwriters did this kind of intervention with FB just before noon and again during the final hour of trading on its first day.

How do we know?

The underwriters make no attempt to hide their identity or their intentions.  They want other traders to know they have a huge amount of buying power and intend to defend the IPO price.

How did I find out?  I looked at a chart of FB on my cellphone.  I saw the stock stopped its normal minute-to-minute gyrations just after 11:30 and flatlined–just like when someone dies on a TV medical drama.  That’s not natural.  Someone was making a statement about the $38 level.

In listening to hundreds and hundreds of IPO roadshows, I’ve never heard the over-allotment mentioned–ever.  Professionals know it’s there.  For the underwriters, it would be like a restaurant saying it had a great food-poisoning doctor on call.

underwriting group vs. sales syndicate

This is really arcane.  There’s no reason to read any further, except that this distinction may explain the bad treatment of some retail investors in the FB IPO.

The money that brokers charge in an IPO is for two slightly different functions.

–They have a percentage interest in an underwriting group.  Although I use underwriter and broker as synonyms in everything I write, that’s not precisely correct.  The underwriting group buys the stock from the company and then resells it. It’s paid a small amount for taking the “risk” that the members will be unable to resell the stock.  Remember, though, that the brokerage companies have firm–though not legally binding–commitments to buy the stock from clients who know they’ll never see another IPO allocation if they renege (legally, any client can return the stock and get his money back up until shortly after the final prospectus is issued.  See my post on preliminary and final prospectuses).

–the underwriting group employs a selling syndicate to distribute the shares it buys from the company.  It’s made up of the same firms that comprise the underwriting group, but possibly in different proportions, based on the size and strength of institutional and retail distribution networks.  Normally, the selling commissions are much higher than the underwriting fees.

Why write about this?  The accounts I’ve read mention only Morgan Stanley as a broker whose retail clients received much larger allocations of FB stock than they anticipated.  My guess is that Morgan Stanley carved out for itself an especially large piece of the selling syndicate pie.

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