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.

Facebook (FB), looking back after three days of ugly trading

a failed IPO

The long-awaited IPO of FB has come and gone.

The stock opened late, due to a NASDAQ computer snafu.  It almost immediately gave up its initial gains.  It closed a mere 25¢ a share above its $38 offering price–and that only due to “stabilization” (read: price-fixing) efforts by the underwriters in the final hour of trading.

It’s been falling since.

a successful offering??

One interesting aspect of the fiasco is that many commentators–as well as many retail participants in the offering, and apparently also the CFO of Facebook–are basically clueless about how the IPO process is supposed to work.

In particular, I’ve heard media proponents of the tooth-and-claw school of capital markets trying to burnish their Darwinian credentials by claiming that Morgan Stanley actually did a good job with the offering.  Explicitly or implicitly, they point to the poor trading performance of FB as evidence that the bankers achieved the highest possible price for FB.

I think this is crazy talk.  When FB conjures up in investors minds words like “overpriced,” “disaster,” and “huge losses,” that’s not good.  Nor is it when retail investors feel they were tricked into buying more stock than they wanted   …or when the lead underwriter is being investigated for disclosing negative opinions about FB only to a few customers.  And, of course, none of the money from sales of extra shares went to FB itself.

An IPO is supposed to go up!  

Not necessarily by 100%, but maybe 20% or so.  Why?

Psychologically the company is associated with success when its stock rises.  Retail investors, who will buy/use the company’s products and loyally support management, feel good about themselves and the stock they own.  This positive association lays the groundwork for the market to absorb more stock when lockups expire and when employees want to cash in more of the stock that’s a key part of their compensation.

A failed IPO, in contrast, generates questions–well-founded or not–about the stability of the company and about the trustworthiness and competence of its management.

what went wrong?

As I see it, there were two separate problems:

1.  The main one is that FB issued too much stock all at once.  Up until a week ago, the plan had been to sell 388 million shares at a maximum price of $34 each.  That’s $13.2 billion.   Which is enough money to buy all of the stock of Sony or Omnicom or Applied Materials or Ralph Lauren or Limited Brands, at yesterday’s closing prices.

Last Wednesday the amount of stock was increased by 25% to 485 million shares and the offering price was upped to $38.  So the total take from the IPO went up by 40% to $18.4 billion.  That would be enough to buy Marathon Oil or Kellogg or Yahoo–or to pick up Whole Foods or Charles Schwab and have a couple of billion left over.

This decision had two negative effects:

–it took $5.2 billion out of investors’ pockets that might have gone into buying FB in the open market after the launch.

–worse, the underwriters were unable to find happy homes for all that extra stock.

In any “hot” IPO, institutions routinely place orders for many times the amount of stock they actually want, in the hope that this will influence the underwriters to give them larger allocations than they’d get otherwise.  You want 250,000 shares so you ask for a million.

I don’t think this tactic works, since the parties know one another very well.  But people do it anyway.  Maybe it makes them feel good.  Occasionally the move backfires and the institution gets more stock than it wants.  Maybe it gets 500,000 shares.

When this happens, the message is clear–the issue is in trouble.  The institution probably decides to stay on the sidelines rather than buy more.  Or it turns into a seller.

Lots of retail investors seem to have been playing the same game with FB.  Institutions have battle scars and regard being burned like this as a cost of doing business.  But for a retail investor, finding 5,000 share of FB in you account last Friday when you expected 500 must have come as an incredible shock.   That’s enough to turn you from a greedy buyer into a panicky seller.

2.  NASDAQ had a computer meltdown.  The details aren’t clear.  My broker, Fidelity says it still doesn’t have complete execution information on buy and sell orders it placed for clients during the first few hours of FB trading last Friday.  This doubtless raised the level of panic individuals have been feeling.

Just as important, I think the NASDAQ mess also had the effect of transferring some selling from last week into this–prolonging the period of trading turmoil.

who decided to up the offering size?

Normally it’s the underwriter, who, after all, is the one in continual contact with potential buyers.  If so, Morgan Stanley and the others had exceptionally tin ears.

In this case, my reading of stray media comments says that the Facebook CFO made the final decision.  At the very least, he seems to be the one being thrown under the bus.  I’ve never seen comments like this before.  My inclination is to say this means they’re true–and that the underwriters don’t like David Ebersman very much.  Let me amend that–they don’t think they’ll need to be doing business with him again.

who benefits from the pricing decision?

The underwriters, of course, whose fees are determined by the size of the offering.

Company officers other than Mark Zuckerberg are still listed as making no sales.  Mr. Zuckerberg remains as seller of 30 million chares, which he notes will go to pay taxes.

The largest chunk of extra stock, 54 million out of the 97 million added, is listed in a catch-all category of people who have given voting rights to Zuckerberg.  Their sales go from 71 million shares to 125 million.  The rest of the shares come from venture capital investors.

To me, this says the company FB had nothing to gain by raising the offering size.

what to do

This is still the same company, with the same prospects, as before.  If you liked it at $38, you’ve got to like it more at $32.  I don’t know the company well enough to have an investment opinion.  The stock does seem to be starting to trade more normally today, though.

capital flight and brain drain (II): Greece

what would Greek exit from the Eurozone look like?

I mean what happens in general terms, not the nitty-gritty details of how a sovereign debt default and currency devaluation would be put into place.

Several things would occur, I think:

1.  Greece would stop making principal and interest payments on its sovereign debt and open negotiations with creditors for new, more favorable, terms.

2.  The country would force conversion of all cash held by Greek citizens or Greek companies into a new currency–call it the drachma.

3.  Greece would prevent reconversion of drachmas into foreign currency.  It might ban citizens from holding foreign currency outright, for example.  It would certainly make it illegal for anyone to transport foreign currency in and (especially) out of the country.

4.  It might institute a crawling peg (a specified daily weakening of the exchange rate) or some other mechanism for continuing devaluation of the drachma vs. the €.

how would Greek citizens react?

This default/devaluation path is well-defined.  Look at Mexico in the early 1980s as an instance.  Knowing the roadmap far in advance, what can Greek citizens do to defend themselves against loss of wealth?  Again, the moves are pretty standard:

–move cash holdings to a bank outside of Greece

–raise cash locally–either by selling assets or by borrowing from a local bank (in the hope that your debt will subsequently be devalued)–and move that out of the country, too


Businesses would presumably be thinking of similar measures.  In addition, they would likely begin to drag their feet on paying for stuff bought from Greece, while accelerating payment deadlines for Greek customers.

what about investors?

They do pretty much the same.  They extract cash.  They stop making new investments.  Yes, they study what they might like to buy once devaluation occurs, but otherwise they sit on their hands.

taking a very long time…

…makes the situation worse.  While uncertainty remains high, an increasing number of citizens are likely to make and execute capital flight plans.  And the flow of new investment in the country drops to a trickle.  So the country sits in neutral and idles.

effects on the rest of the EU?

I perceive a sharp difference between the local reaction to debt problems in Italy and Spain, on the one hand, and Greece, on the other.

I think the former two have made it clear they accept responsibility for their weak economic situation and are taking action to fix their problems as quickly as they can.  In contrast, Greece seems to me to believe that its sovereign debt is basically an EU problem.  Its strategy appears to be to implement no reforms and instead bargain for ever better terms.

If that’s an accurate representation, one could argue that the contagion effects–the adverse impact on Spanish and Italian bond markets–of Greece leaving the Eurozone (and, presumably the EU) shouldn’t be severe.

In an investment world dominated by short-term chart-oriented traders, however, I don’t have a lot of confidence other investors will see things my way.  I certainly wouldn’t want to bet the farm that I’m right.

capital flight and “brain drain” (I): what they are

a Guatemalan airline

I got my first practical exposure to the phenomenon of capital flight when I started to work on Wall Street.  It came from a creative colleague at work who gave me a prospectus to read for a bond issue from a Central American airline.  Kind of like a puzzle, he asked me what I thought was unusual.

I had no idea what was going on…

…until he pointed out four things:

–the company was family-owned,

–it bought planes outright rather than leasing them (a much more expensive way of operating),

–it would sell perfectly serviceable planes when they were two or three years old and replace them with brand-new ones, plowing all the firm’s cash flow into this effort (again, very inefficient), and

–the planesalwaysspent the night in foreign airports, mostly in the US.

On the surface, this behavior seems crazy.

But think about it.  Most of the family wealth was tied up in the planes; they spent most of their time outside the country.

Perfect in case of a sharp change in the political winds.  And not obvious enough a move to catch the sitting government’s eye.

The airline was the family’s vehicle for capital flight (no puns intended).

two sides of one coin

“Brain drain” is the term coined in the UK for emigration of its highly skilled and educated citizens to the US after World War II.  It has become synonymous with the flight of human capital in general.

The term “capital flight” typically refers to the flight of financial capital.

why does capital flee a country?

Three main reasons:

–political repression, actual or feared

–limited economic prospects in the home country

–high taxes, either on current earnings or on accumulated wealth.



In the early 1980s, China announced it would not renew the UK lease on Hong Kong.  Therefore, the colony would revert to Chinese rule in 1997.  The UK then said it would not grant citizenship to anyone in Hong Kong (because they wouldn’t like the harsh UK climate).  So Hong Kong citizens began to look for other places in the Commonwealth to obtain passports and shift their wealth.

economic prospects

Emigration from Europe to the US post-WWII is a prime example of this phenomenon.  New Zealand or the Australia of twenty years ago might be others.


There has been a steady flow of people out of high-tax states in the US like California and New Jersey into neighboring areas like Nevada and Pennsylvania, where levies are lower. For decades, Ireland has attracted multinational corporations by offering very low tax rates.  One of the planks in the electoral platform of Mr. Hollande, the new head of government in France, was to raise income taxes on yearly earnings of over €1 million to 75%.  Reportedly, real estate agents in the UK have seen a surge in interest in London residences from French buyers.

fighting capital flight:  closing the borders

Generally speaking, there are two ways to stop capital flight/brain drain:  fix the problems that are causing the flight, or forcibly prevent capital from leaving.

Practically speaking, then, there’s only one way–closing the borders.

For financial capital, a government does this by limiting the amount of foreign currency a holder of the domestic currency can buy, or the amount of local currency he can transport out of the country.

For human capital, a country can restrict the ability of citizens, or their families, to leave.  In addition, a potential emigrant has to have someplace to emigrate to, which can make this issue a lot more complicated.

Tomorrow:  the situation in Greece.






Facebook’s first day

I’m writing this at about 3pm, so the trading day isn’t over.  Several aspects to the FB IPO are already notable, though.

The stock opened at $43 and quickly reached a high of $45.  It then dropped to the IPO price of $38, where it met stiff resistance.  It now seems to be settling in at around $40 (note: I have a limit order in for today a tiny amount at $38.25).

1.  The day before yesterday the underwriters announced that the FB offering would be increased by 25% from an already hefty size.  This virtually always has the effect of tempering any first-day appreciation of the stock.

We should assume this was the main purpose of the move.

It isn’t clear if in this case the number two reason was:

–to accommodate holders chomping at the bit to sell or

–to ensure that the stock wouldn’t reach a crazy-high price in the first few days of trading and then collapse.

2.  The extra stock comes predominantly from selling shareholders, not from new shares issued by FB.  Normally that’s a bad thing, because the market argues (reasonably) that employees and venture capital investors know a lot more about the true worth of their firm than the rest of us do.

But the dynamics of this case aren’t so crystal clear.  The more new stock that’s issued by FB itself, the more Mark Zuckerberg’s margin of voting control over the company shrinks–and the less able he is to sell shares in the future and still maintain his voting majority.  This is not a worry for today or tomorrow, but Zuckerberg may have been quite happy to encourage employees or early investors to sell more.

3.  It’s not well-known, but underwriters have a short period of time in which they’re legally permitted to “stabilize” the price of a new issue (read:  step into the market and prop the stock up so it won’t fall below the IPO price).  That appears to have occurred with FB shortly before noon.

…not a great sign.  It raises the question of what will happen to FB next week, when the stabilization period expires and underwriters can’t stabilize anymore.

4.  The stock didn’t open until around 11am.  “So what,” you say.  That’s normal for a “hot” IPO.  Historically, that’s true.  But the brokerage industry trade association, FINRA, changed the IPO rules late last year so buyers can only place limit orders (that is, ones that specify a maximum price) before the first trade.  This eliminates market orders (ones where the buy price is open-ended) and should make the process of finding an initial market-clearing price much simpler. So a ninety-minute delay before opening is a lot.

5.  There are continuing reports of problems with trading in FB.  No one seems to know why.