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.

Greg Smith’s resignation letter from GS

the letter

On Wednesday, the New York Times published the resignation letter of Greg Smith, a (former) derivatives salesman at Goldman Sachs.  Smith, a 12-year employee, says he’s leaving because the GS work environment has become “toxic and destructive.”

My first reaction:  plus ça change…

In 1989, Michael Lewis, of later Moneyball fame, wrote Liar’s Poker, an expose of the culture of cutthroat competition and macho banality of Salomon Brothers while he was a bond salesman there.  Salomon, you may recall, had to be rescued by Warren Buffett after top executives colluded to illegally manipulate prices in the US government bond market.  What’s left of the firm now resides inside Citigroup.

Yes, Moneyball shows that Lewis is sometimes reluctant to let facts stand in the way of a good read.  Nevertheless, I think Liar’s Poker is an important book.  In fact, I’ve asked all the securities analysts and portfolio managers I’ve trained since its publication to read it.

Three points from the Lewis account still stand out to me:

–the strong internal pressure for salesmen to get unattractive, illiquid bonds off the company’s books by persuading some gullible customer to buy them

–a sketch of the growing dismay of a certain client as the realization dawns that he has been sold a toxic security that he can’t resell and which will get him fired when his bosses figure out what he’s done (why they don’t already know is beyond me)

–the feverish rush to unload dud bonds on a client the brokerage community figures is so unskilled that he’ll soon be fired.  Like blood in the water to sharks.

Welcome to Wall Street.

an adversarial relationship

What the Michael Lewis book and the Greg Smith letter bring out most strongly, to my mind, is the simple truth that the relationship between broker and client is a commercial one where the interests of the two sides are not aligned.

Two senses:

–Every time you trade, you think you know more than the other party.  You think any security you buy is undervalued and that the other side of the trade will give up future profits by selling it to you at today’s price.  You expect anyone you sell to to lose money by taking your offer.  You also expect the broker to act as the counterparty if he can;t find someone else.  It’s like baseball.  You take the field expecting to beat the other side.  You’ll win; they’ll lose.

–Investment managers earn higher fees by having superior performance, which helps attract new assets; brokers get paid in direct relationship with the amount of trading the client does.  Experience shows, however, that for most managers superior performance and the amount of trading are inversely related.  So, what’s good for the manager isn’t particularly good for the broker, and vice versa.


In addition, each side markets itself to the other.  That is, each tries to replace the cold commercial structure of the relationship with a warmer “like me, trust me” one.  That’s partly because we’re all decent people.  It’s partly so the other side will continue to do business with you after you’ve traded them into the dust.  And it’s also partly because it’s a way of gaining a competitive advantage, of tilting the ratio of compensation to services in your favor.  In my experience, brokers are much more successful in getting clients to deliver excess compensation than clients are in getting excess services without payment.

the business has changed

A generation ago, the principal business of investment banks was providing comprehensive financial services and advice to companies of all sizes–everything from working capital finance to strategy to mergers and acquisitions.  For small- and medium-sized firms, its investment banker may well have held a seat on the board of directors.

Not any more.  In today’s world, however, most firms have an in-house staff of financial professionals who do most of this.

At the same time as businesses based on building long-term relationships of trust have eroded, the trading business, which focuses on rapid-fire, reflex-action, individual transactions, has exploded in size and scope.

As the composition of company profits for brokers has changed, so too has the character of those who rise to positions of control.  The traditional investment bankers, whose temperament is to focus on long-term relationships, are out.  High skilled traders, who focus on short-term profits, are in.

playing hardball vs. cheating

Where to from here?

The huge profits that trading businesses have generated during the past decade are already spurring changes.  Institutions are already shifting to electronic crossing networks, where fees are much smaller and where the activity won’t be seen by a broker’s proprietary trading desk.  Retail investors are doing more business with discount brokers.  They’re increasingly shifting, I think, to passive products like ETFs as well.

Institutions have long memories.  In cases where they believe a broker has crossed the line between aggressively competing and cheating, they simply won’t do business with them anymore.

there’s something about Europe, too

Did it really take Greg Smith 12 years to figure out what brokers do for a living?   …or was it his final year, in Europe, that changed his mind?  Why is it that the losing end in all the toxic credit default swaps was a European bank?



business has changed away from long term repationships—now cos do for selves, change of control toward traders in brokerage firms

dealing with hedge funds: institutional salespeople and industry analysts

a new SEC move

A little less than two weeks ago, the media heralded the opening of another in a long line of investigations by the SEC of insider trading involving hedge funds.  This time, those reportedly targeted include an institutional salesman from Goldman Sachs and the former head of GS’s research in Taiwan, as well as hedge funds who allegedly traded on inside information passed by the GS pair.

what do these people do for a living?

The press reports made me start to think that I should write on three associated topics:

–what does an institutional salesman do?

–what does a sell-side securities analyst do?

–why the focus on hedge funds?

three posts, starting today

I’ll answer these questions–from my perspective as a former client, never myself having been a hedge fund principal, an institutional salesperson or a sell-side analyst–over the next three days.

Before I start, though, I should say that the brokerage landscape has been changing, with increasing speed, over the past decade, and to the detriment of many institutional salesmen and industry analysts.

Two reasons:

–pension fund clients and mutual fund boards of directors are paying increasing attention to the amounts paid by traditional long-only investment managers to brokers.  This is only natural, since this money comes out of the pockets of the clients, not the managers (more about research commissions in Wednesday’s post), and

–increasingly, successful traders (think: Jon Corzine) have become the heads of major brokerage firms.  They’ve been reshaping the firms in their own image, and shifting emphasis away from areas like research and institutional sales.

what does an institutional salesperson do?

An institutional salesperson is a marketer.   He’s is in charge of the overall relationship between the broker and a specific set of money manager clients.  The job is to ensure that the broker makes a profit on each client relationship.

The institutional salesperson is a gatekeeper, in two senses:

–he regulates access to brokerage services, depending on the level of client payments.  “Access” includes things like: phone calls or private visits from industry analysts; private meetings with companies on road shows hosted by the broker; one-on-one company meetings at broker-hosted industry conferences; favorable allocations of initial public offerings (the salesman is only one of several parties in this discussion, though).

–he also regulates the timing of access.  Does a requested analyst drop everything he’s doing and rush to the client’s offices?  …or does he make a phone call the following day?  Is a company meeting for an hour at 10:00am?  …or twenty minutes at 5:30pm?  …or a conference call, instead of face to face?  …or a canned presentation at a group lunch?  If the salesman makes personal calls to relay information from the broker’s morning meeting (in addition to internet dissemination) about companies he knows the client is interested in, who is the first call and who is the tenth?

relationship:  commercial to emotional…

As is the case with any effort to sell recurring services, part of the job is to try to turn a commercial relationship with the client into a personal one.  To that end, institutional salespeople study and cultivate their clients very carefully.

In my experience, salespeople know much more about the client and what makes him tick than he would ever dream.  If the client likes to be taken to lunch or to sporting events, fine.  If the client likes to gossip about rivals, okay.  If he likes flattery, so be it.  If the client responds better to salespeople who are tall/short, young/old, male/female, slim/portly, sports nut/nerd–even if the client is unaware he does so–assignments will be altered to suit. (I’ve even seen one brokerage house–long since merged away–that wanted to establish a certain image.  It had only salespeople who were young, slim, good-looking and very tall.)

…or maybe not

An intelligent salesperson (and that’s just about every one I’ve come into contact with) also makes judgments about the client’s overall business.  Is it on the rise, or has a former hot hand turned permanently cold?  Adjustments are made, accordingly.  One of my friends used to classify clients explicitly in terms of the BCS matrix.  I never asked where I stood.

information collection

The salesperson also has an information gathering function.  Particularly in the US, money managers take pains to separate research decisions made by portfolio managers and their implementation through the trading desk.  One reason is to disguise their investment strategy from their trading partners (another is to guard against bribery).  However, experienced institutional salespeople can often ferret out information by reading between the lines in their conversations with clients–data which is immediately relayed to the broker’s trading desk.  Salespeople also usually know their clients’ analytic strengths and weaknesses very well.  If they believe a key client is buying a stock in an area where he’s an expert, the salesperson may give other clients an extra nudge–after alerting the trading desk, of course.

In a good year, an experienced institutional salesperson in the US can make millions of dollars.  And a strong working relationship with a client who becomes a super-star manager can make an institutional salesperson’s career.  On the other hand, high compensation also makes someone like this an obvious target for downsizing during a period of brokerage retrenchment like the one we’ve been going through over the past few years.

Back to the media reports on the SEC investigation:  can an institutional salesperson develop inside information on his own?  Maybe, but that would be very unusual, in my view.  I think a more likely accusation would be that a salesman either traded on inside information himself or passed it on to a client who did.

Tomorrow:  the sell-side securities analyst.