Facebook Stock Drops: What Really Goes On In IPOs ~ MAKE MONEY BLOG$

MAKE MONEY BLOG$~So by most accounts, theFacebook IPO is disappointing. Facebook’s stock ended its first day of trading a mere $0.23 above the deal price and today, Day 2, it has dropped more than 10% intraday. It was no accident it closed ever so slightly above the IPO price, but many investors don’t fully understand what is going on behind the scenes of an IPO, how banks might be betting against them, and the problems that arise when a stock trades below its IPO price.

So first things first: The Facebook IPO is only disappointing from a deal perspective – it is too early to pass judgment on whether it is a disappointment as an investment. Many great investments don’t have the most auspicious beginnings, while others might jump 50% on the first day of trading, only to flame out later. In other words, don’t judge the stock on one day of trading. The nextGoogle or Apple rarely comes with the hype that they are the next Google or Apple. Facebook’s lack of a first-day trading pop creates a host of headaches for the dealmakers, funds that were looking for a quick profit, and perhaps some people at Facebook.

FB went public at $38 and spent most of the day in the $40-$42 range. Then, in the afternoon, the shares were met with heavy selling. Why did the stock sell off? Though there’s no way of knowing exactly why, it is fair to say that one key driver is quick profit-taking. If you are a mutual fund or hedge fund and had a million shares allocated to you in the deal, and could sell those for a quick $5 million profit, you might be smart to do so. The annualized return is staggering. But why did FB shares close ever so slightly above the deal price on Day 1? Banks in IPOs often support deals, especially in the final trading hours, in order to keep them from closing below the IPO price. In my opinion, this is something the SEC should focus on, as it is an area that is ripe for improved transparency to protect investors. For investors, the most important questions about how FB might trade over the next few weeks might just be “How many shares collectively do the banks own of the deal right now?” and “Are the banks net long or net short FB today?”

Banks Might Be Betting Against You

Very few investors realize that when a company goes public, the banks taking them public are often making trades on their own behalf, including shorting the very stocks they are taking public. Investment banks can short the companies that they take public – and they usually do. In fact, banks can take naked short positions in the companies they are taking public. In addition, banks can also buy shares of the companies they are taking public. What some term “stabilizing the market” may actually be creating a false sense of security.

It is all clearly expressed in the Facebook registration document and in almost every IPO document: underwriters may engage in transactions like shorting the stock, creating naked short positions, and even being long the stock. Know that they are doing this not to intentionally hurt investors, but in the hopes of creating a more orderly market. It might have the unintended consequence of doing just the opposite.

That is, individual investors might see a stock that went public staying at it’s IPO price at $38 and think that it represents the true market of investors, when in fact it does not.

So let’s see what typically happens. A company goes public and the bank that is leading the offering sells 10 million shares. With most offerings, the underwriters allow for a 15% “Green Shoe” or an extra number of shares to be sold. So for this example, the bank would be selling 10 million share + 15% of 10 million, or a total of 11.5 million shares. So on day 1, the bank sells more shares than it actually has, and creates a short position. Later in the day or weeks, the bank will cover the short position by buying the 1.5 million shares in the open market. Any shareholders who had a quick profit and were selling their shares, would meet with some demand from the bank.

But what happens when the shares drop, as they did with Facebook? Initially the shares went up, and the banks sell more shares than they have – meeting the demand for shares by over-selling the shares, creating a short position for themselves. They create this short position, knowing they will have to buy shares later in the day or week. If the stock drops a little from its highs, the bank can even make a profit on the short trade. Yes, the bank might be selling to you at $43, only to make money later in the day when the stock drops to $38.23, effectively betting against the investor they are selling to.

But if the stock continues to fall, the bank is faced with another dilemma – they need to stabilize the market and they start buying the shares. But how many shares can they buy? Do they cover their whole short position and then go long the stock? There is no proscribed limit. By buying the stock, the bank is doing its job of stabilizing the market, but it is also creating risk because then it owns a stock that can go down further. Like a finger in a dike, there is only so much a bank can do and is willing to do to stabilize a share price.

All CEOs Want To Look Like A Champ

For a variety of reasons, banks do not want the shares to fall below the deal price. When a deal trades below the IPO price, it is called “breaking deal price” and it sends a chill and sometimes panic into banks, investors, and issuers when a deal “breaks deal price.” Why? First, it makes the customers – mutual funds and other investors – upset. Investors often blame the investment banks if a deal goes below the IPO price, as though the banks were supposed to guarantee them a profit. Second, the issuer often gets upset – “How did you misprice my deal?” Few CEO’s want to see their stock price fall on their first day of trading as their ego is often tied into the share price as though somehow the stock price is a proxy about how investors feel about them. If you are the bank that messed up the IPO of a tech highflyer, you are less likely to get the call back to handle the other business like M&A or secondary offerings.

Third, a deal that trades below the IPO price makes getting the next IPO tougher. Banks keep track of deals they are on and when they pitch new business, they show tables to prospective IPO candidates touting their performance in a number of areas – these are called “league tables.” Banks measure themselves against each other based on the size of the deals, the marquee deals, the aftermarket performance of deals. If a stock goes up, the bank likes to take some credit that they take “winning” companies public.

Selling Begets Selling

But there is another, more practical reason banks don’t want deals to close below their IPO price. The public market panic of a deal that falls below the IPO price is palpable. Some portfolio managers who do not want losing trades on their books, and who do not want to look stupid to investors, start selling quickly and indiscriminately once a stock crosses the deal price. Many portfolio managers know that playing an IPO can be a crap shoot and rule #1 is take profits quickly and if you are not going to win big, the second most important thing is to make sure you don’t lose big. So they sell.

So you have the banks that started buying the shares to help stabilize the market and to make sure the deal does not unravel for their own downstream goals, but a whole host of investors wanting to sell quickly if the deal crosses the deal price. Banks can help sop up some of the selling, but they cannot control the market and they cannot alone buy enough shares to sway a market that decides to sell the shares. The banks are willing to lose a little on the initial trading, especially when the fees and the marquee of a deal is as big as Facebook, but no bank is willing to lose sizable money or take on too much risk, so their ability to buy is limited by their risk tolerance. If the stock dips far enough below deal price, the banks that had been buying the stock, either stop buying or even are forced to limit their losses by selling the shares – pushing the share price down further.

What I don’t like in IPO situations like this is that investors do not know what the market really looks like in a normal sense. That is, on any given day there are buyers and sellers of a stock, and the stock price movement reflects that collective net trades more or less. However, with IPO’s you have another party in the mix that is not fully aligned, rational buyer or seller – the banks. Banks may be supporting the stock and buying the shares creating a riskier trade for the other buyers in the market.

So what should be done?

As a start, I think the SEC should look into this much more closely than they have. It seems perfectly appropriate for the SEC to ban short selling and naked short selling by banks on IPO and secondary offerings. There might even be a good argument for banning the role of banks as acting as a stabilizing agents as they might in fact not be stabilizing the market at all, especially in extreme situations. At the least, investors should be able to know the net long or net short position of the banks either real-time or at the end of any trading day. While this does not help investors intraday, it does increase transparency. People should know “How much of the deal does the bank own?”

Would a reasonable investor make a better informed trade knowing whether the syndicate owns a lot of a recent IPO? Yes, they would, so by this simple test, new IPO trading rules could help protect investors and make bank balance sheets less risky. Clearing up the conflicted interests of market participants should improve IPO transparency for investors, although IPO investing with or without these changes is still a very risky prospect.

source: forbes.com

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