Why Wall Street's Usually Well-Oiled Machine Failed To Deliver Bonanza to Facebook's First-Call Big Institutional Investors!

MAKE MONEY BLOG$~Mark Zuckerberg has done something the public and Wall Street outsiders have yet to grasp: He has bucked the Wall Street machine that invariably mainly serves its big constituents–their selected top-tier  clients.

Nowhere is that more evident than in the initial public offering (IPO) of shares of young companies aspiring to turn “public,” so they can peddle their stock to the rest of us.

IPOs are one of the most lucrative businesses of Wall Street houses. That’s when they can turn plain paper worth pennies into billions of dollars. That would be fine if the process were fair and where the huge returns are also accessible to the public. But in fact, the enormous profits from IPOs only mostly benefit investment banks, their cohorts and selected few clients.

That is, until Facebook and its founder and CEO Mark Zuckerberg came along and did what  even Google or Apple failed to do. Zuckerberg insisted that the real public investors should have access to Facebook’s shares at the outset of the IPO–not after the big guns have scooped up their profits.

In other words, the public was allowed early, initial access to Facebook’s shares–and not confined to the aftermarket when the large institutional investors and chosen clients have already unloaded and sold their to the so-called public.

That’s how the real big profits used to be bagged by the investment banks and their blessed clients. The IPO process as conceived and manipulated by the banks is simple–and brilliant. The Wall Street banks decide how many shares will be sold, and at what price. Then they decide who and which firms will sell the shares.

The chosen are usually the early investors who had put in huge amounts of money for one clear purpose: to get gigantic profits from their investment.

That’s fair. But what isn’t is the fact that the investment banks initiating the IPOs limit the number of shares to be sold–and select the Wall Street houses or securities brokerage firms that will be allocated shares. These handpicked outlets in turn choose and limit access to their allocated shares to their top moneyed clients, who are advised not to flip or sell the shares until they are cleared to do so.

During this process, the so-called “public,” for whom the IPOs are supposedly initially designed, don’t get any of the allocated shares for the simple reason that they are likely to sell once the price of the IPO climbs. The securities brokerage houses aren’t able to control them, so when they start selling the shares, the stock price breaks and falls. There goes the bonanza for the big guys.

So what do investment banks do to prevent such a mishap? Prevent the public any access to the initial shares that come out. The lucky or fortunate big clients who are able to buy shares are strictly ordered to avoid selling when the price starts to shoot up. There is a process where the securities firms are handcuffed from allowing their clients to sell right away.

In my book, “Secrets of the Street” — The dark side of making money — published by McGraw-Hill in 1995, I revealed this Wall Street Money Machine in one of the chapters, where I disclosed how the IPO process is replete with basic insider trading. I described the IPO process as a license for Wall Street to print money. Without doubt, this opportunity to raise capital is a vital feature of free enterprise, of capitalism. But it is often abused.

In many, if not most IPOs in the past, the securities brokerage firms that are allocated shares instruct their clients to buy an equal number of shares first allocated to them when the stock price starts to rise by at least 10%. And in some cases, the clients are ordered to buy a third set of shares at higher prices.

And there is a secret agreement as well: The brokerage firms won’t accept or execute sell orders from these initial beneficiaries when the IPO begins to jump. And so, with such a process well controlled, it is destined that the price of a “hot” IPO can continue to rise.

No doubt the investment banks will deny that such manipulations take place. But, believe me when I say that the IPO insiders know these things happen.

But in Facebook’s IPO, any possible conspiracy in controlling the price did not happen mainly because Zuckenberg made sure that the non-institutional shareholders also get a big piece of the action. So with the small shareholders getting shares, they were able to sell their shares at will. Brokers at Morgan Stanley, the investment bank that sponsored the IPO, were forced to buy those flipped shares, as did other securities firms that were allocated IPO shares, thus limiting the stock’s price drop. Reluctantly, they had to execute the sell orders that came in.

After initially shooting up to $42 a share, the Facebook IPO initially priced at $38 on May 18 closed at just a tad higher, to $38.23. By way of comparison, Google jumped 18% on its IPO in 2004, while LinkedIn (LKND) soared 109% when it went public last year. And Groupon’s (GRPN) IPO jumped 31%. The IPOs of Google, LinkedIn, and Groupon weren’t much available to the average or small investor.

What Face and Zuckerberg proved is that the IPO system could be done better –and fairly –by forcing Wall Street banks to cater more to the average shareholders, or the so-called “public” for whom the initial offerings are, after all, supposed to be designed.

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Posted in: Facebook,IPO,Mark Zuckerberg,Wall Street