IPO Pricing As A Function Of Your Investment Banks’ Past Mistakes: The Case Of Facebook
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November 28, 2015
On May 18, 2012 Facebook held its initial public offering (IPO), raising over $16 billion making it one of the largest IPOs in history. To the surprise of many investors, there was no underpricing ? the stock closed the first day of trading flat from its offer price. The IPO was described as not only disappointing but also detrimental to the broader market. We explore why one IPO should have such widespread consequences. We document that the IPO market was silent for 41 days following Facebook. When it re-opened 41 days later, the average level of underpricing increased from 11% pre-Facebook to 20% post-Facebook. The common blame was an overall increase in risk-aversion among investors. We offer an alternative explanation. We show that the entire increase in underpricing is concentrated in the IPOs of the Facebook lead underwriters. We find no statistical difference in underpricing pre and post-Facebook for non-Facebook underwriters. We argue that investment bank loyalty to their institutional investor client based propelled the underwriters to increase underpricing to compensate for the perceived losses on Facebook.
IPO Pricing As A Function Of Your Investment Banks’ Past Mistakes: The Case Of Facebook – Introduction
On May 18, 2012 Facebook held its highly anticipated initial public offering (IPO) on NASDAQ, raising over $16 billion making it one of the largest IPOs in history. To the surprise of many investors, there was almost no underpricing, as the stock closed the first day of trading almost flat from its offer price. The financial press described the IPO as not only disappointing but also detrimental to the broader market in more than one financial media outlet. The “failed” IPO was blamed for causing everything from mutual funds’ declines in assets under management to subsequent canceled IPOs. A headline in the Financial Times on May 25, 2012 read, “the botched flotation has embarrassed Wall Street.” The New York Times on May 30th wrote, “institutions that buy shares in these deals [IPOs] are demanding progressively more protection against busted offerings.” In this paper, we investigate the consequences of the busted Facebook IPO and dispel the notion that the pricing of all IPOs changed as a consequence.
Morgan Stanley (MS) was the “lead-left” underwriter with JPMorgan (JPM) in the second seat followed by Goldman Sachs (GS) and 30 other underwriters. The lead underwriters set the initial price range for the offering at $28-$35 per share offering 337 million shares. During the roadshow, nine days before the IPO, the underwriters selectively verbally disclosed to some institutional investors that Facebook may not meet its projected revenue and earnings estimates. In spite of the selective disclosures, the offering was still significantly oversubscribed at the completion of the book-building process. Institutional demand for Facebook shares exceeded five times the shares available. As a result, Morgan Stanley, Goldman Sachs and J.P. Morgan collectively agreed to increase the offering range to $34-$38 per share with 421 million shares offered, a 25% increase in the number of shares. It was reported that the increase in the number of shares offered would allow early Facebook investors to sell more shares in the IPO.1 Overall, 74% of the IPO shares were placed with institutional investors and 26% went to retail investors.
On May 18, 2012 Facebook opened for trading at 11:30 a.m. slightly above the offer price of $38 per share. During the first sixty seconds of trading, over 158 million shares changed hands and the price ranged from a low of $42 to a high of $45. The high price for the day of $45 happened within the first minute of trading. The stock subsequently fell back to the offering price of $38 per share within 19 minutes of the open. Over the course of the day, Morgan Stanley was actively buying shares to provide price support to keep Facebook from falling below its offering price. Facebook closed the first day of trading at $38.23. In the days and weeks following the IPO, without the price support of Morgan Stanley, Facebook continued to drop. By the beginning of September, Facebook had fallen over 50% and closed for trading on September 4, 2012 at $17.73.
“If the goal of the underwriters was not to leave a penny on the table, then it was a success. But if it was to ensure that the shares had a favorable market to trade in, then it wasn’t.” (Brian Wieser, Pivotal Research Group (White, 2002))
After the Facebook IPO on May 18, 2012, the financial press almost unanimously described it as a disaster and a failure. An article in Forbes on May 20th was titled: “The Failure of Facebook’s IPO.” A Financial Times headline on May 23, 2012 read, “How Facebook Went from Triumph to Disaster.” A headline in the Wall Street Journal on May 25th read, “Facebook’s Sin? Breaking the IPO 10 Commandments.” In addition to the numerous articles describing the Facebook IPO, analysts predicted what would happen in the overall stock market after the event. A Bloomberg headline on May 26, 2012 read, “Facebook IPO Seen Deepening Investor Distrust of Stocks.”
“… amid the turmoil of recent weeks, the institutions that buy shares in these deals [IPOs] are demanding progressively more protection against busted offerings. That translates into weaker prices for initial public offerings, creating a gap that sellers are increasingly unwilling to bridge.” (De La Merced, New York Times Dealbook, 5/30/2012)
The literature on IPOs is extensive and a sizeable portion focuses on the underpricing of IPOs. The average level of underpricing in the United States has varied significantly from year to year with the distribution highly skewed to the right. Ritter (2014) reports that the equal-weighted average first-day return for IPOs is 18% for the period 1980-2014, ranging from a low of 3.6% in 1984 to a high of 71.1% in 1999. IPOs rarely close at a price below the first day offer price: investment banks provide price support by managing the supply of shares following the IPO. In addition, if an IPO firm doesn’t garner enough interest during the bookbuilding phase (“enough” seems to be defined as “oversubscription”), the IPO application is withdrawn. Bartling and Park (2010) argue that banks underprice, because they “wish to avoid incurring the reputation costs involved if the offer fails due to insufficient demand.”
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