You don’t have to spend too much time around the stock market to discover that there’s something fishy about many stocks’ initial public offerings, (IPOs). The standing joke is that IPO really stands for “It’s Probably Overpriced”. While that may or may not be true in any given case, there are a large number of pitfalls awaiting the would-be IPO trader or investor. It’s a case of caveat emptor, and in order to be suitably wary you need to understand how an IPO works and how it can be manipulated to your disadvantage.
An IPO is the means by which a private company is sold to the public. The owners of the company will approach a major investment bank (sometimes referred to as a “bulge bracket” bank) to underwrite the IPO. That bank will then create a syndicate of banks and brokerages to run the IPO. Stock shares are then sold by the company to the syndicate and by the syndicate to the syndicate members’ customers. The deal can be structured a couple of different ways, but in general the syndicate guarantees they will find buyers for the shares, accepting financial risk if they fail. The syndicate sells the shares of the soon-to-be public company at a higher price then they acquired them. This gap is set as part of the underwriting contract, and has historically been about 7%. Once the shares have been “allocated” to the syndicate’s customers, the stock can begin trading on an exchange. The bulge bracket bank which lead the IPO typically acts as the primary market maker or specialist for the new stock.
There is nothing inherently wrong with this setup. Yes, the syndicate and the bulge bracket bank anchoring it is taking a big cut. But they’re also providing an army of salesmen to place the IPO with prospective customers. Without those salesmen to drive demand, the shares might not be sold at all or might sell for a much lower price. So they are providing a potentially very valuable service at an agreed upon price. That’s fine. But, as you might imagine, when there’s a lot of money moving around people get greedy trying to grab a bigger slice of the pie. And when people get greedy sketchy things start to happen.
The first thing that happens is the syndicate, and the bulge bracket bank in particular, don’t try to find the highest priced possible buyers for the stock. Instead they allocate the shares at an intentionally low price to favored customers. At first glance this doesn’t make any sense – since the bank is getting a fixed cut of the sale, they should want to sell for as much as possible. But as we’ll see in a bit, the bank can potentially make more money selling for less. This practice of less than aggressive pricing pretty much insures that the price of an IPO will open above the allocation price when the shares start trading on an exchange. This in turn represents a direct transfer of wealth from the IPO company’s ex-owners to the investment bank’s favored customers. Those with allocated shares could sell as soon as the stock goes live an make a nearly locked-in profit.
Now, if you know anything about investment banks it that they don’t just give away money. So why give under priced shares to their favorite customers? The answer is that those customers are “favorites” because they are willing to overpay for other services offered by the investment bank outside the scope of the IPO. In return for that patronage, the investment bank kicks them a nice block of IPO shares. What this means is that all the money “given away” by letting shares out the door below cost comes back in the form of future banking fees. So instead of the investment bank getting just a 7% cut, they basically get all that money back eventually, capturing the other 93% too. Pretty sneaky.
If the process stopped there, it wouldn’t have much effect on market dynamics once the IPO shares became exchange traded. But there’s more to the story. The bank can retain some of the IPO shares for themselves. This is in part to provide inventory for the subsequent market making operation, but since the allocation is intentionally under priced it also represents a nearly locked in profit for the bank. In order to realize this profit, the bank needs to sell their shares on the open market at inflated post-IPO prices. That’s where the market making and sales organizations come in.
In order to facilitate getting bank-owned shares out the door at high prices, prices need to stay high. That’s where the market making operation (controlled by the very same bank) comes into play – they have substantial ability to “stabalize” the price of the security at a high price by being willing to buy any shares that come for sale on the open market. These activities are regulated by SEC Reg. M rule 104 and the older 10b-7, but in practice the market making operation can buy more or less as much stock as they want to hold the price high.
Now this might seem counterproductive since in order to stabilize the price the bank has to buy shares when what they want to do is sell shares. But never fear – they’ve got a solution 🙂 The same giant sales organization that placed the IPO shares below cost now goes to work convincing less than favored customers (read: suckers) to buy shares on the open market at a much higher price. By doing this, they can move the bank’s inventory (plus any shares acquired via stabilization) out the door. Eventually the bank shares, as well as those of favored customers that want to sell high, are moved to the sucker customers and the bank retains only the bare minimum shares required for market making operations. The more effective the sales operation, the higher the average selling price of the bank’s retained shares. Result: yet another profit for the bulge bracket bank.
Now the market making operation can stop “stabilizing” the price and let it fall, leaving the suckers holding a loss. Again, wealth has been transferred, but this time to the bank from their worst customers. Remarkably, everything that has happened up to this point is legal assuming the bank respects rule 104. The only limit on how much money can be made this way is the sales force’s ability to sell shares and the amount of IPO shares the bank can retain. In most cases I believe retention is limited to 10% of the total shares – basically the SEC has decided that it’s OK to screw the customers, but put a cap on how much. Nice.
Now, if the bank finds that 10% cap irksome, they can try to get around it by allocating shares to stooges who will funnel the profits back somehow. This is illegal, but it’s a popular kind of illegal. I know of at least two investment banks that were brought down by criminal charges related to stashing IPO shares with stooges: Drexel Burnham Lambert and Stratton Oakmont. Drexel used to be the 5th biggest bank in the world.
One thing worth noting is that the sales job to move post-IPO shares isn’t necessarily that hard. Since the stock opens above the IPO price (sometimes substantially) and “stabilization” keeps it from falling, the chart and general behavior of the stock may well appear attractive to the naive investor. When there’s a good “buzz” around the new stock, it can be very easy to get it moved off the books.
The whole shady IPO process creates a stereotypical price pattern for IPO stocks. The initial allocation is at an attractive price, but there’s no way to get any. When trading opens, it opens at a much higher price and frequently rises for a period as salesmen sell stock like cocaine fueled monkeys and the market making operation provides “stabilization”. When everyone who needs to sell has sold, the salesemen move on and the stabilization is removed and prices drop noticeably. Now, past that point the market is in a more efficient state. Many companies do plenty well after the IPO and make good money for their investors. But in the short term, price is governed by the IPO dynamics.
As a trader or investor, you need to understand that if you buy IPO shares right after trading starts, you’re mirroring the behavior of the bank’s sucker customers. The big players are trying to sell at that point, and no matter how attractive the chart may appear you’re likely in for trouble. A good example of this to watch is the LinkedIn (LNKD) IPO.
- the IPO price was $45
- trading opened at $83 (yeah, $45 was the best we could sell it at…right)
- initial sales and hype drive price as high as $120 within the first week
- it’s now sitting at $65
- anyone who bought in the initial week is now under water
Now, you might think that if the bulge bracket bank is selling into an IPO, you should be smart and do the same thing – sell the stock short. But this is difficult for two reasons:
- Selling a stock short requires that shares be available to borrow. It usually takes a while before borrow is available on IPOs at a decent rate. This can be very broker dependent.
- Initially you will be fighting the bank’s sales force, and you will lose. Had you shorted LNKD at $84, you would have lost 50% withing the first week. Very few people can stomach those kind of draw downs just to get to profits months down the road.
In general, shorting IPO shares can be as fraught with peril as buying them and at best it’s a maneuver which requires very careful timing.
Hopefully this helps you understand the dynamics of IPOs a little better. I’ve said this before, but be careful: it’s a jungle out there..
This post appears in the Carnival of Financial Camaraderie #13, Totally Money Carnival and The Carnival of Wealth