May 21, 2012
Facebook IPO: Where Did the Underwriters Go Wrong?
Posted by Usha Rodrigues

In a comment to my Facebook IPO post, Steve Bainbridge asked: "How does the fact that Morgan Stanley had to intervene to keep the price from dropping below $38 factor into your analysis? Zuckerberg may be laughing all the way to the bank, but are the underwriters?"

Here's what I started to type in the comments: "To me it depends on how much you buy the underwriter conspiracy theory. If you think the big bad investment banks' standard playbook is to enrich their banking clients at the expense of poor powerless issuers by underpricing IPOs, then Facebook is a rare case of an issuer with the clout to set the pricing terms.   So it made sure that it (and its investors) didn't leave money on the table, and it passed on the risk of overpricing to underwriters who were, until last Friday, feeling pretty lucky just to get a seat at the IPO of the year.  

Instead, if you think the underwriters are good-faith actors that are up against big information asymmetries, then FB is a case where they just misjudged the market's appetite for FB shares.  Either way, it's interesting to me that there was such apparent mispricing when (unlike in most IPOs) there was an active secondary market in Facebook shares pre-IPO, so valuation should have been a good bit easier." 

Then I figured I was getting long-winded for the comments section!  FB, in case you missed it is now trading down 13% from its offering price. The question that's nagging at me now is, what's the deal with Morgan Stanley's book?  If you're not familiar with book-building, here's a good introduction from Forbes' Darcy Travlos:

For a “normal” IPO, a company that goes public in the normal course with little media attention, the first step is to build a strong “book” of orders for the offering.  If a company wants to sell, for example, one million shares to the public, the order book needs to exceed that one million by some multiple.  Back in the less frenzied days in less frenzied industries, having order demand exceed supply by 3-5 times was a good book.  The reason why the demand had to exceed supply was that accounts that really wanted the stock would put in inflated orders to make sure they got “filled” on what their true demand.   With this level of demand, underwriters would be confident that there would be enough demand in the after market (once the stock begins trading) to support the offering price.

 The whole description is worth a read, but the gist is that normally underwriters won't price unless they're looking at an offering that is oversubscribed by 5x or more. 

So what went wrong?  Did Morgan Stanley not have a big enough book?  Travlos speculates that "that institutions probably put in orders larger than they wanted to ensure they received IPO stock, but sold out of the offering when the stock didn’t pop.  Institutions got out at whatever profits they could lock in (the stock did trade at $42) and retail investors bought in."  Sounds plausible.  She also references the private secondary market that I've been so hung up on, noting "It brings into question institutional support, since many institutions were able to buy Facebook prior to the IPO on the private market."  

The short answer to Steve's question is, of course, that the underwriters are sobbing into their single malt scotches and trying to piece together what went wrong.  I share Steve's skepticism about Facebook's path to profit, which has an Underpants Gnome quality to it.  But, given how it has upset our expectations about the underwriters' role, this IPO may be one for the ages.


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