The botched flotation has embarrassed Wall Street, exposing technical failings and questionable practices
©BloombergMarkets: Facebook unfriended - Bubble trouble: the Facebook ‘like’ symbol reflected in water droplets. The IPO’s failure to ‘pop’ hit hopes of a boom in media stocks
It was meant to be the launch party for the social networking boom. But Jeff Sica knew something was not right.
A few days before Facebook’s initial public offering on May 17, his broker contacts at some of the big banks underwriting the deal had called with surprising news: the New Jersey financial adviser could have as many shares as he wanted.
Nearly all of Mr Sica’s hundreds of clients had been pestering him about the best ways to buy as much Facebook stock as they could, leading him to believe clients everywhere were doing the same. He had assumed it would be a rare commodity.
Instead, the brokers said the cap of 500 shares per order had been lifted to 5,000 – and that if he pressed he might be able to acquire even more. “That was the first sign of trouble,” Mr Sica says. After hearing the pitch, he declined to take any shares, and he advised his clients to do the same.
“There was a lot of buzz about people wanting to sell when trading opened. It just seemed like everyone was very, very skittish,” he says.
Mr Sica was proved right. Rather than representing the first step of a new dotcom boom, America’s third biggest IPO by cash raised – with an initial market capitalisation of $104bn – shed nearly $20bn in two days. Decisions about how many shares to sell, and at what price, raised questions about the supposed “science” of valuing shares that earns Wall Street’s most illustrious banks big fees. It also proved unrealistic some investors’ expectation that, no matter the price, the deal would deliver an immediate trading gain, or “pop”.
The troubles began with an unusual decision in the days before the IPO price was set to raise an already high price by 20 per cent, and to sell 25 per cent more shares in what was already by far the biggest technology IPO. Difficulties accelerated as initial trading on the Nasdaq electronic stock exchange was delayed; then technical problems meant traders failed to receive confirmation of the positions they had taken. The situation became a frenzy when the stock failed to pop – rising just 0.6 per cent on day one and in fact falling precipitously on its second day.
The chain of events that led to the fall has called into question Wall Street’s ability to apply yesterday’s way of going public to tomorrow’s company. The question is whether bankers, who tightly control the process of pricing and allocating shares, were able accurately to read demand for a company with an untested business model and a consequently volatile valuation – and which had already been actively traded on the growing private share markets dominated by tech groups for several years.
It has also cast an unflattering light on how Wall Street operates. From the failures in Nasdaq’s trading systems, which threw sand into the wheels of what was already a difficult debut, to the secret flow of information that tipped off favoured investors to the likely impact of a deterioration in Facebook’s business, this was not the face leading banks wanted to show the world for their biggest set-piece event for years.
These aspects of the botched IPO are already subject to investigations by Massachusetts regulators and the Securities and Exchange Commission. The issues raised will resonate long after the drama surrounding the instant boom-to-bust in Facebook’s share price has passed – to Wall Street’s discomfort.
Investor frustration at the deal has several focuses. Some are angry at Nasdaq for allowing trading to continue despite a series of glitches. Others think Facebook’s selling shareholders, who cashed out more than $8bn, were greedy. But perhaps the most anger has been directed at Morgan Stanley, which was Facebook’s lead adviser and underwriter of the deal, responsible for taking the shares and selling them to investors.
Google tried to do things differently – in 2004 it attempted to auction shares to the highest bidders, regardless of who they were. But Facebook’s choice of Wall Street’s league-table leaders in tech IPOs was seen as a signal of its confidence in the traditional IPO market, in which banks set the price and then allocate shares to investors of their choosing.
Some companies distrust banks’ role in IPOs, however – partly because they have so many different arms. As the offering’s underwriter, the lead bank – in this case, Morgan Stanley – has an obligation to support the price of the company by buying shares in the first days of trading. But the banks are also in the business of lending out the shares to short-sellers, who bet that the price will fall.
In this case, the decision to sell more stock was made by David Ebersman, Facebook’s chief financial officer, brought in because of his public company experience, with the support of Morgan Stanley, representing a syndicate of banks whose sales forces would be marshalled to spread the stock around the world, people familiar with the process say.
At the time, Facebook and Morgan Stanley felt they were being conservative. Demand appeared to be as strong as the deal was said to be “many, many” times oversubscribed, and indications of interest existed for all the 421m shares, at a price as high as $41, according to these people. James Gorman, Morgan Stanley chief executive, was personally on the conference call during which the final price was set on Thursday May 17, as was Michael Grimes, the bank’s senior IPO banker in Silicon Valley.
“Morgan Stanley was running the show, and on a deal like this they wanted to exert their muscle,” says a senior banker from the group of banks that underwrote the deal.
At least one fierce critic found no fault with the decision to take the top price. After all, a company should try to raise the greatest amount possible. That fact alone made its approach more effective at raising cash than that of Google, which was forced to cut its IPO price in the weeks before its debut, only to see the stock jump nearly 25 per cent in the first day of trading. It had raised $450m less than it theoretically could have.
“It was such a prestigious offering, there was a lot more desire on the part of the underwriters to deliver a maximum price for them,” says Bill Hambrecht, the investment banker who pioneered the “Dutch auction”.
But one problem was that what appeared to be real demand may have been partly vapour. The hype around the deal was so extraordinary, with round-the-clock television coverage, that orders to buy may have been unusually aggressive as people expected to receive just a portion of what they asked for. On receiving surprisingly large allocations, many moved to sell rather than buy more, traders report. “It’s basic fear and greed. When markets are greedy, you should be fearful,” says a senior banker on the deal.
Another difficulty concerns the question of whether investors believed Facebook’s value was as fixed as it was for other IPOs of similar size, such as Visa and General Motors. In fact, estimates by independent analysts for Facebook’s fair value ranged widely, mainly because the core of the company’s business proposition – monetising the countless user hours dedicated to the platform – has yet to be fully fleshed out.
That problem was borne out when Facebook amended its public prospectus on May 9 to indicate that increasing use of mobile devices, where no advertisements are shown, could slow its revenue growth. The worry was that “grandmothers in Omaha”, as one banker puts it, did not know what the revision meant. Securities lawyers say first-time issuers of stock do not have to abide by public companies’ “fair disclosure” rules.
The question that the state of Massachusetts regulator is asking is whether only favoured clients of the banks were informed of the significance of this revision. Morgan Stanley has responded that the revised prospectus was disseminated to all investors, and that the bank followed its normal procedures for speaking to clients ahead of an IPO. But some investors believe that the rules should be changed to make them clearer.
“The rules of fair disclosure should be employed for IPOs, and any talk revealed when they start marketing a deal,” says Kathleen Shelton Smith, a former banker and principal at Renaissance Capital, a research company focused on IPOs.
Another wild card in the process was the fact that Facebook had traded since 2009 on private secondary markets, primarily the one run by SecondMarket in New York. Even before it was went public, wealthy individuals and big institutions – the only participants the law allows in this market, which does not require public disclosure of financials for stocks to trade – were buying the stock.
Investors who bought at well below $30 a share, where Facebook was trading until 2010, did see a pop in the IPO at $38, and even as it fell below $31. Academics have defended the system of the IPO pop, in which deals are underpriced to deliver first-day trading gains, as a key way to reward institutional investors for taking on the risk of a new company. But in this case, with shares already available in the private market, not all institutions demanded a pop.
“Facebook’s lacklustre IPO performance also affirmed what we all know – the public markets are significantly broken,” says Boaz Rahav of GreenCrest Capital, a broker that focuses on private share markets.
Ultimately, investors, bankers and companies will be prompted by Facebook’s offering to consider that the IPO game has changed: bankers cannot assure a pop to win positive headlines and reward small investors; exchanges cannot be counted on to smooth trading; analysis may never be fully transparent.
For those such as Mr Sica, who are experts at reading the vagaries of the present opaque process, that may put them at a relative disadvantage. But the rest of the market can hope that this experience will prompt a rethink.
Additional reporting by Richard Waters and Tracy Alloway
http://www.ft.com
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