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On Friday, The New York Times published an exhaustively detailed history of Mitt Romney’s relationship with Goldman Sachs. The article examined their connections long before Goldman, and to a lesser and more recent extent, Bain, had become household names for all the wrong reasons.
In the context of Friday’s big Facebook IPO news, this bit stood out:
In May 1999, a few months after he left Bain to run the Salt Lake City Olympics, Goldman allowed Mr. Romney to buy at least 7,000 Goldman shares during the firm’s lucrative initial public offering — a generous allotment even among Goldman clients, according to people with knowledge of the deal. When Mr. Romney’s trusts sold the shares in December 2010, a few months before he formed his presidential exploratory committee for the 2012 race, they returned a profit of $750,000.
This passage is a perfect example of how banks runs the so-called ‘book building’ process during an IPO, which determines who gets how many shares. After underwriters stoke demand and gauge clients’ interest in the offering, they finally ask investors to submit the precise number of shares they’d be willing to buy at what price.
The key is that the total number of orders, in a successful IPO, is far more than the company is selling. This is referred to as ‘oversubscription.’
Any time you hear a banker tell you an offering was ‘oversubscribed’ x number of times, check to see if they are physically patting themselves on the back, because metaphorically, that’s what they’re doing.
They’re telling you how great a job they did creating demand for the company’s shares.
And now that there is more demand than shares available, who decides who gets what? The underwriters, in consultation with the company. The level of company input in this process varies, and is likely to be high in Facebook’s case, but nonetheless there is an inherent bias to award shares to the largest institutional and high-net worth clients of the bank.
In other words, mutual funds, hedge funds, pensions and endowments, and people like Mitt Romney. For every institution or individual that a bank pushes to receive a large number of shares, you can bet that same institution or individual is an important client of the bank in some way or another.
Technically (i.e. legally), banks are prohibited from handing our shares based on revenues, but in practice it happens and there are other ways to justify the share allowance. At the most basic level, the biggest clients of the biggest banks are the biggest institutional investors and the wealthiest individuals, exactly the kinds of shareholders companies want.
What about the retail investors?
There’s been an ton of hype about how much ‘retail demand’ there is for Facebook. This is probably true. Your average individual investor uses Facebook, knows it makes money and knows that it might be valued at $100 billion. And that alone is enough to convince Joe with a brokerage account that he should buy Facebook.
But ‘retail demand’ for Facebook shares and ‘retail access’ to Facebook shares are two totally different things.
In reality, no matter how much they want to buy them, retail investors will have access to only a tiny portion of Facebook’s shares. This makes sense for Facebook. Companies want their shares held by sophisticated investors who respond (theoretically, at least) to things like earnings, valuation, etc. How does you uncle in his basement make his investing decisions? I have no idea either and he probably doesn’t either.
It also makes sense for the biggest banks, who make relatively little, if any, revenue from small investors.
The individuals who tend to get spots in the initial share allocation are people like Mitt Romney. Sure, he’s an individual investor. But he’s not JUST an individual investor. He was a huge client of banks in his role as head of Bain. He knows the ins and outs of corporate valuation, etc.
For Goldman, handing Romney 7,000 shares was an easy way to do a wealthy, influential guy who harbored political ambitions a favour. And Romney returned that favour by holding the shares from their issuance in 1999 until the end of 2010, when they were sold by his blind trust.
And why, precisely, is it considered a favour to be awarded shares in the initial allocation of an IPO?
Because there is a strong argument that banks systematically underprice IPOs, ensuring the coveted opening day ‘pop’ in price and decreasing the chance that the shares will slip below the issuance price. This is a practice that may suit shareholders, but the ensures that the company going public leaves capital on the table.
Note: IPO pricing is a much debated and discussed topic and will be the subject of a separate post in the coming days.