Last week, LinkedIn’s IPO was dramatically underpriced by the Wall Street banks that underwrote it, costing the company and its selling shareholders about $200 million in lost proceeds.This $200 million went into the pockets of big investor clients of the underwriters–rich mutual fund firms like Fidelity and hedge funds like SAC Capital.
In the wake of this mispricing, commentators like Joe Nocera and I observed that IPO “pops” like LinkedIn’s–which are generally celebrated as a sign of success–are actually bad: They rob the company and its existing shareholders of cash that is rightfully theirs and they steer it into the pockets of favoured money management clients who don’t need or deserve it.
This revelation spawned outrage among folks who are sick of getting screwed by Wall Street. And in the wake of this criticism, not surprisingly, Wall Street began to defend itself.
One anonymous Wall Street investment banker, for example, lashed out at Nocera and me, branding us “ignorant sluts.” And he then trotted out some standard sophisticated arguments to defend the LinkedIn mispricing.
These “pro-pop” arguments are nothing new, and they’re bogus. But they appear to have again persuaded some smart people that IPO pops are good, so they’re worth addressing directly.
I USED TO THINK “IPO POPS” WERE GOOD, TOO…
Before I address these arguments, though, it’s also worth providing some background: I worked on Wall Street in the 1990s, as both an investment banker and a stock analyst. I watched hundreds of companies go public, and I participated in the underwriting of dozens of IPOs. As a banker and analyst, I made some of the same “pro-pop” arguments that the anonymous investment banker is making now. These arguments were self-serving for me and the firms I worked for (the view that big “pops” are good makes life a lot easier for Wall Street bankers), but I also believed them. It wasn’t until after I left Wall Street and studied how much the IPO process actually costs companies that I began to realise how “IPO pops” screw the companies bankers are supposed to be acting on behalf of.
One thing I want to be clear about: I do not think LinkedIn and other companies with big IPO pops got “scammed” by their bankers. I don’t think the banks intentionally mispriced the deals just to favour their investor clients and themselves (via the “over-allotment option” that allows them to buy 10% of the deal at the IPO price). But I do think the banks did a key part of their job badly, and I think companies should recognise that and hold them accountable for that.
The analogy I used last week to explain why “pops” are bad was that of a real-estate agent who persuades you to sell your house for $1 million and then then next day turns around and sells it to someone else for $2 million. If an agent did that to you, you’d be justifiably furious.That’s similar to what Morgan Stanley and Bank of America just did to LinkedIn.
But the “pop” defenders argue that it’s not at all similar because LinkedIn only sold a portion of itself. They continue this argument by saying that an IPO is a pricing event, not a fundraising event, so the actual amount of money raised is irrelevant. LinkedIn now has a public currency valued at about $90 a share, the pop-defenders say, so it doesn’t matter what it sold those 10 million shares for.
This argument is ridiculous.
So what if LinkedIn only sold a “portion” of its stock? Why should it have sold this portion at a 50% discount to fair market value, when it could have sold it at only a 15% discount? By selling its stock at a 50% discount to the fair market value instead of a normal–and justifiable–15% IPO discount, LinkedIn and its selling shareholders gave away $200 million. And $200 million is real money, even if there’s more where that came from.
IMAGINE YOU ARE SELLING APARTMENTS…
In the interest of fully debunking this “only selling a portion of the stock” argument, let’s change our real-estate analogy slightly. Instead of a house, let’s say you’re selling apartments in a new real-estate development. You have a building with a hundred apartments, all identical. After marketing your building, your real-estate agent proudly informs you that he can sell one of the apartments for $1 million. You say “Go for it!” The agent sells the apartment. And then the next day, the same real-estate agent re-sells the same apartment to someone else for $2 million.
On the one hand, you’re happy: You still have 99 apartments that you now realise have a fair-market value of $2 million apiece. But you also realise what just happened: The fair-market value of your apartments is $2 million. Your real-estate agent sold that first apartment to a good client at 50% off–and, in so doing, plucked $1 million out of your pocket and gave it to the client.Importantly, your apartments were worth $2 million no matter what that first apartment sold for. Your agent selling your first apartment for $1 million did not affect the fair-market value at all.
So, the “portion” argument is bogus, but there are three other arguments/questions that are worth addressing here.
Photo: LinkedIn via Flickr
BUT WHY DOES THERE HAVE TO BE AN “IPO DISCOUNT”?Why does there need to be any IPO discount at all? Why shouldn’t underwriters sell stocks for the exact fair-market value? Why should they “grease” institutional investors with any discount?
The answer is that, on most IPOs, the underwriter does need to offer a carrot to get investors to take the risk of buying the deal. Estimating fair-market value is a craft, not a science, and underwriters do occasionally blow it. If underwriters aimed to price each IPO exactly at fair-market value, there would be no incentive for institutions to take the risk of buying the stock before the shares started trading. Instead, they’d just wait to see where the stock traded and then make their buying decision then.
So you do need a modest IPO discount to compensate investors for taking the risk that the underwriters might price the deal too high and stick them with a loss. The standard IPO discount is about 10%-15%. And it’s perfectly justifiable.
ISN’T FAIR-MARKET VALUE HARD TO ESTIMATE?
But aren’t we being too hard on Wall Street? Isn’t “fair-market value” hard to estimate in advance?
Yes, fair-market value IS hard to estimate in advance. But it’s not impossible to estimate, and Wall Street underwriters are paid massive amounts of money to estimate it, so they deserve to be held accountable when they blow it.
The way the IPO marketing process works is this: Underwriters spend two weeks marketing a company’s stock to institutional clients worldwide (management flies around doing one-on-one meetings, breakfasts, lunches, dinners, etc). During the two weeks, the underwriters ask investor clients for “indications of interest,” which usually include both the number of shares that the client wants AND the price the client is willing to pay for them. With a hot deal, clients usually want a lot of stock, and they know that if they’re willing to pay more for it than other clients, they might get more. So they have an incentive to be somewhat forthright about what they might pay.
At the end of this “roadshow,” the underwriters look at all the “indications of interest” for the stock and estimate what they think the trading value is likely to be. Then they offer the company a price, which the company can either accept or reject. If the company accepts the price, the underwriter then buys all the stock at that price and then allocates it to its clients as it sees fit. (Here’s where being a good, loyal client comes in handy).
Now, especially with a hot deal like LinkedIn, it’s hard to estimate the likely trading price. Clients who want stock don’t want to pay any more for the stock than they have to, so they’re not going to tell the underwriter that they’ll buy it at any price. Instead, they’ll try to “play” the underwriter to get the underwriter to keep the price low. If the underwriter is doing its job well, it will see through this, and get as much money as possible for its corporate client while still giving its investor clients a reasonable discount to the fair market value.
In the case of LinkedIn, the deal was said to be 30-times “oversubscribed,” which means that there were orders for 30-times as much stock as the company was selling. That is a LOT of demand. And it suggests that the underwriters almost certainly knew that the fair-market value for LinkedIn would be much higher than the $45 they sold the deal for.
But they went ahead and priced it at $45 and screwed LinkedIn out of $200 million.
BUT DON’T BANKS HAVE A DUTY NOT TO SELL STOCK AT “INSANE” PRICES?
The most morally persuasive argument defending IPO pops is that Wall Street banks should not participate in the screwing of investor clients by selling them stock at prices they know are unsustainable.
I have a lot of sympathy for that argument. But it hinges on many other factors, including the premise that Wall Street banks actually know what is and isn’t a fair, sustainable price for a stock. And the truth is that they don’t.
As I observed last week, it is easy to dismiss LinkedIn’s current valuation as “insane,” but many smart investors think it will deliver a fine return from here. Two days after the stock started trading, it’s still trading at more than twice the IPO price. And, barring a major market collapse, I suspect that a month or two from now, it will still be trading at a major premium to the IPO price.Meanwhile, in two trading days, the total amount of stock LinkedIn sold on the IPO has been bought and sold more than 4-times over, so any investor who bought stock on the IPO who doesn’t think the current price is sustainable has already had the opportunity to sell it. So, by now, if investors who bought stock on LinkedIn’s IPO end up losing money, they have no one to blame but themselves.
Some observers attribute the high price to LinkedIn’s “small float” and suggest that the stock will crash the moment more stock hits the market. Like the “pro-pop” arguments, this one sounds persuasive, but it isn’t. Many other stocks, even Internet stocks, have small floats, and yet their stocks are tanking. (Take a look at Demand Media, for example). No one has to buy Internet stocks (or any stocks), and the higher their prices rise, the riskier and less attractive they become. So anyone who thinks that LinkedIn’s stock price is “insane” and is trading at $90 just because of its “small float” should long since have dumped the stock.
At its current level, LinkedIn is trading at about 20X this year’s estimated revenues. That’s a very high multiple, especially for a company that has yet to demonstrate that it can deliver huge profit margins. But it’s also the same revenue multiple that Google and Microsoft once traded for (in their hyper-growth years). And it’s the same revenue multiple that another big social-networking company is trading for right now: Facebook. So it’s actually hard to argue that it’s self-evidently “insane.”
THE BOTTOM LINE
If Wall Street defenders want to defend the LinkedIn mispricing by saying “Yes, Bank of America and Morgan Stanley blew it, but everyone makes mistakes, and estimating fair market value is a craft, not a science,” fine. Everyone does make mistakes.
But, as yet, Wall Street’s LinkedIn “pop” defenders are not saying that. They’re saying the underwriters did a great job and that people bitching about the $200 million LinkedIn gave up are ignorant whiners who have no idea what they’re talking about.
They’re wrong. But they are the same folks who are no doubt praying that other Internet companies that are lining up to go public continue to believe that.
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