Forgive me for not sympathising with the gentle whining coming from hedge funds, institutional investors, and traders around the world about Facebook's (Nasdaq: FB) "disastrous" IPO. Articles from Bloomberg, The Wall Street Journal, MarketWatch, and even some at The Motley Fool are calling the IPO a flop on many levels, and most people believe it.
Now reports are surfacing that Morgan Stanley (NYSE: MS) and Nasdaq OMX Group (Nasdaq: NDAQ) are being scrutinised by the SEC and FINRA over issues relating to the IPO. When a stock like this tumbles in its opening days, everyone wants to point fingers and place the blame over the IPO's flop.
But the success of an IPO is in the eye of the beholder, and in my eyes the IPO was a smashing success for Facebook. Let me outline why I think the reports have it wrong.
You scratch my back, I'll scratch yours
What an underwriter like Morgan Stanley normally wants to do is price an IPO just low enough that demand will push the stock higher on the opening hours and days of trading. It wants to do this to make a quick buck for investors who participated in the IPO (usually hedge funds and institutional investors, not you and me) and make it look good for the media. Since the hedge funds and institutional investors the underwriter sold the stock to are clients, it's a case of I'll scratch your back (by participating in the IPO) if you scratch mine (by making me a quick buck in early trading).
It's the dirty little IPO secret that it's the initial buyers of the IPO, the ones who actually paid the advertised US$38 price, whom the underwriters want to please more than the company they're selling. If it makes those investors happy, the next time an IPO comes around the underwriter can call on them to participate again, giving the underwriter bargaining power with potential IPO clients.
But underpricing an offering like this doesn't serve the IPO company very well, so when a stock pops on its opening day, it probably shouldn't be viewed as a success at all. Groupon (Nasdaq: GRPN) and LinkedIn (Nasdaq: LNKD) both exploded higher on their opening day, prompting cheers from the media, but the losers were really Groupon and LinkedIn, because they left money on the table.
But the protocol is to stack the deck in favour of preferred clients buying shares in the IPO, no matter who is really paying the bill.
Who is the client, after all?
What people usually fail to realise is that it's the company being sold to the market that's actually paying the underwriter. In the case of Facebook, Morgan Stanley was the lead on IPO and got a US$67 million fee for its efforts (about 38% of the total) to sell shares to the public.
From Facebook's perspective, and it is the client, it would be a best-case scenario to see the stock fall in the first few days of trading, because it would indicate that the company got more from the market than it should have. If I were Mark Zuckerberg, I would be tweeting about what a great job Morgan Stanley and the other underwriters did in selling the IPO.
How bankers make a fortune from IPO deals
If you want to see another clear example about why an investment bank wants to underprice an IPO, just look at the typical overallotment, a pot sweetener for any share offering. In Facebook's case, the filing said:
"In addition, Facebook and the selling stockholders have granted the underwriters a 30-day option to purchase up to 63,185,042 additional shares of Class A common stock to cover over-allotments, if any."
What this means in reality is that if the stock goes up after the offering, the underwriter can sell additional shares at the higher price, turn around and buy them from Facebook, and pocket the difference. In the case of Groupon and LinkedIn, I'm sure the underwriters made off like bandits.
No sympathy from this Fool
When an IPO declines soon after reaching market, the media likes to call it a failure or a flop — but that's true only for the investors who bought shares at the IPO price or early in trading. Maybe what we should be doing is cheering the IPO for taking money out of the pockets of hedge funds, institutional investors, and other preferred Morgan Stanley clients and giving it to Facebook. I would much rather see a company get too much from an IPO than watch a preferred group of investors make a quick buck.
As with anything, success is in the eye of the beholder. If you don't yet own shares of Facebook, if you will in the future, or if you're just hoping Facebook does well as a company, you should see the IPO as a smashing success. Forgive me for not feeling bad for those who lost out when they thought the game was stacked in their favour. I'm sure you'll have better luck next time.
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The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by Travis Hoium, originally appeared on fool.com
