Had to go on a stock market on Facebook

Facebook and the pitfalls in IPOs

Facebook has shown how quickly a critically acclaimed IPO can turn into a pitoyable debut. Many participants and observers want to attach the responsibility for this to the lead manager.

Before the first price can be set for an IPO, there is plenty of work for experts for several months. The threads come together at the lead bank, the lead manager. As a rule, this is an investment bank that leads a consortium of underwriters. The example of Facebook has recently shown what can go wrong in preparation and what damage a lead manager, in this case Morgan Stanley, can or must do. Alfred Mettler said that he could not remember a comparably prominent IPO in which so many voices pointed out on the day of the issue that the issue price had been set too high. Mettler is a professor at Georgia State University.

The lead manager cannot claim that he was not informed. One reason that an IPO takes around six months is the extensive due diligence of the candidate on the stock exchange by the syndicate banks. This review is not performed by the analysts who later monitor and review business developments for investors. The due diligence should show the relevant valuation of the company. Depending on the industry, experts such as physicians, process technologists and biochemists are also involved, explains Andreas Neumann, Head of Equity Capital Markets at Zürcher Kantonalbank. Neumann mainly deals with Swiss and European IPOs (Initial Public Offering). The IPO business is very international and therefore comparable worldwide.

Equation with unknowns

In the IPO area, Swiss law is closely based on US regulations. A connoisseur of the US capital market points out that due diligence in technology companies, especially in the Internet sector, is tricky. The few existing assets are quickly valued. But the value of a company depends above all on the development of the number of users and the related advertising and possibly subscription income. These predictions could change quickly. In contrast, forecasts made by a production company in April are still relevant in May.

The result of a due diligence can be seen as a preliminary stock market prospectus that has to show everything that could be relevant for potential investors. The most important points are the description of the business activity, the management, historical developments and possible risks. Facebook listed 51 risks in its prospectus that could endanger the company. That was clearly more than for an average Swiss candidate on the stock exchange. But even with the IPO of Google, risks were pointed out on several pages.

The social network Facebook, which is repeatedly criticized for not adequately protecting customer data, also cites advances by governments as a risk, but the ups and downs on the stock market are also mentioned as a danger. With this, the aspirant wants to exclude possible liability claims for the IPO. However, the prospectus does not contain any outlook or estimates. Since prognoses were not exactly fulfilled anyway, they would only open up possibilities for legal action. Stock market prospectuses have meanwhile reached a volume of 200 or more pages; A few years ago it was around 50 pages on average. Before the disclosure of a preliminary prospectus, IPO candidates hold presentations with a view to preparing analyst reports from the syndicate banks. The Facebook consortium comprised Morgan Stanley, JP Morgan Chase and Goldman Sachs. In addition, more than 30 bookrunners were brought on board. During the presentations, certain indications of the growth potential are given. However, every analyst has to get an idea of ​​the company for himself and make his own estimates. Management of expectations is required here so that very positive and very negative assessments do not diverge too much.

The analysts then create their own research reports and use them to approach their customers. There they get a market opinion and sound out the interest in subscribing for shares. For example, a pension fund says it is interested in subscribing to 1 million shares at $ 40 each. Gathering all of these sales intentions before an IPO leads to the determination of the range of the issue price. Facebook set the price range at $ 28 to $ 35 on May 3. Four days later, Facebook started its roadshow to present itself to interested investors.

At the same time as the roadshow, around two weeks before the IPO, the bookbuilding phase begins, with which the issue price and share volume are determined. The investors are now placing binding orders. In principle, these can be withdrawn. Institutional investors try to avoid this in order not to lose credibility for future share allocations, as Andreas Neumann from ZKB says. The great demand caused Facebook on May 15th to increase the price range to $ 34 to $ 38. Such a step was time-consuming for the bank consortium, because now all interested parties who had made their offer “perfectly” had to be asked whether this also applies to the new price range. For this reason, adjusting the price range is rarely used in Europe. On Facebook, some existing shareholders announced that they wanted to sell some of their securities under these conditions. The issue volume rose by a quarter to 421 million shares.

Background noise on Facebook

Bookbuilding ends one day - in exceptional cases two days - before the first day of trading. Shares are now allocated to interested parties. The Swiss Bankers Association has issued guidelines for the allocation of oversubscribed offers (as is the case with Facebook), i.e. if the offers to buy shares exceed the actual offer. Similar practices also apply to other countries. In principle, the allocation must be «sensible and fair» and in the strategic interests of the listing candidate. A proportional allocation can be selected for this: If the issue is oversubscribed seven times, for example, everyone receives a seventh of their purchase offer. An allocation can be supplemented with upper and lower limits. For example, nobody receives more than 3% of the shares, and very small orders (fewer than 10 stocks) are canceled.

A candidate on the stock exchange is free to give preference to individual investors who were helpful in the roadshow or who have expressed an extraordinary long-term interest in the company. Consequently, investors who are suspected of speculating only for a short time, such as hedge funds, can be disproportionately taken into account.

The fact that Facebook shares had a turnover of 138% of the shares on offer on the first day - that is, many shares changed hands more than once - probably reflected very different opinions of the stock market audience. Significantly lower values, on average around 25% of the outstanding shares, are the rule for initial share issues. The hustle and bustle was partly due to Facebook itself. A few days before the initial issue, the company's chief financial officer reportedly informed two banks from the consortium that the figures for the second quarter would be lower than previously assumed. According to press reports, the CFO recommended analysts to correct their forecasts, which they would have done.

In addition, as reported in the media, major investors have been informed by analysts about the changed prospects. As a result, numerous institutional investors reduced the purchase offers to $ 32; Facebook shares closed last Friday at $ 31.91. If the rumors were to come true, that would be very unusual, say those familiar with the IPO business. As a rule, according to von Neumann, the analysts of the syndicate banks have to commit to a so-called “blackout period”, which ends 40 days after the completion of an IPO. Because it is in the interests of the consortium that stable conditions prevail around the IPO.

The stock exchange is not a one-way street

Allegedly, Morgan Stanley tried to avert impending losses through support purchases on the first day of trading. Mettler adds that it is customary for the syndicate bank to guarantee to keep the price within a certain range on the first few days of trading. A fixed exchange rate is usually not stipulated in a contract, because maintaining such a rate could be very expensive for consortium banks. In any case, a lead bank has a fundamental interest in bringing a candidate on the stock exchange at an appropriate price and ensuring that there are no major price setbacks. Otherwise the reputation in this often lucrative business will be permanently damaged.

What should be most to talk about is whether in the case of Facebook the adjustment of the prognoses was made “at an inopportune time” and the information was only passed on to hand-picked people. Violation of the disclosure regulations tends to be punished more severely in the USA than in Switzerland, for example. Presumably, the behavior of the Facebook chief financial officer immediately before the IPO will concern the securities regulator. Because no specific growth expectations were mentioned in the prospectus, there was in principle no direct reason for the CFO to issue a corrected sales and profit forecast during the bookbuilding process.

Ultimately, it was at the discretion of Facebook to cancel, postpone or change the issue price on the last day before the IPO. A business lawyer interviewed said that the candidate on the stock exchange decides independently at what price to go public, even if this is usually done in close consultation with the syndicate banks. Mettler believes that the IPO market was not permanently damaged by the events surrounding Facebook. On the one hand, this has already cooled down in recent years for other reasons (Sarbanes-Oxley), and on the other hand, the current excitement is to some extent part of the American system. What can be sued is just being sued.

Once these proceedings are over, the rules may be tightened. If Morgan Stanley found misconduct, this could be expensive for the bank. But then you go back to “business as usual”. The American economy has a vital interest in the continued IPO in the USA. In addition, the whole thing might even be beneficial. In any case, it has been made clear to investors that there is no guarantee that new shares will achieve price gains on the first day of trading.

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