With the Dow Jones industrial average and the Standard & Poor’s 500 index hovering at or near all-time highs, one would think the stock markets would be highly receptive to initial public offerings in 2013, even if the economy disappoints.
But 2012 casts a cloud over the IPO market. While there was slight improvement over 2011 and 2010 in terms of IPO capital raised in U.S. offerings—about $43 billion—more than one-third of this amount was from the troubled Facebook IPO.
Facebook’s share price is now about 25 percent off from its $38 offer price, having fallen dramatically on the first trade day after the offering and remaining down around 50 percent through most of the fourth quarter of 2012.
Given its size and profile, Facebook’s experience can provide useful guidance as to what stock markets are looking for in 2013.
The typical IPO is “underpriced” in the early aftermarket, meaning its share price usually jumps, about 15 percent on average, in the first few days of open trading. Some have argued that this systematic underpricing amounts to leaving the issuing firm’s “money on the table” unnecessarily.
In Facebook’s case, the management team was unusually aggressive with the lead underwriter, Morgan Stanley, in terms of negotiating both the underwriting fee, of only 1.1 percent, and the final offer price.
The original offering prospectus to investors indicated that Facebook shares would be offered in the $28 to $35 range. This was revised to $34 to $38 before finally settling at the top of this range and also increasing the size of the offering an additional 84 million shares, to 421 million.
These additional shares came entirely from those who had invested in Facebook in its early stages, well before it went public. In total, almost 60 percent of the 421 million shares came from the cashing out of early investors, which helps explain the unusually aggressive pricing.
Meanwhile, Facebook revised its internal revenue forecasts downward and communicated the estimates to institutional analysts, while retail investors were left to imply this from qualitative revisions to the prospectus. Just before the offering, retail investors remained enthusiastic about the Facebook IPO, although there were some rumblings of doubt among institutional analysts.
When the Facebook offering commenced May 18, both institutional and retail investors received larger allocations than anticipated, and most institutions understood this meant the offering had been overpriced.
Some blamed this on Morgan Stanley for issuing an additional 15 percent of shares, or 63 million, than the 421 million allotted, but this over-allotment, or “green shoe,” option is standard industry practice used by underwriters to stabilize the price by repurchasing the additional shares when the price flounders, as it did in Facebook’s case.
Unfortunately, Facebook’s price still plummeted in the face of relentless sell pressure when Morgan Stanley ceased price stabilization on the morning of May 21.
We will never know what Facebook’s price would be today if it had not been so overpriced. Would it have fallen to $17.55, as it eventually did on Sept. 4?
There are several implications for firms considering an IPO in 2013.
1. The prospectus should reflect what is disclosed to analysts to reduce the potential for lawsuits.
2. The market is likely to discount offerings in which a significant portion of the proceeds go to early investors cashing out.
3. The current IPO market is more skeptical of firms with prospects for growth based on a story rather than an established record of earnings.
4. A modest level of underpricing should be viewed as a necessary cost of going public, and overly aggressive pricing may result in the “falling knife” metaphor, where investors let the knife hit the floor before they pick it up. In which case, the price might not reflect value for some time, to the consternation of managers and shareholders.•
Jones is an associate professor of finance and evening MBA chairman at the Kelley School of Business at IUPUI. Views expressed here are the writer’s.