By: Cameron Reid
On May 18th, 2012 Facebook had its Initial Public Offering (IPO) and the company seems to have been making headlines ever since. This IPO, troubled by technical problems and tangible losses for recent investors, continues to draw the scrutiny of the investment community. I believe that the challenges encountered in the IPO represent those of two varieties. The first being those that we can expect will lead to better future outcomes, and the second being those that highlight the fundamental conflicts of interests embedded in Wall Street and the brokerage community more broadly.
Nasdaq continues to be troubled by its poorly executed Facebook IPO. UBS and Citigroup are requesting that the Securities Exchange Commission to reject an offer by the exchange to cover losses incurred, saying the $62 million proposal would only cover a small portion of their total losses. For many of the parties involved, this IPO is not only deeply embarrassing, it will most likely lead to meaningful legal expenses as well.
It has been reported that on the day of Facebook’s IPO, the Nasdaq’s computers were overwhelmed by a huge number of cancellations and changes to standing orders. The result being that for several hours millions of dollars of trades went unconfirmed. Without trade confirmations, trade desks could only guess at their positions and some found their net positions meaningfully out of balance when confirmations finally came in.
As a consequence to the botched IPO, UBS has said it lost $356 million. Citi has only said that its losses are in the millions. In addition, Citadel Securities and Knight Capital Group have said they have incurred losses of $35 million or more because of what happened. “We strongly urge the commission to reconsider the level of the proposed cap in light of the actual damages caused by Nasdaq in its mismanagement of the Facebook IPO,” UBS officials wrote. Citi’s comments were much sharper: “Nasdaq was grossly negligent in its handling of the Facebook IPO, and as such, Citi should be entitled to recover all of its losses attributable to Nasdaq’s gross negligence, not just a very small fraction as is currently the case.”
Will anything change in the future? That is always hard to know, but I suspect that Nasdaq will take its technical failures very seriously. I believe they will make very significant investments to bolster and upgrade the software and hardware systems that allow them to facilitate the trading of hundreds of millions of shares every day. And, I expect that other exchanges will critically analyze Nasdaq’s failure and their resulting changes to ensure that Nasdaq’s failures are never replicated elsewhere. In summary, I expect these technical faults to generate meaningful improvements in public capital markets.
Despite the obvious technical difficulties with the offering, we must also keep in mind that Facebook’s IPO was a success on a number of metrics. The company and its advisors successfully raised $16 billion. This represents the largest technology IPO in history and the third largest IPO ever completed. The management team was able to raise more than $10 billion in funds to support the continued growth and development of Facebook and deliver billions of dollars to Facebook’s early Venture Capital investors – thereby securing, in part, the availability of future financing for the next generation of technology companies.
However, in other ways, their IPO was deeply disappointing. Determining the price of an IPO is not a precise science. Typically, at the conclusion of a company’s roadshow presentations, potential investors are invited to indicate the number of shares they wish to buy. Expecting their orders to be cut back, investors have learned to ask for more shares than they expect to receive for high demand offerings, sometimes twice as many. Anticipating outsized demand for Facebook shares, it is believed that investors submitted orders for triple or quadruple the size of the allotments they expected to get.
Here, I’ll suggest that it was greed on the part of institutional and private investors that blinded their ability to fairly value Facebook’s shares. Having seen the early investors earn fortunes by investing in Facebook, their desire not to miss out on future gains became palpable. Forgetting that IPO was priced at nearly 100 times earnings they stampeded in with oversized orders hoping not to be left behind.
Balancing out the greed of investors was the management team at Facebook, and perhaps most importantly, Mr. Ebersman. He is Facebook’s CFO who played a key role the offering. It would appear, at least from our vantage point that the bankers who were advising him and Mr. Ebersman himself did not appear to have a firm grasp of what was happening. Perhaps they believed their own hype and thought all those orders as real, giving them the unfounded confidence to lift the IPO to the highest possible price and issue an even greater number shares.
The example offered by LinkedIn’s IPO would complicate matters further for Mr. Ebersman and the bank underwriters. Its shares rose 110 percent on its first day of trading. That might sound like a positive outcome; however it meant that early investors sold mispriced shares so badly undervalued that they effectively gave new investors a gift of nearly $350 million. According to a number of people close to him, Mr. Ebersman was committed to making sure Facebook didn’t “leave money on the table.” Consequently, he may have created even more pressure on the stock by leaving investors with little upside.
The fallout from the offering suggests that Mr. Ebersman had seriously misjudged the real investor appetite for Facebook’s IPO. However, Mr. Ebersman did not act alone; his actions were supported by imprudent advice from a core group of Wall Street’s top investment banking advisers, each of whom had a strong incentive to offer the maximum number of shares at the highest possible price. Goldman Sachs suggested that they aught to be sold for a slightly lower price, JPMorgan Chase believed that the shares could be offered for a higher price, while Morgan Stanley expressed comfort with $38 a share. Reportedly, when Mr. Ebersman decided on $38 dollars per share all of the underwriters moved quickly to support the valuation.
Some things will stay the same. Investment Banks, and indeed nearly all organizations that stand between their issuing clients and institutional and public investors, will be troubled by their inherent conflicts of interest. Companies and their existing investors want to sell at the highest prices they can. New investors want to invest at the lowest values they can. This, I suspect, will never change. And the organizations that bring these two groups of investors together will always try to balance these respective interests. And, they will from time to time continue to get this balance wrong; sometimes egregiously so.
The lesson for all of us is that Investor enthusiasm has the potential move asset valuations to unsustainable levels in any market. Our role as professionals is to steer our clients away from these investments where we can or at least moderate their exposure were we cannot.