Red faces in the aftermath of Facebook fallacies

Financial Review

PUBLISHED: 26 May 2012 

Anna Bernasek 

Facebook’s 19 per cent share price decline in its first two days of trading as a public company came as a shocker. Disappointed investors issued recriminations, while rivals and analysts offered criticism aplenty. One regulator after another wants to examine the IPO, while the professionally aggrieved have predictably filed lawsuits against the company and its underwriters.

But since when is an IPO a guarantee of a stock price gain? Wasn’t the whole point of a public share listing to allow the market to set its price?

For Facebook, the market has spoken. At least for now the value of Facebook seems to be closer to $32 a share than the initial offer price of $38.

There’s an art to pricing an IPO, particularly for a speculative technology play lacking a steady track record of fundamentals. In Facebook’s case, it looks like the lead underwriter, Morgan Stanley, missed the mark.

Set too low a price and the company feels cheated. Reach too high and investors feel duped. The sweet spot would have been about 10 per cent below the first day’s close, affording a tidy but not outlandish initial gain.

There was little sign of weakness leading up to the IPO. The hype was exceptional, including blanket media coverage. n the US, only a person deeply uninterested in business could have been unaware of the historic nature of the offering.

The first inkling of concern came when final share allotments were announced. The way the game is played, underwriters try to drum up investor demand well in excess of supply. In return investors submit requests for more shares than they actually want, expecting to be cut back to something close to the right amount.

So when investors learnt that their allotments weren’t cut back, they instantly knew two things: they were holding more shares than they wanted and buyers would be few and far between.The result was a classic rush for the exit, driving down prices.

Morgan Stanley has to shoulder the lion’s share of responsibility. It took a very big fee for its service, reportedly in the $100 million range. With the IPO coming off so poorly, that fee looks more than a tad rich in hindsight.

Of course it didn’t help that the Nasdaq exchange had problems – still essentially unexplained – that resulted in potentially devastating delays in confirming early trades.

Funny that the Nasdaq system couldn’t handle what seems to be a routine, albeit large listing. It may have been a simple glitch but with such a prominent internet company, one has to wonder whether there was something akin to hacking going on.

Less obvious but potentially more important is the role Facebook itself played in the pricing. It had enjoyed remarkable growth and had confidence to match.

Facebook worked on its IPO for the last year, reportedly preparing the principal offer document even before selecting its bankers.

When the company conducted a beauty contest to select underwriters, it’s pretty clear who was in the driver’s seat. Although a fee in the $100 million range sounds like a nice payday for Morgan Stanley, that was actually a big cutback from the fee that a more ordinary company would have paid.

A typical IPO commission in the US is close to 7 per cent, which on a $16 billion deal would have meant over $1 billion to divide among Morgan Stanley and its peers. The message to the bankers was clear: they were lucky to be selected.

With Facebook in such a strong position, the company had a lot of influence over pricing. Even if Morgan Stanley had some concerns about the $38 price, it would have been extraordinarily hard to say, “Cut the price or the deal’s off,” and risk losing a $100 million fee.

Whether you blame Facebook for increasing the size of the stock offering at the last moment or Morgan Stanley for misreading demand or not standing up to its client, they both put their names behind a $38 price tag. That was the very top of the proposed range, showing just how confident they were right up to the last moment.

Unfortunately there’s no do-over for an IPO. No matter what’s going on in the business, a disappointing IPO story takes on a momentum of its own.

For the time being losing investor money is part of Facebook’s image. Regaining credibility may be even more difficult because the company has been relying on its potential, not its history. Facebook simply doesn’t have a track record to justify its valuation. Changing the market’s momentum will take time and sustained, incremental success. So the company faces more pressure than ever to hit its ambitious quarterly marks.

The most intriguing thing about Facebook’s debut is not what it says about Facebook but what it says about the sharemarket more broadly. Facebook traded down not on bad news but on lack of demand. The seemingly unlimited potential of internet technology to create wealth has its sceptics.