The Real Problem With Facebook's Disaster IPO

By: Investor Solutions

Amid all the salacious details, finger-pointing, investigations, legal actions, and recriminations following the Facebook IPO, an obvious question has never been raised: Why would you want to participate anyway?

Unless you are living under a rock in the wilderness you know that NASDAQ’s system choked, there were issues around disclosure of negative information, etc. In the old days in the Air Force we would have called this a SNAFU or even FUBAR. (Don’t ask!) But, that’s not the important issue.

Personally, I’m over Facebook. After my initial enthusiasm for something new, I find myself going there once a month when I’m really bored. General Motors and I agree that the impact of advertising there is underwhelming. Many analysts wonder if Facebook will be left behind in Internet 3, mobile computing? But, still the amount of hype surrounding the offering was enormous and generated a strong sense of déjà vu. I’m dating myself, but it feels like AOL all over again. But, that doesn’t matter either. I could be dead wrong.

Every successful start-up is eventually acquired or goes public. In the global scheme of things, access to capital in a public market is a very good thing. It’s the foundation of our global economy. Our world would not be recognizable without fully functioning liquid capital markets. And every firm represented in those capital markets started as an IPO.

The IPO process is messy and decidedly unfriendly to retail investors. By design everybody along the chain makes money except that any profits for the retail investor are an unintended unanticipated happy byproduct.

An IPO provides a liquidity event for the owners and participating employees, and an exit strategy for venture capitalists while enabling access to additional capital to grow the business. So far so good. Like everyone else, I envy the few IPO billionaires and appreciate the vision that got them there. They richly deserve their payoff day. And a very few of these companies will be important players in tomorrow’s economy.

The attorneys, accountants, and consultants all generate massive fees. But, those fees pale in comparison to the underwriters. To be completely fair underwriters assume considerable risk in return for a fat piece of the action. And an IPO is a very complex undertaking. So, while the fees are fat, expertise is critical and the competition is intense to lead the effort.

Brokers are incented to sell the IPO even though the initial offering technically carries no commissions. They are paid through offering allowances, and as part of the distribution channel they are generally expected to enthusiastically support the offering. In the real world in which brokers live, very few of them can afford to be negative. Their job is to sell the offering.

Like many other activities on Wall Street, the underwriting brokerage firm and the end investor may have enormous conflicts of interest.

To maximize their position, the brokerage firm must secure enough public support to “fully price” the offering and further create sufficient demand that they themselves, along with their institutional and preferred clients have an opportunity to realize instant profits through initial surge in prices at the opening. There is a natural tension between the desire to fully price the offering and leave sufficient upside for secondary profits.
If there is no price surge, the institutional and other preferred clients will be very disappointed. Many of them plan to “flip” the offering for a fat almost instant profit. Even a modest few percent profit on a stock held for a few minutes or hours is a juicy reward for being a preferred client.

On the other hand, no price surge, and important partners and clients are disappointed big time. Reputations, prestige, important client relations and future IPO business opportunities are all jeopardized. Almost as bad, a dud IPO may find the underwriters supporting the price from their own capital.

Notice so far that we haven’t mentioned the great unwashed retail client. She’s expected to create the price surge after the institutions and other preferred clients get the initial offering. The paradox, as in any auction, is that the “winner” pays top price and almost by definition has overpaid. This role is reserved for the retail investor. She’s the gal at the end of the food chain that buys into all the hype created around the IPO. No one above her in the pecking order much cares what happens to her.

Let’s be perfectly clear, the “average” Forbes reader with a $1 million account at XYZ brokerage is not a preferred client and is unlikely to be offered first crack at any decent IPO. She is the secondary market, the one that everyone is counting on to buy into the hype and make them fat. In fact, if she is offered first crack at an IPO, then the brokerage is desperate to unload their commitment because their preferred and institutional clients have all passed on an offering without attractive prospects.

In short, that IPO must really suck. The brokerage does not want to be left holding the bag on a dud offering. The good stuff always goes to the big kids.

Exhaustive academic research indicates that median performance on IPOs lag the market by significant amounts for several years. And because most IPOs are small companies, they can be expected to lag the appropriate small company indexes which have higher average returns than the broader market by even more. Generally speaking this is not an attractive proposition.

But, we also know that as a “long shot” the IPO may somewhat more often than the broad market produce outsized returns. And those rare outsized returns get widely publicized to keep the suckers coming back. But, unless you have some reason to believe that you have insight denied to a few billion of your closest friends also looking at the offering, the odds of winning big are distinctly discouraging.

On a very fundamental level purchasing an IPO is like any other single stock purchase: an undiversified bet against the efficient market which is seldom a good idea. But, it’s even worse because any rational person looking at the data should know that the expected return is less than the market while the risk is exponentially higher. And because the expected return is less than the market, you can’t diversify your way to a market return through purchasing many IPOs. It’s a crap shoot with the odds distinctly against you. The more you purchase, the higher your certainty of underperforming the market.

So, while we can all agree that IPOs are a distinctly good thing for the world’s economy, an informed retail investor might very well be wise to discount all the hype and cocktail party conversation to invest in the broad global market. There is time enough to invest in those companies after the hype has dissipated and the companies are better seasoned. It’s boring but prudent and offers a much higher probability of a good outcome.

By | 2018-11-29T16:06:26+00:00 June 18th, 2012|Blog|

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