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Facebook IPO's Scorched Earth
Just when you thought that the Facebook IPO fiasco couldn't get any worse, UBS ( UBS ) parachutes in and prominently moves to the top of the victims list with a Facebook ( FB ) related trading loss that could be as much as $350 million.
The three goats in this saga - Facebook ( FB ), Morgan Stanley ( MS ), and Nasdaq - will continue the finger pointing at one another. Ultimately Nasdaq will need to reach quite a bit deeper and come up with more than its opening offer to settle the matter with $13.7 million in cash and $26.3 million in supposed trading cost rebates.
And then once it finishes with Jamie Dimon and JPMorgan - and barely before the water pitchers can be refilled - Congress will drag that trio of culprits into the same hearing room for the perfunctory upbraiding. After a lecture or two about Wall Street screwing the little guy (again), everyone can go home with the mission accomplished and closure to the matter. Right?
Actually, no. That's not how this one plays out.
Why? Because the Facebook IPO fiasco has left an unthinkably wide swath of scorched earth in its path. The equity capital markets are badly shaken, confidence is broken and trust has been destroyed. In short, the damage is deep and will be long lasting.
The story of what went wrong has been exhaustively reported, but little has been said about the implications of this epic failure. Pierpont Morgan famously made loans based on character, not collateral. However, collateral will do just fine, thank you very much, for today's investors in bonds.
In the equity markets trust is everything. Investors trust that management is capable, honest and has interests that are fully aligned with those of stockholders. They trust that corporate governance is sound and that independent directors act in the interest of stockholders. They trust that financial results are reported accurately. Most importantly, participants trust that the market is not a rigged game and that investors have an opportunity to earn returns over time commensurate with the risk that they willingly accept for being at the bottom of the capital structure.
Nowhere is that trust more severely tested than at the time of a company's IPO. Investors rightly demand a price discount in the form of a lower valuation as appropriate compensation for providing capital to an unseasoned issuer. If all goes well-as it should be expected to most of the time-the result is the IPO price "pop." Historically, this number has been about 15%.
But underwriters serve two masters: the issuer and the investor. And the balance is precarious. For the issuer and the early investor and founders lucky enough to sell shares in the IPO, the goal is to get the highest price possible. For the investor, the goal is simply to provide the IPO pop of 15%--at least. However, in Facebook's case, it appears their underwriters may have "engineered" the IPO for no IPO pop - evidenced by the IPO's pricing above the initial range, the sale of more shares in the IPO by early investors, founders and employees to avoid a lockup period, and consequently the creation of greater public float post-IPO which tends to limit against the potential for the traditional pop.
And therein lays the paradox: The underwriters would probably say they were trying to protect their retail clientele against a big pop and drop. But if the pricing and sizing of IPOs is not engineered for fundamental return to IPO investors, especially for larger companies like Facebook that have already achieved substantial growth before their IPO, investors won't make money in IPOs over time and will stop investing in new issues and allocate their capital elsewhere. It's really that simple. The venture capital industry is Exhibit A in how this game works. Median returns have been abysmal for a decade and limited partners are now looking elsewhere for opportunity.
Without successful IPOs, there is inadequate (or worse, no) return for the venture capitalists and others who provide risk capital. Without this risk capital, there is no capital formation. Without the capital formation, there is no innovation and job creation. It's a very vicious spiral.
Now back to Facebook and what it means. The stakes are far larger than the reputations of one Silicon Valley company, one investment bank and one (of the two remaining) stock exchanges in the country. No, it's much, much bigger.
Consider: Up to Facebook's IPO on May 17th, 2012 had been a solid year for new issues. There had been 64 IPOs raising $10.7 billion in aggregate gross proceeds. Of the 64 new issues, 38 or 59% had increased in price, with a median aftermarket return of 9%. In the month since the Facebook offering, there have been no new IPOs and 14 companies have withdrawn from the process altogether, not including those companies that have postponed their plans to go public.
The JOBS (Jumpstart Our Business Startups) Act signed into law on April 5th was designed to make it easier for emerging growth companies to go public. Over time, this legislation should prove very helpful in reinvigorating the IPO market. The more immediate antidote is a far simpler one, and one that doesn't require a Congressional hearing, blue ribbon commission, or reform on Wall Street. It's simply for investors to be able to profit by investing in IPOs. Animal spirits will be stirred, risk capital will follow, and the results will be beneficial for all.
Unless and until a new auction market disrupts the status quo (unlikely for at least the near future), the current system for underwriting new issues will remain unchanged. Under this system, it is in the collective best interests of investment banks to save the goose that lays the golden eggs. This can be achieved by pricing each new IPO - one at a time - so that the balance is tipped in favor of the investor. It takes a long time for scorched earth to regenerate itself to a productive state. This should be Wall Street's real lesson and take away from the failed Facebook IPO.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: The opinions expressed in this article are the opinion of Timothy J. Keating only and are not intended to be a solicitation to purchase or sell any security. Neither Timothy J. Keating nor Keating Capital own shares of Facebook and have no plans to purchase shares of Facebook.
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