Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Country reportsSeptember 3 2012

Facebook IPO shows high price of failure

Bookrunners have taken the blame for hyping the Facebook public offering and undermining sentiment towards other public listings, but the reality is more complicated.
Share the article
twitter-iconcopy-link-iconprint-icon
share-icon
Facebook IPO shows high price of failure

When Facebook reported its first set of quarterly earnings as a listed entity in late July, it slightly exceeded its own revenue forecasts. However, the news did not stop the company’s share price falling by as much as 8% in after-market trading, bringing its decline since the company’s May initial public offering (IPO) to nearly one-third.

The problem for Facebook was that while it made $295m in the second quarter of 2012, it had failed to provide investors with a performance to justify the extraordinary 100 times earnings valuation assigned to it just 10 weeks previously, or the 70 times earnings still implied by its share price. For investors, the cold, hard realisation was dawning that they had bought the hype and overpaid for their investments.

The biggest tech IPO in US history was mired in controversy almost immediately from the moment Facebook chief executive Mark Zuckerberg rang the bell to launch the stock on New York’s Nasdaq exchange on the morning of May 18. An immediate technical glitch caused chaos in early trading and, while the stock closed its first day little changed, it was not long before the price began to fall.

Investors watched as Facebook’s $38 launch price trended steadily lower in May and June, hitting $20.80 in early August, and before long the blame game started. Nasdaq had messed up, it was claimed, while Facebook and the banks managing the issue had been over-optimistic in their pricing.

The Facebook flotation furore is likely to distract the company and its advisers for months ahead, but the impact on the wider IPO market may be even longer. The so-called second great tech-bubble has burst in spectacular fashion, and the ability of equity capital markets to deliver value for stakeholders across the board has been seriously questioned.

Looking elsewhere

The immediate result of Facebook was that the IPO door slammed shut. There were some $28.4bn of US IPOs from the beginning of January to May 17, according to data provider Dealogic, and there have been about $3.2bn since. In Europe, there was $3.7bn of IPOs this year before May 17, and $326m after. Some 50 companies globally, including names such as Manchester United Football Club and Formula 1, shelved or amended IPO plans in the second quarter.

“Facebook was a classic case of the hype taking over from the fundamentals, and that is borne out by the way the stock has traded,” says Adam Gishen, a partner at corporate finance advisory firm Ondra Partners. “We saw a perfect storm in terms of weak trading on the back of a badly handled IPO, followed by very average earnings and a technology glitch, and it’s going to take a very long time for confidence to be restored.”

One of the issues for the IPO market was that Facebook was not an isolated case. Several of the hottest technology companies have looked to the equity capital markets to raise funding in the recent period, and while the owners may have generated large amounts of money for themselves, public investors were left nursing nasty headaches. 

Zynga, the social gaming company tied to Facebook, went public at $10 in December, reported weaker-than-expected earnings in July, and was recently trading under $3. Groupon, which at its IPO in November priced its shares at $20, was trading as low as $6.40 in late July.

We saw a perfect storm in terms of weak trading on the back of a badly handled IPO, followed by very average earnings and a technology glitch, and it’s going to take a very long time for confidence to be restored

Adam Gishen

For many tech companies, the experiences of Facebook, Zynga and Groupon have been salutary, with the result that many are looking away from the capital markets for next-stage financing, and towards alternative routes such as direct sales to competitors.

Buddy Media, a company that helps companies promote themselves through Facebook, was sold in June to enterprise software company Salesforce for $800m, while in May social marketing platform Vitrue was bought by software giant Oracle for $300m. While those deals showed that confidence in the social media model remains intact, it also suggests owners feel more secure selling, rather than building with a view to an IPO down the line.

“Facebook operates in an eco-system of similar companies, many of which rely on it to some extent for their business, and its IPO was supposed to be the launchpad for the next wave of share offerings,” says Victor Basta, managing director at merger and acquisition (M&A) advisory firm Magister Advisors. “Basically, Facebook was going to get a huge a valuation and drag up a whole bunch of other companies – now that is not going to happen.”

Blame game

For many, the blame for the poor share performance at Facebook, as well as Zynga and Groupon, lies not so much with the companies, or an inherent problem with business models, but rather the IPO itself, in which the firms were 'priced for perfection', generating plenty of juice for insiders but leaving little upside for the last investors on board.

With that in mind, there has been much focus on the role of the bookrunners, in the Facebook case comprising Morgan Stanley, Goldman Sachs, Barclays, Bank of America-Merrill Lynch, JPMorgan and a host of other Wall Street firms. The actions of Morgan Stanley, which was lead arranger on the deal, have in particular been put under the spotlight.

“The two things you need to get right with an IPO is that you need to price it appropriately and you need to allocate it correctly – you need to establish a long-term and solid shareholder base,” says Mr Gishen. “There were serious questions in the Facebook IPO over whether either of those were achieved.”

Problems for Morgan Stanley and the deal arrangers started soon after Facebook announced it was going to float the company in a regulatory filing on February 1. A few weeks later the company announced plans to buy Instagram, a photo-sharing social network, for $1bn. At first-quarter earnings on April 23, Facebook said net income fell 12% to $205m.

On May 3, the company set a price range for the IPO of $28 to $35. According to press reports, the pricing range was the result of daily, and sometimes hourly, discussions between Facebook chief financial officer David Ebersman and Michael Grimes, co-head of global technology banking at Morgan Stanley.

Four days later, Facebook began a roadshow for the deal in New York, and just one week later the company raised its price range for the share sale to between $34 and $38. If the high end of the estimate was delivered it would raise about $12.8bn and value the company at $104bn.

“The banks may have had a mind to the LinkedIn IPO a year earlier, which priced at the top of the revised range and then almost doubled in price on its first day of trading,” says Mr Gishen. “On that occasion, the banks were accused of mispricing downwards and they were keen for that not to happen again.”

On May 15, The Wall Street Journal reported that General Motors planned to stop advertising with Facebook, after deciding that paid ads on the site were having little impact. The move raised questions about whether Facebook's business prospects could support its valuation, but nonetheless the buzz around the flotation was extraordinary, and the following day Mr Ebersman added an additional 84 million shares to the offering, bringing its total value to $16bn based on a $38 price.

“When it came to the actual call on which the shares were priced, as we understand it the most senior bankers from Morgan Stanley and the other leads were on the call,” says a source with knowledge of the situation. “So James Gorman, Morgan Stanley’s chief executive, was on the call, which is unheard of for an M&A transaction.”

On May 17, Facebook priced its IPO at $38 per share, raising $16bn. Four days later the shares closed below the sale price, and on May 29 the price dropped below $30 for the first time.

Two-track communication

As investors sought an explanation for their losses, details began to emerge, specifically of earnings guidance that Facebook had released to analysts on May 9, suggesting the company was finding it more difficult to sell advertising on its mobile platform than on desktop pages. In other words, revenues were growing more slowly than user numbers.

According to press reports, that information led to earnings downgrades from analysts at several of the deal’s underwriters, which as per normal procedure would have been communicated to the bank’s institutional clients, but not the wider public. Certainly no hint of the concerns was given by the pricing and allocation decisions made some days later, despite the analyst downgrades being widely reported in the press. Meanwhile, early-stage investor Goldman Sachs increased the number of shares it planned to sell at the IPO by 25%.

“The banks and Facebook filed the right forms at the [Securities and Exchange Commission], so legally they did nothing wrong, but this was an IPO with a huge retail investor uptake, and not many retail investors read SEC filings five days before an IPO,” says Chicago-based securities lawyer Andrew Stoltmann. “Ultimately the banks are the bad actor in this entire soap opera. Morgan Stanley knew what it was doing – it maxed out the price and share allocation, and if you wonder why retail investors’ trust in banks and in the market has been eviscerated, it is because of conduct like that.”

Ultimately the banks are the bad actor in this entire soap opera. Morgan Stanley knew what it was doing – it maxed out the price and share allocation, and if you wonder why retail investors’ trust in banks and in the market has been eviscerated, it is because of conduct like that

Andrew Stoltmann

In a statement, Morgan Stanley said: “Morgan Stanley followed the same procedures for the Facebook offering that it follows for all IPOs. These procedures are in compliance with all applicable regulations. After Facebook released a revised S-1 filing on May 9 providing additional guidance with respect to business trends, the amendment was widely publicised in the press at the time. In response to the information about business trends, a significant number of research analysts in the syndicate who were participating in investor education reduced their earnings views to reflect their estimate of the impact of the new information. These revised views were taken into account in the pricing of the IPO.”

Kicked by the greenshoe

While banks may have taken some criticism in the Facebook debacle, it is likely they suffered from more than just a few bad reviews. While the banks received $176m in fees for their work on the deal (1.1%) they were also, according to S-1 filings at the SEC, left owning some $13.86bn of shares and may have bought more as they sought to support the share price following the IPO.

The reason the banks would have been buying shares is because of their duties as 'stabilisation agents' on the deal. This relates to their 15% greenshoe, or over-allotment option. This is a call option common in IPOs, under which the banks leading the deal are offered an option to buy 15% more shares. When the IPO is priced the banks sell 15% more shares than they are allotted – in other words they are short by 15%.

If following the IPO the price of the shares rises, the banks simply exercise the option at the IPO price, and make an underwriting fee. If the share price falls they tend to buy the stock in the market to defend the IPO price, or 'stabilise' it. The greenshoe allows them to do this without becoming hugely long the stock on their own account, and will have likely accounted for the slight delay before the Facebook price took a tumble.

Incidentally, a sensible thing for Morgan Stanley to do might have been to wait for the price to drop then cover its short position, but this for obvious reasons carries considerable reputational risk. “A greenshoe allows the banks to defend the share price without using their own capital, but in the Facebook case the downward pressure was so heavy that the firepower got drained very quickly,” says Mr Gishen. “What this shows is that the banks squeezed every last cent out of the pricing.”

Negative sentiment

Given the sharp decline in IPOs following the Facebook deal, there has been a temptation to ascribe a direct causal connection to how the deal was handled. However, according to some bankers, the explanation is not quite so simple.

“It is a little bit simplistic to blame only the arrangers, and remember a large number of investors generated an enormous amount of demand for the Facebook IPO at the price that was given. I am not sure any bank is capable of doing that amount of arm-twisting,” says Thierry Olive, global head of equity capital markets at BNP Paribas. “Also, while IPOs have dropped off since May, the most common reason I hear from clients is the macro environment created by the eurozone sovereign crisis.”

Further, while the lead managers took a huge amount of criticism following the Facebook episode, they were not the only culpable players. The Nasdaq exchange was also in the firing line after technical glitches on the first morning of trading prevented investors from placing buy and sell orders, leading to confusion over prices.

In fact, some 58% of respondents to a survey by capital markets research firm Tabb Group of investment funds following the Facebook IPO said exchange technology was the primary cause of the debacle, while 35% said it was investor expectations. Only 31% said the IPO target price increase was the primary cause, while 27% said it was the allotment of shares.

“In the end, a number of things went wrong with this IPO, from the technical glitches to investor expectations, allotment and price,” says Miranda Mizen, a Tabb Group principal and director of equities research. “Still, about half the people we surveyed thought the impact of recent IPOs on the equity capital market would be less than six months, which suggests in the end people will assess each deal on its own merits.”

Was this article helpful?

Thank you for your feedback!