The Facebook (FB) story is now turning towards the lead underwriter, Morgan Stanley (MS). A lead underwriter makes virtually all of the major decisions in the IPO process.
Today, James Gorman, MS’s CEO, said his company broke no rules during the transaction. The trading of FB, Gorman commented, was in “disarray.” He is effectively trying to assign the trading problems to NASDAQ, the stock exchange that took FB public. Gorman and his colleagues were “disappointed” by the movement of FB stock since the opening day. Tomorrow, he will appear on CNBC, and will undoubtedly answer questions about the FB IPO, deny any “nefarious” activities, and reiterate that MS aggressively supported FB stock in a totally legal manner.
Perhaps a few words about an underwriter’s responsibilities in an IPO would be helpful given the shift in the Facebook controversy. Companies ask investment banks to “underwrite” their stock offerings. In theory, a syndicate of banks commits to buy shares, and the entire offering is completed before the first share trades on an exchange.
Prior to making commitments, the underwriters solicit institutional clients to obtain their commitments to buy the shares from the underwriters. In essence, underwriters are in virtually no risk of being stuck with unsold shares.
Underwriters do assume various other kinds of risks in the process. One of the most important issues is due diligence. Before underwriters move forward with a stock offering, especially an IPO, they must verify the issuer’s financial statements, the viability of the issuer’s business model and operations, the risks inherent in the issuer’s business that could impact its stock price, management acumen, pending litigation and much more. All of this information appears in the issuer’s S-1, a Securities and Exchange (SEC) document that is made available to all potential purchasers of the stock in an IPO.
There are serious consequences relating to this aspect of the process. The SEC could be critical of the underwriters if they do not do a complete job explaining the issuer’s business, financials, risks, etc. In the case of FB, the company and the lead underwriter are being criticized relating to inadequate disclosures about the impact of mobile on future revenues and the reliability of FB’s advertising business model. If serious problems ultimately surface in these areas, the issuer and the lead underwriter may be called out.
The other major activity for the underwriter is setting the size of the offering and the price of new shares. This is the most “artful” part of the process because there are many conflicting interests at work. The issuer, the lead underwriter’s client, obviously wants the highest valuation for the company, which ultimately determines the price per share. At the same time, the institutional investors, who are also clients of the underwriter, want a low valuation.
Using empirical evidence such as public valuations of comparable companies and decades of data relating to pricing, underwriters must negotiate a price with the issuer. Keep in mind, this part of the process begins long before a lead underwriter is chosen by the issuer. So, those banks in the “beauty contest” to be lead underwriter must give the issuer their best valuation (meaning the highest valuation that the data can support) in competition with other underwriters.
After a tentative price range is agreed to, the underwriter will go to the market to solicit interest from institutional investors. Ultimately, these investors will submit orders based upon their assessment of the proposed price range for the stock. In the case of FB, the early order book was several times the proposed size of the offering (according to rumors). This meant that MS may have been leaving too much on the table for investors, so it increased the size of the offering and increased the offering price. I am sure we will hear more about this as time passes, especially if FB shares continue to fall.
Because the FB share price is now significantly lower than its offering price, it can be concluded that MS did not price the shares properly. This could be a function of reading the empirical evidence incorrectly, being too aggressive in winning the FB business, caving into strong-arm tactics by the issuer and/or any other number of things. (Note: MS is now being targeted by disgruntled institutional investors, retail investors, other Wall Street firms, regulators, Congress and litigants. So, there is risk in underwriting securities.)
MS is an outstanding, premier investment bank that is a leader in high-tech underwriting. The firm is recognized as having the highest integrity and as an aggressive competitor in the business. When this is all said and done, I am sure that MS will not be accused of any improper actions. Rather, it was probably too ambitious relating to the size and pricing of the offering. It is very wise for the CEO of MS to meet with the press to dispel unfounded accusations and rumors.