Thursday, May 24, 2012

Heads I Win, Tails You Lose ... Caveat Emptor.

In the recent Facebook IPO debacle, the role that Morgan Stanley and other underwriters have played is a curious one. (See Morgan Stanley made money on Facebook share drop).

As a routine procedure, it seems that the underwriters typically get to buy an additional number of shares from the company offering stock to the public.

"Investment bankers typically sell 15% more shares in an IPO than they actually have. ... Included in every IPO deal is an agreement that gives underwriters the ability to buy more stock from the company at a slight discount to the IPO price. So if the price rises after the offering, the underwriters can buy the shares from the company that they have promised to other investors, but don't actually have, and book a small profit. ... In effect, the underwriters were short the stock. ..."

So far, so good. Underwriters, in effect, have a call option on the stock.

However, in the case of the Facebook IPO, the stock tanked on the 2nd and 3rd days, ending below the IPO price. So, what did Morgan Stanley do? It bought shares from the open market, and not from Facebook, and sold them at the IPO price to investors — many of them retail — at the IPO price and, of course, pocketed the difference.

Thus, whether or not Facebook stock rose or fell after the opening on IPO day, Morgan Stanley and other underwriters were already set to make money. Beautiful! The underwriters could not lose either way.

This episode reminds me of "Heads I win, Tails you lose." The underwriters, it seems, get to play this game.

Is this fair capitalism? Caveat Emptor.

1 comment: