The IPO Process: Separating Fact from Fiction

by David Topper, Special Advisor to GA

As a former capital markets banker I frequently get calls from reporters asking questions about various capital markets related issues.  By far the topic that gets asked about the most is IPOs.  Most major media outlets have one or more people dedicated full-time to the IPO market, and the demand for information and opinions seems insatiable.  To read and listen to the stories out there, one would think that the system is completely broken, that all participants are bad people and that companies and investors alike are mistreated.  It's amazing to me, given how diligent the media is about researching topics, how misunderstood the IPO process is.

One only has to look at the mountain of print covering many aspects of the Facebook IPO - the role of retail investors, who has access to research analyst thinking, how pricing judgments were made, how the greenshoe works - to see how little of it is really understood and why many management teams dread the process. By developing an understanding of the various rules and regulations that govern the IPO process and the concerns that market participants have for different types of investors, one can begin to get a much clearer idea why the market functions the way it does and how to prepare accordingly.  While covering the entire process would take many times as much space as I've been allotted, I've chosen a few areas to review as examples.

1. Fiction:  Retail investors are under-allocated in IPOs. 

It seems like everyone I meet thinks they are stock market experts.  Most also believe that IPO stocks are a panacea.  The reality is that most people know very little about equity valuation.  It's also a fact that IPOs as an asset class are very risky.  Pricing an IPO is more art than science: so some go up nicely (the "IPO pop"), but others never see issue price and lose lots of money for investors.  Most underwriters are understandably concerned about letting individual investors make that kind of risk decision particularly in a culture as litigious as the U.S. In fact one of the primary reasons that most major banks do not embrace the pure auction form of IPO is they do not want "widows and orphans" to be the marginal bidders for such a risky asset class. They would prefer to let most of that risk be assumed by professional money managers like mutual funds and hedge funds.  Besides let's not forget that mutual funds (the largest group of IPO buyers) are managed for and owned by retail investors anyway, so the relatively small direct allocation to individuals probably makes sense.

2. Fiction:  The benefits of research are only available to large institutions. 

The rules around research in the U.S. are very different than other markets. In Europe for example the research analyst actually writes a report, builds a model and goes on a full blown marketing trip prior to the launch of the deal to pitch the company to investors (known as "pilot fishing").  In the U.S. where most banks are signatories to the "Spitzer settlement," research analyst involvement in the IPO process has been severely limited; since that settlement, analysts have not been allowed to publish a report until 40 days after the deal is priced.  In fact, Spitzer limits their role to investor education and specifically forbids any substantive role in selling the deal.  While some of this may change a bit as a result of the JOBS Act, the analyst role will still be restricted.  Their financial model is provided to salespeople/ brokers but not given directly to investors.  The salespeople discuss the financial outlook with investors and communicate changes in the model that may occur during the marketing process as happened in Facebook.  If the rules allowed broader dissemination of research analyst product during the process, I have no doubt that banks would take full advantage of it.

3. Fiction:  Underwriters are not thoughtful in pricing deal.

 It's very difficult to decide - do you want a nice "IPO pop" on the first day of trading, do you want the stock to stay flat so you feel you got the highest price possible or do you want something in between? Most people would say the latter and hope for a 10-15% pop on the first day.  That way investors make a nice return and are comfortable retaining the stock, and management doesn't feel they left an undue amount on the table. The trouble is that pricing an IPO is a very inexact science and engineering it to appreciate exactly 10-15% is very difficult. Everyone tries their best to predict market reaction to various price levels but the investor input can be very inconsistent and mistakes do get made. One element that makes it particularly difficult is the frequent high level of over subscription in IPO's. It's not uncommon for the final book of demand in an IPO to represent 3 to 4 or more times the deal size. With that much unmet demand there inevitably will be large scale buying at the open resulting in at least a temporary pop. The important thing is not to focus much on the first few days or even weeks. The real important measure is the stock's performance over the first months and quarters. The excessive focus on the first day is unwarranted.

4. Fact:  The IPO market opens and closes regularly. 

On this point they are right.  Remember nobody is a fulltime IPO investor.  So when there are high levels of uncertainty in the markets, investors dial back on risk and among other things stop buying IPO's to focus on their existing portfolio.  After the financial crisis, this seems to happen with more regularity.  All you can do is get fully prepared with the SEC filings, marketing materials etc. so that you can launch on very short notice when market receptivity returns.

There are certainly many other areas that are not well understood including the greenshoe/ stabilization, the relative attraction of long-only investors vs. hedgefunds and others.  The central point though is that the IPO process is not as mysterious, nor are the participants as nefarious as some would have us believe.  Working with the right owners, underwriters and lawyers, the IPO process can be very rewarding and productive, creating financial flexibility and shareholder value over the long term.

If you have any questions about the IPO process, please contact your GA team.

Contributed by David Topper, a Special Advisor at General Atlantic. Read his bio here.