Home > news, rant > I.P.O. pops

I.P.O. pops

August 16, 2011

I’ve decided to write about something I don’t really understand, but I’m interested in (especially because I work at a startup!): namely, how IPO’s work and why there seem to be consistent pops. Pops are jumps in share price from the offering to the opening, and then sometimes the continued pop (or would that be fizz?) for the rest of the trading day. Here’s an article about the pop associated to LinkedIn a few weeks ago. The idea behind the article is that IPO pops are really bad for the companies in question.

The way a standard IPO works is that, when a company decides to go public, they hire an investment company to help them assess their value, i.e. form a sense of how many shares can be sold, and at what price.

A certain number of people (insiders and investors at the investment bank in particular) are then given the chance to buy some shares of the new company at the offering price. This is an obvious way in which the investment bank has an incentive to create a pop- their friends will directly benefit from pops. In fact the existence of pops and their accompanying incentives have inspired some people (like Google) to use Dutch auction methods instead of the standard.

And the myth is that there are consistent pops (here are some examples of truly outrageous pops during the dotcom bubble!). Is this really true? Or is it a case of survivorship bias? Or is there on average a pop the first day which fizzles out over the next week? I actually haven’t crunched the data, but if you know please do comment.

One question I want to know is, assuming that the pop myth is true, why does it keep happening? If it’s good for the investment bank but bad for the business, you’d think that businesses would, over time, train investment banks to stop doing this quite so much- they’d get bad reputations for big pops, or even possibly would get some of their fees removed, by contract, if the pop was too big (which would mean the investment bank hadn’t done its job well). But I haven’t heard of that kind of thing.

So who else is benefitting from pops? Is it possible that the investors themselves have an incentive to see a pop? While it’s true that the investors sell a bunch of their shares into the IPO to provide sufficient “float,” which they’d obviously like to see sold at a high price, they also have the opportunity to buy a restricted number of “directed shares“, which are shares they can buy at the offering price and then immediately sell; these they’d clearly like to buy at a low price and then see a pop. So I guess it depends on the situation for a given insider whether they are selling or buying more – I don’t know what the actual mix typically is, but I imagine it really depends on the situation; for example, there are always shared created out of thin air on an IPO day, so it will depend on how much of the float is coming from the investors and how much is coming from thin air.

The most standard thing though is for someone like an employee is to have common shares (or options to buy common shares) which they can only sell 6 months (or potentially more if the options are vested) after the IPO, which I guess means they are probably somewhat neutral to the pop, depending on its long term effect.

Speaking of long term effects, I think the biggest and most persuasive argument investment banks make to investors about stock evaluation, is that it’s better to underestimate the share price than to overestimate it. The argument is that a pop may hurt the business but it’s great for investors and thus the reputation value is overall good (this argument can obviously go too far if the pop is 50% and sustained), but that an overevaluation could result in not being able to sell the shares and having a sunken ship that never gets enough wind to sail. In other words, the risks are asymmetrical. I’m not sure this is actually true but it’s probably a good scare tactic for the investment banks to use to line their friends’ pockets.

Categories: news, rant
  1. August 17, 2011 at 8:48 am

    I’m not an expert on this by any means, but found this post at Interfluidity plausible-sounding, at least.

  2. FogOfWar
    August 19, 2011 at 5:10 pm

    There’s a *lot* of literature on this topic. Here’s what I remember:

    Pops do exist and are persistent over time. Not all stocks pop, and a stock that does not pop then underperforms the market in the following period (maybe 6m-1yr horizon). Stocks that do pop tend to outperform the market for 3mo then underperform the market thereafter. Mixing the winners and losers there’s still a persistent pop over time.

    Dutch auctions in theory remove the pop. Google popped anyway, but they also used a ‘modified’ dutch auction (somewhere between a dutch auction and a regular IPO), and they are Google (extremely highly anticipated IPO), so it isn’t a great data point. As an aside, GOOG asked it’s I-Bankers to “think outside the box” on the IPO. GS came back with some minor tweaks, but basically the same thing, and ML (if I remember correctly) came back saying “why don’t you think about a dutch auction? It’s really interesting in theory but no one does it in practice, it could work out great for you guys, and by the way, our fees are lower in a dutch auction.” GS got kicked out of the lead underwriter spot.

    There are companies out there that do pure dutch auction IPOs. It’s a lot cheaper and gets a better price per share. Tends to be for smaller companies you’ve never heard of.

    The pitch given by I-Banks is that the buzz and the float from having a pop is worth taking a lower price per share. I’m not a specialist, so this might have some truth or might be pure bullshit to get companies to shell out 7% IPO fees to the I-Banks instead of going with the dutch auction places.

    Some guy from Citi (the CEO?) during the dot com bubble was giving pre-pop IPO shares to people on the board of one of the high end private elementary schools in Manhattan to bribe them to get his kid in. New York Fuckin’ City…

  3. August 20, 2011 at 5:13 pm

    Cathy,

    IPOs are well-studied by financial economists, who actually have some sensible things to say about them. Check out Jay Ritter’s web site. You will like the web site and you will like Jay; he shares a lot, not just his papers, but also data. Here is Jay’s most recent and thoughtful and complete piece on IPO pricing.

    http://bear.warrington.ufl.edu/ritter/AnnualReviewofFinancialEcon_July22011.pdf

    Not all IPOs pop. If the offer price was adjusted down during the registration period, the average pop is zero. But if they don’t, the average pop is big. Investment bankers love popping IPOs because it allows them to give presents to their friends and those they are trying to cultivate. For example, check out what Meg Whitman made on pre-IPO allocations of stock given to her by investment bankers while she was running eBay. It is outrageous. Was she in a position to choose bankers for her firm? Yes. At most firms the most lowly purchasing agent cannot accept a bottle of wine at Christmas from a vendor, but here are the bankers giving hundreds of millions of dollars to high-level executives in hope they remember something nice about them next time their firm needs to raise money. It is an unsubtle form of corruption. And the profits are taxed at capital gains rates if the stock is held for the requisite period. Oh dear.

    Love, Aunt Susie

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