Direct listing

So it seems like Swedish music streaming company Spotify is going to do a “direct listing” on the markets. Here is Felix Salmon on why that’s a good move for the company. And in this newsletter, Matt Levine (a former Equity Capital Markets banker) talks about why it’s not.

In a traditional IPO, a company raises money from the “public” in exchange for fresh shares. A few existing shareholders usually cash out at the time of the IPO (offering their shares in addition to the new ones that the company is issuing), but IPOs are primarily a capital raising exercise for the company.

Now, pricing an IPO is tricky business since the company hasn’t been traded yet, and so a company has to enlist investment bankers who, using their experience and investor relations, will “price” the IPO and take care of distributing the fresh stock to new investors. Bankers also typically “underwrite” the IPO, by guaranteeing to buy at the IPO price in case investor demand is low (this almost never happens – pricing is done keeping in mind what investors are willing to pay). I’ve written several posts on this blog on IPO pricing, and here’s the latest (with links to all previous posts on the topic).

In a “direct listing”, no new shares of the company are issued, the stock gets listed on an exchange. It is up to existing shareholders (including employees) to sell stock in order to create action on the exchange. In that sense, it is not a capital raising exercise, but more of an opportunity for shareholders to cash out.

The problem with direct listing is that it can take a while for the market to price the company. When there is an IPO, and shares are allotted to investors, a large number of these allottees want to trade the stock on the day it is listed, and that creates activity in the stock, and an opportunity for the market to express its opinion on the value of the company.

In case of a direct listing, since it’s only a bunch of insiders who have stock to sell, trading volumes in the first few days might be low, and it takes time for the real value to get discovered. There is also a chance that the stock might be highly volatile until this price is discovered (all an IPO does is to compress this time rather significantly).

One reason why Spotify is doing a direct listing is because it doesn’t need new capital – only an avenue to let existing shareholders cash out. The other reason is that the company recently raised capital, and there appears to be a consensus that the valuation at which it was raised – $13 billion – is fair.

Since the company raised capital only recently, the price at which this round of capital was raised will be anchored in the minds of investors, both existing and prospective. Existing shareholders will expect to cash out their shares at a price that leads to this valuation, and new investors will use this valuation as an anchor to place their initial bids. As a result, it is unlikely that the volatility in the stock in initial days of trading will be as high as analysts expect.

In one sense, by announcing it will go public soon after raising its last round of private investment, what Spotify has done is to decouple its capital raising process from the going public process, but keeping them close enough that the price anchor effects are not lost. If things go well (stock volatility is low in initial days), the company might just be setting a trend!

Revisiting IPOs

I’ve written several times (here, here and here) that the IPO pop is unfair to existing shareholders since they end up selling the stock cheaper than necessary. Responses I’ve received to this (not all on the blog comments) have mostly been illogical and innumerate, talking about how the pop “increases the value of the entrepreneurs’ holdings”, and that the existing shareholder “should be happy that the value has gone up” rather than wondering why he sold his shares at the low value.

Thinking about this in the context of the impending Cafe Coffee Day IPO, I realised that a pop is necessary (though not maybe to the extent of the MakeMyTrip and LinkedIn pops), because investors need some incentive to invest in the IPO rather than buying the stock in the secondary market after listing.

Secondary markets have superior price discovery compared to primary markets since the former have several (close to infinite) attempts at price discovery, while the latter have only one attempt. Also, prices in the secondary market change “slowly” (compared to the price difference between primary and secondary market), so even if someone has invested at a price they later have dissonance with, they can reverse the investment without incurring a high cost.

For this reason, if you want to invest in a company and want to know that you are paying a “fair price”, investing in secondary markets is superior to investing in primary markets. In other words, you need a higher incentive in order to buy in primary markets. And this incentive is provided to you in the form of the IPO pop.

In other words, the IPO pop is an incentive paid to the IPO buyer in exchange for investing at a time when the price discovery is in a sense incomplete and cannot be particularly trusted. Rather than pricing the IPO at what bankers and bookbuilders think is the “fair price”, they will price it at a discount, which offers IPO investors insurance against the bankers having made a mistake in their pricing of the IPO.

And how much to underprice it (relative to any “fair price” that the bankers have discovered) is a function of how sure the bankers are about the fair price they have arrived at. The greater their confidence in such a price, the smaller the pop they need to offer (again, this is in theory since investors need not know what fair price bankers have arrived at).

The examples I took while arguing that the IPO pop is unfair to existing shareholders were MakeMyTrip and LinkedIn, both pioneers in some sense. LinkedIn was the first major social network to go public, much before Facebook or Twitter, and thus there was uncertainty about its valuation, and it gave a big pop.

MakeMyTrip was a travel booking site from India listing on NASDAQ, and despite other travel sites already being public, the fact that it was from an “emerging market” possibly added to its uncertainty, and the resulting high pop.

So I admit it. I was wrong on this topic of IPO pops. They do make sense, but from a risk perspective. Nothing about “wealth of existing shareholders increases after the pop”.

More on IPOs

In the past I’ve written on this blog that IPOs that open with a pop are actually unfair to the existing shareholders of the company, and are not as “successful” as reported by the media. To this, people from the industry have pointed out that the “pop” (increase in share price on the day of listing) actually increases the value of the shares held by the existing shareholders and hence this is a good deal.

I’ve always been unsure about this kind of analysis, and have held it suspiciously as one of those views held by people who accept “received wisdom” without much questioning and so much of such wisdom gets received that it becomes a thing. While investment bankers are usually incentivised on a percentage of the money raised by the IPO, considering that they are a platform for trading, they choose to forego some of that income by transferring money to the other side of the market – the “buy side” who are their more consistent customers.

In the aftermath of the LinkedIn IPO which I had written about in a similar context a few years back,  Facebook went public and it seems like they had put immense pressure on their bankers (Morgan Stanley if I’m not wrong) to “not leave money on the table”. And the IPO had opened rather flat. Not great for investors but excellent for Mark Zuckerberg and other old shareholders in Facebook.

Anyway, the reason I revisit this topic is this IPO by this Chinese company called Beijing Baofeng. Check out its share price movement:

The reason you see the neat step graph is that on each trading day following its IPO the share has hit the upper circuit breaker (at which point trading in the security is closed for the day). The inimitable Matt Levine has mentioned in his daily newsletter (which I subscribe to, and you should, too) that the stock has gained 1600% after the IPO, which makes LinkedIn’s doubling of share price on IPO day look like child’s play!

A takeaway from this is that investment banking remains strong as an industry, and bankers continue to shaft their hapless clients (or, if we should give them more credit, are so inept that they consistently underprice IPOs). It would be a great industry to get into except that they’re not hiring (a straw poll I conducted in the IIMB class I taught showed that hardly anyone had got a banking job)!

I continue to wonder how the IPO industry can be disrupted!

50% Stake Sale

It’s finally happening. My mother has decided for good that I’m unable to manage all of myself, and hence I should divest 50% in myself. “The better half”, she says. She has been utterly disgusted due to my utter failure, and lack of effort, in conducting this divestiture by myself, and has now decided to take matters into her own hands.

Her second sister, along with her husband, has been appointed the lead investment banker for this deal. My mother’s eldest sister is going to be the chief scout in order to scout for possible counterparties to the deal. It is preferred, and desirable, that there be a single buyer for this entire 50%, and the current understanding is that if we are not able to tie up any good single investor, we will rather postpone the sale rather than going in for an IPO and selling the stake in bits and pieces to retail investors.

Thinking about it, I wonder if it is technically correct to call this a stake sale, since I don’t plan to take any dowry. Maybe if you take all costs into consideration, and not just the monetary ones, and if you assume payment to be a continuous thing rather than like a lumpsum (these  investment bankers, they can arrange just about anything), it won’t be inaccurate to call this process a stake sale.

Usually, in these circumstances, most of the work is done by the bankers, but it seems that in this case that I, as the person divesting the stake, will need to put in considerable effort. The effort that I was too lazy to put when I was supposed to be trying to do the deal myself, without any asssistance from any bankers. Actually this is something that a lot of companies that indulge in M&A transactions forget about.

Think about your own incentives and the banker’s incentive. For the banker, this is just a deal. All they are caring for is to find a buyer for your sale, and a seller for anyone who wishes to buy stake. Once the deal is through and the cheques and documents signed, they ask you to sign on a set of fairly heavy cheques, and walk away; job done. It is you, as the company who is selling the stake, who has to deal with the new investor for maybe the rest of your life – transaction costs in these kind of deals are high, and it is preferable it be done exactly once.

One thing I realize is that the effort required here is of a different nature to the one that you need to put when in the market without bankers’ support. In the latter case, you need to engage in an elaborate ritual of tikitaka, slowly moving towards the goal, and then unleashing a shot at the right moment. It is a well-respected and common algorithm, and any attempts to side-step it, and use short-cuts, usually end in disasters.

In the banked world, though, one thing is clear – you are sitting in that conference room together in order to strike a long-term deal, and not for a random networking meeting. All parties in the conference room are aware that the reason they are all sitting there, together, is so that they can work out a long-term deal. And thus, explicitly mentioning the deal, and explicitly working towards it, are not frowned upon – like it sometimes is in the outside market. You don’t need an y tiki-taka here. Tiki-taka is also seen as a waste of time. You better follow a direct approach and just put the ball in the box and then have a striker shoot it.

And remember that in such brokered deals, there is usually no goalkeeper.

PS: I need photos of myself for the offer document. I realize that I dont’ have too many of those. I’m not too narcissistic in my photography exploits, and I dont’ bother to collect pics that others have taken of me, and hence the shortage. Last night, my mother looked through my facebook pictures and pronounced each of them as “useless”. So, if you have good pictures of me, plis to be sending me. If you dont know my email ID, just leave a comment here and I’ll give you my email ID.