Tag: ipo

IPOs and right to match

Long time readers of the blog might know that I’m not a big fan of the IPO pop. I’ve traditionally belonged to the party (led by Bill Gurley) that says that a big IPO pop is akin to “leaving money on the table” for the company.

And so as my party has grown, the IPO process itself has also changed. Way back in 2004, Google allocated shares using a simple Dutch auction. Facebook pushed its bankers hard enough on the IPO price that the IPO “pop” in that case was negative. Spotify and Slack and a few other companies went public in a direct listing. Nowadays you have SPACs. It’s all very interesting stuff for anyone interested in market design.

Over the last few years, though, Matt Levine has been trying hard (and sort of succeeding), in getting to move me to the side that says IPO pops are okay. His first compelling argument was the demand-supply (and market depth) one – in an IPO there is a large offload of shares, and so an IPO buyer can expect to get a discount on the shares. Another is that since the IPO is the first time the stock will be traded, buyers in the IPO are taking risk, and need to be compensated for it in the form of a lower price. Fair enough again.

Matt has outdone himself in his latest newsletter on the topic, where he talks about the IPOs of Roblox and Coupang. About Roblox, he wrote:

I mean, I’ll tell you the answer[1]: Roblox sold stock to venture capitalists at $45, and then it traded up in public markets to $70. In a traditional initial public offering, a company sells stock to mutual funds at $45, and then it trades up in public markets to $70. Venture capitalists are not happy when mutual funds get underpriced stock: It dilutes existing shareholders and “leaves money on the table.” Venture capitalists are of course perfectly happy when venture capitalists get underpriced stock; that’s the business they are in.

This served the purpose of moving me more to his side.

This blogpost, however, is about the Coupang IPO.

All normal enough. But here’s the unusual thing about Coupang. Apparently, of the hundreds of investors who put in orders to buy shares in the IPO—many of whom did roadshow meetings and put in work to understand the company and come up with a price—fewer than 100 were allocated any shares, with most of those shares going to about 25 accounts handpicked by Coupang. Coupang apparently kept tight control over the allocation, choosing its investors itself rather than deferring to its underwriters (led by Goldman Sachs Group Inc.). Now those favored investors—investors favored by Coupang, not investors favored by Goldman—will benefit from the IPO pop. Everyone else, who put in the work and decided they wanted to own Coupang, will have to buy in the aftermarket, from those initial investors, and pay up to do so.

Obviously Coupang has left money on the table, but who cares? Coupang underpriced its IPO, but the beneficiaries of the underpricing are the existing investors that it wanted to benefit.

Basically Coupang announced an IPO at a $27-30 price range. It did a roadshow to gauge investor demand. Demand was strong. And then the price range was upped to $31-34. Demand was strong once again. And then, instead of letting its banker Goldman Sachs price the IPO at 34, and allocate the shares to who Goldman thought would make the best investors, Coupang went to its existing investors and told them “we have a bunch of investors willing to buy our stock at $34. What do you think?”

And the existing investors, finding validation, said “Oh, in that case we can pay $35 for it”. In IPL auction parlance, Coupang’s existing investors basically had a “right to match option”. All the other potential investors were asked, and then the existing investors were “more equal” than the others.

The stock duly popped.

Now, right to match in an IPO might be an interesting structure, but I highly doubt that it will sustain. Basically banks won’t like it. Put yourself in Goldman’s shoes for a moment.

They have done all the hard work of pricing the IPO and taking it to potential clients and doing all the paperwork, and at the end of it, their buy side clients are a mostly pissed of bunch – they’ve again done all the hard work of deciding whether the IPO was worth it and then told that they were cut out of the deal.

The least Goldman’s buy side clients would have wanted is the right to match Coupang’s original investors’ offer ($35). Having done all the hard work, and then being forced to buy the stock (if at all) at the popped price of $49, they will be a totally miffed lot. And they would have conveyed their displeasure to Goldman.

One thing about IPOs is that the companies selling the stock play a one-time game, while the bankers (and IPO investors) play a repeated game, participating in IPOs regularly. And because of this, the incentive structure of IPOs is that bankers tend to favour buy side clients than sell side, and so the big pop. And so bankers will not regularly want to do things that will piss off the buy side, such as offering “right to match” to the selling company’s chosen investors.

So will we see more such IPOs?

My take is that inspired by Coupang, some more companies might insist on a right to match while selling their shares in an IPO. And this right to match will piss off the buy side, who will push back against the bankers and demand a right to match for themselves.

And what happens when both sides (company’s favourite investors and bank’s favourite investors) insist on a mutual right to match? We get an auction of course.

I don’t think anyone will have that much of a problem if IPO share allocation gets resolved by a Dutch auction, like Google did way back in 2004.

More On Direct Listings

Regular long-time readers of this blog might know that I’m not a big fan of IPO pops (I’ve written about them at least four times so far: one, two, three and four). You can think of this as Number Five, though this is specifically about Direct Listings.

In case you don’t have patience to click through and read my posts, what is the big deal about direct listings? And what is the problem with traditional IPOs? To put it simply, companies looking to raise capital through IPOs are playing a one-time game (you only do an IPO once), while companies that are investing in them are playing a repeated game (they participate in pretty much every IPO that comes on the market – ok may be not WeWork).

This means that investment banks, which stand between the buyer and the seller in such cases, have an incentive to structure the deal to favour the (repeated) buyers, and they price the IPO conservatively. This means that when the company actually lists on the market, it usually does so at a price higher than the IPO price, resulting in a quick win for the IPO investors.

This is injurious for the original investors in the company (founders, VCs, employees) since they are “leaving money on the table”. A pop of 10-20% is considered fair game (a price for the uncertainty on how the market will react to the IPO), but when MakeMyTrip lists 60% higher, or Beyond Meat lists 160% up, it is a significant loss to the early shareholders.

Over the last few months (possibly after the Beyond Meat IPO), Silicon Valley has woken up to this problem of the IPO pop, and suggested that the middleman (equity capital markets divisions of investment banks) be disintermediated from the IPO process. And their vehicle of choice for disintermediation is the direct listing.

A direct listing is what it is. Rather than raising fresh capital from the market, the company picks an auspicious date and declares that on that date its stock will list on the exchanges. The opening auction in the exchange on that day sets what is effectively the IPO price, and the company is public just like that.

Spotify was among the first well-known companies in recent times to do a direct listing, when it went public in 2018. Earlier this year, Slack did a direct listing as well. Here is Benchmark Capital’s Bill Gurley (a venture capitalist) on the benefits of a direct listing.

Direct Listing is all well and good when a company doesn’t have to raise capital. The question is how do you go public while at the same time raising capital (which is what a traditional IPO does)? Slack and Spotify were able to do the direct listing because they didn’t want capital from the IPOs – they just wanted to offer liquidity to their investors.

The New York Stock Exchange thinks it can be done, and has proposed a product where companies can use the opening daily auction to price the new shares being offered. There are issues, of course, about things like supply of shares, lock-ups, price support and so on, but the NYSE thinks this can be done.

NYSE’s President Stacey Cunningham recently appeared on the a16z podcast (again run by a VC, notice!) and spoke eloquently about the benefits of direct listing.

The SEC (stock regulator in the US) isn’t very happy with the proposal, and rejected it. Traditional bankers are not happy with the NYSE’s proposal, either, and continue to find problems with it (my main source of this angst is Matt Levine, who is a former ECM Banker and who thus has solid reasons as to why ECM Bankers should exist). In any case, the NYSE has refiled its proposal.

So what is the deal with direct listings?

In a way, you can think about them as a way to simply disintermediate the market. The ECM Banker, after all, is a middleman who stands between the buyer (IPO investor) and seller (company raising capital), helping them come up with a smooth deal, for a fee. The process has been set for about 40 years now, and has become so stable that the sellers think it has become unfair to them. And so there is the backlash.

Until now, the sellers were all independent entities with their own set of investors, and so they were unable to coordinate and express their displeasure with the IPO process. The buyers, on the other hand, play the game repeatedly, and can thus coordinate among themselves and with the middlemen to give themselves a sweet deal.

The development in this decade is that the same set of VC investors invest in a large number of go-to-public companies, and so suddenly you have sellers who are present across deals, and that has changed the game in a sense. And so direct listings are on every tech or investing podcast.

Among the things I wrote in my book (which came out a bit over two years ago) is that one important role that middlemen play is to reduce uncertainty and volatility in the market.

One concern with direct listings is that there can be a wide variation in the valuations by different players in the market, and the opening auction is not an efficient enough process to resolves all these variations. The thing with the Spotify and Slack listings was that there was a broad consensus on the valuation of these companies (more in line with public company valuations), a set of investors who wanted to get in and a set of investors who wanted to get out. And so it all went smoothly.

But what do you do with something like WeWork? The problem with private market valuations is that with players like SoftBank, they can be well divorced from market realities. In WeWork’s case, the range of IPO valuations that came up differed by an order of magnitude. And that kind of difference is not usually reconcilable in one normal opening auction (imagine a bid of 8 billion and an ask of 69 billion, and other numbers somewhere in between) without massive volatility going forward. In that sense, the attempted traditional IPO did a good job of understanding demand and supply and just declaring “no deal”. “No deal” is usually not an option when you do a direct listing.

OK I’ve written a lot I know (this is already 2X the length of my usual blog posts), so what do I really think about IPOs? I think all this talk about direct listings will shift the market ever so slightly in favour of the sellers. Companies will follow a mixed strategy – well known companies (consumer brands, mostly) with stable valuations will go for direct listings. Less well known companies, or those with unstable valuations will go for IPOs.

And in the latter case, I predict that we will move closer to a Dutch auction (like what Google did) among the investors rather than the manual allocation process that ECM bankers indulge in nowadays. It will have the benefit of large blocks being traded at time zero, at a price considered fair by everyone, and hopefully low volatility.

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 tiki–taka, 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.