Facebooks IPO and Underpricing

Stock Underpricing and Market Efficiency
Underpricing can and does occur for numerous reasons. It can act as a type of insurance on the part of the underwriter, as when a stock is overpriced at its IPO, legal suits may follow: investors who end up holding heavily overpriced issues may well have an incentive to sue the underwriter and/or the company directors for publishing misleading or incomplete information in the prospectus (Saudners, 1990, p. 7). There is also the theory that underpricing is a way to compete in the IPO market, where “some investors are viewed as informed while a larger group is viewed as uninformed” (Saunders, 1990, p. 7). Other explanations include uncertainty about liquidity and/or demand: underpricing is a way to hedge against this uncertainty—i.e., better to be safe (and leave a little money on the table) than sorry (and overprice). This paper will examine the uses of underpicing, its impact on organizations, and why underwriters might adopt it as a strategy.
Underpricing can be seen as a strategy in a competitive market; and it can also be seen as a way to safeguard oneself (if one is an underwriter). However, market efficiency in today’s day and age, where markets are impacted by unconventional monetary policy on the part of central governments, is not quite what it used to be. With central banks acting as “a significant buyer of assets” underwriters might be more inclined to reconsider the likelihood of demand for the IPO when they price the underlying (Joyce, Lasaosa, Stevens & Tong, 2011).
The implications of stock underpricing on an organization’s IPO may affect the short-term outlook (in that the initial issue takes in less than it otherwise might have had it been priced to reflect the demand manifested in the secondary market). However, if the demand is kept up, the organization could follow the IPO with another offering at a later point in the future. Few organizations are going to complain that their stock is too high in value: that value can always be leveraged in a number of ways to benefit the company and strengthen its operations. The IPO is but one step in the process of building a company’s future and underpricing certainly has much more appeal than overpricing. A stock that is overpriced and tanks upon its IPO may not ever recover. One can compare IPO’s if one likes: Twitter and Facebook, for example, serve as good illustrations of IPOs that are overpriced and underpriced. Twitter’s initial offering was at $26. It dipped and soared and dipped and soared again as investors struggled to find its real value in the months following the IPO. Finally it fell below its IPO price and today remains under $20. Facebook on the other hand debuted was priced by underwriters at $38—at the top of its valuation range—and went on to briefly drop following the IPO before going on a tear that it has not pulled back from since. Today, the company’s stock is valued at $172. Clearly Facebook was underpriced and Twitter was overpriced—though in the brief month following the IPO investors might have been forgiven for thinking the exact opposite.
Of course, as Krigman and Jeffus (2016) point out, the common blame for Facebook’s underpricing in the months that followed was “an overall increase in risk-aversion among investors” (p. 335). Indeed, what Krigman and Jeffus (2016) argue is that underwriters will underprice in order to compensate key core clients—which is what they say happened in the wake of the Facebook IPO: Krigman and Jeffus (2016) note that the IPO market was inactive for more than a month after the Facebook IPO, and that when the IPO market did re-open, “the average level of underpricing increased from 11% pre-Facebook to 20% post-Facebook” (p. 335). The researchers argued that the increase was entirely “concentrated in the IPOs of the Facebook lead underwriters” and that there was otherwise “no statistical difference in underpricing pre- and post-Facebook for non-Facebook underwriters.” In other words, “investment bank loyalty to their institutional investor client based propelled the Facebook underwriters to increase underpricing to compensate for the perceived losses on Facebook” (p. 335). This finding just goes to show that market efficiency and financial theory have less to do with the cause of underpricing than do behind-the-scenes issues that stem from client-provider relationships. The simple fact of the matter is that underpricing can be executed for a reason that is obvious: it is done to benefit someone, and that someone might not always be the investor in the secondary market. Sometimes it can be the clients of the lead underwriters who seek to make up perceived losses from other IPOs underwritten by the same banks.
In conclusion, underpricing can be a way to limit risk in an uncertain market: if liquidity and demand are unknown or unclear, the underwriting may use underpricing as a way to keep the IPO from going south quickly. At the same time, it can be a tool in a competitive market, where informed and uninformed investors compete for shares. Underwriters may adopt it as a strategy to hedge against legal risk, as overpricing could lead to law suits, which they would surely like to avoid. And as Krigman and Jeffus (2016) show, underpricing can be a method that underwriters use to compensate their key core clients. In terms of market efficiency and financial theory, underpricing can have positive and negative effects for an organization, but these may also change from the short term to the long term.
References
Joyce, M., Lasaosa, A., Stevens, I., & Tong, M. (2011). The financial market impact of
quantitative easing in the United Kingdom. International Journal of Central Banking, 7(3), 113-161.
Krigman, L., Jeffus, W. (2016). IPO pricing as a function of your investment banks’
past mistakes: The case of Facebook. Journal of Corporate Finance, 38, 335-344.
Saudners, A. (1990). Why are so many new stock issues underpriced? Federal Reserve
Bank of Philadelphia, Business Review, 3-12.