May 16

I just received this letter from a friend in the banking industry. He prefers to remain anonymous (you’ll see why soon enough).

Dear Mark,

There’s been a lot of ballyhoo recently about your IPO and your choice of investment bankers. Indeed, a war was fought by the banks to win your “deal of the decade.”  As reported in the press, the competition was so intense banks slashed their fees in order to win your business. Facebook is “only” paying a 1% “commission” for its IPO rather than the 3% typically charged by the banks.

Congratulations, Mr. Zuckerberg! On the surface it appears your pals in investment banking have given you a quite a deal!… Or have they?

Let’s take a closer look and see what you’re getting for your money.

To start, your bankers have the task of selling 388 million Facebook shares to the public. In return, these banks will receive $150 million for their efforts.  Morgan Stanley will get the largest share of that amount—approximately $45 million. But is $45 million all that Morgan Stanley makes off your deal?

Before we answer this question, let’s first dissect the sales pitch that Morgan Stanley probably gave you to justify “only” the $150 million fee. We’ll look at what they told you, and then what that actually means.

1) We will raise the optimal amount of money for the company, for our 1% fee. (Translation: How great is it that Zuckerberg believes he got a great deal by getting us down to a 1% fee! We can’t believe he got hoodwinked into agreeing to any level of what are actually variable commission fees.)

2) The definition of a successful deal is having a good price “pop” on the first day of trading. This will make all parties happy and you, Mark, look like a rock star. (Translation: No one benefits more than us if Facebook’s share price rises significantly on day one. That first day price “pop” will take money directly out of your pocket and puts it in ours and those of our “best friends”—not yours or the public stockholders. We will, at almost all costs, make this happen.)

3) This is a very complicated process, especially for such a large company, but we are here to successfully guide you through it. (Translation: It actually takes the same amount of work to do a large IPO as a small one. Thus for approximately the same amount of work we’re doing for Facebook, we sometimes get only $10 million—$140 million less than we’re making on Zuckerberg’s IPO.)

4) We will perform due diligence on your company to make sure the business and its finances are as they seem. (Translation: While it certainly does take some time and effort to perform reasonable due diligence, Facebook is a very large and well-known company, and we have done this same procedure hundreds of times.)

5) We will write a prospectus that outlines Facebook’s strategy, business plan, financials, and risks, and we will get it approved by the SEC. (Translation: Per the regulatory guidelines, a prospectus is largely a boilerplate document; for the most part, it’s just a lot of cutting and pasting.)

6) Once this prospectus is completed and with input from the Facebook team, we will come up with “the range” or the approximate price we think your IPO shares should be sold at to the fund managers. (Translation: The price of your IPO will be determined by where and how we can best optimize our (secret) profits on the deal.)

7) We believe the best shareholders are large fund managers, as they will become long-term holders of Facebook stock.  However, at your request, we will allocate 25% of the IPO shares to sell to individual investors. (Translation: There are 835 million Facebook users worldwide. One could argue that what is best for Facebook would be to let all of Facebook’s legally eligible customers enter orders to buy Facebook stock. Then through the broker of their choosing, they could enter the quantity of shares they want to buy and the price they want to pay, just like the fund managers do—or are supposed to do. More on this scenario below.)

8) Our 10-day sales process will begin. For this important “road show,” you will be introduced to our large fund manager clients. These fund managers will receive our pitch for why they should buy your stock, and we will assess their interest and at what price. (Translation: Far from being long-term holders, many of our large fund manager “best friends” will, as soon as Facebook shares start trading, sell (or “flip”) for a windfall profit on all the underpriced shares we’ve given them. We’ll enable this by creating a perceived “feeding frenzy” for the stock by putting out an artificially low initial estimate ($28 to $35 per share) for where we think the IPO will be priced.  We will then raise that estimate during the road show. Rumors about this begin to circulate over the next day or so.)

9) At the end of the road show on the night before the IPO, we will review the overall supply and demand for the stock and then “price” the shares. This is the price at which the large fund managers will receive their “winning” Facebook shares. (Translation: The price of the stock is already known. For the past few years, Facebook shares have been actively trading on such venues as SecondMarket and SharePost.)

10) And finally, we will put a mechanism, called a Greenshoe, in place that “supports” your share price after the IPO. (Translation: Thank God Zuckerberg doesn’t understand one of the greatest investment banking profit enhancing creations of all time—“The Greenshoe.” The Greenshoe will likely be our most profitable part of this deal.  It’s a secret windfall, and although we market it to Facebook as a method to stabilize its share price, it’s really just another way for us, with little effort, to make huge amounts of money.)

We’re not done yet, Mark. Now, I’d like to dig a bit deeper into what’s going to happen and show you all the additional ways your banker friends and their large fund manager clients are going to make oodles of money off your deal.

1) Morgan Stanley only gives Facebook shares (“golden tickets”) to their best client “friends.”  In other words, it’s no coincidence that Morgan Stanley’s biggest fund manager clients get the bulk of the shares offered in this kind of deal.

2) How do you become best friends with Morgan Stanley?  There are lots of ways, such as trading tens of millions of shares with them or using the firm as your prime broker.

3) I’m sure there are a lot of conversations going on right now between Morgan Stanley’s salespeople and their clients. These conversations are probably along the lines of (wink-wink) “before we allocate our Facebook shares, we’d like to ask first if you plan to do more trading with us over the next week to six months….”

4) Let’s assume that 50 of Morgan Stanley’s “best friends” trade an extra 2 million shares so they can get access to more shares of the Facebook IPO. Let’s also assume that the average commission these clients pay to Morgan Stanley is 2 cents per share. Well, those extra trades will dump an additional $2 million dollars into Morgan’s coffers.

5) Now comes the part where Morgan Stanley actually gives free money to its friends. If the Facebook IPO is like the majority of other recent Internet offerings, here’s what Morgan Stanley will likely do.  They know Facebook will be a “hot” deal. Especially, with all of the “5% orders” coming in, there will be huge demand for Facebook shares.  My prediction is that Morgan Stanley will “price” Facebook at approximately $40 per share.  This is the price at which Morgan Stanley’s “best friends will be able to buy the bulk of the 388 million shares offered.

6) Now let’s now assume that Facebook shares open for trading at $50—a lower percentage premium than Groupon’s opening share-price “pop.”

7) Let’s assume that one of Morgan Stanley’s “best friends” decides to sell 3 million shares right after the opening at $50 per share. That “best friend” will instantaneously make a $30 million profit.  That’s right, a $30 million profit.

8) Here’s a question for you Mark. If Morgan Stanley’s “best friends” are selling Facebook shares at $50, who’s buying them? The answer is your “friends,” individual investors, most of whom are your customers.

9) Now for the final insult—the Greenshoe. Technically speaking, the Greenshoe gives your investment banks a 30-day option to purchase up to 15% more stock from Facebook than was registered and sold in the IPO. In layman’s terms, this means that, over the next 30 days, your “best friends” at the investment banks are able to buy approximately 50 million of your shares at $40 per share.

10) As in our example above, let’s say Facebook shares do trade at $50 soon after the IPO. Now I am a simple person, but if I were given the opportunity to buy something at $40 that I could immediately sell at $50, I would do it all day, every day…. And so will the investment banks.  The Greenshoe actually gives these banks the ability to do this for 50 million of your shares.

11) So let’s assume that Morgan Stanley and its other banking “friends” buy 50 million shares at $40 per share and then sell these shares at $50.  Morgan Stanley and its banking “friends” will make an additional $500 million- yes, $500 million- a HALF BILLION DOLLARS off your company.

So let’s now do a tally to see how much money all of your banking friends are going to make just for the privilege of doing your IPO.  Let’s also see where this money comes from.

“Discounted” fees/commission: $150 million

Greenshoe profits: about $500 million

Extra trading commissions from large fund managers: approximately $10 million

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Investment Bank Profits:   $660 million

As the lead bank on your deal, Morgan Stanley is likely to get 30% of the overall take. This means that your closest investment banking “friend” will make a bit more than $200 million from your IPO.

Morgan Stanley and the rest of the investment banks involved will also make sure that their favorite fund manager client “friends” are given lots of free money. Assuming that these “friends” are given 75% of the total number of IPO shares, or a total of 291 million shares, and assuming that the stock does rise from $40 to $50, then these fund managers will collectively, in one day, make $2.9 billion dollars in realized or unrealized profits.  That’s right, 2.9 BILLION DOLLARS.

Mark, by now you must be asking yourself the obvious question. “Where and out of whose pocket does this money come from?”

Well, just think of it this way… Let’s assume you own a very expensive piece of waterfront real estate, and you hire a broker to sell it for you. After exploring the market and after getting indications of interest, your broker advises you that $10 million would be a great price for your home.  You meet with the potential buyers and decide to sell it for $10 million.  After the $1 million commission you have to pay your broker, your net proceeds are $9 million. An hour later, you drive by the house and see your broker in the driveway shaking hands with some different people. You pull over to see what’s going on, and you find that the people you just sold the house to for $10 million are very close friends of your broker.  To your dismay, you also find out that those friends just sold your (former) house to somebody else for $15 million.

The same exact game is going on here, Mark. You’ll be selling 388 million shares of Facebook stock in your IPO. A likely scenario is that your broker “friends” are telling you to sell your shares at $40 per share. You’ll take their advice and sell at $40 per share, and the buyers will be Morgan Stanley’s biggest fund management clients. By the time you drive around the block, these folks will have sold their shares at $50 per share. In other words, using the same real estate scenario, you’ll have sold something of yours for $15 billion that is really worth $19 billion. And for that “unique” privilege, you’ll be paying your “friends” at the banks $150 million as a fee.

Makes you wonder who your real friends are…

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End of letter

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I find the points that my (real life) friend makes here highly disturbing, but I suspect that they also fit with what we now know about dishonesty.

First, although there are many ethically questionable practices occurring here, it’s not clear that anything illegal is going on.  Second, I think that while this banking industry’s IPO process is artfully designed in such a way that, although overall it’s good for the bankers and less so for the companies, no single individual believes he/she is doing anything wrong.  Third, I also suspect that since this is such a common practice, the bankers most likely truly believe that mechanisms such as getting a first-day IPO “pop” is great for Facebook and that the Greenshoe is fact put in place to stabilize the Facebook stock price, and not simply to generate more windfall profits for themselves.  Forth, they probably believe in their own definition of a “successful” IPO, which in their terms is one where the stock is priced at $40 and quickly trades up to $50. In the case of Facebook, this process simply redistributes $4 billion from Facebook to the banks and the large fund managers. For Zuckerberg and his team, I have to wonder whether the emotional value of a first day share price “pop” is worth $4 billion.

I am not sure about you, but I find all of this very depressing.

Irrationally yours,

Dan