The Facebook IPO: A Note to Mark Zuckerberg; or, With “Friends” Like Morgan Stanley, Who Needs Enemies?
I just received this letter from a friend in the banking industry. He prefers to remain anonymous (you’ll see why soon enough).
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
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…
End of letter
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.
The psychology of money and habits
Money is an integral part of modern life. We constantly make decisions about whether we’re willing to pay for different products and, if so, how much we are willing to pay. In fact, we make decisions about money so often that we consider money to be a natural part of our environment.
However, money is a relatively recent invention, and despite its incredible economic usefulness it does come with its own set of problems. In particular, it turns out that decisions about money are often non-intuitive and, in fact, quite difficult. Consider the following situation as an example: You are thirsty, tired, and annoyed and just want a cup of coffee. You see two coffee shops across the street from each another. One is a specialty coffee shop that sells handcrafted, designer coffee and the other is Dunkin’ Donuts which sells standard, decent coffee. The price difference between the two options is $1.75 for your cup-a-joe. Now, how do you decide if the benefit of the handcrafted coffee drink is worth the additional $1.75?
What you should do (if you wanted to be rational about it) is consider all of the things that you could buy with that $1.75, now as well as in the future, and decide to buy the expensive coffee only if the difference between the two coffees is more valuable than all of those other possibilities. But of course this computation would take hours, it is incredibly complex, and who even knows all the possible options to consider?
So what do we do when we need to make decisions but making them “correctly” is too time consuming and difficult? We adopt simplifying rules, which academics call heuristics, and these heuristics provide us with actionable outcomes that might not be ideal but they help us to reach a decision. In the case of coffee and other, similar decisions, one of the heuristics we often use is to look at our own past behaviors and if we find evidence of relevant past decisions, we simply repeat those. In the case of coffee, for example, you might search your memory for other instances in which you visited regular fancy coffee shops. Assess which one of those two behaviors is more frequent and then you tell yourself “If I’ve done Action X more than Action Y in the past, this must mean that I prefer Action X to action Y” and as a consequence, you make your decision.
The strategy of looking at our past behaviors and repeating them, might seem at first glance to be very reasonable. However, it also suffers from at least two potential problems. First, it can make a few mediocre decisions into a long-term habit. For example, after we have gone to a fancy coffee shop three times in a row, we might reason that this is a great decision for us and continue with the same strategy for a long time. The second downfall is that when the conditions in the market change, we are unlikely to revise our strategy. For example, if the price difference between the fancy & standard coffee shop used to be 25¢ and over the years has increased to $1.75, we might stay with our original decision even though the conditions that supported it are no longer applicable.
In light of our current financial situation, many people these days are looking for places to cut financial spending. Once we understand how we use habits as a way to simplify our financial decision-making, we can also look more effectively into ways to save money. If we assume that our past decisions have always been sensible and reasonable then we should not scrutinize our long-term habits. After all, if we’ve done something for five years, it must be a great decision. But if we understand that long-term, repeated behaviors might reflect our habitual decision-making in the face of complex financial decisions more than they reflect what is truly best for us, we might first examine our old habits and carefully consider whether they indeed make sense or not. We can examine our subscription to the ESPN Sports Package, our annual subscription to the opera, our yearly Disneyland vacation, or our monthly visit to the hairdresser. By examining these habits, and quitting them when it makes sense to do so, we might actually discover ways in which we could reduce our spending on a long-term basis.
Yes, money is complex, and it is incredibly difficult for us to carefully examine every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create good ones that will benefit us for a long time.
surprises from our recent economic history
Reflecting back on our recent economic history bring to my mind a two sad surprises.
Even as a behavioral economist who generally believes in the prevalence of irrationality in our every day life, I place some stock in the main mechanism that should have maintained the efficiency of the financial markets: competition. In principle, the drive for competition among individuals, banks, and financial institutions should get the actors in the market to do the right thing for their clients as they fight to outdo their competition. After the Wall Street fiasco, I expected and hoped that in the spirit of competition some financial institutions would change their way given the new information about the risks they were talking and self-impose restrictions on themselves. I did not expect that they would do so because they were benevolent, but because they wanted to get the business of those who have lost trust in the financial institutions.
Surprise one: Sadly, the forces of competition do not seem to have any effect on the functioning of our financial institutions and Wall Street seems to be back to is pre-fiasco structure.
We are now discussing the possibility of health care reform, which arguably is even more messed up than our financial institutions (about 18 percent of GDP, bad incentives, bad intuitions, and the leading cause for bankruptcy before the current housing problem). When I look at the health care debate, it seems to be fueled by ideological beliefs about the importance of competition and freedom of choice on one hand, and the evilness of regulations and limits on the other. As someone who loves data beyond theories, it is surprising to me how little we know about the effectiveness of different versions of health care, and how sure people are in their own beliefs — which makes it an ideological and not a very useful debate (this is just a small surprise).
But what is the most surprising to me is that the tremendously expensive lessons we have experienced about the efficiency of markets and self interest do not seem to carry to the health care debate. As a society, we still seem to be enamored with the ideology of free markets, and have not seemed to update our beliefs in their efficiency despite the evidence. On the bright side, it looks like behavioral economists will have a lot of work for the foreseeable future.
Is Free Bus Fare a Good Idea?
Someone should remind Michael Bloomberg that free does not always mean free lunches.
The billionaire New York City mayor recently rolled out a transit proposal that sounds too good to be true – probably because it is.
In order to speed up the pace of Manhattan’s famously slow crosstown buses, mayor Bloomberg suggested eliminating the $2.25 fare on a few of the buses, as it would put an end to all the time passengers spend fumbling for their MetroCard and cash at the bus door. It would mean free bus rides for all, but without much additional cost to the city, he reasoned, since the majority of crosstown passengers are already riding for free, using their MetroCards to transfer from the subway. If we aren’t charging folks anyway, it’s not a big money loss, is the gist of his claim.
In short: win-win.
Except, there’s a flaw to his argument. If bus fare falls to zero, it’s likely that more people (many more people) will start riding the bus, which will lead to even worse congestion and potentially require the city to spend on introducing more buses.
In other words, mayor Bloomberg is harboring under the assumption that demand for the cross town bus will not change as the price drops. In all likelihood, however, the number of bus-riders will go up dramatically because free is exciting. In fact, according to our research on free, such a change will cause many people who now walk a few blocks, to switch their ways and hop on the free bus.
Given Valentine’s Day and the state of the market, let’s consider which approach to finding love is better: 1) the free market system where everyone can find their own date and figure out who and what is best for themselves; or 2) a regulated market where your parents, family, or perhaps some kind of matchmaker have a say. This may be an impractical question these days (how many people let their mothers set them up?), but this is still a complex problem that’s been discussed for millennia, without any apparent solution. But here’s a boon for anyone who is starting to lose hope of finding love: a study that shows the importance of commitment to happiness.
The world of dating has grown increasingly complex, we have online dating, speed dating, casual dating, traditional dating (I think it’s still around anyway), and so on. The problem is, that with so many options, commitment to a relationship becomes difficult—you never know if there’s someone more perfect for you just around the corner. In a world where switching partners is difficult, people are likely to hang on and attempt to work things out. But in a world where it’s easy, or seems easy, to switch partners, people are likely to give up when things first go wrong. And yet, the ever-present temptation that there is someone out there who is better can be incredibly devastating to our personal happiness.
So we have to wonder then, how important is commitment? Dan Gilbert and Jane Ebert conducted a study with this question in mind using photography. In their experiment, they gave students a short course in taking black and white photos and taught them how to develop their pictures in the darkroom. Half the people were told that they could pick one of their pictures to be professionally enlarged and developed, which they could then keep. The other half were told to pick two pictures to keep, and that they could change their minds until the minute that the film was sent off. These people had a continual temptation to change their choices, so they had time to consider and reconsider which of their prints were the best.
Later, each participant was asked to rate their level of happiness with their prints. Guess who was happier, those who chose a photo and stuck with it, or those who had flexibility and time to make the perfect selection? As it turned out, the people who could alter their choices were much less happy than the first group. The principle behind this is that when we have to deal with a certain reality, we get used to it and often come to prefer it. But if we think we can change it, we don’t force ourselves to cope, so inevitable imperfections—whether in people or in pictures—can drive us to distraction. And the same thing happens with marriage. If we think of marriage as an open market and always have half an eye on other options, we’ll be less likely to be happy.