Excerpted from the University of Michigan Ross School of Business. Here, professor Amiyatosh Purnanandam sees a number of factors, including the company’s private placement, muddling its public offering.
ANN ARBOR, Mich. -Why did one of the most anticipated IPOs in recent years, Facebook Inc., turn into such a debacle?
Amiyatosh Purnanandam, associate professor of finance, says a couple of storms combined to create a hot mess for Facebook, underwriter Morgan Stanley, the NASDAQ exchange, investors, and the market for IPOs. Major technical problems trading the stock on the NASDAQ were followed by lawsuits from investors who claim there was selective disclosure on future expectations for Facebook. Purnanandam says any question about future growth will sink an IPO price. But another issue that’s been overlooked is that Facebook had private shares floating around more than a year before its IPO, he says. That raises interesting questions about disclosure for stocks that transition from a private placement to the public market. In this Q&A, Purnanandam also shares ideas based on his research as to why IPOs historically have been poor long-term investments.
Right off the bat, the Facebook IPO was bedeviled by technical problems at NASDAQ. The buys and sells were not matched up, and some firms lost millions. Has this happened before with large IPOs?
Purnanandam: Not with a big one like this. It’s definitely an exception, especially for a large IPO. You’d think they would have been ready. When Google went public, it was an equally important IPO and there were no problems. It should not have happened. It’s bad for NASDAQ, for sure. The New York Stock Exchange is courting Facebook to come to their exchange.
The bigger issue seems to be the complaints over disclosure. That already has prompted lawsuits that accuse Facebook and the underwriters of not widely communicating changes made in analyst revenue forecasts. These information gaps have been issues with IPOs before. Morgan Stanley says it followed the rules. How much of a case is there?
Purnanandam: An IPO is a classic setting where there would be information asymmetry. By definition, it’s a new company with a very limited number of past public filings. A road show is common, where the underwriters will disclose information they get from the company and people will make their valuation call based on those numbers. That’s standard practice in any IPO. Right now this is a legal issue, so it’s hard to comment from the outside on what happened. But the allegation is that there was some information selectively disclosed to institutional investors and not to retail investors. That’s a problem if it turns out to be the case. But whether there was a violation of disclosure rules remains to be seen.
The nature of valuing a company like Facebook, which doesn’t have a lot of tangible assets, makes the issue of disclosure a big deal. One of the most important inputs for the valuation of such a company is future growth expectations. That and current earnings will mainly determine the firm’s IPO valuation. Small changes in future growth expectations can change Facebook’s valuation by several billion dollars. That, in my mind, is what’s happening here. If investors thought a company was going to grow at 20 percent, and now it’s only 15 percent, those five points difference can wipe out billions in value. As the growth expectations came down, the $38 IPO price has dropped to below $30 in market trading, a little more than 20 percent.
Will disclosure regulations come under review?
Purnanandam: The disclosure policy for IPOs always has been under scrutiny. And, yes, it will be examined again.
But a bigger issue has been brewing for the past year and a half. Through Goldman Sachs, Facebook started selling its shares in the private market to private investors in what’s known as a private placement. You sell a relatively small amount of shares privately, without coming under public purview. In this private market, a valuation was being discovered, and the share price was going up accordingly. In my opinion, the IPO valuation was driven quite a bit by the traded price in the private market. That price was quite high, valuing the company at more than $70billion-$80 billion. But that’s a different market, and it wasn’t being sold to retail investors. So I think regulators will ask themselves some questions about that. When you sell in the private market, what kind of disclosure should there be? When you transition from a private placement to a public market, do you create some sort of information advantage for one group or the other? How many shares can you sell and be considered private? At what point do you become a quasi-public company? The SEC and stock exchanges probably will look at those issues.
It’s been said that IPOs benefit the insider owners and the underwriters more than shareholders. Is that the case and something people forgot with all the hype?
Purnanandam: History shows that in the long run an IPO is not a good investment, on average. But there is qualifier. When big-time investors buy IPOs, often they will buy several and most will fail. They’re betting on finding the next Google or Microsoft and making big money on those hits. But, on average, IPOs have not been a good investment, and it’s one of the puzzles in finance research. Is there some kind of behavioral bias, or is it investors trying to hit the next Google and picking up a bunch of lousy stocks in the process? Through some of my own research, I think it’s because people focus too much on future growth and too little on current earnings. Facebook fits that pattern. An IPO company is new, and the bulk of its value comes from future growth. I have found that just before an IPO, these firms will show a remarkable growth rate but very little earnings. People think this growth will continue and these low earnings will become big in the coming years. Unfortunately, when you look at the data, that growth doesn’t materialize for the average company. In fact, we find the average firm does very poorly on earnings growth two years after the IPO. Very few continue to grow at 15-20 percent in the long run. But investors have, in the past, paid quite a premium for that 15-20 percent growth. In my opinion, it’s an extrapolation error.
Will it turn out that way for Facebook? We don’t know. But once people started doubting the disclosure policy, which centered on how it was going to grow, then that combination knocked down the market’s valuation.
How does Facebook rate in terms of short-term IPO performance?
Purnanandam: Very bad. It’s more than 20 percent off the IPO price. Historically, the first day should see an average 10-15 percent jump on the price, depending on what the overall market is doing. On average, a stock keeps going up for six months to a year after an IPO. So one, the investment bankers were not able to price it right, and second, questions over the disclosure policy equal worry about information. Finally, this stock has wide implications for the market. It was very much talked about as an indicator of IPO sentiment. So it’s pretty bad news for the IPO market.
How much does this hurt Morgan Stanley?
Purnanandam: A lot. Whether the lawsuits are valid or not, and I have no idea whether they are, one thing is certain: Morgan Stanley will suffer a loss of reputational capital. They also probably lost money. On day one, they must have put a lot of their capital in the market. When the price goes down, underwriters usually give price support. So on day one and maybe the first couple of days, they likely bought shares to keep the shares from dropping too much. But you can’t do it for too long, and Facebook’s price kept dropping.