Thomas M. Eisenbach, David O. Lucca, and Karen Shen
Stocks are usually offered in initial public offerings (IPOs) at a discount,
leading to large first-day IPO returns. When there is a risk of a negative initial
return, underwriters are known to actively support the aftermarket price of a
stock through buying activities. In this post, we look at the trading book for
Facebook stock on May 18, 2012, the day of its highly anticipated IPO. Using
what we call a “large integer–price bid” identification assumption to indirectly infer which investors are bidding, we find evidence of significant trading by underwriters seeking to stabilize the stock’s price. This evidence suggests that underwriters incurred significant costs as a result of these activities.
In an IPO, a company sells its
shares to the public on a securities exchange for the first time. IPOs are generally
conducted with the assistance of one or more investment banks acting as
underwriters. The underwriters play three roles in the IPO process: They
provide the company with procedural and financial advice, they buy the issue
from the company, and they resell it to the public. A major task of the
underwriters is setting the IPO price. The finance literature finds that IPOs
are generally underpriced in the short run and overpriced in the long run. To
date, there is no consensus on the drivers of these patterns (Ritter and
Welch 2002).
The underwriters in an IPO try to
get the price of its shares “right” by gauging demand in roadshows and
conducting their own analysis. In addition, however, the issuing firm may offer
underwriters a way of reducing initial market price volatility that is known as
the over-allotment or “greenshoe” option. Under this option, which is
sanctioned by the Securities and Exchange Commission, the underwriters sell to
the public a certain number of extra shares, usually 15 percent of the
issuance, in addition to the original offering that they purchased from the
issuing firm. If demand for the stock is unexpectedly high, the extra shares
reduce upward price pressure and are issued to the underwriters retroactively at
the IPO price. However, if demand for the stock is unexpectedly low, the underwriters
buy back the extra shares in the marketplace, thus helping to stabilize the
price. In economic terms, the “greenshoe” option lends some elasticity to the
supply of shares so that the price impact of demand fluctuations is dampened.
As explained by Aggarwal (2000)
and Lewellen
(2006), this over-allotment option is the main mechanism used by
underwriters to stabilize the price. In the case of Facebook, the underwriters
were given
the right to sell slightly more than 63 million additional shares, 15 percent
of the issuance of about 421 million shares.
Writing about the Facebook IPO in a post
on the blog Dealbreaker, Matt
Levine found evidence of stabilizing trades by dealers in the fact that about 43
million Facebook shares were exchanged exactly at the IPO price of $38 on the
IPO day. Is there any additional support for this interpretation or evidence of
other such trades during the day?
Price fluctuations on the IPO day were
significant, as shown in the chart below. After being issued at a price of $38
per share, the stock traded at $42.05, quickly dropped to $38, and then shot
back up to around $41.50, all in the first hour of trading. Later in the day,
after trading at around $41 for a while, the stock gradually returned to $38
before closing the day at $38.23.
To find potential stabilizing
activities, we look at the depth of the order book and plot the number of
stocks that sellers were willing to sell at the best ask price (the “ask size”)
and the number of stocks that buyers were willing to buy at the best bid price
(the “bid size”) during each minute.
The chart shows an interesting
pattern in the willingness to buy, which spikes suddenly at several points
during the day. The initial spike in bid size occurs at around 11:50 a.m., when
the price first drops to $38, and disappears once the price increases again. The
second spike occurs around 2:40 p.m., when the price hovers at $40, and
disappears once the price falls below $40. Finally, the third and largest spike
appears in the half hour before the market closes, when the price is again
around $38, disappearing when the price starts climbing in the final few
minutes of trading.
This pattern suggests that there may
be something special about the prices of $38 and $40. The two charts below show
the distribution of ask sizes and bid sizes across prices by plotting for every
price the maximum willingness to sell and maximum willingness to buy observed at
that price during the day. The plots show that the depth of the buy book at $38
and at $40 is indeed significantly greater than at any other price (followed by additional spikes at the other integer prices of $39 and
$41). By contrast, the distribution of the willingness to sell appears to be
relatively evenly distributed across prices; there seems to be no difference
between integer and non-integer prices, consistent with the idea that selling behavior
was driven by small individual investors. We suggest that the large bids at the
integer prices of $38 and $40 are likely stabilizing trades by the underwriters
as they attempted to support the falling stock price at these points during the
day. (Note that since our data do not identify individual investors, this
identification is based only on indirect inference.)
The two attempts at $38 appear to
have been successful, as the price never dips below this point. By contrast, the
support at $40 appears to have been unsuccessful, lasting for just over fifteen
minutes. To study this episode in more detail, we zoom in on the time period
between 2:35 p.m. and 3:00 p.m. and track the depth of the order book at $40.
We first observe the willingness to buy
at $40 at 2:39 p.m., when a depth of 7,015,600 shares is observed once the
price falls to $40. As the price hovers at or slightly above $40, we see the
buy orders being depleted. Shortly before 2:55 p.m. the willingness to buy at
$40 appears to be fully depleted and we see that the price immediately breaks
the barrier of $40 and drops significantly.
We compare this chart with the same chart
for the period between 3:35 p.m. and 4:00 p.m. below. Around 3:38 p.m., the
price falls to $38, and we observe a willingness to buy of 9,999,900 shares.
(Note that 9,999,900 shares is the maximum number the Nasdaq feed is able to
display even if actual orders are higher.) The price stays around $38, never
falling below $38, for the next twenty minutes, and we again see the
willingness to buy being slowly depleted. However, in contrast with the $40
case described above, the buy orders in this case are never fully depleted. In
fact, at about 3:55 p.m., more orders at $38 seem to be added to the order
book. Shortly after this addition, the price begins to rise and doesn’t fall
back to $38 that day. We conclude that the underwriters’ attempt to support the
price at $38 was successful.
What are the underwriters’
incentives to stabilize prices? Underwriters have conflicting objectives on the
day of the IPO when the stock price appears at risk of falling below the
issuing price. Their obligation to the firm—and their reputation—pushes them to
support the stock, especially around the IPO price. However, this does not
serve their short-run profit interests. Indeed, notice that because of the greenshoe
option, which is equivalent to a short position on the stock and a call option
at $38, the underwriters are effectively long a put option with a strike price
of $38. (For simplicity, we ignore the fact that underwriters receive all
shares, including the over-allotment, at a small discount to the issuing
price.) Such an option would become valuable were the price to drop below $38
and should therefore never be exercised above the strike price. In particular, in
order to cover the short position created by the over-allotment, underwriters
should never buy at a price above $38 in the open market because they could instead
exercise the greenshoe option. Contrary to this reasoning, we find that the
greenshoe option was never exercised (based on the free-float level following
the IPO of 421 million shares), but that there was significant buying activity
at and above the strike price (specifically, at $38 and $40), which we
interpret as being driven by underwriters’ stabilization attempts.
Based on our identification assumption, the evidence we produced suggests that not only did the underwriters forfeit the profits they could have made by covering their short position with shares bought in the marketplace below the offering price had they let the price fall, they also incurred costs through the stabilization attempt at $40. Assuming that they
purchased all shares traded at the $40 price (about 34 million shares), we
calculate that underwriters spent about $66 million supporting the stock, or
almost 40 percent of their underwriting fees. If this estimate is correct, underwriters’ reputational concerns and obligations to the firm may have outweighed their short-run profit motive.
Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Thomas M. Eisenbach is an economist in the Money and Payments Studies Function of the
New York Fed’s Research and Statistics Group.
David
O. Lucca is an economist in the Capital Markets Function of the Group.
Karen
Shen is an undergraduate intern in the Capital Markets Function of the Group.
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