IPO Rant - Everybody Lies.

The IPO Game.

This is going to be a rant. I am going to rant, not because of any particular market view I may have, but, because you all may not really understand what the IPO Game is about and how it works. You may find it informative or entertaining or hopefully both. Its definitely suitable for criticism like this meme.

I am old and have seen some things and my brain has shrunk in my dotage. “Back in the day” is how these always start. Back in the day I was the global head of equity derivatives and member of the the seven person equity management committee at Salomon Smith Barney/Citigroup during the tech bubble. I was right in the middle of everything at an extremely senior level. Perhaps 1 of less than 100 people on earth with as clear and detailed picture of that time frame. This rant is about IPO’s and specifically the various incentives of the participants. While certain rules were written to curb some abuses since then the incentives have not changed and what has changed is mostly to not write stuff down that can be subpoenaed in the future. During that time there were thousands of IPO’s.

We were not the best IPO firm. Many firms that did a lot of business have been absorbed or gone out of business. BUT we were the favorite co-lead manager on the planet. So we were busy. Let’s break down the various participants in an IPO.

• The Issuer

• The Outside Selling Shareholders (whether in the deal or locked up)

• The Founders

• The Investment Banker

• The Commercial Banker

• The Private Banker/High Net Worth Retail Broker

• The Sell Side Research Analyst

• The Biggest Institutional Investors

• The Middle sized Institutional Investors

• The “friends of the firm” Institutional investors

• High Net Worth and Private banking investors

• Pure retail

• The Regulators/Government

• The Media

When you look at this list you might think that these participants have incentives that are by definition in conflict. The seller and buyer “must” have different interests. This would be a mistake at not only the macro level of the whole IPO environment but at the micro level of a particular deal. By and large every single participant wants an IPO to raise the money AND rally in the after market.

The cohort selling is selling a small portion of what they own. They are happy to leave a ton on the table. Any cohort getting an allocation wants the shares to rip. The entire sell side is dedicated to making that happen and just wants to collect the rent from being in the middle for as long and as much as they can. The entire regulatory and policymaker construct wants this to go well and have the money raised, investors happy, and the economy stimulated while they are in office. The media absolutely thrives on all the stories plus they know that while post IPO boom stories can be snarky and I told you so in nature no one likes those stories as much as get rich quick.

Of course a specific deal has conflicting incentives between the seller and buyer and the lead manager needs to manage a deal well such that they capture repeat business from the seller while not pissing off the buyers so the bank can win the next IPO mandate but these conflicts are tiny in comparison primarily because the issuer is selling so small amounts of shares and what they want long term is a successful IPO which encourages after market buying.

When incentives are powerful “Everyone Lies”

The Issuer lies

It stretches every possible limit in its roadshow. It “negotiates” with the banks by winking about future business which is a lie. It negotiates with the underwriters and potential buyers to make the deal “special” in some way. It demands after market support both in market making and research coverage from the Sell Side. It engages in allocation decisions to favor its key buyside investors who “promise” to buy more in the secondary market. It encourages giving retail, hnw, and private banking clients just a taste causing them to “want more”. I have even seen IPO issuers requiring their underwriter to allocate over the shoe and essentially go short deals forcing the underwriter to actually take losses on hot deals. BUT all that said they absolutely want the deal to trade up and stay above the issue price post IPO. A hot deal has no stigma a deal that trades down in the aftermarket is a momentum killer. Look at Figma for example.

The Outside selling shareholder lies

They claim they will buy 1BN on the IPO despite owning 15BN at a much lower cost. They are both pumping the deal for obvious reasons as they own the company AND simultaneously negotiationg the minimum lock ups possible to allow themselves liqudity in the future. As long as they are NOT sellers on the IPO’s they are entirely aligned with the world to have the deal go well. In rare cases like the FB IPO the selling shareholders are a large portion of the deal size. This is the rare and extremely important case of an IPO where the seller wants the top tick. Know this before investing.

The Founders Lie

They use sophisticated collars and borrow arrangements to hedge their exposure after the deal. While founders have to disclose their actions and pretty much always have they always lie spinning their sales as “necessary” tax and estate planning while locking in mega wealth. All along they have built this thing and they deserve their wealth in my eyes but. down a level these guys pump to dump.

The Investment Banker lies

This was me. Oh boy what a bunch of lying goes on at an investment bank during an IPO. They lie to the seller creating false narratives out of anecdotal evidence which itself is a lie. They lie to the buyers about the conditions of the other demand. They perpuate the lies from the road show and the lies from investors overinflating their interest in an allocation. They simulateously offer founders clever hedges, while providing buyers with derivative access to deals. They promise various investor cohorts special treatement in hot IPO’S for more busimess in other areas. In the aftermarket they simultaneously penalize investors who flip their holdings and rely on other investors they have placed shares specifically for liqudity when they need the flippers.

The commercial bank lies

The commercial bank’s interest in an IPO is future business from the now “liquid” corporation. They lie to the corporation in the lead manager pitch promising attractive financing for the company after the IPO and lie to their investment bank side of their holding company to say they will make money on the loans to encourage the investment bank to win the business. They don’t deliver on these lies.

The Private Banker lies

The private banker/high net worth advisor lies to two cohorts. In the IPO pitch to get the business they offer the world to newly rich founders and insiders that becoming a HNW client of their firm will ensure rich stay rich then they sell expensive hedging products and high fee diversifying investments to insiders and founders. They ration IPO allocations to their investing clients lying on how they have “taken care of” their client to get the hot deal allocation.

The Sell Side Research Analyst Lies

I am not even going to start on this. Liars all of them. Spitzer helped a bit.

The Biggest Institutional Investors lie

So “back in the day” Fidelity Investments paid the highest commisions, bid offer spread, and fees of all sorts to the sell side writ large. They decided that they were going to leverage their size by demanding a 10% allocation of every IPO they had interest in buying. NOT EVERY IPO just the ones they wanted. They lied that their size made it necessary to own 10% or it wasn’t worth doing the work to buy the IPO. They lied about which IPO’s they liked because they claimed that they were stock pickers and so sometimes they didnt want a stock. This was a lie because in practice they wanted the hot ones that were going to double immediately. The street was paraded through the offices up in Boston and capitualted to those demands. Not sure if they were in writing or not. But today those sort of demands could still be made “illegally” as long as they werent on paper. I have no idea what exists today. That said the incentive is still 100% as strong. The investment bank depends on the full range of fees paid by their biggest accounts and the biggest accounts know this creating a clear situation where big profitable accounts get the lion’s share of hot deals. As mentioned the investment bank lies to every investor about “taking care of them”. Every investor attempts to leverage their overall relationship to get the good deals.

The big lie from this cohort is the 2-10X order size they place vs what they actually want to get. They lie because they know they wont have to honor this order size or could change their mind last second. They also know that they aren’t going to get jammed by a bad IPO because they would respond by pulling their massive business. The investment bank knows its a lie but is happy to play along because it can then lie to many cohorts including the seller and other buyers about the health of the book.

The Middle sized Institutional Investors lie

Unfortunately these guys are mostly screwed in the IPO process. They try to lie about directing business toward the lead manager but they don’t have a stack. Instead they lean on their “investment process” where they have some sort of long term franchise and expertise to help the “quality of the book” by being long term holders and after market buyers. The lie often has believability. Still a lie when the they get a sweet allocation and dump it soon after.

The “friends of the firm” institutional investors lies

I was one of these guys. I started my hedge fund in 2003 and we were a hot fund. We grew from 100MN to 3BN in two years. When we were tiny an IPO Allocation of a hot deal could drive a significant return for us. At 100MN a $500,000 profit IPO flip could generate a 50bp return which would make our month. We lied. We sucked up to a few dealers who were in the deal flow and leveraged prime broker and repo service agreements and our bright and growing future to get a couple of decent (and entirely undeserved allocations). Every sell side firm has a couple of dozen house accounts. The investor knows they are going to flip the allocation immediately, The sell side firm depends on the flip for market making, both parties are in bed with the future of the relationship. Its grease that allows the machine to run. Its not investing. It’s an unspoken, unwritten agreement. It’s a lie.

High Net Worth and Private banking investors lie

Unlike pure retail which I’ll cover next. This group lies by promising private bankers and high net worth brokers incoming assets, relatively high fee paying income, and perhaps corporate business from companies they control in return for hot deal allocation. This cohort is provided allocations to hot deals by the Investment Bank as a long term strategic initiative. This cohort also is attractive from a friends and family perspective of the wealthy founder or VC firm doing the IPO.

Pure Retail lies

Unfortunately pure retail only lies to themselves. They think that somehow they will get lucky in some sort of lottery way and get a random decent allocation that spikes higher. They won’t as a group. Like the lottery retail IPO orders are substantially negative expected value. Pure retail puts in an oversized order relative to their portfolio hoping it impacts the chance of a hot deal fill. When it actually turns out they get a full fill of this outsized order its because the deal will trade down. This cohort has no leverage whatsover and is purely negative selection. They lie to themselves that they will get filled on a huge win. They won’t. I won’t even discuss the negative expected value once they fail to get filled and FOMO a market order for the opening of a hot deal and pay the top tick. Just lying to themeselves.

The Regulators/Government lie

The formation of capital is a national interest. Transferring cash from those who want to save to those who want to invest in the real economy IS the function of the capital markets and capitalism itself. It works! Governments and Regulators are cheerleaders for this process. They lie about “protecting small investors”. They lie because small investors don’t matter to their interests. Big investors, corporations, banks, investment banks, and the growth in the economy during their elected and appointed terms are what matter to them. So they lie. How do I know. I’ve written 1000’s of word just now about a process that works great at the big picture level and is built on everyone lying and everyone but pure retail knowing that everyone is lying. 25 years ago the IPO market collapsed in the tech bubble popping and Eliot Spitzer made a big splash with new powerful regulations and laws and fines. Today? Nothing has really changed. The incentives are too strong.

The Media

I just can’t.

Rant over

This may seem like an extreme cynical rant about the IPO process. It’s really not. It’s reality. It works but it is messy and ugly and better than the alternative where a central government picks the winners and losers in the private sector. Oh jeez, another rant brewing.