The talk on Wall Street all weekend was the Facebook (NASDAQ:FB) IPO — but not for the reason many people would think. Yes, the company pulled off a $16 billion offering to mark the largest tech IPO in history. And yes, boy wonder Mark Zuckerberg got married on Saturday.
But the big talk was about how Facebook would fare Monday morning, and how much the shares would tumble. And tumble they have, down as much as 14% in early trading. Though the newly minted FB hit the market at $38 and closed up a few pennies from there, there was no doubt that the closing price was a farce and that this stock was about to get hit — and hit hard.
Surprised? Well let me explain how this happened, and why many Wall Street insiders expected the double-digit decline (so far) we’re seeing today in Facebook stock.
First, a brief overview of initial public offerings: Basically, when a stock goes public, it doesn’t throw shares willy-nilly to the masses. Rather, it uses an “underwriter” as a middleman, parceling out shares to lucky investors and orchestrating the process for a fee.
The underwriter is the gatekeeper to an IPO — and in the case of a company like Facebook, the fee for your labor is only part of what you’re after. If you have access to FB stock before the general public does, a large amount of prestige and power come with your role.
Take Facebook’s lead underwriter, Morgan Stanley (NYSE:MS). As the gatekeeper for a hot new stock like Facebook, clients were banging down the door to get in on the action. MS could earn new business with FB as a carrot, or reward its best accounts with exclusive shares and keep them loyal. There are other perks, too, but you get the general idea.
That’s perhaps why the underwriters on Facebook, led by Morgan Stanley, charged a rock-bottom 1.1% fee on the IPO. That’s not chump change, since the roughly $16 billion stock offering dished out $176 million in fees, but the big payday comes from simply having a finger in the Facebook pie.
At least, in theory.
You see, the idea was that Facebook would pop dramatically after shares hit the market — and your only way to get in on the profits was to play ball with Morgan Stanley and other underwriters. But that didn’t happen, and the price people paid for access now doesn’t seem worth it. In fact, some investors may feel duped.
Worse-case scenario, of course, would have been if Facebook didn’t just hold firm but actually performed poorly as it hit the market. Then what company would trust you to underwrite another IPO if you botched the job so badly? Why would anyone want “exclusive” shares, if they’re just going to tank on the first day of trading?
Good thing Morgan Stanley and the underwriters avoided that, right?
And here’s where we arrive to the dirty little secret. That’s exactly what would have happened to Facebook if MS hadn’t made a heroic effort to prop up the stock price by buying frantically as the closing bell approached on Friday afternoon. Just look at a chart of FB stock … it was like the natural market forces magically stopped working — and shares hit an equilibrium. With around 600 million shares in volume, that is just impossible to credit to natural market forces.
In fact, it appears to me that Morgan Stanley tried to hold the line at exactly $40 to lock in a fictitious 5% gain from the offer price of $38, but realized it would cost a fortune to defend that amount for two hours. After all, if you’re buying a few million shares, that extra $2 adds up in a hurry.
In short, Morgan Stanley wanted to save face by going into the weekend with a “gain” in Facebook for its IPO investors. The problem is that the gain was a fiction, and the market swiftly “corrected” Facebook shares on Monday morning.
Did Morgan Stanley do anything illegal? Though it may sound unethical and preposterous, it doesn’t appear so. Those are just the rules of the market — and the firm is free to buy and sell shares like everyone else.
But one thing is for sure: The black eye that MS is going to get from this botched IPO will last for a very long time. Clients who were promised an exclusive opportunity will jump ship. And some of the shares Morgan Stanley was frantically buying will never be allocated to a disgruntled client, and the firm itself may wind up eating a hefty loss if Facebook continues to decline.
The good news for regular retail investors? If you were angry at underwriters like Morgan Stanley because they wouldn’t give you a shot at those “exclusive” FB shares at $38, this is your chance. You can now buy for under $34.
Or if today’s losses keep up, maybe even lower.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace??.com or follow him on Twitter via @JeffReevesIP. As of this writing, Jeff Reeves did not own a position in any of the aforementioned securities.