Wednesday, May 30, 2012

The Epicurean Dealmaker replies to my Facebook post

The Epicurean Dealmaker (TED) has replied to my Facebook post. As usual TED is worth reading.

The Epicurean Dealmaker: As Long as the Right People Get Shot

His argument comes down to the IPO discount being a cost of doing business.

However I would like to turn this into a real estate deal. I go to a real estate agent and ask her to sell my property at the best price.

I enter into a contract which obliges the real estate agent to sell at the best price.

She sells it at less than the best price - as she always does.

She has a queue of buyers willing to buy because she always sells at the best price.

In this case I would think she is a shonk more concerned with her own franchise (her queue of buyers) than my best price and her legal and moral obligations.

I think precisely that of investment bankers. Always have.

My view of the morality of this trade differs from TED's view. And I would like to explain how I think that TED has got to his strange position.

To do that I need to look at this transaction from Morgan Stanley's viewpoint

Morgan Stanley (at least on this deal) appear to have broken the cardinal rule of investment banking. The cardinal rule of investment banking is to look after the investment bank (in the hope that at bonus time they will look after you).

Morgan Stanley's interests are clearly damaged by the Facebook IPO. Their ability to do more IPOs of scale is somewhat limited. Their ability to do future deals is contingent on a reasonably predictable IPO discount.

In my post I defended Michael Grimes (the Morgan Stanley investment banker) as he did what the law and ethics required of him. He looked after the client. I stand by that moral assessment.

Michael Grimes should most certainly NOT be investigated by the SEC for this.

But here my deeply cynical side comes out: Michael Grimes should be fired by Morgan Stanley for this deal. He broke the cardinal rule of investment banking which is the investment bank's interests come before the client interests. By selling too much Facebook at too high a price he has damaged the franchise of the investment bank. That is untenable.

People get fired in investment banking for lesser infractions.

So where does the Epicurean Dealmaker's moral position come from

TED is an investment banker. His background is M&A.

Morality for him is defined by the cardinal rule of investment banking. After all that is what you have to do. It is the moral pact of everyone who works in investment banking.

Indeed it is a moral pact that almost all humans make. What feeds you becomes (in your eyes at least) moral.

This was the very point of my post. People's morality is defined not around what is right and just but what they need to do to make a buck. We are human. Even TED.

Investment bankers learn to rip of clients. That is what they need to do to get by.

And the Epicurean Dealmaker - and everyone else in the industry - has accepted that as the new fair and just.

Its not the Epicurean Dealmaker is a bad man. (I like and respect his blog. I think I would like and respect the man.) It is just that circumstances make the morals.




John

30 comments:

Anonymous said...

You did not address the argument that it might be in the sellers interest to price the offering low so that it will be easier in the future to sell the rest of the company? After all Facebook sold 15% of the company but they are going to have one hell of a time selling the other 85% now?

John Hempton said...

I know I did not address that. Firstly the IPO pop thing seems to want to apply even when the vendor sells the lot (eg Myers in Australia sold by TPG).

But more to the point I flat do not believe that the stock price in 3 years is going to have much if anything to do with the trade of this week.

If the insiders want to keep most the rest for a while the concern is irrelevant. Really I do believe that. FB in two years is going to be determined largely by earnings and revenue progression.

In this case FB instructed MS to sell more at higher prices. And MS did. FB was the client. MS duty is to the client. End of story...

J

Anonymous said...

John,

I think you are mistaken that it was in Facebook's interest to sell at the highest price possible, for the following reasons.

1. There is the standard argument that they will need to do follow-on sales, and not in 2-3 years' time, as you say: aren't they going to need to sell 277 million shares in 6 months' time to cover the tax liability arising from the expiration of the lockup on their employees' RSUs? As an investor, are you more likely to buy at 32 if you bought at 28 in the IPO and are sitting on $4/share of profit, or if you bought at 38 and are sitting on $6/share of losses?

2. Most of the net worth of most of Facebook's employees is tied up in its stock. A rising share price from here on, until lock-up expiration and beyond, makes for a happier workforce. As a fast moving tech company whose employees are its secret sauce, it is important to keep the workforce happy (and yes, we are motivated not just by the level of our wealth but also its recent and perceived future trajectory).

3. The share price is also a potent marketing tool, to use on its users and advertisers. The value of Facebook as a communication medium is still driven more by belief than hard data; what the stock market thinks of FB is an important factor in support of that belief. Had the shares done well post-IPO, I am fairly confident the likes of GM would be reconsidering the decision to pull their ads from Facebook.

It was Grimes' job to explain all this to Facebook, to the extent that any of this is correct, and convince Facebook to set the size and price accordingly. It was certainly not his job to take Facebook's price-maximization instruction and run with it without any push back.

Also, I agree with TED that companies entering the IPO process are buying the distribution franchises that their banks have to offer; as such, the fact that you have to give the folks at the other end of that distribution channel a good deal to keep them and the banks interested is a clearly understood cost of business.

cig said...

The real estate metaphor cuts both ways: there's a chance she'll get known for selling cheaply, and thus ultimately fail to get new mandates, especially if the sellers know what they're doing (e.g. are property developers). So here self-interest works for everybody, the equilibrium discount/premium will be where the queue of buyers balances the queue of sellers. Adding a moral layer to the story isn't going to help make the parties better off.

It's a bit trickier when some of the parties are vulnerable, but the only vulnerable people in an IPO situation are people who shouldn't be there in the first place (e.g. the naive end of retail); and if someone should be in charge of keeping them out of the field, it's not the players.

That people tend to justify their line of work is true, but I don't think that has relevance here. He's not even an IPO banker, and he's not denying investment bankers are self-interested, but that self interest here doesn't create a material moral problem. It's also a bit of a weak argument, in that you can always use it as a wildcard to disqualify people who are in any way professionally involved with the topic you're talking about.

Another problem, if in a similar way a weak wildcard, is that it's hard for people to admit they've been wrong on something, including to themselves. We've all been there. Time does help though, and it would be interesting to see if your future self comes to disagree with your current self, in say a couple of years' time.

Tyler Maynard said...

"However I would like to turn this into a real estate deal. I go to a real estate agent and ask her to sell my property at the best price."

Are you not describing an M&A deal, where value maximization is the primary objective? People don't generally sell a portion of their house to a variety of customers who then trade their positions on a public exchange; they sell their entire house to one party.

Robert in Chicago said...

Your response to the first comment seems surprisingly naive about how stocks get valued over time -- especially tech companies with highly uncertain futures whose stocks have very high valuation multiples. FB sold 10-15% of its stock. It may want to issue more stock in the future, but more likely it will want its existing holders to be able to float a big chunk of the remainder over time, either individually or through secondaries (see, e.g., almost every tech stock to IPO in the last year). Those floats may start as soon 4 months out, not 2 years. Even if the earliest wasn't for 2 years, it is not _that_ much harder to argue why FB is overvalued or undervalued at 50x earnings than it is at 30x earnings; whether the market feels "comfortable" with 50x or 30x will depend a lot on many things other than how the business has done, including the self-reinforcing history of its stock price movements. If FB had gone out at $33 and popped to $38 and then drifted higher, its "great story" and "momentum" and "strong technicals" might lead it to a 50x multiple in 2 years. As it is, FB is a "broken stock" and it might end up with a 30x multiple on those same earnings. It happens all the time with "story stocks" -- their high multiple sustains until it cracks big-time, and then it never recovers. FB cracked at the open.

So in theory, MS's obligation wasn't to get the highest price for the 10-15% that was floated, it was to maximize FB's value over time, which requires balancing the consideration of get-the-highest-price against that of future-momentum.

In this case, that theory got blown up by another factor: FB told MS to get a higher price. Then their obligation was to do what they were told. Facebook's itself made a big mistake.

Either way, your core point still stands: It is ridiculous for people to argue that MS breached some ethical obligation by setting a high price.

Finally: how sure are people that the SEC is investigating MS for that reason? I am not following that news. Is it possible they are investigating why the trading that day was so shambolic, just as they investigated the flash crash? (...and what a bang-up job they did on that investigation...)

Anonymous said...

[ I posted this earlier but it hasn't appeared yet; apologies if it was in the moderation queue and not deep-sixed by my inability to read the captchas ]

John,

I think you are mistaken that it was in Facebook's interest to sell at the highest price possible, for the following reasons.

1. There is the standard argument that they will need to do follow-on sales, and not in 2-3 years' time, as you say: aren't they going to need to sell 277 million shares in 6 months' time to cover the tax liability arising from the expiration of the lockup on their employees' RSUs? As an investor, are you more likely to buy at 32 if you bought at 28 in the IPO and are sitting on $4/share of profit, or if you bought at 38 and are sitting on $6/share of losses?

2. Most of the net worth of most of Facebook's employees is tied up in its stock. A rising share price from here on, until lock-up expiration and beyond, makes for a happier workforce. As a fast moving tech company whose employees are its secret sauce, it is important to keep the workforce happy (and yes, we are motivated not just by the level of our wealth but also its recent and perceived future trajectory).

3. The share price is also a potent marketing tool, to use on its users and advertisers. The value of Facebook as a communication medium is still driven more by belief than hard data; what the stock market thinks of FB is an important factor in support of that belief. Had the shares done well post-IPO, I am fairly confident the likes of GM would be reconsidering the decision to pull their ads from Facebook.

It was Grimes' job to explain all this to Facebook, to the extent that any of this is correct, and convince Facebook to set the size and price accordingly. It was certainly not his job to take Facebook's price-maximization instruction and run with it without any push back.

Also, I agree with TED that companies entering the IPO process are buying the distribution franchises that their banks have to offer; as such, the fact that you have to give the folks at the other end of that distribution channel a good deal to keep them and the banks interested is a clearly understood cost of business.

o. nate said...

I think TED's strongest argument, which he relegates to a footnote, is that in order to sell in bulk you need to offer a discount. If I understand him correctly, the structure of the IPO market relies on the participation of what are in effect "wholesalers" - ie., buyers who have the means and are willing to take large chunks of IPO stock on a regular basis in the hopes of flipping it for a profit. The alternative I guess would be to try and cut out the middlemen and only deal with buyers who intend to be long-term investors. The difficulty would be lining enough of them up on day one, since every deal attracts different natural buyers. It's much easier to line up the usual crowd of "flippers", if you consistently offer them a safe and juicy stag. So maybe it's not so much greed as it is simple laziness on the part of the investment banks.

Admin said...

> Indeed it is a moral pact that
> almost all humans make. What feeds
> you becomes (in your eyes at
> least) moral.

Perfectly put and absolutely right.

I see this all the time. For example, those I know who work for the State *cannot* to themselves have the view that the State or what it does is wrong. How could they? It's just impossible, because to hold that view would mean they would need to change their jobs, all that trouble; and so their subconscious, which instinctively knows this, protects the conscious mind by blocking acceptance of that view.

The problem with this is that it stops reasoning and it also prevents people reaching views which go *beyond* the threatening view but which where the reasoning required to reach thsoe views can only occur once the threatening view has been consciously expressed. People get blocked.

Admin said...

> Indeed it is a moral pact that
> almost all humans make. What feeds
> you becomes (in your eyes at
> least) moral.

Perfectly put and absolutely right.

I see this all the time. For example, those I know who work for the State *cannot* to themselves have the view that the State or what it does is wrong. How could they? It's just impossible, because to hold that view would mean they would need to change their jobs, all that trouble; and so their subconscious, which instinctively knows this, protects the conscious mind by blocking acceptance of that view.

The problem with this is that it stops reasoning and it also prevents people reaching views which go *beyond* the threatening view but which where the reasoning required to reach thsoe views can only occur once the threatening view has been consciously expressed. People get blocked.

evwarsh said...

Life is all about justification.

Anonymous said...

Tyler is correct. John, who is my favorite blogger, is continuing to take terrible metaphors and apply them wholesale and inaccurately. The house example is awful.

Second, as TED said, there are no patsies in the FaceBook v MS IPO dept v Inst'l buyers. Everyone knows and agrees to all conflicts, fin'l and otherwise.

The buyers can ALWAYS step away. The issuer can ALWAYS setp away, both parties often do if they don't like the price.

Every single CEO I've worked for, worked with in I-banking, or managed money for wants his IPO to pop in the after-market. Every single one over the past 20 years, and it's a large number.

TED was also right with his metaphor of a large spot secondary -- they get priced at a discount to market! Shock!

Zimmer said...

In your original post on FB, you said that MS has a moral and legal duty to get the best price for FB.

I reviewed the Underwriting Agreement between FB and MS. MS only agreed to buy the shares from FB for a fixed price. If there is a legal duty for MS to seek the best price for FB, it isn't in the Underwriting Agreement

Hank said...

I guess what I don't understand is that there is no correlation between value and IPO price. I have read arguments that FB should be valued at $5-$45. Having tens of billions of dollars as a margin of error makes it difficult to see what discount means. (And such large margins of errors pricing an ipo isn't unique). The day one pop is pretty strong evidence that the underwriter's are not discounting value, but guessing at value- unless a majority of ipos were popping in a consistent and narrow band.
An established public company can have a discount, because it's a known quantity, and there is rarely ever a pop- because the guesswork is minimized.
I also don't understand the point that you have to price a stock to attract future investors. That suggests the market is both wildly irrational and abhors efficiency. In the shorterm, maybe, but the longterm?

Elf Owl said...

John, you raised a valid question and, in this case, TED explained perfectly perfectly the error in your reasoning. Even you admit this (indirectly) by applying the metaphor of real estate. The seller wants the highest price, but any salesman will point out to the seller that a higher price increases the risk of the house not getting sold for a long period of time. If the salesman consistently does not succeed in bringing down the asking price the agency will get stuck with a large inventory, little turnover and a bad reputation. That is bad for the agency (which you admit) but also bad for the customers that don't get served.

And yes that does leave a glaring conflict of interest between the agency and the seller which some people only understand afterwards and prompts others not to trust their home sale to an agency. On the other hand, the majority of the customers are happy (and sometimes ignorant).

Anonymous said...

John,

I pretty much agree with your view of the IPO and the actions of the various players.

As I watched it unfold and the pricing start to firm up, my over-riding thought was that it was a very aggressive price - to such an extent that I thought it was immediately a great short.

However, as I have listened to the griping since flotation, I realised that there is a significant proportion of the market that was just lazy. They didn't do their own homework and just relied on a significant uplift from IPO. That this didn't happen was not a surprise.

Over the last few years, we've witnessed the consequences of lazy investors - whether they bought into the FB IPO or relied too much on rating agencies judegements, they've been unwilling to accept they didn't do their homework and have been caught short.

What I really wonder is what it will really take to force investors to 'man up' and take responsibility!

Ken.

Anonymous said...

you did not really answer to the rationale of selling at a discount due to signalling effects, real estate is not exactly comparable to companies selling an ownership stake, given that you would be selling the house as a whole just as if a company is sold in an m&a transaction, in which case, you would be rightfully to be pissed off if your agent /banker undervalued your assets in a sale.

James said...

Just a couple of points from a securities lawyer.

1. Following the eToys decision, all underwriting agreements in the US make it explicitly clear that the underwriters are not acting as the fiduciary of the issuer. I have never seen an issuer successfully make changes to the stock language in underwriting agreements.

2. I think that you and TED may not be in agreement as to what follow-on offering means. I think that TED is referring to the fact that some issuers set up the IPO (or any other securities offering) as the first of a series of offerings to occur within a relatively short period. So the issuer has an incentive to keep the market happy. (For example, a start-up might file one registration statement to sell a small percentage of the company and then file a second registration statement to sell debt and a third registration statement to do secondary offerings, which admittedly isn't technically a follow-on.) Also, existing pre-IPO stockholders, whether venture funds or PE firms or stockholders paid in equity, who want to sell in the market benefit from a healthy stock price post-IPO (or post-offering) if they wish to sell into the market without the benefit of a registration statement.

Anonymous said...

Elf Owl you are mistaken. There is an art to pricing a house and if you price it too high you will not draw buyers. That is true. However, there are bidding wars that happen over a price set low and the art is pricing it low enough to peek interest and high enough to set a vague lower limit. The broker should not price the house too high but should get his client the highest price possible.

Anonymous said...

As a former investment banker that ran IPOs we used to run a book of demand whereby investors bid for different volumes of shares at different price points. In theory the IPO could then be priced at the maximum price where all the shares could be sold.

In reality where there were IPOs that were highly sought after investors would often bid for a multiple of the number of shares that they truly wanted (anticipating scale back) which obviously sends a false signal of true demand to the invesment bank and issuer.

Who is to blame in this situation - the investment bank / issuer acting in good faith based on the bids received in the demand book or the investors that bid for too many shares?

buboe said...

@o.nate - I think you hit that nail on the head - the analogy of an equity raising performed at a discount is the closest I've seen.
Where TED goes off the rails a bit (and like John, I am a big fan) is twofold - firstly, he conveniently ignores the history of these sort of IPO pops. If the day 1 increase is 100%, that's hard to dismiss as a bulk discount - it's a cosy agreement between an IB and their buy-side clients.
Secondly, his argument that the bank has no _moral_ duty to find the best price is underpinned by saying that they have a contract.
My understanding of a moral duty is that it's one which supersedes legalese - I'm sure that in different circumstances so is TED's

Anonymous said...

I believe the quote that applies is:

"It is hard to get a man to understand something when his compensation is dependent upon not understanding it."

- Upton Sinclair

Or, as my father used to say:

"Where you stand generally depends upon where you sit."

Thomas said...

Defending John, who I disagree with on this point for the reasons stated by Anonymous #1 and others, there is a chance that MS told FB that to maximise their overall stake they had to have a 1st day pop, beat two sets of quarterly figures, and then issue loads more stock at what would inevitably be a higher price.

There's a chance that FB said "Look - our valuation is so ridiculously high, and p.s. our active users are declining, that there's no way we can sustain a decent rating. We know the business is worth $20bn max, so if you can sell 15% at a $100bn valuation, then we'll be chuffed to bits. It doesn't matter about the rest."

It's a shame that the Instagram founders only took $200m in cash.

Thomas

Mario said...

Thank you John for standing up for the truth in this industry. It's great to see someone (an Aussie no less) stand up to TED and the rest of these great "thinkers." They love to spout and make it LOOK LIKE they love the arts and humanities and are cultured, but really they are just greedy sophists and well rounded orators. I respect TED tremendously but let's face it, a shark is a shark no matter how you slice it (or quote it as the case may be). Rationality is only a fraction....a "ratio" of the whole. When you are dishonest and "justifying" or (normalizing) your defaults, inconsistencies, and/or flaws you end up with severe and inherent deviations in your models and frameworks. Hey that sounds like our economy today right!?!?!?

My wife is an Aussie from Sydney and we now live in LA, so I am somewhat partial to your blog and very much appreciate your thoughts and work. Keep it up bud! Cheers!

Anonymous said...

Given that TED's argumentation can be reduced to the good old "business as usual" and "free contracts under consenting adults" kind of tirade, it would be interesting if you could shed more light onto this topic. I think the central question is: are investment banks just honest middlemen doing unappreciated, but much demanded middlemen's work? Or are they more in a monopoly position, capable of extorting fees from their clients like parasites (the recent "scandal" at Goldman Sachs seems to suggest the latter)?

If you want to sell or rent your real estate, you can relatively easily do so without paying any agent's fees. What are your prospects if you want to place an IPO? (Being an outsider, I honestly don't know, so this is not a rhetorical question.)

Another topic worth consideration: is there some sort of external costs induced on third parties by the middlemen cornering the market (if such cornering exists)? We have seen that externalities are a huge issue when the soooo-smart bankers in tandem with much-more-clueless politicians (and the voting public at large, no doubt) manufacture debt crises. Could it be argued that a similar kind of risk is also present in case of (big) IPOs? Is this the direction into which the SEC is investigating now?

Overall, I can't help getting the impression that the high finance folks despite their cunning are dumb and rotten at the core. The main asset and long-term foundation of the banking profession is trust. By undermining it and afterwards acting in a smug, derisive manner toward the lay public, they are basically sawing off the branch on which they are sitting. Reading TED's posts I wonder whether this behavior is just cold, cynical calculation (grab as much as you can, knowing that you might not ever get a second chance) or simply being blinded to the fact that readers *do* see through the shallow, apologetic, conceited style and draw their own (unintended?) conclusions from both the content and the form of message.

Manc Trader said...

Here are TED's own words on the difference between doing things on an "agency basis" vs "principal basis" in an essay on swap pricing:
"As I have said many times before, investment banks' businesses can be characterized in one of two ways: agency businesses, where the bank acts on behalf of a client to execute a transaction and earns a fee for doing so, and principal businesses, where the investment bank acts as a counterparty to its customer, and earns a profit or loss on a trade. Traditional investment banking businesses like mergers & acquisitions advisory and securities underwriting fall squarely in the agency camp, whereas full-blown proprietary trading, in-house hedge funds, and in-house private equity funds fall squarely on the side of principal activities. Traditional market-making—where an investment bank stands ready to buy or sell existing securities, commodities, and derivatives for trading customers who want to execute the other side of the trade—can range from relatively riskless agency-type business, where the bank takes on very little inventory or balance sheet exposure to changing market prices, to much more proprietary operations, where the bank hopes and expects to make a profit by holding market positions for more extended periods of time."


http://epicureandealmaker.blogspot.co.uk/search?q=swaps+pricing
I think there is a contradiction between the views espoused by TED in this article versus those in response to yours.

Absalon said...

The Epicurean Dealmaker does not know what "best efforts" means.

He's wrong. Mr. Hempton, you are right.

Anonymous said...

Now I see why the right has such a hard time with protecting the environment. They won't even protect the capitalist environment -- the public markets -- which has been the key to American business prosperity for so many years. All in the name of squeezing out a little bit more of short term profit. It's a no win situation if people only want to win by strip mining the commons, whether it's the physical environment or the social trust/capital built up over generations.

Anonymous said...

Now I see why the right has such a hard time with protecting the environment. They won't even protect the capitalist environment -- the public markets -- which has been the key to American business prosperity for so many years. All in the name of squeezing out a little bit more of short term profit. It's a no win situation if people only want to win by strip mining the commons, whether it's the physical environment or the social trust/capital built up over generations.

Mark T said...

I suspect that MS also fell victim to their own selling tactics. The pitch to the 'professional' market was basically a form of front running; "this is going to be heavily over-subscribed so put in for more than you need as you will be scaled back" with the obvious implication that price will rise in the aftermarket. As all market stags know, the expected level of demand is a key factor in the subscription decision. I suspect the problem came when the institutional salesmen came back with indications of demand that were in effect fifty per cent higher than the actual amount wanted. The Bankers then fed their own false information back into the model and inflated the supply such that everyone got filled with their fake level of demand. Result, day one the extra stock is immediately dumped into the market with some of the faster moving traders seeking to make their return on the other side of the trade by shorting.

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