There’s a strange new creature on Wall Street: the cautious investment banker. Born of the disastrous Facebook (FB) initial public offering, he’s well-groomed, relatively sober (thanks to 2008), and terrified of another flop. In pricing U.S. IPOs this year, he has seemingly underestimated investors’ appetite for new stock. As a result, some companies raising money from the public may have left a lot of cash on the table.
The average first-day return of almost 200 companies that made their debut on public markets in 2013 was 17.3 percent, by far the biggest average “first-day pop” since the late-’90s tech bubble, according to Ipreo, a market intelligence firm. “The banks are pricing conservatively,” says Moshe Cohen, a finance professor at Columbia Business School. “It’s not conservative based on the fundamentals of a lot of these companies, but it is conservative based on the demand for the stock.”
When going public, a company—along with some insiders and early investors—sells shares at a set price to the investment banks underwriting the offering. The banks in turn sell the stock to their customers, who are generally free to offer it on the open market. Zulily (ZU), an online retailer that started trading on Nov. 15, sold shares at $22 apiece and saw the stock end the day at $37.70. If the stock had initially been priced at the level of its first-day close, the company and other sellers would have captured an additional $181 million, an amount equivalent to almost seven months of sales. A few days earlier, Twitter (TWTR), in one of the most anticipated and scrutinized IPOs since Facebook, surged onto public markets with an almost identical first-day increase—73 percent. For Twitter, that gain represented a gap of $1.3 billion, more than four times its 2012 revenue.
Six U.S. companies that held IPOs more than doubled in value in their first 24 hours on public markets; only five businesses accomplished that feat in the preceding 12 years. In somewhat simplified terms, investors were willing to pay twice as much for those companies as the bankers handling the offerings thought they would.
IPO pricing isn’t easy. When a promising young company is losing money—a budding biotech or an ad-shy social network—value is based on long-term potential. That doesn’t give bankers a lot of metrics to use in setting an initial share price. Investment banks have an incentive to price IPOs on the low side. The hedge funds, mutual funds, and other institutional investors that buy IPO shares from the banks also route lucrative trading business through them. An underwriter that delivers a chunk of shares that surge out of the gate is more likely to get a bigger share of trading business in return, according to Jay Ritter, a University of Florida finance professor who studies IPOs. “If I’m a banker, part of my job is to con issuers into thinking that underpricing is in their best interest,” he says.
Bankers also have legitimate reasons to fear a flop. Early stock gains build confidence. A company whose stock falls after months of carefully scripted publicity finds it harder to persuade investors to bet on it. When Facebook shares slumped in their first day of trading, it took 14 months for the stock to claw back to the IPO price, despite a string of healthy financial updates.
The Facebook fiasco cast a shadow over subsequent IPOs. “Whenever you see a disaster like that, we always say you can buy any IPO you see for at least the next month and make money” because the shares will be underpriced, says Kathleen Smith, chairman of Renaissance Capital, which advises institutional investors and runs an IPO-focused fund.
The episode also spooked executives waiting in the IPO queue. Columbia’s Cohen says executives at Twitter, in particular, were sensitive to market mood, because the company’s business model is still evolving. “Ultimately it’s a game of beliefs, and some of those beliefs can become self-fulfilling very fast,” he says. “Were Twitter to start getting some negative momentum, it’s just not clear how long it would take to turn around.”