The game theory of IPOs
Fund managers and traders embark on a subtle game in the lead up to when a company goes public and once it lists. The FT's Rob Armstrong and Alan Livsey explore the dark arts of IPO game theory.
Filmed by Rod Fitzgerald. Produced by Seb Morton-Clark and Filip Fortuna.
Alan. Snapped, the parent company of Snapchat, which is, I know, an app that you use all the time--
All the time.
--comes public today, starts trading, the IPO process is nearing its end. So this makes it a good time to talk about how IPOs work. Now, you were once a fund manager. I've always assumed this process worked in a very simple way. In that, the IPO is upon you and you call up and you say to your broker, "broker, I would like 10,000 shares within the price range." I guess, for Snap that was 14 to 16. Is it so simple?
It's not that simple.
I wish I was. First of all, you have to back up a little bit. You will have done some, I hope, some valuation work.
So I've read the S-1. And I've--
You've looked at what is available to you in terms of research prospectuses in the United States at least.
See whether you're actually interested in it. Assuming you've done that work, then you would move on to the stage of, can I get any. Is it going to go up?
Ideally. And, can I actually get some shares? Because if it's a popular deal calling up your broker doesn't necessarily mean you're going to get your allocation.
What do I have to do to get an allocation?
Well, you have to, first of all, it would help, say in the case of snap, to have a good relationship with the lead managers. In this case Morgan Stanley and Goldman Sachs would have been ideal.
So I call up Morgan Stanley and I say, it's Armstrong, you know what a good client I am for you guys, give me some shares.
If you're a very large fund manager, like BlackRock. It's very possible that they will say, yes sir, yes madam, you know, we will do what we can.
Yes. Because you've given them lots of shares in the past.
If you're less high up on their commission list.
You may not get there.
You may not get there. There's other decisions that they have to make at that level. The client, i.e. their client, which is the company that's selling the shares, will want to have the shares go to the best clients, the tier 1 clients. The ones that are most likely to hold onto the shares and not just tip them out.
So the lead manager is actually going to make discrimination.
There's lot of political decisions.
But if I'm on the inside.
Or on the inside enough.
Yeah. You have a favoured position.
I'm a classy guy. I've got a trustworthy face.
I've come from a huge firm.
You're a long-term holder.
Do I get what I order?
If it's a very popular issue, no--
--is the answer. I think you will probably be scaled back. Is what they would say. And then the game begins. You are guessing how much will you be scaled back in your order? So say you put in some insane order for something like $100 million for a $10 billion IPO. You put in this big order, but you're actually hoping to get what?
2? 5? 10?
A percent of that.
But everybody is playing that game at the same time.
It's order inflation.
The logical conclusion of that game is that everybody orders all the shares. And you see what happens.
Multiple times. So that's when you hear--
Six or seven times oversubscribed.
And the question to ask is, at what price? OK. Very good. So I'm playing chicken, sort of, with everybody else who's bidding on the IPO, as it were.
There's probably a more textbook, game theoretical--
Multiple chickens. Game theory.
Yeah. Multi-chicken game. I guess the worry I would have is that I end up with way more shares than I actually wanted. Is that a possibility?
Here's the really weird thing.
You may get filled, as they would say, your order. You will get everything you want and maybe more, not the whole $100 million so say, but you may get more than you wanted if the deal actually doesn't go that well. If it seems that late in the day before the actual pricing and--
So this is the thing that if the deal goes badly, meaning there's less demand than I hoped, I'm going to get more shares than I wanted.
And then I face the nightmare, you know, if I'm a trader, I got the shares maybe hoping for a day one pop when they open to the public. If the demand slacked off on the last day of the IPO process--
Out they go.
Out they go. Am I now going to look at losses when the market opens.
It's possible. And so then we get into the Mr. Market thing that Warren Buffett would hate. But it gets very, very interesting at this point, because then it just to take some of the Mr. Market away, the lead managers will offer a kind of stabilisation service sometimes. And they will buy some shares in order to prevent an unruly market. And, as we might say, the definition of unruly is down.
So you have-- part of the reason the lead manager is a lead manager they have some financial firepower. Hopefully, they'll come up and support the price if you had a bad first day. Alan, thanks very much.