Secondary Market Price Stabilization of Initial Public Offerings
William J. Wilhelm, Jr.
Wallace E. Carroll School of Management, Chestnut Hill, MA 02167
(617) 552-3990;
January 1999
For many investors, a double-digit first-day return is the defining characteristic of the initial public offering (IPO). Historically, U.S. IPOs have exhibited average first-day returns of about 10-15%.[1] Substantial in its own right, this average masks extraordinary episodes like the recent series of internet-related IPOs involving eBay, EarthWeb, and Broadcast.com that culminated on November 13, 1998 with a 605% first-day return on TheGlobe.com’s IPO. Of course, not all IPOs exhibit large price runups, but because underwriting syndicates routinely “stabilize” the secondary market price for poorly received offerings, few suffer sharp price declines during the first day of trading.
Price stabilization practices have drawn considerable interest in recent months following a series of articles by Michael Siconolfi and Patrick McGeehan of the Wall Street Journal questioning the use of “penalty bids” that discourage immediate resale or “flipping” of IPO shares, particularly by retail investors.[2] Although the apparent discriminatory application of penalty bids has triggered litigation and attracted the attention of the regulatory community, in a 1997 article in this journal, Lawrence Benveniste and I argued that there may be a sound economic rationale for such discriminatory practices.[3]
In an effort to shed further light on this debate, the Wallace E. Carroll School of Management at Boston College recently sponsored a roundtable discussion of price stabilization practices moderated by former Securities and Exchange Commisioner Steven Wallman.[4] In this article I will describe the various practices that fall under the rubric of price stabilization and outline several economic rationales for what is by definition a manipulative but legal practice. I will also summarize recently published evidence characterizing the winners and losers when IPOs are stabilized and outline some conclusions from the roundtable discussion that might serve as a guide to policymakers.
Price Stabilization: An Overview
The Securities and Exchange Commission (SEC) defines price stabilization as “…transactions for the purpose of preventing or retarding a decline in the market price of a security to facilitate an offering [italics added].”[5] Such practices are permitted because:
Although stabilization is a price-influencing activity intended to induce others to purchase the offered security, when appropriately regulated it is an effective mechanism for fostering an orderly distribution of securities and promotes the interests of shareholders, underwriters, and issuers. (SEC release No. 34-38067, p.81)
To gain some appreciation for the potential impact of price stabilization, consider the price and volume behavior following Landstar Systems’ March 5, 1993 IPO illustrated in Figure 1. The lower panel shows the difference between seller-initiated and buyer-initiated volume during the first 40 days of trading. Daily net selling pressure is almost uniformly positive and substantial during the first 22 days of trading and yet Landstar’s price remained at or above the offer price of $13.00 per share. Over the next several days, presumably with the conclusion of the price stabilization effort, Landstar’s price fell sharply despite relatively balanced buying and selling activity.
FIGURE 1
LANDSTAR SYSTEMS (3/5/93)
Offer Price: $13.00
Closing Stock Price for the First 40 Days of Trading
Trade Day: 1 1 2 6 15 24 40
Net Seller-Initiated Volume during the First 40 Days of Trading
From Lawrence M. Benveniste, Sina M. Erdal, and William J. Wilhelm, Jr., 1998, “Who Benefits from Secondary Market Price Stabilization of IPOs?” Journal of Banking and Finance 22, 741-767.
Stabilization of an IPO’s secondary market price usually involves one or more of the following practices: stabilizing bids, penalty bids, syndicate short positions. In the following sections I will describe each practice and summarize recent evidence of their relative importance
Stabilizing Bids
An underwriter can post a stabilizing bid in the secondary market whereby it agrees to repurchase shares (typically) at the offer price. This approach to price stabilization is essentially a reaction to selling pressure created by immediate resale or “flipping” of share purchased in the offering. Rule 104, requires that those placing stabilizing bids “…disclose the purpose of such bid to the person to whom the bid is entered (e.g., the specialist or executing broker-dealer).”[6] For shares traded on Nasdaq, stabilizing bids are identified by a symbol on the quotation display. Consequently, price stabilization efforts implemented by way of a stabilizing bid are transparent to market makers and, in principle, can be made so to investors at large.
Penalty Bids
In contrast to stabilizing bids, penalty bids are designed to prevent selling pressure by providing an incentive for syndicate members to place shares with investors who will not immediately flip their allocations. Regulation M, Rule 100 defines a penalty bid as:
…an arrangement that permits the managing underwriter to reclaim a selling concession otherwise accruing to a syndicate member (or to a selected dealer or selling group member) in connection with an offering when the securities originally sold by the syndicate member are purchased in syndicate covering transactions.[7]
Managing underwriters are required to disclose the presence of penalty bids, so defined, to the regulatory body of the market in which the stock will trade and to maintain records of their scope, duration, and enforcement. However, public disclosure of penalty bids is not currently required. Moreover, Regulation M does not contemplate the possibility that managing underwriters can use both explicit penalties unrelated to the selling concession and implicit penalties, such as the threat of exclusion from the manager’s future transactions, to create similar incentives within the syndicate membership.[8]
Syndicate Short Positions
Finally, a syndicate manager can create buying power to offset selling pressure by overselling or taking a syndicate short position during the allocation of the offering. This practice is best illustrated with a simple example. Suppose the issuing firm desires to sell 1,000,000 million shares in its offering. The managing underwriter might make commitments to investors for an additional 20% thereby committing the syndicate to deliver a total of 1,200,000 shares to investors. If the first 200,000 shares delivered to investors are immediately flipped, the syndicate can cover the remainder of its commitment by simply repurchasing shares at the offer price and then placing them (at the offer price) with investors to whom shares have yet to be distributed. In the event that significant selling pressure does not arise, the syndicate manager generally exercises an overallotment option that permits the syndicate to sell up to 15% more shares than issuing firm originally desired. The difference between the 20% overcommitment and the 15% overallotment option is referred to as the syndicate’s naked short position. The risk in establishing the naked short position is the possibility that the syndicate manager will be forced to repurchase shares at prices in excess of the offer price to satisfy its original commitments to investors (at the offer price).
Regulation M defines this type of share repurchase as a syndicate covering transaction and imposes the same disclosure requirements as those imposed on penalty bids. Consequently, investors need not be informed that an offering is or will be stabilized by way of a syndicate short position. Rather, investors need only be exposed to language indicating that “the underwriter may effect stabilizing transactions in connection with an offering of securities” and a characterization of possible stabilization practices in the “plan of distribution” section of the prospectus.
Figure 2 summarizes Reena Aggarwal’s recent review of price stabilization practices from the first quarter of reporting under Regulation M (May-July, 1997).[9] Aggarwal reports that about 50% of the syndicate contracts (54 out of 112 IPOs) contained explicit penalty bid provisions. However, penalty bids were actually assessed in only 28 cases. The fact that syndicate short positions are covered both in the presence and absence of penalty bids suggests that these stabilization practices are used both independently and in a complementary fashion. Perhaps most striking is Aggarwal’s failure to find even a single instance of price stabilization being implemented via the posting of a stabilizing bid. As a consequence, the early returns suggest that price stabilization efforts generally may not be highly transparent to secondary market investors.
It may be useful to recognize that the SEC effectively presents underwriting syndicates with a tradeoff. By posting a stabilizing bid, the syndicate does not put significant capital at risk because it can always withdraw the bid. The “price” imposed on the syndicate, however, is that it must make its intentions transparent. On the other hand, a syndicate short position puts capital at risk because the syndicate may be forced to cover its position at a loss if the deal is well received. In “exchange” for bearing this risk, the syndicate is not required to make its intentions transparent. It is obvious from Aggarwal’s findings how syndicates rate these alternatives.
The Economic Consequences of Price Stabilization
Risk Transfer
Cast in the most negative light, price stabilization might be seen as a means of transferring risk to a relatively naïve segment of the investor population. Returning to Figure 1, we see that during the first three weeks of trading Landstar Systems shares traded almost exclusively at 13-131/8. Consequently, any secondary market investor unaware of price stabilization or expecting stabilization to be a short-term phenomenon might reasonably assume that Landstar’s IPO had been fairly priced at $13.00 per share. Unfortunately, buying shares under this assumption would have been costly as the price declined sharply during the fifth week of trading and remained at its apparent equilibrium level of 121/4-121/2.
Risk Reduction
In the sense that price stabilization postpones the market’s search for an equilibrium price level, it is similar to secondary market trading halts, or “circuit breakers,” introduced in the aftermath of the 1987 market crash. Economists generally see little benefit in interventions that essentially throw sand in the gears of the market’s price discovery mechanism. However, Jeremy Stein and Bruce Greenwald provide a compelling argument for doing so when markets are subject to large volume shocks.[10] The basic idea is that under ordinary circumstances “value buyers” respond to price declines and thereby prevent prices from falling “too far.” However, when selling volume is large and concentrated, value buyers may hesitate to express their demands because the “transactional risk” arising from uncertainty surrounding the price at which an order will executed may be too great. Although a circuit breaker sacrifices timeliness, it might facilitate price discovery under such circumstances by reducing transactional risk and thereby encouraging a more complete expression of demand among value buyers when trading resumes.
Initial public offerings might be subject to volume shocks of the type imagined by Greenwald and Stein by virtue of the fact that there is no price and volume history against which to judge the early stages of secondary market trading. To make the idea concrete, consider two possible inferences secondary market participants might draw from an institutional investor selling a 50,000 share allocation of Landstar Systems at the offer price of $13.00. If such a trade involved the liquidation of the investor’s entire allocation, one might reasonably infer that the investor did not view the IPO favorably at the offer price, but for some reason was willing to accept an allocation from the syndicate.[11] If, on the other hand, the sale of 50,000 shares at the offer price represented a partial liquidation of a much larger allocation for diversification purposes, a less negative inference might be in order. The problem facing both potential secondary market investors and those receiving allocations in the offering is that it is impossible to distinguish between these two motives for the sale of an initial allocation.
In the absence of a commitment to price stabilization, investors have an incentive to respond rapidly to the noisy signal associated with the sale of a large initial allocation by liquidating their own positions. Unfortunately, when the liquidation of a large initial allocation occurs simply for the purpose of improved risk sharing, this may not be the optimal response ex post. A commitment to price stabilization weakens this incentive by temporarily shifting the risk of the deal being fundamentally overpriced to the syndicate. Presumably this provides both initial investors and secondary market investors an opportunity to develop a more measured perspective on volume shocks during the early stages of trading. If this in turn reduces the chance that investors will mistake a liquidation motivated by risk sharing considerations for an informationally motivated liquidation, price discovery might be facilitated by a more complete expression of aggregate demand conditions.
Price Stabilization and Bookbuilding
Even if it does not diminish the transactional risk described by Greenwald and Stein, I have suggested in a recent article with Lawrence Benveniste and Walid Busaba that price stabilization might be an important element of the bookbuilding effort that precedes the pricing and distribution of an IPO.[12] The basic idea, which is outlined in my 1997 article in this journal with Lawrence Benveniste, stems from the notion that the indications of interest collected from institutional investors during the lead manager’s bookbuilding effort provide information about market demand conditions and thereby promote more efficient pricing. In the same article we outlined the evidence supporting this theory and have since provided additional evidence in a recently published article with Sina Erdal.[13] Coupled with the fact that the bookbuilding approach is rapidly gaining popularity outside the U.S., the evidence suggests that this practice contributes to the relative vibrancy of the U.S. IPO market.
The banker’s challenge in a bookbuilding effort is to gain the trust of the investor community. A central tenet of this practice is that if after canvassing the investor community the lead manager finds that demand is stronger than expected, it will be in a position to set the offer price in excess of the price estimate suggested in the preliminary prospectus. However, because the syndicate’s compensation is a fraction of gross proceeds, it is in the lead manager’s interest to price aggressively regardless of what it learns from investors. If the investor community perceives this incentive distortion as being severe, it may be unwilling to cooperate in the bookbuilding effort in the first place. We argue that a commitment to price stabilization bonds the lead manager against overly aggressive pricing. The idea follows directly from the fact that a commitment to repurchase shares at the offer price is equivalent to providing initial investors with a put option. Any attempt on the part of the lead manager to mislead investors about the outcome of the bookbuilding effort will backfire on the syndicate. Thus a commitment to price stabilization promotes cooperation by lending credibility to the lead manager’s dealings with investors.