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Pre-IPO Investors Are Not Supposed To Lose Money. Fix That, Morgan Stanley.

Two things that I have thought before and occasionally committed to these pages are:
(1) conflicts of interest at investment banks are actually sort of interesting and potentially value creative and not to be dismissed with knee-jerk “ooh conflicts evil,” and
(2) it just cannot be that hard to execute basic common stock capital markets transactions (but they pay well).

Now point (2) has always struck me as a bit shaky because of point (1). The absolute classic nexus for banking conflicts of interest is the big capital markets transaction, by which I mean mainly the big IPO, because this is the place where two sets of important clients square off against each other in a more or less zero-sum way. You can find win/win solutions on lockups or share structures or whatever, but ultimately you have investor clients who want to pay $X per share and an issuer client who wants to get paid $Y per share and Y>X and your job is more or less to make Y=X. Your business is making that trade happen with valuation models and technical arguments and wheedling and persuasion and steak dinners and threats and implicit promises of better deals in the future and whatever other tools you have available to you. This is complicated. Some of those tools are not tools you’re supposed to have.

A good capital markets bank makes the best possible use of the tools that it legally can use to get lots of deals done that everyone feels good about. It’s not rocket science necessarily, and it sometimes ends up being pretty easy, but at least sometimes it requires quite a bit of finesse and skill.

A deal that not that many people feel good about is the IPO of Zynga, led by Morgan Stanley and Goldman Sachs, which fell below its IPO price on day one and hasn’t looked back. So, sad for Zynga, or at least for its buyers. Even sadder:

But there were even bigger losers before Zynga’s shares began trading: some of Morgan Stanley’s wealthiest clients. The bank’s investment management group used a collection of 11 of its mutual funds to buy into pre-offering shares of Zynga in February, when it paid $14 a share on behalf of its investor clients. In total, Morgan Stanley invested $75 million of its clients’ money to buy about 5.3 million shares of Zynga. As of Monday, its clients had lost a third of their investment, or about $25 million on paper.

Morgan Stanley, which has been the top underwriter of hot technology I.P.O.’s, has often used client money to invest in pre-I.P.O. shares. Coincidentally or not, it has often later found a way to land a role as a lead underwriter. In that position, it reaps eight-figure windfalls for the firm.

Such investments raise a question that has long been whispered about but rarely asked aloud: Should investment banks seeking underwriting roles in I.P.O.’s be allowed to invest client money in prospective corporate clients ahead of a potential deal? …

Frank Partnoy, the director of the Center on Corporate and Securities Law at the University of San Diego and a longtime critic of Wall Street (and a former Morgan Stanley employee) has an even more skeptical view. “It’s another example of how the cash cow of I.P.O.’s creates corruption and self-dealing,” he said, adding that he takes “the corruption part as a given.”

This is absurd, right? You can do a quick proof of why it’s absurd: substitute the words “shares in an IPO” for “pre-IPO shares.” Then you get the following:

“Morgan Stanley has often told its clients to invest in shares in IPOs. Coincidentally or not, it often leads IPOs, which brings it fame and fortune but not Christmas parties, never Christmas parties. This raises a question that has long been whispered about but rarely asked aloud: Should investment banks underwriting IPOs be allowed to tell their clients to invest in those IPOs?”

Okay fine that’s a little unfair. There is a difference between pre-IPO shares and at-IPO shares. (I guess?) And these investments were made by a MS-managed mutual fund, rather than an independent client exercising its own discretion. For myself I have trouble taking those differences that seriously: people invest in Morgan Stanley’s (or whoever’s) mutual funds because they like to make money. Part of the way they make money is by investing in hot pre-IPO shares. As Henry Blodget puts it:

Normally, these late-stage private placements are like shooting fish in a barrel: You get a sweetheart deal on some preferred stock just months before the IPO is sold to less-discriminating investors in the public market who usually pay a lot more for it.

And part of the way they make even more money is by investing in hot pre-IPO shares in companies that Morgan Stanley thinks are viable enough IPO candidates that it’s pitching their IPO. (I mean, I can offer you shares in all sorts of pre-IPO companies. I incorporated one just now. MS has yet to show up to pitch its IPO. Give it time.)

Part of the way they don’t make money, of course, is by investing in very cold pre-IPO shares, which happened here (at least on the evidence of three day’s trading). You win some, you lose some. If you lose a lot, though, you start parking your mutual fund money with someone other than Morgan Stanley. This is not in any substantial way different from what Morgan Stanley’s investor clients do: they buy MS-led deals as long as those deals mostly make them money; if those deals are all dogs, they start going elsewhere.

This is all just obvious and it’s weird that smart people like Frank Partnoy (who, I mean, sold derivatives!) and Andrew Ross Sorkin are bamboozled by the ooh-conflicts-are-evil story. Are there conflicts here? Sure, absolutely. Are they surprising? No, they’re the same as in every IPO. They’re not some evil secret hidden beneath the financial system. They’re what an IPO is. An IPO is just a bank resolving the conflict of interest between its corporate client and its investor clients to make everyone sort of happy.

If I were someone who liked to feel all persecuted about the public image of the financial business, I might say “hey, wait a minute, why is this ‘conflict’ situation different from all the other ones?” and I might come up with the answer “well, pre-IPO shares are supposed to go up, not down, and so it’s a scandal when they go down.” And I might go on to feel all persecuted about the asymmetry of these perceptions: when clients get advantageous access to pre-IPO investments, they have no particular reason to cry foul; when they get disadvantageous access to pre-IPO meltdowns, they can complain about conflicts of interest. Pity the banks, who are writing free public-perception puts on their conflicts in IPO underwriting. No wonder they charge so much.

Two Ways for Banks to Win With I.P.O.’s [DealBook]

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93 Responses to “Pre-IPO Investors Are Not Supposed To Lose Money. Fix That, Morgan Stanley.”

  1. Guest says:

    Matt, as you have actually worked at an investment bank, you can't possibly believe that the conflict between the corporate client and the investing clients is the only conflict of interest inherent in the IPO. The investment bank has a lot more conflicts of interest in the transaction than that one, and not all of those conflicts are detailed in full in the prospectus.

  2. J. Corzine says:

    It's really, really important to have a smooth IPO process, believe me.

  3. GuestLove says:

    Matt! No graph-y, no read-y!

  4. guest says:

    These IPO's since 1999 for the most part have been such such horsecrap it is amazing to me that there are still enough suckers out there to put money into them.

  5. Puck It says:

    Too Matt; didn't read

  6. fakelaugh says:

    Those tags are a real laugh factory.

  7. HungryIntern says:

    I was going to read this, but instead I decided to read about tOSU getting a slap on its wrist from the NCAA.

  8. Hipocracy Quant says:

    Having Henry Blodget criticize the conflicts involved in your IPO is the NKI

  9. Pitchbook says:

    "I mean, I can offer you shares in all sorts of pre-IPO companies. I incorporated one just now"

    Margs & Charts Inc.?

  10. Guy with A.D.D. says:

    Matt,
    Thanks again buddy <wink wink>

    -Alastair Lyons, Chairman, Towergate Insurance

    "The only thing longer than our advertisements are Matt's articles"

  11. Guest says:

    The real conflict is that they don't have Christmas parties. I'm going to pray for them.

    – Tebow

  12. Vinnie says:

    It doesn't matter that I sold you a stock I knew was worthless. That's what's beautiful about the invisible hand, baby…if I keep selling you worthless stuff, you just stop doing business with me! And nobody got hurt!

    • Thurston Howell, III says:

      Exactly. Getting paid huge fees to stuff my captive mutual funds with Farmville pigs is a problem that solves itself. And by the time it does, I'll be playing Mob Wars on an island somewhere.

  13. Pedantic Guy says:

    Here's why there's a conflict of interest. Say I think that the pre-IPO price I am being offered at $10.00 overvalues the company by $1.00; if I guy a million shares, I expect to lose a dollar. However, I know that the fees I will generate if I lead the IPO are, say >$10 Million. I also know that I am more likely to lead the IPO if I play nice now, and buy in at inflated prices. So, the higher ups at MS, knowing the deal is shitty, execute the trade anyway. Why because:
    1)They like to make money
    2) What kind of person invests in a mutual fund and doesn't asked to be raped (They don't even have a minimum investment). I mean, it's retail money. Ripping them off is almost an obligation.
    3)It's expected value is positive

    Finally, an equation just for Matt:
    E[V] = [change in likliehood I get to lead IPO if I buy shitty deal]*[value of leading IPO Deal] – [amount I expect to lose investing in shitty deal].
    If E[V]>0, rip of retail clients and make money.

    -Quant who doesn't need five pages and ten charts to make a simple point/likes to shake his head and say "fucking lawyers."

    • buboe says:

      Interesting attitude in re retail money.
      Hope it catches up to you, fuckwad.

      • Hey, whoa now... says:

        It's just an anthropological assumption about I-banks. One Matt seems to be blissfully ignoring. PG is on YOUR side, buboe, though that may be mildly embarrassing for him.

        • Pedantic Guy says:

          Thank you. And for everyone who "plussed" him, you should be embarrased both for yourself and your IQ score.

          • Pedantic Guy says:

            And I meant, anyone who "plussed" the "buboe" guy should be embarrassed. Thank you was to "Hey, whoa now…"

            -Guy who is not a fan of ambiguity and hates a poorly worded post, even when it's his.

  14. Spanishmoon says:

    I think it shows particular panache on the part of Morgan Stanley to fuck clients twice in the same deal while making money for the IB department bonus pool. Frank Quattrone is green with envy.

    To complete the Triple Crown, MS will sell Zynga in 18 months, at a figure below the IPO price, to Electronic Arts and book a 5% M&A fee.

  15. Biff says:

    MS can't sell Zynga. Nice try though. If their shareholders agree to some random < IPO price that's up to them.

  16. FinkNottle says:

    “Are there conflicts here? Sure, absolutely….They’re what an IPO is. An IPO is just a bank resolving the conflict of interest between its corporate client and its investor clients to make everyone sort of happy.”

    Can you just get Morgan Stanley’s lawyers to write that down please? kthx.

    – Every plaintiff’s lawyer in the world

  17. woth79 says:

    Now, now – Lotus was waaay past its prime in 2007. Except for maybe MS.

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