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Of all the things you can get mad about in the world, volatile prices for companies that have recently IPOed seems like sort of a silly one. Like, yesterday there was no market for this stock, and today there is, and tomorrow that market may have a price that is very different from today’s, and you’re mad about that? Something was created out of nothing! It’s magic! And you’re complaining about some bugs in that creation?
Speaking of magic, the Journal today has a cute story about the Indian stock market and how its IPOs are volatile. There is of course an implication of “… because of fraud” but it’s not clear how much more than an implication it is:
“There was a feeling in this country that many IPOs are manipulated,” U.K. Sinha, chairman of the Securities & Exchange Board of India, said in an interview.
Note the delicacy of saying “there was a feeling that IPOs are manipulated,” which means “IPOs are volatile,” versus saying “IPOs are manipulated,” which means “IPOs are manipulated.” He only said the first one.
Anyway here is Mr. Sinha’s entertaining solution:
In September, SEBI proposed a rule that would provide refunds, to investors who apply, for up to 50,000 rupees in IPOs that fall sharply.
The refund would be given if the stock fell more than 20% from its issue price within three months of listing, even as the broader market was stable or rising. If the broad market was also falling, the refund would occur if the stock lost 20 percentage points more than the market.
The company’s founders, or controlling shareholders, would have to buy the investors’ shares back with their own money, without drawing on company funds.
Bankers say the rule, if implemented, could make some companies rethink their plans to sell shares for funds. “Trying to give some sort of protection…is in principle against the spirit” of equity markets, said K. Srinivas, founder of Mumbai investment bank Saffron Capital Advisors Pvt.
But Mr. Sinha, chairman of the regulator, doesn’t think the rule would have a major impact on the IPO market. The refunds would be capped at 5% of the IPO’s total size, he said. … “The basic idea is to force realistic pricing,” he said.
So much to love here! First of all, build a simple model where:
- You have some stock in your opaquely valued private company.
- You sell it for X rupees
- If the price in three months – call it Y – is below 0.8X you buy 5% of it back for X
- If Y is above 0.8X, you keep your money.
If you magically knew that Y was, like, 100 rupees, and you were IPOing this company, where would you set X? If you answered “I would set it at 100 rupees so as to accurately price the IPO and avoid having to refund anyone’s money,” you are … not good at math? Because the answer is more like “I would set it at infinity, because if I take in infinity rupees and only refund 5% of them, then I’m ahead by approximately 0.95 infinity.” See, here.1
Of course that’s not how it works – that thought process proves too much. (If it’s right then every IPO, everywhere, should price at infinity because more money is better than less money.) For one thing it doesn’t work that way for all sorts of repeat-player-reputational-consequence-what-have-you reasons: if you’re the founder of a company, you tend not to want to sell IPO shares for the very last marginal penny, because (1) you normally hold on to a lot of stock and want it to trade well, (2) you may need to come back to the capital markets again and want to maintain some goodwill, (3) there is value – for employee retention, M&A, etc. – in having a robust trading market in your shares, (4) etc.2
For another more important thing, it doesn’t work because you don’t actually get to decide the price at which you sell shares. The market – sort of – decides, and people don’t want to pay infinity dollars or rupees or anything else for an untested stock.
Neatly, the Indian refund plan helps with both of those things. How much should you pay for a stock that IPOs with a built-in refund plan? Well, sort of definitionally, more than you’d pay for a stock without that built-in refund.3 (How much more? The answer is sort of (1) 5%-ish more4
times (2) 5%-ish for the refund cap!, plus maybe discounted for the credit risk of whether the major shareholders of a busted and/or fraudy company will actually make good on the refund. Leaving, I’d guess, an ultimate answer of “not really that much more,” though I suppose there are psychological factors that might make it a bit more than that.) So it becomes at least a little easier to sell the stock for a higher price, not a lower – er, “more realistic” – one.
As for all the reputational stuff: well, before the refund plan, you either cared about your stock cratering or didn’t; clearly some founders didn’t. After the refund plan, you care to the same degree, plus perhaps five percent. But! Now you’ve got a natural stabilizer on the price, for the first three months anyway. After all, if a company IPOs at $125, and the stock price drops to $100, why would anyone then sell for $99? Investors can keep their stock and either (1) it will rally or (2) they can demand a refund. What could possibly go wrong? (I mean, there’s a cap on refunds, but you’re paying attention, I’m sure you’ll file yours first, don’t worry about the 5% thing.) Of course after three months, I guess, the stock craters.
Anyway. I’m sure I’m missing something in this plan, though I’m less sure that what I’m missing is what makes it make sense. I just thought it was strange and magical: a plan intended to crack down on overpricing of and weirdness in IPOs that should in theory lead to higher pricing and more weirdness. I like it so much! So much that I’m wondering why more companies don’t just do it themselves: “Buy our stock! Sure we’re putting an unusually high valuation on it, but if it tanks, we’ll give you your money back! What could possibly go wrong?5”
1. A caveat is that in an all-primary offering, where the company gets all the proceeds but insiders need to do all the refunding out of their own pockets, that calculus is reversed; in a mixed primary/secondary offering it’s somewhere in between. You can fiddle with that in the spreadsheet.
2. Also, in the US and many other places, (5) because if the stock drops a lot you tend to get sued for fraud, but let’s leave that aside since we’re talking here about basically an alternative to that.
3. With a caveat like “but only if the regulator requires the refund plan” or something. Like, this Indian plan should increase the realizable price of Indian IPOs, but generally speaking if you are offered two investment opportunities:
- Thing A costs $100 and is expected to return 8% a year, and
- Thing B costs $100 and is expected to return 8% a year and comes with a personal money-back guarantee from its founder so you can’t lose,
The right answer is almost always Thing A. This is investment advice.
4. Ha no that’s totally fake. Here:
5. For the answer, see footnote 3.