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

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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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