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Even The Underwriters Were Sick of Facebook By The Time The IPO Priced

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This weekend the New York Times published an amazing, front-page-of-Sunday-business article about ... well, there was this guy, see, and he was annoyed because he thought some people had access to his personal opinions that he had formed based on public information before some other people had access to those personal opinions, and he decided that that was "insider trading" even though he had no inside information about any public company, and he spent seven years complaining about it to a bunch of people, and they all pretty much ignored him because they knew what insider trading is, and then at the end of the seven years he complained to Gretchen Morgenson, who had the advantage, from his perspective, of not knowing what insider trading is, and so she wrote a huge article that was like "HERE IS CRAZY NEWS FROM 2005." Life is too short etc., and others admirablydebunked the bunk, so, y'know, moving on.*

Except did Gretchen Morgenson have inside information that this old story would become relevant again? Because here is a thing that happened lo this very decade:

In the run-up to Facebook's $16 billion IPO, Morgan Stanley, the lead underwriter on the deal, unexpectedly delivered some negative news to major clients: The bank's consumer Internet analyst, Scott Devitt, was reducing his revenue forecasts for the company. ...

"This was done during the roadshow - I've never seen that before in 10 years," said a source at a mutual fund firm who was among those called by Morgan Stanley.

JPMorgan Chase and Goldman Sachs, which were also major underwriters on the IPO but had lesser roles than Morgan Stanley, also revised their estimates in response to Facebook's May 9 SEC filing, according to sources familiar with the situation. ...

The people familiar with the revised Morgan Stanley projections said Devitt cut his revenue estimate for the current second quarter significantly, and also cut his full-year 2012 revenue forecast. Devitt's precise estimates could not be immediately verified.

"That deceleration freaked a lot of people out," said one of the investors.

Let's reconstruct the story, which I think goes something like this:

(1) Facebook went on the road and was all "buy our stock, we have a web page and on that web page we sell advertising."

(2) Some investors asked questions along the lines of "but in The Future no one will use web pages, which have ads, but will instead use mobile apps, which don't, more or less, so how will you make the moneys?"

(3) Facebook was like, "fair point, we probably should have made that clearer."

(4) They did, by amending their prospectus to say "Based upon our experience in the second quarter of 2012 to date, the trend we saw in the first quarter of [daily active users] increasing more rapidly than the increase in number of ads delivered has continued. We believe this trend is driven in part by increased usage of Facebook on mobile devices where we have only recently begun showing an immaterial number of sponsored stories in News Feed ..."

(5) That is a pretty unquantified statement!

(6) This Devitt guy at Morgan Stanley quantified it through what I suspect was plausible guesswork and extrapolating from the previous quarter's trend but maybe not? After all he was talking to the company, so maybe they helped him quantify the revenue slowdown. Here is Reuters again:

Companies do not make their own financial forecasts prior to an IPO, and underwriters are generally barred from issuing recommendations on the stock until 40 days after it begins trading. Analysts often rely on guidance from the company in building their forecasts, but companies doing IPOs are not permitted to give out material information that is not available to all investors.

Institutions and major clients generally enjoy quick access to investment bank research, while retail clients in many cases only get it later. It is unclear whether Morgan Stanley only told its top clients about the revised view or spread the word more broadly.

Well I'll take a stab at that; I'm a retail GS and JPM client (though not MS) and here are the revenue projections that I've received at this point almost two weeks after the S-1 revisions:

Maybe Morgan Stanley is different? Meh. I'm going to guess that Scott Devitt is still more likely to take calls from Fidelity than from me. Anyway Henry Blodget thinks this sounds bad:

Earnings forecasts are material information, especially when they are prepared by analysts who have had privileged access to company management. As lead underwriters on the IPO, these analysts would have had much better information about the company than anyone else. So the fact that these analysts suddenly all cut their earnings forecasts at the same time, during the roadshow, and then this information was not passed on to the broader public, is a huge problem.

Maybe? Like, yes, if the analysts had privileged information it does seem rather dodgy - and possibly illegal-ish, in a selective-dissemination-but-not-insider-trading way - that they told some of their clients but not others. On the other hand, though, analysts really pretty much never give their forecasts to "the broader public" - only to their clients. If you bought your Facebook shares through, say, E*TRADE, or even worse in the aftermarket, you can't really complain that you had no access to Morgan Stanley research.

The real legal issue would be, not the underwriters all cutting their earnings forecasts at the same time right after Facebook publicly announced that its earnings growth was slowing, but Facebook giving those underwriters material nonpublic information that is not disclosed in the prospectus. The whole point of a prospectus is to make all the material nonpublic information that a company has public: loosely speaking, any time a company sells stock it is trading, and it has inside information, so it will always be "insider trading" unless it discloses all the material information to its trading counterparties. It does that with the prospectus. There is of course a big fat gray area about what is material and what isn't - are Facebook's internal projections material? mostly no, but isn't that weird? - but at least in theory Facebook is supposed to be disclosing everything material to the public.

It's Facebook's job to tell everyone all the facts. It's Morgan Stanley's job to tell its clients how to interpret those facts. If Facebook was telling Morgan Stanley research analysts facts - material facts, anyway - that weren't in the prospectus, and then Morgan Stanley research was using those facts in projections that it shared only with some of its clients, the selective dissemination to clients by Morgan Stanley seems like a far smaller problem than the nondisclosure of material information by Facebook.

One more thing. Ask yourself what information would you rather have about the Facebook IPO on Friday morning:
(1) The fact that, right after Facebook publicly filed that revision to its S-1 saying "mobile is going to cause problems for our revenue growth," the Morgan Stanley research analyst cut his projections for Facebook's revenue growth, or
(2) The fact that big investors - Fidelity or T. Rowe or Capital or whoever - put in for 20mm shares and was allocated 10mm?

Thing (1) is one man's opinion about the growth rate for a company selling for around 103x earnings, based on public information though also maybe on private discussions with management where presumably management wasn't telling him anything material that they hadn't disclosed publicly but hey whatever define "material." Thing (2) is an objective fact about the world that is known to Morgan Stanley and to Fidelity or T. Rowe or whoever**; it says absolutely nothing whatsoever about Facebook's business. So which would you rather have?

I submit to you that if you chose (1) you should not ever buy IPOs, or stocks really. Here is DealBook:

Some institutional investors were also surprised by the size of their allocations, expecting to get far fewer shares. In the process of jockeying for I.P.O. shares, investors will typically ask for a large block, even if they expect to only receive a fraction.

“We got more shares than we expected, which spooked us,” said one portfolio manager, who spoke on the condition of anonymity for fear of upsetting Facebook’s underwriters. Concerned that the size of its allocation implied a lack of broad investor support, the manager sold all of the firm’s Facebook’s shares on Friday. “If it was truly a hot, hot deal, we would have gotten less.”

See the thought process? Not "revenue trends are down so we flipped our shares," but "we were over-allocated so we flipped our shares." That has to be right. I searched diligently for public information about allocations*** and could not find any. I called my retail brokers at GS and JPM**** and, again, they wouldn't tell me who got filled with how many shares. You know who has a pretty good idea of how many shares Fidelity got? Fidelity. That's who. Sure, whatever, insider trading "destroys confidence in public markets, giving an upper hand to Wall Street’s well-connected elite and putting average investors at a disadvantage." But there's only so much shock you can legitimately manage at that fact, because so does everything else.

Morgan Stanley cut Facebook estimates just before IPO [Reuters]

* I'm being a little meaner than necessary; Felix Salmon's debunking is fairer though, like me, he's kind of discussing what insider trading ought to be rather than what the SEC thinks it is. Morgenson probably has a better argument than either of us is giving her credit for. But that's not saying much.

** It's certainly known to them after allocations are out, i.e. by Friday morning, when it wasn't known to the broader market and they could still sell out above $38. It's not exactly known to them on Thursday, when it could cause them to cut back their order or get out of the offering altogether, though the better customers probably do have some sense of how much they'll be filled and can adjust accordingly.

*** This is a lie.

**** This is an even more blatant lie. But, trust me, that's how it would have gone.